© Institute for International Economics.
C. Fred Bergsten, Olivier Davanne, and Pierre Jacquet naturally have differing sensitivities and views on what is ultimately feasible and desirable in terms of the evolution of the international monetary system (e.g., see Bergsten 1998 and Bergsten and Henning 1996; Davanne 1998; Jacquet, 1994), but they strongly share the presumption that governments can and should develop a systematic approach to managing exchange rate flexibility, and they discuss here how this could emerge. This paper was originally prepared for the Conseil d'Analyse Economique, created by Prime Minister Lionel Jospin to advise him and the French Government. It will be released in French in "Architecture du Système Financier International," Collection des Rapports du Conseil d'Analyse Economique (Paris: La Documentation Française, forthcoming).
The succession of severe financial and exchange rate crises in recent years has given a new sense of urgency to the debate on the "international financial architecture." Given the severity of these events, it is hard to justify the claim made by some that what is really at issue is a coincidence of local, independent mistakes rationally sanctioned by investors.1 While studying the local, specific origins of each of the recent crises may provide useful insights on how to behave in today's highly interdependent international economy and how to accommodate "hot" capital flows, it is essential to focus on the systemic reasons why such crises occur as they have such severe implications.
The debate on the international financial architecture involves several crucial aspects-the appropriate regime for capital mobility worldwide and financial openness in emerging markets; the absence of a proper international lender of last resort; and the crucial need for better regulation and supervision of international banking and finance. In this paper we argue that the current difficulties and vulnerabilities are also due in part to exchange rate regimes and policies but that it is possible to improve the working of the international monetary system without a "new Bretton Woods." Our view is that many of the problems of the world economy are attributable to a poor functioning of the exchange rate market and that part of the problem is to be found in the lack of coordination of economic policies. A coordinated approach to managing exchange rate flexibility, though unlikely to solve the overall coordination problem, can make the lack of coordination more palatable and less costly and, occasionally, help coordination take place.
The severity of the recent crises, the imminence of a series of major current account adjustments in the world from Asia to the United States, and the birth of the euro, a currency likely to achieve world status and to lead to substantial portfolio movements, all point to the need to reconsider current international monetary arrangements. We argue that there is a useful middle ground between a "do nothing" posture and the drive to "reform the international monetary system," and that modest but crucial steps can help to restore a sense of control over events that seriously affect the economies of industrial and developing countries alike.
More specifically, our proposal focuses on the interaction between governments and markets. We believe that governments, by jointly and closely monitoring exchange rate movements against a benchmark of transparent, consistent estimates of long-term equilibrium exchange rates, can help substantially to increase the efficiency of foreign exchange markets, thus limiting the risk of major, unforeseen exchange rate crises. This approach also would improve the incentives for private investors to base their expectations more on a careful assessment of current, relevant economic fundamentals. The gains in foreign exchange stability could prove substantial with a relatively small investment. With enough ambition, we believe this first step could prepare the ground for a move in the direction of "quiet" target zones, as explained below, in the not-too-distant future.
The paper is organized as follows: In the first section we argue that current international monetary arrangements are unsatisfactory and need to be improved. In the second section we review the obstacles to consistent and substantial international monetary reform and establish a few feasibility and desirability principles that should guide reform. In the third section we discuss a range of options for managing exchange rate flexibility among industrial countries and introduce our proposal for an "enhanced surveillance mechanism" and for "quiet" target zones. In the fourth section we address exchange rate management in developing countries, and in a final section we offer some concluding remarks.
The International Monetary System: A Half-Empty Glass That Needs a Refill
In international money matters, as in many other areas, there are always a number of good reasons not to act. Churchill's famous remark on democracy is often said to apply equally to the current hybrid international monetary system: it is the worst system, with the exception of all the others. For its supporters, its resilience since the early 1970s, in the face of major supply shocks in the world economy followed by highly divergent macroeconomic policies and differential disinflation strategies, has been truly remarkable: exchange rate flexibility has allowed the accommodation of huge differences in the economic situations and policies of major countries. Although the system does not provide the policy independence that some of its proponents expected, it has proved to be a useful response to the lack of policy coordination worldwide as well as an occasional device for such coordination. Economic agents, faced with the risk of large shocks due to currency volatility, have learned how to deal with exchange rate movements, with the help of many financial innovations. It should be no surprise, therefore, that many claim that the current exchange rate system successfully reconciles economic interdependence and national policy autonomy: the glass is half full, they say, and it may be the best we can hope for.
This benign approach is misleading, however. Not only does it ignore the considerable difficulties developing countries face in choosing an appropriate exchange rate regime, but also it misrepresents the coordination problem between industrial countries, making floating appear as a solution to the problem while it is both a symptom and an aggravating factor. Moreover, the current international monetary system faces potential shocks from the adoption of the euro and from the alarming deterioration of the US current account deficit and might produce major exchange rate instability with high costs for the world economy as well as for transatlantic relations.
The Quest for Exchange Rate Stability in Developing Countries
There is no room for complacency as far as exchange rate movements in developing countries are concerned. Over the past two decades, a typical pattern has emerged. In order to avoid excessive price instability and to attract foreign capital, developing countries tend formally or informally to peg their currency to the dollar or to a basket of foreign currencies.2 This policy can be very successful for a while in sustaining economic growth. However, a fixed exchange rate is sustainable only if there is no divergence between the inflation rate in the anchor country and in the country with pegged rates. Often this condition is not fulfilled, and the combination of excessive real appreciation and external deficit leads to a crisis and a sharp exchange rate adjustment. As emphasized by the International Monetary Fund (IMF) in a careful examination of the exchange rate arrangements in developing countries, "more often than not, the end of a peg comes about with disruptions to the economy" (IMF 1997, 91).
Recently this pattern of "boom and bust" seems to have been especially pronounced, and exiting a pegged regime smoothly seems to have become even more difficult than before. We should not be surprised, however, given the powerful transformation the world economy has undergone over the past decade, particularly in the considerable rise in international capital mobility. As long as the peg is viewed as credible, capital inflows can be enormous and lead to overinvestment or overconsumption, especially if the local banking sector is badly supervised and encourages excessive indebtedness of both private and public agents. But overvaluation of the exchange rate, weak balance sheets, and a large foreign-currency-denominated debt leave a country highly vulnerable to a change in sentiment among investors. Not only can the money that came into the country so easily also depart easily, but also, in this new brave world of high international capital mobility, pegged exchange rates become quite vulnerable to massive speculative outflows of additional capital. The Asian, Russian, and Brazilian crises of 1997-99 and the Mexican crisis of 1994-95 amply illustrate this vulnerability.3
In this context of recurrent and costly exchange rate mismanagement by developing countries, one easy reaction would be to argue that exchange rates should not be managed in the first place. Indeed, the new international consensus leans toward floating rates as the only satisfactory option. The consensus also holds that ultimately what matters most is the quality and credibility of domestic economic policies. While one may fully agree with this stance, the argument misconstrues the macroeconomic policy problem in most developing countries. Besides, it remains to be seen how the emerging countries that recently had to move to a more or less free float will eventually fare.
First, the exchange rate is a crucial price for small open economies. It matters a lot more for them than it does for larger, industrial, well-diversified countries. Its fluctuations play havoc with domestic stability, and it is hard to argue that governments should be indifferent to it.
Second, the choice of the exchange rate regime is not unrelated to the quest for domestic macroeconomic policy credibility and quality. It is an open question whether, freed from exchange rate constraints, most emerging countries would be able to follow a policy of stability as far as monetary and fiscal policies are concerned. Indeed, they often lack the institutional setting that could deliver credible monetary and fiscal policy. Moreover, uncertainties about future policies may make it more difficult to enlist foreign investors in financing domestic investment.
Exchange rate instability in emerging countries can have a lasting negative impact on the availability of external finance through a second channel as well as though this loss of economic policy credibility, and that is in the need to compensate foreign investors or local investors relying on foreign finance with a potentially hefty risk premium for an increased exchange rate risk. Overall, the cost of capital and the level of investment are likely to be severely affected in emerging countries that do not try to limit exchange rate volatility.
These consequences of excessively volatile exchange rates on international capital flows should also be analyzed from a more global perspective. In this respect, exchange rate stability in emerging countries can be seen as a public good, as it makes it easier to recycle savings from the rich and aging populations of the industrial countries to the capital-hungry economies of the developing countries. Indeed, one can argue that growth today in the world economy would be much healthier if it was based on dynamic investments in developing countries rather than on extremely low nominal interest rates in most industrial countries and the exuberance in the US stock market, which contributes excessively to the strength of US private consumption. The current situation, in which the cost of capital is high in most emerging countries because savings generated in mature economies are in some way "trapped," cannot be considered satisfactory.4
Emerging countries' exchange rate policies should be a major focus of the current discussions on the new financial architecture. The issue at hand is to find the right balance, country by country, between flexibility and stability. We discuss the available options later on, in the section "Exchange Rate Policy Options for Emerging Countries."
Exchange Rates and the Coordination Problem
In the case of mature industrial countries, the idea that exchange rate flexibility reconciles economic interdependence with national policy autonomy rests on a circular argument. Floating exchange rates are said to insulate economic policies, thus allowing for divergences that in turn require exchange rate flexibility. The implication that divergences in economic policies need to be accommodated through floating exchange rates is unwarranted and simplistic. Floating exchange rates in fact provide no alternative to economic interdependence. They do not make the lack of coordination of economic policies less costly-and indeed, by accommodating it they may even implicitly encourage uncoordinated policy outcomes, thus exposing countries not only to the costs of excessive exchange rate volatility but also to those of perpetuating the lack of policy coordination.
In the same vein, it is important to realize that floating exchange rates permit the kind of beggar-thy-neighbor policies that the architects of the postwar international economic system tried to prevent. For example, they allow a country to combat inflation by exporting it to other countries through an exchange rate appreciation, thus increasing for the other countries the costs of stabilizing prices. This is what Reaganomics did in the first half of the 1980s: the dollar became grossly overvalued, leading to a tightening of monetary policy all over Europe in response to the inflationary shock. Ultimately, floating exchange rates between the United States and Europe had the same disinflationary impact as fixed exchange rates did within Europe between Germany and other European Monetary System (EMS) member states. In each case, unilateral policies imposed convergence to the lower inflationary standard, as opposed to coordination, which would have implied the joint determination of a common inflation target.
The point is that the exchange rate matters, whatever the regime. If prices and wages were fully flexible, exchange rates would be irrelevant, as they would not affect the real economy. The prevalence of price and wage stickiness, however, gives exchange rates a crucial role in economic adjustment and as a channel for international economic interdependence. It also implies that exchange rate misbehavior is costly. Finally, it makes it likely that any two countries, at any given time, in general will have divergent views about what constitutes an equilibrium exchange rate. Exchange rate stabilization, which cannot exist without a certain degree of policy coordination, signals a willingness at least to address the problem. A regime of floating exchange rates, however, makes it a constant, conflictual feature of international economic relations.
Admittedly, countries feel the domestic impact of exchange rate movements unequally. Large countries can afford what has come to be known as "benign neglect"-calculated indifference to the movements in their country's exchange rate. As the rate affects other countries, however, the neglect could in fact be more malign. In some instances, the United States has been tempted to use what could be termed "exchange rate diplomacy" to advance foreign economic policy interests. For example, after the 1987 Louvre Accord, "American Treasury Secretaries continued to seek expansionary policy from their trading partners, and sometimes to threaten a renewed depreciation of the dollar as an alternative" (Frankel 1992);5 and in the early 1990s, talking the dollar down occasionally provided the United States with leverage to exert pressure on Japan to proceed with domestic structural reform or trade liberalization.
Nevertheless, prolonged misalignments levy substantial costs on large countries as well as on smaller ones. For example, the massive dollar overvaluation of the middle 1980s-which ensued under a regime of virtually free floating-generated three huge effects on the US economy (as well as on the rest of the world). First, the tradables sector, including much of manufacturing and most of agriculture, suffered continued recession for several years after the rest of the economy had recovered; some of the resulting losses were permanent, especially for American workers, as US firms were forced to invest abroad to regain competitiveness. Second, as a result, the politics of trade policy shifted substantially, and the United States experienced its most severe outbreak of protectionism since the 1930s; the "free trade" Reagan administration instituted import quotas (mainly through voluntary export restraint agreements) on automobiles, machine tools, and steel, and congressional leaders testified that the "Smoot-Hawley tariff itself would have passed had it come to the House floor in 1985." Third, despite G-5 efforts to manage the process via the Plaza Agreement, the inevitable reversal of the exchange rate came close to producing the feared "hard landing" of the economy in early 19876 and played a major role in triggering Black Monday later that year.
Likewise, the excessive depreciation of the yen in the latter 1980s contributed directly to the onset of Japan's bubble economy and to its subsequent bursting, which ushered in the stagnation of the 1990s, from which Japan (and the world) still suffers. After the sharp appreciation of the yen between 1985 and 1987, Japan had to stimulate domestic demand to offset the desired sharp fall in its external surplus. Had the yen been under an effective exchange rate constraint, Japan would have had to use fiscal policy for that purpose. In the absence of any such constraint, however, Japan relied wholly on monetary policy. The results were both a substantial renewed depreciation of the yen, which triggered large new Japanese trade surpluses and global trade friction by the early 1990s, and the bubble economy. In this case the failure of policy coordination to avoid a large currency misalignment was an important factor in triggering at least three major international problems: the global impact of Japan's "lost decade" of growth; renewed trade conflict with the United States and Japan's other trading partners as large surpluses reappeared; and the Asian financial crisis, in which the subsequent sharp fall of the yen (and rise of the dollar) from 1995 to 1998 surely played a part.
Reasons to Act Now
The combination of the introduction of the euro as an emerging world currency likely to generate sizable portfolio reallocations7 and the need to accommodate huge adjustments in external imbalances worldwide (and economic policy failure in Japan) suggests that major exchange rate fluctuations will take place in the short to medium run and could have a devastating impact. The exchange rate regime between the United States, Europe, and Japan is a floating regime that is an almost constant source of preoccupation, at least outside the United States. As alluded to earlier, this is because the exchange rates at any given time never please everyone; any two countries will generally have different views about what constitutes for them a desirable level for their exchange rate. The floating exchange rate regime exposes the lack of coordination between economic policies. This is particularly acute in the current environment. In addition, the emergence of the euro introduces the possibility of Europe's emulating the US stance of "benign neglect" vis-à-vis its exchange rate. For all these reasons, the future evolution of the exchange rates of the yen, the dollar, and the euro promises surprises and major uncertainties. In the current context, such uncertainty may well have huge costs in terms of economic growth, as it encourages caution and may blur the focus of businesses' expectations.
The course the Japanese yen will take, for example, is beset with considerable uncertainty. Should and will the yen go up or down? Is the current level in any sense an "equilibrium"? Most likely, the current behavior of the Japanese currency reflects little more than the inconclusive economic policy debate and action in Japan.
But the evolution of the yen will have a strong impact on the prospects for recovery in the rest of Asia, as any weakening of the yen could unleash a new wave of depreciations and undermine the current Chinese policy of not devaluing. Moreover, it would add to the political tension between the United States and Japan over the rising US trade deficits and Japanese trade surpluses. Alternatively, it is hard to imagine an appreciation of the yen benefiting the Japanese economy in the short term, and the longer it takes for Japan to engineer a domestic economic recovery, the longer the rest of Asia will suffer.
Discussing the exchange rate of the Japanese currency will not fill the macroeconomic policy vacuum in Japan. But it may nonetheless provide a useful stabilizing device in a region particularly vulnerable to a resumption of currency volatility.
As far as the US dollar is concerned, the US economy will have to correct a still rising current account deficit, which points to a real depreciation of the US dollar in effective terms. While this may come gradually and allow for a "soft landing," there is a risk that the realization of the need for such adjustment, when it crystallizes in expectations, will lead to a free fall in the US dollar that would push the euro strongly upward. In the current context of a still-hesitant world recovery, and a world economy that stays afloat thanks to the dynamism of the US economy and of domestic demand in Europe, the implications would be ominous. The obvious and desirable response would be an aggressive lowering of interest rates in Europe, despite their already low level. Unfortunately, this would conflict both with the quest for credibility on the part of the newly established European Central Bank, and with the double prisoners' dilemma that besets macroeconomic policy in Europe, where the unwillingness to further relax monetary policy is sometimes seen as the key to both structural reform and the pursuit of fiscal adjustment.8
The first half of 1999, marking the first six months of the newly established European currency, may at first seem to have invalidated these fears, as the euro in fact weakened against the dollar. This seeming contradiction is resolved, however, by two considerations. First, expectations of an early rise in the European currency were widespread in 1998, which led to an early weakening of the dollar against the forthcoming euro. Second, economic growth in the United States so far has been unexpectedly strong, despite anticipation of an inevitable slowdown. This surprising development, together with the weakness in economic activity in Germany and Italy, has led to an increased divergence between US and European interest rates. In the first half of 1999 the Fed had to raise interest rates by 25 basis points while the European Central Bank cut them by 50 basis points. This evolution of economic activity and monetary policy had not been expected at the beginning of the year and has naturally led to a strengthening of the US dollar. This conjunction of events, however, is inherently temporary and does not contradict the longer-term forces discussed above.
Our point here is that talking about current and future exchange rates may help to focus policymakers' minds on the dangers of the current situation and help them to find the way to more adequate policy responses. We see actual and expected exchange rate movements as useful indicators of the interaction of economic policies between countries and of the coordination problems that may emerge. We will develop this theme in our discussion of practical options later on.
Guidelines to International Monetary Reform
In the sections following this one we discuss a number of options likely to improve the way the international monetary system is working, and argue that feasible and desirable solutions may well differ according to country specifics. In this section we start with a discussion of a few core principles, which form the common basis of our later analysis.
The basic concept underlying any meaningful discussion of international monetary reform is the now well-known "inconsistent triangle": free capital mobility, fixed (or fixed but adjustable) exchange rates, and national monetary policy autonomy are mutually inconsistent.9 Suppose, for example, that a country's policymakers want to maintain full capital mobility; in that case, they cannot maintain over time the option of using domestic monetary policy for stabilization purposes while pretending to keep the exchange rate stable. That is because speculators will fly from the currency if they fear that the commitment to defend the exchange rate conflicts with stabilization objectives. The experience of the pound sterling in 1992 is a case in point. Alternatively, suppose the policymakers desire fixed exchange rates. Then, if they wish to have full capital mobility, they must credibly commit domestic monetary policy to the defense of the exchange rate and therefore credibly forgo the use of monetary policy for stabilization purposes. Finally, suppose they want to maintain the option of conducting stabilization policies. If they want at the same time to maintain stable exchange rates, they must discourage speculation, which requires some restraints on capital mobility.
This inconsistency has at least implicitly been understood for a long time; all monetary systems in history have taken it into account, and most actually broke down-i.e., reversed to a substantial degree of floating-when the inconsistency was allowed to resurface. The gold standard benefited from the fact that the idea of active monetary policy had not yet emerged,10 and it collapsed in part because that idea gradually developed in the 1920s and there was a lack of monetary policy coordination among major nations. The Bretton Woods system involved capital controls, and so did the EMS early on, before it turned to a regime in which monetary policy autonomy was abandoned de facto as national central banks all shadowed the Bundesbank's monetary policy. Such de facto release of sovereignty was deemed credible by the markets because it was anchored on the ultimate goal of creating a monetary union. Two referenda-producing a "No" in Denmark and a lukewarm "Yes" in France-destroyed that credibility, unleashed inconsistency, and led to the EMS crisis of September 1992.
A "Cartesian Impasse"
A full "Cartesian" approach to the inconsistent triangle will lead to the conclusion that at least one of the objectives has to be at least partly abandoned. Some might argue that the world can live happily under free floating; our earlier discussion, however, suggests that the shortcomings are many. Of the other two objectives, the one that might seem easier to drop is full capital mobility: at first sight its benefits are far less visible than those of exchange rate stability and stabilization of the real economy through an active monetary policy. Moreover, negotiating limitations on monetary policy autonomy is a political dead end in the major countries (notwithstanding the exceptional case of the European Monetary Union).
Indeed, the exchange rate crisis within the Exchange Rate Mechanism of the EMS in 1992 has revived older proposals about "throwing sand in the wheels," including the Tobin tax (Tobin 1978), or suggestions for a non-interest-bearing deposit on foreign currency transactions (Eichengreen, Tobin, and Wyplosz 1995).
Restricting capital mobility was one of the basic tenets of the Bretton Woods agreements and, later, one of the reasons why the EMS could successfully deliver exchange rate stability (including through its various realignments) between 1981 and 1987. The discussion on capital controls, however, should distinguish between developing countries, where capital markets and the financial system are underdeveloped, and industrial countries, where modern capital markets and dynamic financial institutions contribute in an essential way to financing the economy.
In the industrial countries there are three major difficulties with capital controls, whatever form they take. First, technological change has made capital mobility extremely difficult to control. This has two central implications: one is that any control would offer only a temporary protection against speculation; the other is that the administrative costs of implementing tight capital controls could be high. Second, the development of capital markets in Europe and the United States was fed by capital mobility and a high degree of competition among financial services companies, leading to more efficient capital markets and resource allocation. Capital controls would be a serious setback in this regard and introduce inefficiencies and incentives for rent-seeking. Third, controls distort competition and penalize those who bear their costs. Hence in countries where financial institutions have become key players, the imposition of controls could prove very costly unless it was undertaken on a truly international basis-and therefore it cannot be considered a viable option on an individual country basis.
In emerging markets, however, the situation is different. The lack of development of financial markets suggests that there is some room for maneuver in dealing with foreign capital. A crucial distinction must be made between capital account convertibility and opening to competition from foreign financial services providers. The benefits from the latter should not be underestimated; opening to foreign competition can be expected to contribute through increased efficiency in resource allocation from the sheer impact of competition-led innovation and the transfer of management and product technology as well as of supervisory and regulatory know-how.11 But opening to foreign competition, although related to the liberalization of the capital account, is a different issue technically. Of course, some freedom of capital movements, especially foreign direct investment and long-term portfolio investment as well as proceeds from investments, is necessary to allow foreign services providers to enter domestic financial markets. But it is possible to have such opening while keeping some restrictions on capital movements, notably those of the shorter-term variety.
A second issue for emerging markets involves distinguishing controls on capital inflows and controls on outflows. Controlling outflows may actually erode confidence and deter inflows, and it therefore appears as a stronger measure. Controlling outflows has many drawbacks. On the one hand, over the medium term, it proves almost impossible to avoid capital flight when domestic savings have a strong incentive to exit. This is particularly true in countries with weak-and in some cases sometimes corrupt-administrations. On the other hand, "trapping" domestic savings can shield the authorities from some of the pressure to maintain sound economic policies.
Capital inflows are another matter. They expose the domestic financial system to an excess of liquidity in search of uses, and the domestic banking system to the accumulation of several types of risk: the traditional transformation risk, based on the transformation of short-term deposit liabilities into long-term, illiquid assets; the risk of currency mismatch, as banks receive foreign currency deposits and re-lend in domestic currency; and the traditional credit risk, which depends on the quality of the debtor. Massive capital inflows considerably increase the risk of currency mismatch, making the banking sector highly vulnerable to exchange rate depreciation. They also increase the credit risk, because so many funds compete for too few productive investments.
The Asian crisis provides a case in point, lending empirical support to the idea that controls on inflows can be useful. The Chilean encaje, an implicit tax on capital inflows, seems to have served the country rather well in protecting it from the vulnerability to sudden reversals that penalized Asian countries and other countries in Latin America. Conditions for liberalizing inflows include an efficient domestic financial system-a condition too often ignored by emerging markets embarking on liberalization. Without that, capital inflows not only build up an ominous vulnerability to the risk of later reversal but also contribute to inefficient resource allocation, as inefficient intermediation fails to direct them toward productive uses. Again, the Asian debacle illustrates the dangers involved in hastily embarking on capital account liberalization.
In short, capital controls do not provide a workable solution for the developed countries. For developing countries, however, resort to controls on inflows opens the possibility of pursuing exchange rate stability while keeping some degree of domestic economic policy autonomy. It is a worthwhile option, provided the country is capable of conducting a wise macroeconomic policy-though not every country can emulate Chile in that respect. Controls, however imposed, are a poor device to use in countries in which the administration is inefficient or corrupt. They cannot serve as a substitute for sound macroeconomic management.
We believe that capital controls can have only a very limited role in a reformed international monetary system. Hence in resolving the inconsistent triangle, the central task is to find the best ways to manage the tension between stable exchange rates and independent monetary policies. One should not jump to the conclusion that there are only two feasible exchange rate systems-outright float or monetary union. Solutions to the inconsistent triangle involving managed floating exchange rates are possible and promising. We will argue that the world, and more specifically the G-3 (United States, Euroland, Japan), can develop a middle-of-the-road system in which there is some degree of managed floating that is both desirable and feasible. Moreover, it is easier to cooperate in devising a hybrid combination than to negotiate extreme choices, as the former is more likely to crystallize cooperation. Managed floats do not have the clean, clear-cut allure of full institutional purity, but, in a world of second-bests, they are worth exploring.
Managed Floating Exchange Rates
In the next two sections we shall explore two broad classes of managed floats. One is based on monitoring and signaling, and we argue that it constitutes a promising option for industrial countries. The other puts the exchange rate at the center of the macroeconomic policy dilemma in emerging markets; focusing on it exclusively is irresponsible, but ignoring it is costly.
The promise of managed floats rests on two key principles. First, whatever the exchange rate regime, all countries need a credible monetary policy committed to a low and stable inflation rate. The central bank should never compromise price stability for the stake of a stable exchange rate. This is a mistake with a high cost: excess inflation eventually brings a collapse of the exchange rate target, and the exit cannot be smooth in a country where credibility was built exclusively on the sand of an exchange rate commitment.
Issues related to the institutional setting of monetary policy-independence of the central bank, existence of an inflation target-are important whatever the exchange rate regime. For developing countries experiencing moderate two-figure inflation, an appropriate transition is needed. Gradual disinflation is crucial to their institutional credibility, and may be helped by a careful nominal anchoring of the currency; this option presents both advantages and dangers, as discussed below.
Secondly, unless countries are locked in a monetary union, it is important to recognize the many dangers of fixed exchange rates. In normal times, on the one hand, fixed rates do not encourage investors to monitor the country's economic performance properly, as the authorities try to insulate the exchange rate from the economic fundamentals. On the other hand, fixed exchange rates invite one-way bets in which market players have little to lose in launching a speculative attack. Their only cost is related to the interest rate spread between the pegged currency and its anchor, and as a result interest rates often must be raised to extreme levels in order to make speculation costly. High interest rates may have an enormous negative impact on the economy, and if market players feel that such rates are unsustainable, even a very tight monetary policy will not stop the speculative attack. When a speculative attack does occur, it makes sense to accept a temporary decline of the currency in order to create an upside potential and reintroduce some risk for the speculators. (This is a point we shall emphasize later.) Overall, except for a country credibly embarked in a process leading to monetary union or to full-fledged dollarization or "euroization," a certain degree of exchange rate flexibility seems both necessary and desirable.
In the discussion that follows, a clear distinction is made between countries that, thanks to credible institutions, can follow an essentially independent monetary policy and countries that need some kind of external anchor. All of the major industrial countries are in the first category, while the second comprises the large majority of the developing countries. A few large emerging countries are in a gray area that requires special treatment.
Options for Major Industrial Countires: Surveillance, Flexible Target Zones, or Hards Bands?
Few would seriously suggest that the central banks in the main industrial countries, especially the G-3, would or should compromise their internal short-term macroeconomic stability for the sake of exchange rate stability. At the same time, however, a significant exchange rate misalignment can constitute a threat for the long-term stability of an economy. A key question for these countries, therefore, is how best to avoid large-scale fluctuations in exchange rates while allowing monetary policy to play its stabilizing role vis-à-vis economic activity and inflation.
Two main options are generally considered and have been used in the past. The first, of course, is that of sterilized interventions in the foreign exchange market. We now know that these are very effective when properly orchestrated,12 especially when undertaken jointly. There have been a number of episodes in which coordinated sterilized interventions helped to stabilize exchange rates, but they often came very late, in the absence of any systematic process that could help to initiate them.13
A second possibility, this one more controversial, entails coordinating fiscal and monetary policies internationally so that the resulting interactions among national policy mixes would be compatible with exchange rate stability. The record of actual "coordination" of economic policies in the G-7 does not inspire much confidence in its ability to provide a systematic-let alone a systemic-approach. In theory, coordination is useful in exploiting the interdependence of national economic policies. It faces a number of barriers to feasibility, however, including political constraints and the inability to foresee the international repercussions of economic policies; basic disagreements about the channels of transmissions of economic policies and their ultimate effects; and doubts about the credibility of coordination commitments (e.g., there are no guarantees that finance ministers will try to implement agreed-upon changes in fiscal policies-and if they do try, that they will succeed in getting them through parliament).14
As far as exchange rate stability is concerned, however, there is a crucial shortcoming in the current approach, which reacts to, rather than anticipates, major exchange rate imbalances. We argue here that a sensible priority for the G-7 would be to establish a mechanism of enhanced surveillance, based on a much-improved monitoring process. There can be no common ground for decisive action if the G-7 countries are not able first to forge a common view on what is going on in the market and how well foreign exchange rates reflect the underlying fundamentals.
Before turning to a discussion of what such a mechanism could consist of, we need to review some basic features of the foreign exchange market, for two reasons. First, if the market were perfectly efficient, G-7 monitoring would be superfluous. Second, finance ministers and central bank governors need to agree broadly on what key economic fundamentals to look at in order to assess the behavior of exchange rates.
Equilibrium Exchange Rates and Efficiency of the Foreign Exchange Market
The experience of the G-3 currencies over the past 25 years has been less pleasant than proponents of free-floating currencies expected. It is tempting to interpret the instability of exchange rates as an indisputable sign of dysfunction of the foreign exchange markets-as proof of their incapacity to spontaneously reflect the economic fundamentals. In itself, however, volatility, however large, is a normal phenomenon and not necessarily a sign of dysfunction. A careful analysis of spontaneous foreign exchange market operations is required in order to reach conclusions.
In the medium to long term, the real economy holds sway: exchange rates cannot diverge forever from their long-term equilibrium. The dominant approach used in estimating a long-term exchange rate equilibrium15 consists in first defining a sustainable current account balance for the medium to long term, and then identifying the internal balance of the economy that enables the current account balance to reach its sustainable level.
The definition of a sustainable current account balance over the medium term will depend on the nature of the external financing constraint faced by the country. For a country without external financial constraints, the sustainable value is determined by the level of net savings (domestic savings minus domestic investment) that the country generates on a path of balanced growth (full employment and sustainable public debt).16 For a country facing an external financial constraint, the sustainable current account balance is equal to the availability of funds.
Once the sustainable external balance has been defined, the equilibrium real exchange rate is derived using equations that link foreign trade, domestic demand, and external competitiveness. This process can lead to long-term equilibrium real exchange rate estimates that are rather far from traditional indicators such as relative prices (purchasing power parities-PPPs-estimated by the OECD, for instance), relative labor costs, or average long-term real exchange rates.17
As far as the euro-dollar rate is concerned, the main explanation for such a discrepancy rests in the low price elasticity of trade volumes typically produced by traditional econometric equations. A large adjustment in relative prices is therefore necessary to engineer any required change in the volume of exports and imports. The low price elasticity found in authoritative empirical studies is somewhat puzzling, as thin export margins suggest a high degree of competition in most international markets. While real equilibrium exchange rate quantification has made important headway and can be relied upon to provide a useful basis for discussion and monitoring, this suggests that applied research on what determines international trade volumes needs to be further encouraged and developed.
Two factors may justify "normal" fluctuations of actual exchange rates around the sustainable long-term equilibrium: discrepancies in real interest rates and risk premiums.
A positive real interest rate differential, for example, implies a real appreciation of the exchange rate relative to the long-term average. This is because the positive differential increases the attractiveness of investment in domestic financial assets. Such a differential can lead to a significant, albeit a rational, real exchange rate overvaluation.18 For example, if domestic real interest rates over a 10-year period are more than 1 percent higher than interest rates abroad, the domestic exchange rate could easily be overvalued by about 10 percent (in real terms): over a long period the investor would earn in interest (10 * 1 percent) what he would lose should the currency go back to the long-term exchange rate equilibrium (progressive elimination of the 10 percent overvaluation).
The natural link between exchange rates and spreads in different long-term interest rates assumes perfect asset substitutability, and will in general be affected by the existence of risk premiums. These can stem either from specific barriers to capital mobility that prevent assets from being perfectly substitutable, or from different assessments of risk. For example, a nation with a large external debt may have to offer its foreign creditors a return higher than they can get at home. At given interest rates, risk premiums may therefore play a crucial role in exchange rate determination. If a given currency has to pay a positive risk premium, either its interest rates must increase by the size of the premium or its exchange rate must depreciate considerably in relation to the "normal" rate and reach a level at which investors will anticipate a future appreciation that will compensate them for the risk. For example, if they require an additional 1 percent return per year and the exchange rate reaches its long-term equilibrium on average over a 10-year period, the currency will have to be undervalued by around 10 percent.
The explanatory record of this simple analytical framework over the past 20 years is surprisingly good for many currencies. Major shifts in exchange rates in the late 1970s and early 1980s can be fully explained by substantial changes in real interest rate differentials. For example, the long-term real interest rate differential between the United States and West Germany shifted from -6 percent to +4 percent between mid-1979 and early 1982, which on the basis of the foregoing analysis fully explains the 100 percent real appreciation of the dollar over that period.
In fact, the most spectacular shifts in the dollar's value, at least relative to the deutsche mark, can clearly be traced to the reversal in US economic policy: an overly lax monetary policy in the late 1970s, followed by the Volcker-Reagan "policy mix" in the early 1980s that entailed a tight anti-inflationary monetary policy and a dramatic fiscal expansion through tax cuts and an increase in defense spending. The result was a spectacular growth in real interest rates and a steep real appreciation of the dollar. Most empirical work thus reveals a fairly close correlation between shifts in exchange rates and changes in long-term real interest rate differentials for certain currencies.19 It is therefore puzzling that most market professionals ignore this relationship when establishing their economic forecasts. Figure 1 illustrates the correlation for the dollar/mark real exchange rate.20
The exchange rate instability visible in the graph often can be traced back to vagaries in economic policies: an increase in inflation and an excessive drop in real interest rates (the United States in the late 1970s or France in the mid-1970s), or an unbalanced policy mix and a real interest rate hike in response to an overly expansionist fiscal policy (the United States in the early 1980s or Germany in the initial phase of unification at the end of the 1980s).
However, rational economic analysis based on interest rate differentials cannot account for all periods of instability. Thus, the sudden surge in the value of the US dollar in terms of European currencies in late 1984 and early 1985 remains rather mysterious, as do its drop in late 1987 and its relative weakness from 1993 to 1996 (see figure 1).21 The dollar peak from late 1984 to February 1985 resembles a speculative bubble.22
As for the recent period, shifts in risk premiums for US assets hardly explain the movements of the US dollar: the ever-rising external debt constitutes a weakening trend factor for the dollar. But the 1993-96 weakness of the dollar has been followed by a partial recovery, despite the fact that the US trade deficit has continued to surge.
Figure 1 should not be taken as an illustration that markets behave rationally most of the time, however. Not only have excessive hikes or drops been recorded at times, but also central banks have often had to intervene in order to stem overshoot situations.
The relative rationality of the market apparent in the figure is in fact due in large part to the actions of the major industrialized nations. In 1985 the dollar drop was accelerated by the intervention of central banks in the wake of the Plaza Agreement; in 1987 it was stabilized for a time thanks to interventions as part of the Louvre Accord; in 1995 it was once again stabilized as a result of interventions.The role of central banks has been even more important in the case of the US dollar/yen rate, major misalignments of which have been reduced only because of massive foreign exchange interventions (notably over the 1985-87 and 1995-98 periods). In fact, most observers reckon that the foreign exchange market quite often behaves in an autonomous way-that is, it is capable of violent shifts unjustified by any theory based on actual economic data. The fact that these shifts are called "technical corrections" hardly conceals our uncertainty about what factors are actually at work. This is when outside guidance can prove particularly helpful in avoiding large fluctuations, unjustified by the fundamentals, suggesting a potentially major role for finance ministers and central bank governors of the G-7.
A Proposal for "Enhanced Surveillance"
A first aspect of strengthening surveillance would entail finance ministers and central bank governors explicitly assessing the evolution of the foreign exchange market relative to three key fundamental variables: the long-term equilibrium value of major currencies, the long-term real interest rate differentials, and tentative movements in risk premiums on different currencies.
More specifically, by "enhanced surveillance" of the foreign exchange market, we have in mind a two-step process:
A rather difficult part of the exercise is to estimate legitimate risk premiums. As far as the G-7 countries are concerned, especially G-3 "countries," political risks and inflation risks are absent, and the major source of risk premium probably resides in differences in net external positions. A country with a large net foreign debt and deficits may have to pay a premium to receive the foreign finance it needs at given exchange rates. At present, however, there is no easy way to assess whether a country's foreign debt is already becoming too large to be easily financed. This is especially true for the United States. There is very little detailed information on how the supply and demand of various currencies match. More detailed insights into international investors' portfolios and expectations would be useful: there is no doubt the need for a risk premium on a currency issued by an indebted country when, on the basis of high expected returns, the average portfolio is distorted in favor of this currency.
For most categories of investors, however, there is little that can be done to collect information on portfolio structures.23 There is an important exception, however: international banks have developed their own internal systems for measuring market risks. They are capable of studying their exposure on various currencies, notably on the euro/dollar parity since 1 January 1999. Data regarding exposure to the main exchange rate risks could be grouped together by the bank supervisors on a monthly or quarterly basis, integrated by the Bank for International Settlements (BIS), and then circulated. Such a procedure would involve several difficulties, notably that of protecting the confidentiality of individual data, but it would provide the monetary authorities and private investors with a much closer monitoring of the exchange market. Such a process already exists as far as international credit risks are concerned: the BIS and the community of bank supervisors collect data on credit to foreign counterparts and publish the aggregate results on a quarterly basis. The same could be done with exchange rate exposures.
Whatever the methodology employed, a better monitoring of financial portfolios is needed. With the birth of the euro, this need is even more pressing in order to anticipate diversification strategies more reliably and to develop a better grasp of the factors likely to influence a potential excess demand for euros and supply of dollars-at the level of the agreed-upon long-term real exchange rate equilibrium. This analysis of supply and demand trends in the foreign exchange market would be an integral part of the enhanced-surveillance process that we advocate.
The major contribution of such a process would be to help forge a consensus among policymakers about what is going on in the foreign exchange market. In normal times, attention would be limited to G-7 currencies (US dollar, euro, yen, pound, Canadian dollar). Two key advantages could be expected:
Beyond Enhanced Surveillance: "Quiet" Or "Flexible" Target Zones
We certainly do not want to suggest that our "enhanced surveillance" proposal will perform miracles in exchange rate management and international economic policy coordination. If properly implemented, it could significantly influence market behavior and the formation of expectations, but it is only a first step in making coordination more effective among G-7 authorities. It is clear, however, that it is a prerequisite for any coherent joint action on exchange rates. In our view, therefore, enhanced surveillance is an essential and realistic first step toward establishing the basis for the needed deepening of international economic policy coordination.
We now turn to three schemes that would achieve such deepening, presented in rank order of political feasibility in today's context. All these schemes share two characteristics. First, authorities not only discuss the right value for exchange rates in a long-term perspective on the basis of IMF expertise but also, building on the surveillance process, jointly agree on a set of "reference parities." Second, they define in common the movements around these reference parities that are acceptable-that is, they agree on the exchange rate levels, 10 to 15 percent on either side of the reference parities, at which action is warranted to avoid further divergence. The three schemes differ, however, on whether or not their agreement is made public and on the strength of the commitment to the target zone.
A first improvement in the enhanced surveillance mechanism would consist in moving from there to "quiet target zones." Under this regime the authorities do not make public their agreement on reference parities and bands. The improvement over simple enhanced surveillance, however, is that governments have a common understanding that they will act to defend the zone, notably through interventions, sterilized or not, whereas the mechanism we elaborated above contained no such commitment.
This option, quite similar to most readings of the 1987 Louvre Accord, nicely combines exchange rate targeting with flexibility. By keeping the agreement "quiet," it avoids the "fixed-rate trap" in which so much political credibility is invested that it becomes very difficult to alter the target. Governments have a strong common understanding but stop short of an actual, much more demanding, public commitment to coordinate economic policies and defend specific levels of exchange rates. The quiet target zone mechanism is a natural extension of the enhanced surveillance mechanism in the sense that, once governments have worked out methods to discuss equilibrium exchange rates, the likelihood that they will agree on some equilibrium "reference" rate increases significantly; presumably so does the likelihood that they might intervene if the current exchange rate departs too much from what they deem appropriate. Again, enhanced surveillance is the place to start but, if it is successfully implemented, quiet target zones become a natural improvement.
The next step that could be implemented would be the adoption of "flexible target zones." For the sake of transparency and in order to guide expectations, now governments not only agree on a set of reference parities but also make their choices public. They also make clear that they will do their best to keep exchange rates between G-7 currencies in a reasonably wide band around these references (10 to 15 percent on either side). However, there is still no binding commitment: exchange rates can leave the target zone. G-7 countries must then explain why this is so, however, and what they plan to do in order to bring currencies back into the sustainable zone in a reasonable time frame.26
The adoption of a flexible target zone framework would send a strong signal that the G-7 countries believe in the benefits of avoiding excessive swings in exchange rates. Indeed, it should be seen as a commitment to cooperate, admittedly with a hedging mechanism that limits the costs of failing to fully implement the scheme. Like the quiet-zone proposal, it also combines flexibility and commitment, though much more credibility is at stake here and the regime is more demanding than the previous one. Making the target public also implies that the mechanism of changing the target, and adapting it to changes in real equilibrium exchange rates, is clearly specified so as to avoid the fixed exchange rate trap and the loss of credibility in the exchange rate commitment that a moving target may imply.
Under what conditions could flexible target zones then evolve into "hard bands," the third variant that should be considered? With hard bands, governments commit themselves to keeping exchange rates strictly inside the agreed-upon margins. The main problem with such a framework is that clear rules must be established to determine how the bands would be protected in case exchange rates show a tendency to diverge. If this divergence is related to real differences in interest rates and cyclical positions, interventions are likely to fail and adjustments of economic policies may prove necessary. How should the adjustment burden be shared?
In general, most of the burden is shouldered by the weaker-currency country. This was, for example, the unwritten (and maybe unintended) rule of the EMS. There is no problem with this rule when the cause of the weakness lies in a lax monetary policy and the market's fear of rising inflation. However, past experience shows how difficult it may be for a country to stabilize its currency by raising interest rates when the exchange rate weakness is related not to concerns about prices but rather to an economic slowdown.
Higher rates can easily upset investors, who may doubt that the rates can be sustained in the face of weak economic activity. In such a situation monetary policy can be a rather blunt instrument: not very effective in stabilizing the currency and quite penalizing as far as economic activity is concerned.
Indeed, there are many cases in which the strong-currency country, rather than the weak-currency country, should adjust its policies. That was certainly the dominant feeling with respect to the appreciation of the US dollar in the early 1980s and of the deutsche mark in the late 1980s, both engineered by a policy mix of tight money and loose budget that had an upsetting impact on exchange rates. In their "blueprint" for the international coordination of economic policies, Williamson and Miller (1987) recognize these difficulties and work out specific rules for sharing the burden of adjustment in an exchange rate misalignment. Implementing such clear-cut rules for burden sharing is probably too difficult to be feasible at present, however. For the time being, there is no political support in major countries for a formal system of coordination that would specify well-defined ex ante constraints on macroeconomic policies.
We believe, however, that it is desirable to couple enhanced surveillance with movement in the direction of quiet target zones. The most immediate issue facing today's monetary system is that of how to manage flexible exchange rates. The dollar, the euro, and the yen will continue to float, but, likewise, their authorities will continue to intervene from time to time. We believe that the costs and failures of the present G-7 process of episodic, ad hoc intervention are simply too high. A combination of enhanced surveillance and quiet target zones could provide a substantial improvement in the system that would be in the interest of both the G-7 countries themselves and the world economy as a whole.
Exchange Rate Policy Options for Emerging Countires
In the developing countries, no regime can be said to outperform any other unambiguously in terms of economic growth and stability. Their experience-before the recent series of crises-suggests that there is a strong empirical link between pegged exchange rates and low inflation (IMF 1997; Ghosh, Gulde, Ostry, and Wolf 1995).
Anchoring the exchange rate to a foreign currency imposes discipline and sustains the value of the currency through greater confidence in it. A number of developing countries have-at least temporarily-successfully used pegging as an anti-inflationary tool. Recent crises, however, suggest that the viability of pegging policies cannot be taken for granted and that their design should be carefully improved.
Emerging countries exhibit, to varying degrees, a number of characteristics that compound the difficulty of adopting a proper exchange rate regime and finding the right mix between monetary independence and exchange rate stability. Although the situation varies widely among countries, three factors stand out:
Economic policy often lacks transparency and credibility, either because it is vulnerable to political uncertainties or because weak institutions poorly protected from political pressures are not in a position to implement consistent policies. As a result, inflation prospects are beset by uncertainty. A free-float regime will overreact to such uncertainties, whereas any other regime will lack essential credibility.
Long-term equilibrium exchange rates can be somewhat more difficult to estimate because of uncertainties affecting key parameters such as the trend of productivity growth, very much linked to structural policies and evolutions, and the "sustainable" current account deficit, which requires assumptions about the availability of external finance. Such estimates exist (see Williamson 1994), but the foreign exchange market still lacks an "anchor"-a view on where the exchange rate should be in the medium to long term.
In a well-functioning world capital market, emerging countries should be in a debtor position: characteristically, a lower capital stock would imply a higher return on capital, which would make it profitable for industrial-country investors to invest in emerging countries. In fact, however, the cost of foreign capital for emerging markets proves to be highly volatile. It depends on many factors, including the general situation in developing countries as a group, but a key determinant is exchange rate instability: importing foreign capital means that someone is taking a currency risk, and the risk premium required as compensation depends a great deal on exchange rate volatility. For an indebted country, a free-float or a pegged regime that lacks credibility can make the cost of capital both high and unstable.27
The challenge of devising workable options is accordingly even greater for emerging countries than it is for the G-7 countries. One the one hand, it is tempting to argue that developing countries need to keep some degree of flexibility while pegging their currency. On the other hand, casual analysis suggests that the combination of flexible pegging with high capital mobility is hardly feasible: a peg invites speculation. In itself, it represents a decision to fix the exchange rate, and speculators know that this decision can be changed. Promises are not enough. The bottom line of this argument is that fixed exchange rates are dangerous unless they are so fixed that nobody will be ever tempted to speculate against them.
This is why, here again, informed debate too often focuses on only two options: either a free float, possibly managed at the margin to limit excess volatility, or a "currency board," which is supposed to improve the credibility of a pegging policy (both are discussed briefly below). We think that this unduly restricts the menu of options. As we argued earlier, intermediate solutions may not have the neat features of extreme arrangements, but they can be designed both to provide the necessary flexibility and to limit the costs of excessive flexibility. In this light, then, we describe in the following section how a policy of "adjustable reference parities" might work.
Managed Floating: A Demanding Option
Many economists have argued in the wake of the recent crises that the only reasonable option is floating. We are not convinced. Floating provides flexibility, but it increases both the need for and the cost of adequate domestic economic policies. The exchange rate is much too important a price for small, open developing countries to be left to the vagaries of international financial markets and investor mood swings. Pegging, as it stands, may not be a workable solution, but floating is bound to make the task of devising a proper domestic economic policy considerably more difficult.
Two aspects deserve emphasis. First, a floating exchange rate leaves developing countries with unclear relative price signals that will inevitably be detrimental to investment and development. For small, open developing countries that necessarily rely a great deal on foreign trade and savings, flexible exchange rates are not an attractive option. Even for the larger developing countries, flexible rates expose them to wide swings in their real exchange rates and can bring undue costs to their economy, even if it is properly managed at the domestic level. Second, the exchange rate may serve as a useful indicator of the monetary policy stance in countries in which monetary policy is underdeveloped and has been used in the past mainly to finance public deficits and to feed inflation and hyperinflation. Hence it seems that for a developing country seeking stable macroeconomic policies, floating is not appropriate. It is more of a luxury available to large developed countries with mature economic policies.
A key issue, in any regime of managed floating, is how to avoid large swings in exchange rates. There are probably two preconditions for a successful float. First, monetary policy should be credible: the lack of an external anchor makes it all the more necessary to have an internal anchor. An independent central bank is a first step. An independent central bank with an inflation target is even better, since the inflation target makes it easier to monitor its performance and increases its accountability. Both central bank independence and inflation targeting are a recent development in industrial countries themselves and can be interpreted as a response to the increase in international capital mobility. Such an option requires advanced institutions and is available only to the more developed emerging countries (see Masson, Savastano, and Sharma 1997).
Second, surveillance does matter, as we argued earlier in our discussion of G-7 arrangements. National authorities-and markets-should consider closely the equilibrium level of the exchange rate in a long-term perspective and assess whether or not the current situation, taking cyclical considerations into account, makes sense. Given the difficulties that we discussed above, the option of floating is again open only for the more advanced emerging markets. The successful implementation of an enhanced-surveillance process in G-7 countries could conceivably help emerging markets as well, both directly because of reduced volatility between the major world currencies, but also indirectly by aiding the development among private investors of more fundamentally based valuation methods.
Moreover, emerging countries would benefit from the experience gained by G-7 practitioners in their enhanced-surveillance process. We strongly recommend that the more advanced emerging countries that decide to pursue the demanding option of managed floating be invited periodically to meet with G-7 representatives to consult on modalities of surveillance and of mutual support. The markets would surely look favorably on such collaboration and might even interpret it as an implicit, stabilizing endorsement.
Our conclusion is that, although regimes of managed floating should not be ruled out, they certainly do not stand out as a universally satisfactory option. They are a demanding arrangement and certainly do not offer the relaxation of constraints that some argue is characteristic of floating.
Currency Boards: A Temporary Fix?
The example of Argentina shows that a currency board can help to restore stability in a country whose currency has lost all credibility. Currency boards provide a particularly effective response to hyperinflation. However, in the medium term, a currency board entails the same drawbacks as excessively rigid systems. If people start to question the willingness to keep the system in place, interest rates have to rise, and the willingness can indeed be weakened.
The risk of a vicious circle should not be underestimated. It is hard to believe that countries with currency boards will never find themselves in a situation where it is so costly for them to keep exchange rates unchanged that investors start aggressively to question their commitment. Both Hong Kong and Argentina have already faced high costs. Argentina's response so far, interestingly, has consisted both in somewhat relaxing the currency board-which raises questions about its future sustainability-and in floating the option of full dollarization, in order to demonstrate determination and to increase credibility. This game is a subtle one that may face many hurdles.
As a result, we cannot think of currency boards as a universal solution either. What may work for Argentina will not necessarily work in other circumstances. Moreover, the currency board solution has a built-in contradiction. As soon as the credibility of monetary authorities has been restored, capital inflows will push the currency upward, at which point it would make sense to relax the system toward more flexible arrangements. The very success of the currency board, therefore, may well dent its credibility. In the meantime, its credibility does not derive essentially from the arrangement itself but from the ability of the country that adopts it to strengthen its institutions, such as an independent central bank and a well-functioning, well-supervised banking system. Institutional strengthening in turn will allow for a change of exchange rate regime. Thus a currency board may be a good temporary arrangement in preparation for a successful move to a managed float.
Currency boards might serve as a useful temporary arrangement in another set of economies as well: the central and eastern European countries that wish to join the euro zone. Policymakers in these countries may see a currency board as the key to a de facto entry into the European Monetary Union (EMU).28
Proposal for a System of Adjustable Reference Parities
Many central banks look for a flexible way of stabilizing exchange rates at predefined levels compatible with balanced medium- and long-term economic development. The adjustable reference parities framework tries to do that while introducing three major changes in order to rectify the fixed exchange policies that have led to recent crises. The reference parity must be redefined on a regular basis, upward pressures should be better managed during periods of rapid economic growth, and the response to downward pressure should be much more progressive.
Maintaining Regular Readjustments for the Reference Parity
The currency crises in Mexico in 1994 and in Thailand and Brazil in 1997-98 also suggest that preventing the pegged exchange rate from adjusting in time can prove very costly and deliver a hard blow to confidence. As is often said, "too much rigidity kills rigidity." When the pegged exchange rate is allowed to build real overvaluation, credibility and confidence are bound to erode; the discipline of maintaining the peg becomes increasingly costly, and eventually the adjustment happens in a free-for-all manner.
A first lesson is that credibility ultimately rests on the interaction of domestic policies with the commitment to peg. The commitment alone may inspire confidence in the first place, but it needs to be sustained by productivity gains that will prevent real overvaluation from taking place. The second-and central-lesson is that the notion of pegging itself needs careful scrutiny: rather than pegging to a single foreign currency, countries should peg to a relevant basket of currencies; rather than pegging the exchange rate itself, countries should in fact "peg a method" for adjusting the exchange rate in line with fundamentals.
A reference parity must be defined as a basket of currencies that reflects the structure of external trade; this should include at least dollars, euros, and yen.29 One of the factors that triggered the Asian crisis was the loss of competitiveness for countries that had pegged their currencies to the dollar between 1996 and 1997, a period during which the dollar dramatically appreciated against the yen. This reference parity should also be adjusted as a "crawling peg," and the gradual devaluation-or revaluation-should be known in advance. The goal would be to maintain the reference parity at sustainable medium- and long-term levels.30 Defining the exact terms for adjustment should be one of the key issues discussed at the annual IMF article IV examination. We shall return later to the general issue of the IMF's role with regard to exchange rate policies.
No Compromise with Inflation during Periods of Strong Economic Growth
The capacity to tighten up monetary conditions during economic overheating could be severely curtailed should stabilizing exchange rates become too rigid a priority. An incipient rise in interest rates is liable to lead to heavy capital inflows, which substantially limits the extent to which interest rates can rise, except for huge sterilized interventions in the foreign exchange market. In such a scenario, the appropriate response may be to let the currency appreciate against the reference parity. Should economic growth be too strong, a reference-parity-based exchange rate policy should not deter authorities from determining interest rates and keeping a lid on inflation. The optimal response in terms of currency appreciation will crucially depend on the economic context.
For example, if the risk of overheating is due to household consumption-the Mexican situation in the early 1990s-the best and most obvious response is a tighter fiscal policy that avoids both an increase in interest rates and an exchange rate appreciation. The latter would penalize the export sector even though it is not the source of the current difficulties and would contribute to an even greater increase in foreign debt.
In many cases, however, fiscal policies cannot be used to address the source of the imbalance, and an interest rate rise and exchange rate appreciation are preferable to letting inflation rise. Moreover, in this situation, targeted controls on capital inflows, such as the now-famous "Chilean tax," can make a useful contribution.
A Credible, Transparent, and Gradual Mechanism for Countering Downward Pressures
The exchange rate crises of the 1990s, in the developing nations as well as in the EMS, have clearly signaled the failure of rigid, automatic policies used to ward off speculation, especially when backed by the total dissipation of foreign exchange reserves and a massive increase in interest rates that could backfire into a recession. These policies are unconvincing, and they fail to restore confidence in currencies, for speculators doubt their effectiveness. They can even spell disaster when the measures fail (depletion of exchange reserves, loss of all monetary or even political credibility). It is thus very difficult to prevent an exchange rate adjustment from happening under a speculative attack.
This ineffective response, however, is not the only option to preserve exchange rate stability. The French exchange rate policy from the summer of 1993 to the spring of 1995 provides an interesting example of a sort of "elastic policy." When the fluctuation margins of the exchange rate mechanism of the EMS were widened on 2 August 1993, the French government decided, against market expectations, not to use the monetary policy autonomy thus restored to promote growth as a priority. Indirectly, through a series of "coded messages," monetary authorities informed the markets that French interest rates would be maintained significantly above German rates so long as the franc/deutsche mark parity did not return to the EMS central rate. The interest rate policy was thus aligned with that of Germany, maintaining a stable and reasonable risk premium that would encourage the purchase of francs. This elastic policy, terminated in the spring of 1995, was a remarkable success as far as the exchange rate was concerned, as it pulled the franc back to its pivotal level within the EMS as early as late 1993.31 It was successful because it responded to a "second-generation crisis": the market did not question the medium- or long-term sustainability of the franc-to-deutsche mark parity, but wondered whether French authorities could continue to foot the bill in the short term. The monetary policy stance that followed the widening in the fluctuation margins provided the kind of signal that markets were ready to heed, and was thus able to pull the franc back to its pivotal rate. The remarkable results of the European central banks' post-1993 approach to exchange rate management has been highlighted by Bartolini and Prati (1998). Their analysis "points to the usefulness of this policy for other countries that target their exchange rates."
Obviously there were many specific factors behind the success of the elastic policy in the French case. The economic fundamentals were much stronger than those in emerging countries, and the prospect of European monetary union substantially enhanced the credibility of the French commitment to stable exchange rates. Notwithstanding these differences, however, this example serves to illustrate some very general lessons on effectively preserving relative exchange rate stability under markets' fire.
First of all, when confronting downward exchange rate pressure, authorities should assess whether the parity that comes under attack is really sustainable. If it was managed correctly in the past-i.e., based on a basket of currencies that was sufficiently large and regularly adjusted-there is in principle no reason to question it. Any problem with sustainability, however, calls for timely readjustments.32 Parity readjustments should not be ruled out by definition, since the possibility of a readjustment gives the market a clear incentive to closely monitor the country's fundamental economic position and the compatibility of the current exchange rate with balanced economic growth in the medium to long term.
Second, a gradual, feedback-based defense mechanism should be used to defend a sustainable parity. What we described as the "elastic policy" consists in defending the reference parity in a flexible way (no hikes in interest rates at unbearable levels, protection of exchange rate reserves), by resorting to something like the French mechanism as soon as the exchange rate has clearly overshot its reference:33 interest rates can be pegged transparently to foreign rates, augmented with a significant and well-defined risk premium that takes into account the characteristics of the country concerned. This risk premium is maintained or increased so long as the currency has not regained its reference parity. If necessary, this defense mechanism can be backed by interventions on the exchange market.
In some ways, what we have just described is a refinement of a target zone framework for emerging countries as discussed by Williamson (1998). The main difficulty with traditional "crawling bands," however, is that, in general, monetary policy inside the band is not specified. One view is that monetary policy should be used for internal stabilization as long as the currency stays inside the band. This view is fraught with problems. Unless the fluctuation margin is very wide, margins for maneuver in monetary policy should not be overestimated. If monetary authorities in emerging-market countries want to use the entire fluctuation margin, without defending the central parity, market players are likely to react in advance, and exchange rates could bounce up or down against the margins before authorities are even willing or able to change interest rates. Indeed, most emerging-market countries using crawling bands try to stabilize their currency close to the central rate, and we have tried to provide some thoughts on the best way to do so in a credible but flexible manner.
The IMF and Emerging Countries' Exchange Rate Policies
Ensuring a smooth working of the international monetary system has been one of the key roles of the IMF from its creation. First of all, it should be a central source of expertise on the issue of exchange rate sustainability. As mentioned earlier, this requires a much more systematic dialogue with both academics and the private sector community. IMF expertise would be used in the context of the G-7 enhanced surveillance process and as a very important input in the annual article IV examination of individual countries.
Our central point here is that there cannot be an honest and open dialogue on these issues, either between governments and the IMF or between the official community at large and the private world, without introducing some flexibility in exchange rate arrangements. Flexibility and dialogue will come together. With rigid exchange rates, governments cannot afford any doubt in the market about their commitment to the current rate, and the IMF cannot afford to comment on sustainability. The recent crises demonstrate how costly this trap has been.
Crisis management involves a completely different set of issues (whether there is the need for an international lender of last resort, how to mitigate the risks of moral hazard, and so on). Although crisis management is not the subject of this paper, three key points on the topic need to be made that are related to our discussion.
First of all, as a rule, in times of crisis the IMF should not help a country to defend a fixed and rigid exchange rate. In general, countries should meet a number of conditions for eligibility to IMF money, including (1) reaching an agreement with the IMF on what is an appropriate level for the exchange rate in a medium-term perspective, and (2) agreeing to use a flexible response to defend the agreed-upon reference level. As with most rules, the latter could suffer a few exceptions, such as when a country is faced with hyperinflation, has lost all monetary credibility, and needs, at least temporarily, a very rigid external anchor. Moreover, low-income developing countries that have generally strong capital controls and are less vulnerable to speculative pressures are better positioned to defend strictly the agreed-upon parity. In any case, the Brazilian program of November 1998 should be the last one in which a country is allowed to use international money without a strong international constraint on its exchange rate policy.
Second, a by-product of more flexible exchange rate policies is that the international community must be much more resolute in avoiding exchange rate overshooting. A currency free fall generates risks of serious contagion and creates a vicious cycle (bankruptcy of indebted agents, and an even greater loss of confidence in the country experiencing the crisis). Here it makes sense to discuss the notion of a lender of last resort: the international community, through the IMF or the G-7, should be ready to engage a very large amount of money in order to avoid panics and free falls in the exchange rate market. Lending massively to defend a rigid exchange rate is more often than not a waste of time and money (such as in Brazil), while bringing some calm to disorderly markets could be a necessity.
Third, to minimize moral hazard, strong strings should be attached to IMF support. Conditionality has two dimensions. The traditional one concerns the future economic policy of the country in crisis. The IMF has considerable expertise on these issues: fiscal policies aimed at maintaining public sector solvency, controlling inflation, and maintaining interest rates at a level compatible with a reasonably stable exchange rate. But the current challenge is to define a new, ex ante conditionality: the degree of help should depend on the country's respect for different "codes of good conduct" in the phase leading up to the crisis. Of prime importance are questions related to exchange rate policy and banking supervision. These issues are central to any discussion of international architecture.
We started this paper with the sobering diagnosis that current international monetary arrangements fall short of anything that could be called satisfactory. The current system produces excessive volatility and prolonged misalignments between major currencies, as the recent record of the yen-dollar exchange rate has amply illustrated. There are also reasons to fear high volatility and overshooting in the euro-dollar exchange rate. But developing countries have borne the brunt of the defects in the current system: inadequate policies have interacted with inefficient markets and produced the most serious financial debacle of the postwar period.
Three important messages emerge from our discussion. First, no system can substitute for economic policy credibility, in industrial and in developing countries alike. In the former, economic policy credibility is a prerequisite for any degree of exchange rate stability. In the developing countries, however, there is a potential dynamic interaction between the exchange rate regime and the gradual building of credibility, and we believe that some degree of nominal anchoring of the exchange rate, properly managed, can bring major benefits.
Second, the efficiency of foreign exchange markets can certainly be improved. As Krugman (1989) put it, "foreign exchange markets behave more like the unstable and irrational asset markets described by Keynes than the efficient markets described by the modern finance theory." Even if economic policies are stable and credible, basic valuation principles are too often ignored, and no consistent attempt at "placing" the proper level of exchange rate is ever undertaken on the markets. This is why monetary authorities have an important role to play in providing markets with more incentives both to search for the level of long-term equilibrium exchange rates, and to analyze correctly the cyclical conditions that may justify a discrepancy between long-term equilibrium rates and current rates.
Third, whatever the efforts made to strengthen credibility and market efficiency, economic policy divergences are likely to play havoc with exchange rate stability. Any consideration of reform of the international monetary system sooner or later has to address the coordination problem. In this paper we have refrained from discussing specific coordination rules because we believe, first, that major improvements can be made without them, and, second, that the time is not ripe politically for a discussion of the coordination of monetary and fiscal policies among G-3 countries. More limited progress cannot be ruled out, however, and this issue deserves further critical analysis.
We make two specific proposals in this paper. We argue that G-3 countries should adopt an enhanced surveillance mechanism, through which they would extensively monitor their own exchange rates. Such monitoring would be based on two central components: (1) estimates of real long-term equilibrium exchange rates, produced by the IMF and tested through regular interaction with outside analysts and markets; and (2) discussion of the reasons for potential divergences between current rates and the equilibrium rates thus defined-taking into account real interest rate differentials, potential risk premiums, and cyclical conditions. We believe that this would considerably help to anchor market expectations and to generate incentives for private investors to question exchange rate valuation on a much sounder basis.
We also advise that this first, albeit crucial, step in international monetary cooperation be coupled with a move toward quiet target zones. We see such an initial step as a realistic mechanism of managing exchange rate flexibility. As we argued above, however, we are strongly opposed to any attempt to limit normal exchange rate flexibility artificially.
With respect to emerging markets, we have developed a proposal based on a system of "adjustable reference parities." This is not, in our view, a one-size-fits-all solution, but for some countries, such as Brazil at the time of writing, it may be considered an attractive compromise between a currency board and a free float. It involves: (1) the definition of a reference parity against a basket of currencies that reflects the structure of external trade, at a level deemed sustainable in the medium to long term, and that would crawl regularly in order to maintain long-term sustainability; (2) an asymmetric policy adjustment process, through which monetary policy favors currency appreciation (relative to the reference parity) against inflation and monetary tightening against depreciation; and (3) surveillance on the part of the an IMF and international community ready to counteract any exchange rate overshooting that might happen despite the "good" behavior of the country in terms of items 1 and 2. This would lead to a type of ex ante conditionality through which, in exchange for respecting codes of good conduct, a country can count on forthcoming international help if needed.
We believe that these are reasonable, concrete, and feasible steps. They do not constitute sweeping reform of the international monetary system, but they do offer the prospect of a much more stable, and therefore more prosperous and successful, world economy. In the wake of the repeated currency crises of the 1990s, which began in Europe and continued through Mexico to the dollar-yen and then into other parts of Asia and subsequently throughout the world, they represent minimum initial steps to reduce the risks of similar-and perhaps even more severe-disruptions in the future. We urge their adoption as soon as possible.
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2. According to the official IMF classification, among 123 developing countries, only 45 were pegging their currency at the end of 1996. This figure is misleading, however, since many countries report having a policy of floating while the exchange rate is effectively set by the authorities (IMF 1997).
4. In the first half of 1999, however, interest rates fell and the cost of capital generally came down from extreme levels, as most countries, from Asia to Latin America, were successful in restoring some currency stability after a period of free float.
9. The first exposition is in Mundell (1968). For a full discussion and extensions, see Aglietta (1997). Krugman (1998) discusses a variant: the dilemma of the "eternal triangle" between adjustment, confidence, and liquidity.
12. See Dominguez (1990), Catte, Galli, and Rebecchini (1994), and Dominguez and Frankel (1993). The latter offers some convincing evidence on the efficiency of most past coordinated interventions. It also clearly describes the various channels by which sterilized interventions can play a role: signaling on future monetary policy shifts, portfolio effect if foreign and domestic bonds are imperfect substitutes for each other from an investor perspective, bursting of a speculative bubble.
13. Over the past 15 years, interventions were deployed only when governments reached the conclusion that the market did not fully reflect the underlying economic fundamentals. Interventions would have proved much less efficient if they had been used without due consideration of the conditions prevailing in the market. Indeed, the Jurgensen Report (1983), submitted by the Working Group on Exchange Market Intervention to the G-7 summit at Williamsburg in 1983, concluded that the effects of sterilized interventions could at most be minor and transitory-because at that time the working group members probably were influenced by their experience with badly devised interventions.
14. For surveys of the literature on international economic policy coordination, see, among others, Cooper (1985) and Horne and Masson (1988). For a history of coordination in the 1980s, see Funabashi (1988) and Dobson (1991). There is a debate on the size of gains to be expected from coordination, however, which available studies suggest are rather small; see Oudiz and Sachs (1984) and Bryant et al. (1988).
16. The central open-economy national accounting identity states that net savings equals the current account balance. This can also be seen from the balance of payments identity that the current account equals net capital flows, that is, the net acquisition of foreign assets, identically equivalent to net national savings.
17. For example, fundamental equilibrium exchange rate (FEER) estimates of the euro/dollar rate generally put the long-term equilibrium between 1.20 and 1.30 dollars per euro, while the OECD puts the PPP rate at 1.06 (1998 figures).
19. See notably Baxter (1994), Coe and Golub (1986), Davanne (1990), and Sachs (1985). Meese and Rogoff (1988) found no strong link, but in their analysis real rates were calculated on the basis of the inflation rate of the previous three months (annualized), which introduced a lot of "noise" in the data.
23. An indirect way is to use expectations surveys in order to obtain insights into investors' asset allocations and the level of risk premium, that is, the expected excess return over short-term bills. Davanne (1998) has urged an improvement in the reliability and regularity of such surveys.
24. Nor is the academic literature particularly clear on what models should be used. Meese and Rogoff (1983 and 1988) maintained that exchange rates do not obey stable economic logic and follow a random walk. These papers are still quite influential, despite the fact that the authors did not correctly test for the existence of a link between real long-term interest rates and exchange rates (see previous note).
27. In general, valuation models assume that risk premiums are related to the square of volatility: multiply volatility by 2, and the risk premium should increase fourfold. Hence in situations of high volatility the risk premium can reach extreme levels.
29. We can also imagine that the IMF might build representative indexes on currencies of emerging nations that could be taken into account in the reference baskets along with the dollar, the euro, and the yen.
30. This type of crawling adjustment policy does not broaden the margins for maneuver for monetary policy. Planning a future exchange rate devaluation cannot be an effective response when faced with an economic slowdown. The favorable effect on competitiveness is deferred, while interest rates should progress initially so as to convince investors to keep a given currency despite a depreciating trend. In a first stage, monetary conditions are tightened. The export sector, however, can react favorably by anticipating the positive impact of the coming depreciation.
31. Of course, this does not address the question of whether the priority thus given to the exchange rate was appropriate in the first place, in a context—that of the summer 1993—marked by hesitant growth and rising unemployment.
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