Mr Macfarlane talks about exchange rate regimes and Australia's experience with them  (Central Bank Articles and Speeches, 27 Nov 98)
Central bank: rba | Type: speech | Date: 1998-11-27

## Mr Macfarlane talks about exchange rate regimes and Australia's experience with themSpeech by the Governor of the Reserve Bank of Australia, Mr I.J.

Macfarlane, to the Asi Forex Congress in Sydney on 27/11/98.

## IntroductionFirst, I would like to add to what Mr Hawke has already said by extending my personal w to Australia for the 1998 Asia Pacific Forex Congress.I am glad to see that the Asian Pacific Congress is continuing to thrive.

A regional such as this is important because, according to the latest BIS world market survey, region accounts for about one quarter of global foreign exchange turnover.

I am hopeful that, as the practitioners in this region, your discussions here over the next couple make a contribution to resolving some of the issues that recent events have exposed.When this Congress last met in Hong Kong a year ago, the so-called 'Asian crisis' had started, but few could have anticipated the toll it would eventually take, not only markets but also on these countries' economies more generally.

None of us thought that the economies of Asia would be in recession by now, or that the effects would have s non-Asian emerging markets.

I am sure the Congress this year will provide plenty of t lively discussion because foreign exchange markets are so central to all that has happe cast our minds back to July last year, we will recall that initially the events in elsewhere were seen as a 'currency crisis' before they became a general economic crisis.I am pleased that the Australian Government has been able to play a constructive role to

understand

the

difficulties

in

the

region,

and

then

to

assist

in

efforts

to

ov Australia was, in fact, the only country apart from Japan which contributed to all thr assistance

packages

in

the

region.

The

Australian

authorities

were

able

to

play

a

u because they had been building an understanding of regional developments for many yea part reflecting the strong trade links with the region, but also a more general intere of our business and academic communities.

Bureaucratic ties, including among central had also been strengthened, particularly through EMEAP, the group of 11 regional centra and monetary authorities that has been meeting regularly since 1991.This understanding led Australia to see more quickly than most other countries the di with the Indonesian rescue package, and it used what influence it had with the IMF to a more

flexible

approach.

Recently,

Australia

has

pressed

for

APEC

to

lend

its

suppor proposed reforms to the international financial system put forward by the three G22 parties.

We recognise that there is a danger that the momentum could be lost if gover this region do not keep up the pressure.

## Exchange rate systemsOne of the areas in which the reshaping of ideas has already begun to occur is that o rate systems.

Until 1997, most countries in Asia maintained some form of pegged exchang In the case of Hong Kong, this was a type of currency board, while other countries ma exchange rates which, although often referred to as floating, were managed within a ti against the US dollar, or some weighted index dominated by the US dollar.Most of the latter group of countries have had to abandon their systems under the pr recent events.

Currency boards such as Hong Kong's (or Argentina's, for that matter) have

survived

rather

better

(though

at

a

high

price

in

terms

of

lost

GDP).

As

a

r commonplace to hear these days the view that countries can choose to have a fixed excha by way of a currency board or a pure float, but not any of the possible systems in betweI confess to some misgivings about this conclusion.

I think it is mainly attractive to like intellectually pure systems, but we live in a very impure world.

I think a lot m needs

to

be

undertaken

before

we

can

be

confident

of

such

a

conclusion.

For

a

star Kong's

version

of

a

currency

board

is

very

different

to

Argentina's.

Secondly,

we examine countries like Singapore, Taiwan or Chile, which do not fall into either of cases, but whose economies seem to have done relatively well in difficult circumstances.Whatever the solution is, it will involve making very difficult choices.

I am remind when I look back over the many meetings I attended with Asian central banks in the midd of this decade.

The ever-present topic of conversation was what to do about the large capital they were attracting.

Everyone knew that they were 'excessive' in the sense were much larger than needed to cover the relatively small current account deficits, we for the economies to absorb productively, and were putting a lot of upward pressure relatively fixed exchange rates.

There were basically three alternatives open to them:Persevere with the relatively fixed exchange rates and sterilise the inflows to make money supply and inflation did not accelerate; put in place some form of control to amount of capital inflow; or float the exchange rate.As we know, they chose the first alternative.

We look at the result and say they made But the second alternative - capital controls - was effectively ruled out by internatio in

anything

other

than

a

crisis

situation.

Remember,

while

the

international

debate reached some form of consensus that 'Chilean' style controls on inflows can play a use this is a very recent development.That leaves the third alternative - a move to a floating exchange rate - and this lo daunting to them.

I am not aware of any country, including developed countries, that h the move without being forced to do so by some form of crisis.The reality is that, even though the theoretical benefits of floating are clear enough, can be, and often is, difficult.

Certainly, that was our experience in Australia in theIn the case of the Asian economies, a move to floating may have brought things to a hea in that it would have removed the exchange rate certainty that underpinned the capita that were driven by interest rate differentials.

But exchange rates which were alrea being overvalued would have risen further, compounding the subsequent correction.With the benefit of hindsight, it now seems clear to me that it would have been difficu some sort of crisis.

With so much internationally mobile capital pouring into econom relatively small financial sectors, there was virtually no prospect of a smooth return t

## Australia's exchange rateSo far, I have talked about possible exchange rate regimes and how difficult it has bee countries to come to terms with these - what of Australia's experience?

As most ofknow, Australia spent the first 40 years of the postwar period trying just about eve fixed exchange rate that was possible.

First of all, the Australian dollar was fixed sterling, then fixed to the US dollar, then fixed to a trade-weighted basket, then a va a

trade-weighted

basket.

Finally,

we

floated,

and

in

two

weeks'

time

we

will

mark

t anniversary

of

the

float

of

the

Australian

dollar.

We

are

very

comfortable

with

th exchange rate, and I know of no serious body of opinion in Australia that would want it way now that we have come to terms with it.

In fact, it is widely seen as being an factor helping Australia put in a good economic performance during the Asian crisis.We certainly have allowed our exchange rate to adjust to reflect economic circumstance particularly

the

international

cycle

in

economic

activity

and

commodity

prices.

We resisted these broadly-based economic changes and the Australian economy has benefite result.

Since 1986 the Australian dollar has fluctuated around a stationary average val cycle being quite pronounced: peak-to-trough movements of around 30% have been common.While we are prepared to accept significant moves in the exchange rate, we do not fo approach of benign neglect.

When the exchange rate moves, we ask ourselves if it is t anything

about

policy

settings.

With

our

inflation-targeting

framework,

the

central always what the exchange rate move means for inflation, not only in the near term but a longer term.There have been instances when monetary policy has been adjusted in response to exchang moves,

but

they

have

not

been

frequent.

We

have

also

used

intervention

to

influen exchange

rate,

finding

it

particularly

useful

in

circumstances

where

market

imperfec resulting in overshooting, as markets tend to do from time to time.Judging when this tendency to overshooting exists is always difficult at the time, and things in life, including making the sorts of decisions you all make in foreign exchang usually easier with at least some hindsight.

As a rule of thumb, however, the exchange not overshooting unless it has already moved a considerable way from its 'normal' level, or level that can be explained by what is happening in the economic and financial environmeAs you know, there is considerable debate about the effectiveness of intervention, ev central bankers.

Some of this stems from a lack of clarity about what it aims to do.

I should not be viewed as a substitute for necessary adjustments in monetary policy. expecting a lot of it to think it can support a fixed exchange rate during times of cr floating exchange rate regime, intervention can play a useful role in limiting extreme in the exchange rate.This is the approach we have taken in Australia.

The result is that our interventions infrequent, coming mainly at or near the peaks and troughs of the exchange rate cycle large, judged against our aims, we believe our interventions have been successful.

They been successful when judged against the test proposed by Milton Friedman, i.e. whether they

are

profitable.

The

Bank

has

fairly

consistently

made

profits

from

its

in throughout the post-float period.During

the

past

year,

the

Bank

intervened

on

three

occasions.

These

occurred

after against the US dollar had already fallen by a considerable amount.

In other words, our intervention has not prevented the exchange rate from falling enough to do the job we floating exchange rate to do.

Australia has been able to maintain growth of about 4% i year, at a time when most of our main trading partners in Asia have experienced negativeOur exchange rate system and the robustness of our financial sector have been two of th this performance.I would hope that countries that have only recently entered the world of floating exch can draw some hope from this.

The move from pegged to floating exchange rates is never Soon

after

the

Australian

dollar

was

floated,

it

fell

by

over

30%,

not

dissimilar recently

experienced

by

some

of

our

Asian

neighbours.

There

is

no

doubt

that

this considerable dislocation to the economy at the time, requiring strict and somewhat un policy decisions.

But I think that businesses, markets and the authorities all learn experience, showing that it is possible to emerge from such disturbances with the econ the financial system in much better shape.

I hope that this will also be true for t currently experiencing difficulties.

The very recent signs of greater stability in reg can give us some confidence that this will be the case.