Stanley Fischer: Exchange rate systems, surveillance, and advice
Text by Professor Stanley Fischer, Governor of the Bank of Israel, of the Mundell-Fleming
lecture, at the Eighth Annual Jacques Polak Research Conference at the IMF, Washington
DC, 15 November 2007.
I am grateful to Thierry Tressel, Cigdem Akin, Meital Gram, Prachi Mishra, and Inci Otker-Robe for essential
assistance, and to Mark Allen, Jeff Frankel, Morris Goldstein, Ken Rogoff, and Shakour Shaalan for helpful
discussions.
* * *
The IMF Executive Board's adoption on June 15 this year of the new Decision on Bilateral
Surveillance over Members' Policies puts exchange rate policies at the center of the
surveillance process. The Fund's description of the new decision and the differences
between it and the 1977 Decision notes that
•
"the new Decision introduces a concept of external stability as an organizing
principle for bilateral surveillance", where external stability "refers to a balance of
payments position that does not, and is not likely to, give rise to disruptive exchange
rate movements";
•
Article IV's prohibition of exchange rate manipulation relates to policies directed at
affecting the level of the exchange rate "in order to prevent effective balance of
payments adjustment, or to gain an unfair competitive advantage over other
members". A member will be considered to be manipulating the exchange rate to
gain an unfair competitive advantage if the Fund determines that the country is
trying to increase net exports by promoting an undervalued exchange rate; and
•
members should "avoid exchange rate policies that result in external instability,
regardless of their purpose ..."
A little over a month earlier, the Board had discussed the Independent Evaluation Office's
Report "IMF Exchange Rate Advice", which presented a critical view of the advice the Fund
had offered in the period 1999-2005 on exchange rate systems, on the level of the exchange
rate, and on the mechanics of exchange markets and of intervention. While the criticisms are
forceful and in many cases appear appropriate, they suffer from the lack of professional
consensus on what the right advice should be. The IEO Evaluation Report struggles with this
issue, but does not adequately resolve it, for example when noting (p.28):
"...Of course, when there is little academic consensus on many points, the
problem of distilling and establishing operational guidance is more
challenging, but management oversight and the right internal structure are
therefore all the more critical."
Similarly, in Chapter 5 on "Findings and Recommendations", the Report
states (p.37):
"68. To improve assessments of the exchange rate level, the IMF should be
at the forefront of developing the needed analytic framework ...
The genuine difficulty in doing this is no excuse for not making more
progress." (italics in original)
In this lecture, I will try to draw together some lessons and questions about exchange rate
systems, and attempt to state what is known and what is not known about them. I will also
comment on problems of IMF surveillance. I start in Section I by revisiting the bipolar issue
with regard to exchange rates, restating the hypothesis and updating it in light of events of
this decade. I will argue that the bipolar view is fundamentally correct for emerging market
and industrialized countries with open capital accounts -a qualification that was stated in
Fischer (2001), but that was perhaps not adequately stressed. In Section II I discuss
managed floating regimes and exchange market intervention, for countries with open capital
accounts. Section III is devoted to the choice of exchange rate regime for countries whose
capital account is not open; and I conclude with comments on IMF surveillance and advice.
I. The bipolar hypothesis
The bipolar hypothesis about exchange rates has come in for serious criticism. For example,
Jeffrey Frankel (2004) argues that there is no analytic rationale for the argument of the
disappearing intermediate regime. The usual justification is the impossible trinity, but Frankel
suggests that a variety of managed floats are fully consistent with the impossible trinity - that
one can have half-stability and half-independence.
In my 2001 article on the bipolar exchange rate approach, I tried to clarify the hypothesis,
and I shall have to quote extensively (Fischer, 2004, p.229):
"... proponents of what is now known as the bipolar view - myself included
- probably have exaggerated their point for dramatic effect. The right
statement is that for countries open to international capital flows: (i) soft
exchange rate pegs are not sustainable; but (ii) a wide variety of flexible
rate regimes remain possible; and (iii) it is to be expected that policy in
most countries will not be indifferent to exchange rate movements. To put
the point graphically, if exchange rate arrangements lie along a line
connecting hard pegs like currency unions, currency boards, and
dollarization on the left, with free floating on the right, the intent of the
bipolar view is not to rule out everything but the two corners, but rather to
pronounce as unsustainable a segment of that line representing a variety of
soft pegging exchange rate arrangements. [italics in the original]
... For countries open to international capital flows, it [the bipolar view]
includes as sustainable regimes both very hard pegs and a variety of
floating rate arrangements, including managed floats. For countries not yet
open to international capital flows, it includes the full gamut of exchange
rate arrangements.
The question that then arises is what exchange rate arrangements are
excluded by the bipolar view. The answer is: for countries open to
international capital flows, exchange rate systems in which the government
is viewed as being committed to defending a particular value of the
exchange rate, or a narrow range of exchange rates, but has not made the
institutional commitments that both constrain and enable monetary policy to
be devoted to the sole goal of defending the parity. ..."
During the decade of the 1990s, it seemed that exchange rate systems were becoming
bipolar in the sense defined above, as can be seen in the comparison for developed and
emerging market countries1 between the data for 1991 and 1999 in Figure 1.2 Figure 1 also
shows what has happened since then for the group of developed and emerging market
countries. In brief, the shift towards bipolarity that was evident in the data for 1991-1999, has
continued, but at a reduced pace. The major changes in the distribution between 1991 and
1999 were due to the introduction of the Euro and the emerging market financial crises of
that decade. Nothing on a similar scale has happened in this decade, although the number of
countries in EMU continues to grow, albeit slowly.
As a reminder, the classification of exchange rate systems used in Figure 1, and in my
previous paper, is that of the staff of the IMF, based on their evaluation of the de facto
exchange rate arrangement in place at the time.3 Table 1 lists the categories of exchange
rate regimes, with the intermediate grouping consisting of varieties of less than very hard
pegs, include crawling pegs and bands. The floating category consists of "managed float"
and "independent float", the latter less managed than the former.
Figure 2 breaks the "Advanced and emerging market countries" grouping down into its two
parts - for advanced (Figure 2a) and emerging market (Figure 2b) countries respectively.
Among the 25 advanced countries, bipolarity is almost complete, with only Denmark, which
shadows EMU monetary policy, in the intermediate category. Among the 39 emerging market
countries, a considerable number still remains in the intermediate category. Tables 2a and
2b list the advanced and emerging market countries and their exchange rate regimes. Note
that the intermediate category for the emerging market countries includes five countries that
are in the process of joining EMU, so that the shift to bipolarity for this country grouping is
likely to continue in the coming years.
It thus appears that the bipolarity view is broadly consistent with recent exchange rate regime
developments, for the advanced and emerging market countries grouping. I should though
emphasize two qualifications. First, the bipolarity hypothesis is about countries open to
international capital flows, which is why the data examined in Figures 1 and 2 are for the
advanced and emerging market group - though, to be sure, some of the countries listed as
"emerging market" have significant capital controls. Second, the "floating" group does not
consist only of freely or almost freely floating exchange rate regimes, for it includes managed
floats: indeed, for both the emerging market and "other" categories, there are more
"managed" than "independent" floaters among the countries listed as having floating
exchange rates. ; Further even among the "independent" emerging market floaters, there are
several countries that intervene frequently and significantly.
The well-known difficult of classifying exchange rate systems has led to a considerable
literature, including articles by Levy-Yeyati and Sturzenegger (2000), Reinhart and Rogoff
(2004), Frankel (2004),4 Eichengreen and Razo-Garcia (2006), Tavlas, Dellas and Stockman
(2006), and others. The fundamental issue in the classification discussion relates to how to
classify countries whose policies appear to be different than they are declared to be by the
country (or by someone else's classification scheme). For instance, how should one classify
countries that declare they have a pegged exchange rate but that in practice change the peg
frequently? Or, as in the case of the "freely falling" category of Reinhart and Rogoff, how
should one classify rates that are flexible only because extremely high inflation prevents their
being anything other than flexible? And most important from the viewpoint of this paper, how
3
The approach is described in Bubula and Otker-Robe (2002). See also, IMF (2003). As of the time of writing of
this paper, the staff of the IMF is preparing a new classification of exchange rate regimes that will make more
use of quantitative information on exchange rate behaviors and reserves, instead of qualitative information as
in the current de facto exchange rate classification. This new classification will change how currency unions
are treated, for example EMU countries will be classified as "independently floating". Moreover, a new
category of "tightly managed float" is being introduced. This new de facto classification, however, will not be
retroactive, so there will be a break in the series in 2007. It is clear that for a member of the EMU, the
exchange rate of the currency it uses is independently floating. But it is also clear that for almost all or all EMU
members, the exchange rate of the currency they use is absolutely fixed against the currencies of the
countries that account for the great bulk of their trade. This suggests a note of caution about the
reclassification of these countries' currency regimes.
4
Frankel (2004) notes: "Placing actual countries into ... categories is far more difficult than one who has never
tried it would guess".
BIS Review 141/2007
should one classify heavily managed exchange rate regimes that are in principle flexible, but
where the authorities intervene frequently and extensively?5
the essential question is whether the authorities
While this discussion is important, I believe
are committed to defending a particular exchange rate or narrow range of exchange rates,
for these are the unstable exchange rate regimes when the capital account is open. Further,
while there are countries whose currencies float freely, as noted in the quote from my 2001
paper above I do not regard intervention per se as being inconsistent with an exchange rate
that is defined as flexible.
The data presented thus far relate to the proposition that as countries become more
advanced and open their capital accounts, they also tend to leave the middle ground of soft
pegs, and move towards either a hard peg or a floating (including managed floating) regime.6
Another way of examining this proposition is to focus on the empirical relationship between
countries' choice of exchange rate regime and the extent of their capital controls. The IMF
has an index of capital controls for which the latest year is 2005.7 It is available for only 90 of
the 186 countries for which exchange rate regime data are available.
A probit regression was run of the exchange rate regime (coded 1 if an intermediate regime,
0 otherwise) on the extent of capital controls, an index that runs from zero to one (e.g. Japan
and the UK are zero, the United States is 0.2, and India is 0.95). The estimated relationship
is positive but weak,8 and significant only at the 15% level. On further examination of the
data, it appears that there might be a bias with regard to the countries for which capital
controls data are available: among the advanced countries, the capital controls index is
available for 23 out of 25 countries; for the emerging market countries, the capital controls
variable is available for 32 out of 39 countries; and for the "other" category (data on which
are presented in Table 3 below), capital controls data are available for only 35 of 118
countries. It is quite likely that the extent of capital controls among the countries in the "other"
group for whom the capital controls index is not available, is significantly higher than in the
advanced and emerging market groupings. The frequency of intermediate regimes is also
higher in the "other" group (47.5% versus 4% for advanced countries and 35.9% for
emerging market countries).
I would like here to make two comments on the impossible trinity, in relation to Jeff Frankel's
statement that one can have half stability and half independence of monetary policy. In the
first instance, while the impossible trinity is usually stated in terms of an independent
monetary policy, it should more accurately be stated in terms of independent macroeconomic
policy, for when a currency comes under serious pressure, typically both monetary and fiscal
policy have to adjust if the exchange rate is to be maintained. This was, for instance, clear in
the collapse of the Argentine currency peg.
Second, an "independent" monetary policy in this context is one that is targeted at something
other than the exchange rate. For many countries that have given up exchange rate pegging,
the monetary regime switches to inflation targeting, in practice typically flexible inflation
targeting. For others, monetary policy is directed to a range of targets, including inflation and
growth, sometimes also the real exchange rate, with tradeoffs among them to be determined
by the policymakers. Once the goals of monetary policy have been specified, monetary
policy is no longer independent of the factors that move the economic variables that it is
targeting. For instance, in setting the policy interest rate, the Bank of Israel, an inflation
targeter, has to take into account changes in foreign interest rates that affect the exchange
rate and through it the inflation rate.
Thus in practice by giving up exchange rate pegging and shifting to inflation targeting, a
central bank does not gain monetary independence in the sense that its monetary policy
becomes independent of monetary policy - more generally of economic developments - in
other countries. Rather it has switched from targeting one economic variable - the exchange
rate - to another, namely the inflation rate, both of which depend to differing extents on
economic developments abroad and at home. This may be the meaning of Jeff Frankel's
statement that a country can have half stability and half monetary policy independence [of
the exchange rate].
Why then the general recommendation to countries to avoid the intermediate regimes if they
are open to capital movements? Primarily because such regimes are crisis prone, in part
because their policy dynamics are unstable: we are all familiar with the syndrome in which
when the exchange rate is not under pressure, the country sees no need to change the
regime; and when it is under pressure the country is reluctant to change it because it is
unclear by how much it will have to change if it is repegged, or where it will go if it is allowed
to find its own level. As they develop and open their capital accounts, some countries, who
have good reasons to do so - for instance those who meet the conditions for being part of an
optimum currency area, or who expect to meet those conditions after joining the hard
currency grouping - will choose to move towards harder pegs. Others will move towards
more flexible exchange rates. As noted by Rogoff et al (2003), for advanced countries "free
floats register faster growth than other regimes without incurring higher inflation".
II. Managed floating
As is evident from the fact that there are more managed than independent floaters among
the floating group for the emerging market and "other" countries, very few countries, if any,
are indifferent to the behavior of the exchange rate. For a strict inflation targeting country, the
behavior of the exchange rate matters, but only to the extent that it affects inflation. For other
countries the nominal exchange rate may matter because changes in the nominal rate also
lead to (partially or wholly temporary) changes in the real exchange rate and thus in net
exports, which are targets of policy.
Interest rate and/or fiscal policy can be used to try to affect the exchange rate; for instance
the Taylor Rule for a central bank that is also targeting the exchange rate can include an
additional term in which the interest rate responds to deviations of the real exchange rate
from its target level. Monetary policy effects on the real exchange rate are likely to be
temporary, but may be of sufficient duration to have a transitional effect on exports and
imports. More fundamentally, changes in fiscal policy can be deployed to affect the real
exchange rate over a longer period: by tightening fiscal policy and increasing national saving,
the government can expect to generate a real depreciation and increase net exports.
There is also the option of foreign exchange market intervention, which can be seen as
introducing an extra policy instrument to deal with an extra target of policy.9 Some countries,
such as the United States, Chile, and Israel and more recently Japan - as well as the ECB -
do not intervene in the exchange markets, or intervene very rarely. Even these central banks
have not totally foresworn intervention; rather they reserve the right to intervene if market
conditions become disorderly, or in other extreme or emergency situations. If they intended
never to intervene then they would presumably not hold foreign exchange reserves.10 In the
Israeli case we have not intervened since 1997, and Chile has not intervened since 1998.
New Zealand had not intervened since 1985, but did so in 2007.
A policy of non-intervention is however rare among emerging market countries, even those
with flexible rates. Among countries listed as having flexible rates in Table 2, Japan ($544
billion), Russia ($263 billion), Korea ($136 billion), and India ($125 billion) have each
accumulated over $100 billion in reserves since the start of 2001 - and these numbers pale
by comparison with the accumulation of over a trillion dollars of reserves by China during that
period. Countries may intervene to build up their reserves, as many did after the crises of the
1990s. But just as clearly, and as is well known, the great bulk of the accumulation of
reserves during the last few years is a result of the desire to prevent exchange rate
appreciation.
Ishii et al (2006) identify four circumstances under which countries intervene in the foreign
exchange market:11 (i) to correct misalignments or to stabilize the exchange rate at a
predetermined level - in other words, to try to set the exchange rate at a desired level, e.g.
one which will encourage exports; (ii) to calm disorderly markets; (iii) to accumulate reserves;
and (iv) to supply foreign exchange to the market - this occurs when the government is a
major recipient of foreign exchange (e.g. through royalty payments for mineral extraction),
and will not be discussed further.12
With regard to (ii), the stabilization of disorderly markets: in extremis, the central bank may
have to intervene to stabilize a disorderly market, but it needs to be aware that the more
frequently and easily it intervenes, the more it will impede the development of a deep and
robust market, in which it is possible to hedge against exchange rate changes without having
to rely on government intervention.13 With regard to (iii), the accumulation of reserves, the
question is how best to do this. A variety of approaches has been used, including buying
preannounced amounts of foreign exchange at a steady rate over a period of months. Other
central banks have added to reserves on an opportunistic basis.
Case (i) is most significant from the viewpoint of the new Decision on Bilateral Surveillance,
for it relates to exchange rate manipulation. Why might such intervention work? Here the
authors identify three channels: (i) a signaling channel - where the signal is one about future
monetary policy or more generally the authorities' preferences about the desired range of
values of the exchange rate; (ii) a portfolio balance channel - where the central bank is a
sufficiently large player in the foreign exchange market to affect the exchange rate; and (iii) a
microstructure channel - where the central bank has sufficient information about the
10
A few years ago the Reserve Bank of New Zealand considered whether to stop holding reserves. This would
have sent a powerful though not totally convincing signal that there would be no intervention, because
intervention can also be financed by borrowing.
11
Included in Ishii et al (2006) is material on the mechanics of foreign exchange intervention, which can be seen
as providing a partial answer to the IEO's concerns that Fund staff are not equipped to give practical advice on
intervention and other practical exchange rate issues, including how to develop the needed market
infrastructure. In any case, it is not entirely clear that the staff should be experts in the nitty-gritty of exchange
rate intervention, which is highly country and institution dependent. It is probably better in this area for the
Fund to help the central bank of the concerned country to obtain technical assistance from a central bank that
is or has been in a similar situation. This was attempted in the Indonesian program in 1997, but it became
clear there that the forces moving the exchange rate were too powerful to be stemmed by intervention alone,
however sophisticated it might be.
12
I have avoided using the Calvo-Reinhart term "fear of floating", preferring rather to try to explain why
countries often intervene.
13
Ishii et al (2006) describe the approach of the Mexican authorities, which involved selling options to sell
foreign exchange if the exchange rate depreciated to a specified value. This approach may have encouraged
the development of hedging instruments by the private sector.
BIS Review 141/2007
operation of the market and the forces active in it to be able to intervene in particular ways or
at a particular time such that it can move the rate.
In the face of significant capital flows, these channels are unlikely to be able to influence the
rate for very long without supportive macroeconomic policy. That is why it has been so hard
to find major effects of intervention per se on the exchange rates of the major industrialized
countries. However, where capital flows are controlled or the country is not yet well
integrated into the global capital markets, and provided policymakers are willing to intervene
on a sufficiently large scale, the portfolio balance channel can operate to enable the country
to have a sustained effect on the exchange rate, as the Chinese and the Russian cases
illustrate.
Interventions are not costless. Unless they are sterilized they are likely to have an inflationary
effect, and as they become larger, they become harder to sterilize. If domestic interest rates
are higher than those abroad, monetary sterilization is expensive for the central bank; and if
in any case the exchange rate will eventually have to appreciate against the currency in
which the reserves are held, there will also be potentially large capital losses on the reserves
on that account. Clearly though, some countries regard the growth- and export-promoting
effects of such actions as worth the cost, for the cost issues are well understood by the
countries accumulating reserves on a massive scale.
In cases where the export proceeds accrue to the government, they can be sterilized by
being reinvested abroad through a sterilization fund. They can also be sterilized through
running a larger fiscal surplus, and building up a stabilization fund that may also invest
abroad. Russia has used exchange market intervention and fiscal policy in the form of
building up a stabilization fund, but nonetheless is paying a price for its sterilization in terms
of inflation that is above the desired level.
Why despite the many reasons central banks may want to intervene in the foreign exchange
markets do some central banks do their best not to intervene? In the case of Israel, where
there are essentially no capital controls, the non-intervention policy is based on the view that
intervention is unlikely to have a sustained effect on the exchange rate, and that monetary
policy decisions are more fundamental. Further, we believe that the foreign exchange market
works better when market participants do not expect the central bank to intervene except in
extreme circumstances, and thus have to focus in their decisions on the underlying forces
that determine the exchange rate.
The passthrough from the exchange rate to prices is large and rapid in Israel - close to 0.3
within a quarter - and exchange rate movements are therefore taken into account in
predicting inflation and the effects of interest rate decisions on prices. But this connection
has not led us to want to intervene in the foreign exchange market, a decision that we
believe - in IMF language - has served the economy well.
III. Other countries
Turning to countries other than those defined as developed or emerging market countries,
Figure 3 shows that while the evolution of exchange rate regimes between 1991 and 1999
was consistent with the bipolar hypothesis, the evolution of exchange rate regimes for this
group of countries since 1999 is not. Rather on balance there has been a move from the
floating rate to the intermediate regimes.
There has been a considerable amount of movement among exchange rate regimes in
Figure 3. Fifteen countries moved into the intermediate regime from the floating regime and
six moved from the intermediate regime to floating. El Salvador moved from an intermediate
regime to dollarization. Table 3 lists the countries in this group along with their exchange rate
regimes; asterisks indicate changes in the exchange rate regime (including shifts among
subcategories within the three major categories) between 1999 and 2006, with asterisked
numbers in brackets indicating the number of countries in each of the seven categories in the
table that were not in that category in 1999.
The economics literature has not yet developed a strong position on which exchange rate
system developing countries should adopt. Frankel (1999 and 2004) and Mussa et al (2000)
emphasize that "no single currency regime is right for all countries or at all times".
et al
Nonetheless, Rogoff (2003) summarize their review of the evidence of the impact of the
exchange rate regime on developing countries' economic performance thus: "relatively rigid
regimes - pegs and intermediate flexibility arrangements - appear to have enhanced policy
credibility and thus helped achieve lower inflation at little apparent cost in terms of lost
growth, higher growth volatility, or more frequent crises."
Mussa et al (2000) provide a list of factors that would favor a country pegging its rate: (i) low
capital mobility; (ii) a high share of trade with the country to which it is pegged; (iii) the
shocks it faces are similar to those facing the country to which it pegs; (iv) it already relies
extensively on its partners' currency; (v) fiscal policy is flexible and sustainable; (vi) its labor
markets are flexible; (vii) it has high international reserves.
In other words, to sustain a pegged rate a developing economy should have the capacity to
perform well and flexibly, and maintain low inflation. Otherwise it would be advised to adopt a
floating exchange rate regime, thereby allowing the exchange rate to act as an extra shock
absorber. Of course, the requirements listed by Mussa et al are also those that, together with
a strong financial system, would enable the country successfully to maintain a flexible
exchange rate system. Mussa et al also note that as countries develop and become more
financially sophisticated and more integrated into global markets, they should consider more
flexible exchange rate regimes.
This is far from a detailed manual or formula that tells each country what exchange rate
system to adopt. Indeed, if the Fund were to develop a detailed manual it would be accused
of having a cookie cutter approach to the issue. It is not surprising that there is no such
manual, for there is no way of specifying the right exchange rate system for a country without
a careful analysis of its circumstances - and there is no question that among those
circumstances is its exchange rate regime history. "If it ain't broke - or likely to break soon, or
being held together only with the help of economically distortionary and costly measures -
don't fix it" is good advice in this area too.
The general presumption then is that as countries become more developed, they should be
moving away from intermediate regimes, towards greater flexibility of the exchange rate - or
in some cases towards a hard peg.
IV. Exchange rate surveillance and advice
To return now to the new Decision on Bilateral Surveillance, the quotes with which this paper
opens raise two questions. First, there seems to be a tension between the focus on an
unsustainable balance of payments position, and that on exchange rate manipulation, which
relates to an undervalued exchange rate. From the viewpoint of what types of situation might
give rise to disruptive exchange rate movements, a currency that is overvalued, or a balance
of payments deficit that is so large as to be unsustainable, can give rise to rapid exchange
rate movements. One example is the current account deficit of the United States in recent
years. There was no exchange rate manipulation; nonetheless by most measures the
currency was overvalued. Possibly the overvaluation could be offset - though not fully, so
long as other countries maintained their dollar pegs - through fiscal policy, thereby reducing
the underlying threat to stability of the global exchange rate system. Which takes us to the
second question: why does the decision relate to "exchange rate policies that result in
external instability, regardless of their purpose ..." (underlining added) rather than to "policies
that result in external instability, regardless of their purpose"?
The failure to use fiscal policy to deal with an unsustainable current account deficit would be
as deserving of staff and Board censure as would policies - such as sustained intervention -
to manipulate the exchange rate to increase net exports. Presumably the emphasis on
exchange rate policies was included to deal with the difficulty that if other countries peg to
the dollar, then a significant part of the normal adjustment mechanism is neutralized - and
that the pegging decision was not that of the United States. That is understandable, but
should not have led to what appears to be a too narrow focus on exchange rate policies
rather than overall economic policy.
As a central banker from a small economy, I am also concerned that the new decision may
focus too narrowly on external stability. For many countries, the Article IV report is the most
thorough and professional evaluation of the country's economy and economic policies. As
such, it provides a valuable service for the smaller members of the Fund. I hope the new
decision does not significantly reduce the scope and depth of Article IV reports f