david klein : the changing exchange rate regime - background, policy and implications ; the case of israel speech by mr david klein, governor of the bank of israel, at the euro - mediterranean seminar, eurosystem and mediterranean country national central banks, organised by the bank of italy and the european central bank, naples, 14 - 15 january 2004. * * * the exchange rate regime is an important component of macro - economic policy. after experiencing a period of sluggish growth and rapid inflation in the ‘ 70s and the first half of the ‘ 80s of the last century, israel changed its economic strategy. in a series of agreements with the european union and the united states, all barriers to international trade were removed. unilaterally israel removed those barriers on trade with other countries as well, and cemented all these changes in a number of agreements in the framework of the wto and by accepting article 8 of the imf articles of agreement. furthermore, in the ‘ 90s and the first few years of this decade, israel gradually abolished all exchange controls. the concept behind this economic strategy was that a small economy like that of israel, can exhaust its growth potential only by being open to the world. as a result of this basic strategy, the central bank, which was its main promoter, had to overhaul its policy to maintain price and financial stability. the change entailed replacing the exchange rate by an inflation target as the nominal anchor. to do that a few steps had to be implemented simultaneously : first, to render the exchange rate regime more flexible. we realized that removing exchange controls would make it difficult, if not impossible, to maintain a fixed exchange rate. this meant moving from a fixed exchange rate regime through a horizontal exchange rate band, to an upward sloping diagonal band, to an ever - widening band and, finally, to a floating exchange rate regime. the gradual approach was required to give time to an inter - bank foreign currency market to develop, including the creation of financial instruments, traded and over the counter, to hedge against the exchange rate risk. second, in order to go along with the lifting of the foreign exchange controls, the central bank and the government had to implement an extensive deregulation of the domestic money and capital markets. this meant abolishing numerous directed credit facilities, and extensive commercialization of government debt in the framework of capital market reform. third, working with inflation and price stability targets required shaping of appropriate monetary policy instruments. in this context we scraped the

who still believed in the exchange rate as a nominal anchor : they continued to vigorously oppose each stage of the relaxation of exchange - rate controls. these elements continue to this day to resist the abolition of the exchange - rate band, even though their reasons have changed and it is perfectly clear that it will be impossible to defend it should the need arise. – those who did not like the by - product of the change under which the bank of israel acquired greater independence in managing monetary policy : the tradition in israel is that changes in the exchange rate can be made only with the agreement of the ministry of finance, while changes in the interest rate can be made solely on the basis of the bank of israel ’ s decision. the person who immediately grasped that aspect of the change - although that was not the reason it was introduced - was the minister of finance, yitzhak modai, when the shift was made from a horizontal to a crawling exchange - rate band, in december 1991. – one question still remains open : can the bank of israel ’ s intervention in the foreign - currency market serve, in certain circumstances, objectives that are also important for the central bank? this question can be placed on the agenda once the exchange - rate band has been abolished. in the last three years the bank of israel has refrained from intervening in the foreign - currency market in any way. as long as that policy continues, changes in the bank of israel ’ s foreign - exchange reserves can result primarily from the government ’ s foreign - currency cash flow, because only the government has direct access to the bank of israel for selling and buying foreign currency, and from profits made from investing the reserves. there are small changes from time to time because of shifts in the banks ’ voluntary deposits with the bank of israel. the level of the reserves is not affected, as some still think, by private capital flows and interest - rate differentials. only a few days ago an analyst explained in an interview why “ israel ’ s foreign - currency market is not a classic target for assault by foreign speculators. ” one of the reasons for this, he claimed, was that “ the foreign - currency reserves are very high ” ( ma ’ ariv, 17. 4. 2001 ). since we are not active in the market, there is no relevance in this context to the question of how large our foreign - currency reserves are. b. the second difficulty : managing monetary policy so as to attain price stability in a regime of