ECONOMIC

ISSUES

38

Moving to a Flexible Exchange Rate

How, When, and How Fa t!

R"#a $"ttag"#ta, %ilda Fe&nande', and Ce( )a&acadag

IN*ERN+*ION+,

MONE*+R-

FUN$

*he IMF la"nched the Econo(ic I "e e&ie in .//0 to (a1e the IMF ta223 &e ea&ch 2inding acce ible to the #"blic4 Econo(ic I "e a&e ho&t, nontechnical (onog&a#h on to#ical i "e w&itten 2o& the non #eciali t &eade&4 *he5 a&e #"bli hed in ix lang"age 6 Engli h, +&abic, Chine e, F&ench, R" ian, and S#ani h4 Econo(ic I "e &e2lect the o#inion o2 thei& a"tho& , which a&e not nece a&7 il5 tho e o2 the IMF3 Exec"tive 8oa&d o& (anage(ent4

ECONOMIC

ISSUES

38

Moving to a Flexible Exchange Rate

How, When, and How Fa t!

R"#a $"ttag"#ta, %ilda Fe&nande', and Ce( )a&acadag

IN*ERN+*ION+,

MONE*+R-

FUN$

9:;;< Inte&national Moneta&5 F"nd

Se&ie edito& + i(ina Ca(ini IMF Exte&nal Relation $e#a&t(ent Cove& de ign and co(#o ition Ma o"d Ete(adi and Choon ,ee IMF M"lti(edia Se&vice $ivi ion

IS8N .7<8/;07=>073 ISSN .;:;7<;/8 ?"bli hed $ece(be& :;;<

*o o&de& IMF #"blication , #lea e contact Inte&national Moneta&5 F"nd, ?"blication Se&vice >;; ./th St&eet, N4W4, Wa hington, $4C4 :;=3., U4S4+4 *el@ A:;:B 0:37>=3;Fax@ A:;:B 0:37>:;. E7(ail@ #"blication Ci(24o&g Inte&net@ htt#@DDwww4i(24o&gD#"b

ii

?&e2ace
+ 2ixed exchange &ate, which #eg the val"e o2 a c"&&enc5 to a t&ong 2o&eign c"&&enc5 li1e the dolla& o& the e"&o, ha (an5 advan7 tage , #a&tic"la&l5 2o& develo#ing co"nt&ie ee1ing to b"ild con2i7 dence in thei& econo(ic #olicie 4 +nd "ch #eg have been a oci7 ated with lowe& in2lation &ate 4 Howeve&, co"nt&ie with 2ixed exchange &ate ee( to be (o&e v"lne&able to c"&&enc5 c&i e , a well a to twin c"&&enc5 and ban1ing c&i e , than tho e with (o&e 2lexible &egi(e 4 Indeed, a econo(ie (at"&e and beco(e (o&e clo el5 tied with inte&national 2inancial (a&1et , the bene2it o2 exchange &ate 2lexibilit5 a##ea& to inc&ea e4 +ltho"gh (an5 co"nt&ie till have 2ixed o& othe& 2o&( o2 #egged exchange &ate &egi(e , a g&owing n"(be&6incl"ding 8&a'il, Chile, I &ael, and ?oland6have ado#ted (o&e 2lexible &egi(e ove& the #a t decade4 *he t&end towa&d g&eate& exchange &ate 2lexibilit5 i li1el5 to contin"e a dee#ening c&o 7bo&de& lin1age inc&ea e the ex#o "&e o2 co"nt&ie with #egged &egi(e to volatile ca#ital 2low beca" e 2lexible &egi(e o22e& bette& #&otection again t exte&nal hoc1 a well a g&eate& (oneta&5 #olic5 inde#endence4 Rega&dle o2 whethe& 2lexible exchange &ate &egi(e a&e ado#ted "nde& t&e o& "nde& o&de&l5 condition , thei& "cce de#end on the e22ective (anage(ent o2 a n"(be& o2 in tit"tional and o#e&a7 tional i "e 4 *he e i "e a&e "((a&i'ed in thi Econo(ic I "e, which wa #&e#a&ed b5 $avid Chene5, ba ed on IMF Wo&1ing ?a#e& ;=D.:0, EF&o( Fixed to Float@ O#e&ational + #ect o2 Moving *owa&d Exchange Rate Flexibilit5,F b5 R"#a $"ttag"#ta, %ilda Fe&nande', and Ce( )a&acadag4 *he wo&1ing #a#e& i available 2&ee o2 cha&ge on the IMF3 web ite, at www4i(24o&gDexte&nalD#"b D2tD w#D:;;=Dw#;=.:04#d24 + "b eG"ent #a#e& b5 the a(e title "b7 (itted b5 the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent to the IMF3 Exec"tive 8oa&d in Nove(be& :;;= i al o available

iii

Econo(ic I "e No4 38

on the IMF3 web ite, at www4i(24o&gDexte&nalDn#D(2dD:;;=DengD .../;=4#d24 *wo ea&lie& Econo(ic I "e on exchange &ate 6Econo(ic I "e No4 :, $oe the Exchange Rate Regi(e Matte& 2o& In2lation and %&owth! b5 +ti h R4 %ho h, +nne7Ma&ie %"lde, Honathan $4 O t&5, and Holge& C4 Wol2 A.//0B, and Econo(ic I "e No4 .3, Fixed o& Flexible! %etting the Exchange Rate Right in the .//; , b5 F&ance co Ca&a(a''a and Hahangi& +'i' A.//8B6a&e available 2&ee o2 cha&ge at www4i(24o&gD#"b 4

iv

Moving to a Flexible Exchange Rate

How, When, and How Fa t!

o(e co"nt&ie have (ade the t&an ition 2&o( 2ixed to 2lexible exchange &ate g&ad"all5 and (oothl5, b5 ado#ting inte&(ediate t5#e o2 exchange &ate &egi(e 6 o2t #eg , ho&i'ontal and c&awling band , and (anaged 2loat 6be2o&e allowing the c"&&enc5 to 2loat 2&eel54 ASee 8ox . 2o& a li t o2 exchange &ate &egi(e 4B Othe& t&an i7 tion have been di o&de&l56that i , cha&acte&i'ed b5 a ha&# de#&e7 ciation o2 the c"&&enc54 + la&ge ha&e o2 the exit to 2lexible exchange &ate &egi(e d"&ing .//;I:;;: we&e di o&de&l5 A8ox :B4 8"t whethe& an exit 2&o( a 2ixed &ate i o&de&l5 o& not, it i alwa5 co(#licated4 What condition a&e nece a&562&o( an o#e&ational #e& #ective6 2o& a "cce 2"l hi2t 2&o( a 2ixed exchange &ate to one that i dete&7 (ined, at lea t in #a&t, b5 (a&1et 2o&ce ! How 2a t ho"ld the t&an7 ition be! +nd in what eG"ence ho"ld the #olicie needed 2o& 2lexibilit5 be #"t in #lace! Co"nt&5 ex#e&ience indicate that 2o"& ing&edient a&e gene&all5 needed 2o& a "cce 2"l t&an ition to exchange &ate 2lexibilit5@ J a dee# and liG"id 2o&eign exchange (a&1etK J a cohe&ent #olic5 gove&ning cent&al ban1 inte&vention in the 2o&eign exchange (a&1et Athe #&actice o2 b"5ing o& elling the local c"&&enc5 to in2l"ence it #&ice, o& exchange &ateBK J an a##&o#&iate alte&native no(inal ancho& to &e#lace the 2ixed exchange &ateK and J e22ective 5 te( 2o& &eviewing and (anaging the ex#o "&e o2 both the #"blic and the #&ivate ecto& to exchange &ate &i 14 *he ti(ing and #&io&it5 acco&ded to each o2 the e a&ea nat"&all5 va&5 2&o( co"nt&5 to co"nt&5 de#ending on initial condition and econo(ic t&"ct"&e4

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Econo(ic I "e No4 38

8ox .4 *5#e o2 exchange &ate &egi(e

Exchange a&&ange(ent with no e#a&ate legal tende& *he c"&&enc5 o2 anothe& co"nt&5 ci&c"late a the ole legal tende& A2o&(al dolla&i'ationB, o& the (e(be& belong to a (oneta&5 o& c"&&enc5 "nion in which the a(e legal tende& i ha&ed b5 the (e(be& o2 the "nion4 +do#ting "ch &egi(e i(#lie the co(#lete "&&ende& o2 the (oneta&5 a"tho&itie 3 inde#endent cont&ol ove& do(e tic (oneta&5 #olic54

C"&&enc5 boa&d + (oneta&5 &egi(e ba ed on an ex#licit legi lative co((it(ent to exchange do(e tic c"&&enc5 2o& a #eci2ied 2o&eign c"&&enc5 at a 2ixed exchange &ate, co(bined with &e t&iction on the i "ing a"tho&it5 to en "&e the 2"l2ill(ent o2 it legal obligation4 *hi i(#lie that do(e tic c"&&enc5 will be i "ed onl5 again t 2o&eign exchange and that it &e(ain 2"ll5 bac1ed b5 2o&eign a et , eli(inating t&aditional cent&al ban1 2"nc7 tion , "ch a (oneta&5 cont&ol and lende& o2 la t &e o&t, and leaving lit7 tle co#e 2o& di c&etiona&5 (oneta&5 #olic54 So(e 2lexibilit5 (a5 till be a22o&ded, de#ending on how t&ict the ban1ing &"le o2 the c"&&enc5 boa&d a&&ange(ent a&e4

Othe& conventional 2ixed7#eg a&&ange(ent *he co"nt&5 A2o&(all5 o& de 2actoB #eg it c"&&enc5 at a 2ixed &ate to anothe& c"&&enc5 o& a ba 1et o2 the c"&&encie o2 (aMo& t&ading o& 2inan7 cial #a&tne& , weighted to &e2lect the geog&a#hical di t&ib"tion o2 t&ade, e&vice , o& ca#ital 2low 4 *he #a&it5 i not i&&evocable4 *he exchange &ate (a5 2l"ct"ate within na&&ow (a&gin o2 le than N. #e&cent a&o"nd a cent&al &ate, o& the (axi("( and (ini("( val"e o2 the exchange &ate (a5 &e(ain within a na&&ow (a&gin o2 : #e&cent 2o& at lea t th&ee (onth 4 *he (oneta&5 a"tho&it5 tand &ead5 to (aintain the 2ixed #a&7

$evelo#ing the 2o&eign exchange (a&1et

O#e&ating a 2lexible exchange &ate &egi(e &eG"i&e a 2o&eign exchange (a&1et that i liG"id and e22icient eno"gh to allow the exchange &ate to &e #ond to (a&1et 2o&ce and that li(it both the n"(be& and the d"&ation o2 e#i ode o2 exce ive volatilit5 and

Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

it5 th&o"gh di&ect inte&vention A aleD#"&cha e o2 2o&eign exchange in the (a&1etB o& indi&ect inte&vention Aagg&e ive " e o2 inte&e t &ate #olic5, i(#o ition o2 2o&eign exchange &eg"lation , (o&al "a ion, o& inte&ven7 tion b5 othe& #"blic in tit"tion B4 Inde#endence o2 (oneta&5 #olic5, tho"gh li(ited, i g&eate& than "nde& exchange a&&ange(ent with no e#a&ate legal tende& and c"&&enc5 boa&d beca" e t&aditional cent&al ban1ing 2"nction a&e till #o ible, and the (oneta&5 a"tho&it5 can adM" t the level o2 the exchange &ate, altho"gh &elativel5 in2&eG"entl54

?egged exchange &ate within ho&i'ontal band *he val"e o2 the c"&&enc5 i (aintained within ce&tain (a&gin o2 2l"c7 t"ation o2 at lea t N. #e&cent a&o"nd a 2ixed cent&al &ate, o& the (a&gin between the (axi("( and (ini("( val"e o2 the exchange &ate exceed : #e&cent4 *he exchange &ate (echani ( AERMB o2 the E"&o#ean Moneta&5 S5 te( AEMSB, which wa &e#laced with ERM II on Han"a&5 ., .///, i an exa(#le o2 thi t5#e o2 #eg4 *he&e i a li(ited deg&ee o2 (oneta&5 #olic5 di c&etion, de#ending on the band3 width4

C&awling #eg *he c"&&enc5 i adM" ted #e&iodicall5 in (all a(o"nt at a 2ixed &ate o& in &e #on e to change in elective G"antitative indicato& , "ch a #a t in2lation di22e&ential vi 7O7vi (aMo& t&ading #a&tne& , di22e&ential between the in2lation ta&get and ex#ected in2lation in (aMo& t&ading #a&tne& , and o 2o&th4 *he &ate o2 c&awl can be et to gene&ate in2lation7 adM" ted change in the exchange &ate Abac1wa&d loo1ingB, o& it can be et at a #&eanno"nced 2ixed &ate andDo& below the #&oMected in2lation di22e&ential A2o&wa&d loo1ingB4 + c&awling #eg i(#o e the a(e 1ind o2 con t&aint on (oneta&5 #olic5 a a 2ixed #eg4

Acontin"ed on next #ageB

deviation 2&o( the eG"ilib&i"( exchange &ate Athe &ate that i in line with a co"nt&53 econo(ic 2"nda(ental B o that E#&ice di cove&5F can occ"&4 In gene&al, the 2o&eign exchange (a&1et con i t o2 a whole ale inte&ban1 (a&1et whe&e a"tho&i'ed deale& A" "all5 ban1 and othe&

Econo(ic I "e No4 38

8ox .4 *5#e o2 exchange &ate &egi(e Aconcl"dedB

Exchange &ate within c&awling band *he c"&&enc5 i (aintained within 2l"ct"ation (a&gin o2 at lea t N. #e&cent a&o"nd a cent&al &ate, o& the (a&gin between the (axi7 ("( and (ini("( val"e o2 the exchange &ate exceed : #e&cent, and the cent&al &ate o& (a&gin a&e adM" ted #e&iodicall5 at a 2ixed &ate o& in &e #on e to change in elective G"antitative indicato& 4 *he deg&ee o2 exchange &ate 2lexibilit5 i a 2"nction o2 the width o2 the band4 8and a&e eithe& 5((et&ic a&o"nd a c&awling cent&al #a&7 it5 o& widen g&ad"all5 with an a 5((et&ic choice o2 the c&awl o2 "##e& and lowe& band Ain the latte& ca e, the&e (a5 be no #&ean7 no"nced cent&al &ateB4 *he co((it(ent to (aintaining the exchange &ate within the band i(#o e con t&aint on (oneta&5 #olic5, with the deg&ee o2 #olic5 inde#endence being a 2"nction o2 the band width4

Managed 2loating *he (oneta&5 a"tho&it5 atte(#t to in2l"ence the exchange &ate witho"t having a #&edete&(ined #ath o& ta&get 2o& it4 Indicato& 2o& (anaging the &ate incl"de the balance o2 #a5(ent #o ition, the level o2 inte&national &e e&ve , and #a&allel (a&1et develo#(ent , and adM" t(ent (a5 not be a"to(atic4 Inte&vention (a5 be di&ect o& indi&ect4

Inde#endent 2loating *he exchange &ate i dete&(ined b5 the (a&1et 4 O22icial inte&vention in the 2o&eign exchange (a&1et i in2&eG"ent and di c&etiona&5 and i " "all5 ai(ed at (ode&ating the &ate o2 change o2, and #&eventing "nd"e 2l"ct"ation in, the exchange &ate, &athe& than at e tabli hing a level 2o& it4

2inancial in tit"tion B t&ade with each othe& and a &etail (a&1et whe&e a"tho&i'ed deale& t&an act with 2inal c" to(e& li1e ho" e7 hold and 2i&( 4 + liG"id (a&1et i one with &elativel5 na&&ow bid7 o22e& #&ead K low t&an action co t K eno"gh t"&nove& to li(it the i(#act o2 individ"al t&ade on #&ice K t&ading, clea&ing, and ettle7

Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

8ox :4 O&de&l5 ve& " di o&de&l5 exit to 2lexible &ate

Exit to 2lexible &egi(e 2all into th&ee catego&ie @ exit 2&o( all ha&d #eg and 2ixed and c&awling #eg to band and 2loat K exit 2&o( band to 2loat K and exit 2&o( (anaged 2loat to inde#endent 2loat 4 + total o2 .3/ exit to 2lexible &egi(e a&e identi2ied in the 2ig"&e below4 Exit a&e incl"ded onl5 2o& &egi(e that la ted at lea t one 5ea& o& i2 the co"nt&5 contin"ed to inc&ea e it exchange &ate 2lexibilit5 d"&ing the 5ea& o2 the exit4

Fig"&e .4 N"(be& and t5#e o2 exit , .//;I:;;:

.: .; N"(be& 8 o2 exit 0 = : ; .//; /: /= /0 /8 :;;; ;:

C&i i 7d&iven exit

O&de&l5 exit

Fig"&e :4 Exit b5 exchange &ate &egi(e, .//;I:;;:

.0; .=; .:; N"(be& o2 exit.;; 8; 0; =; :; ; *otal F&o( ha&d, 2ixed, and c&awling #eg F&o( ho&i'ontal and c&awling band F&o( (anaged 2loat

C&i i 7d&iven exit O&de&l5 exit

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Econo(ic I "e No4 38

(ent 5 te( that 2acilitate the wi2t exec"tion o2 o&de& K and a wide &ange o2 active (a&1et #a&tici#ant 4 *he 2o&eign exchange (a&1et o2 (an5 develo#ing co"nt&ie a&e hallow and ine22icient, howeve&, in #a&t beca" e o2 exten ive 2o&eign exchange &eg"lation 6 "ch a cont&ol on c&o 7bo&de& ca#ital 2low Athe e cont&ol &ed"ce (a&1et t"&nove&B, tight #&"7 dential li(it on net o#en 2o&eign exchange #o ition , and &eG"i&e7 (ent to "&&ende& 2o&eign exchange &ecei#t to the cent&al ban14 Inte&ban1 2o&eign exchange (a&1et 6whe&e the5 exi t6a&e o2ten (all &elative to &etail (a&1et , li(iting the co#e 2o& #&ice di cove&54 Exchange &ate &igidit5 it el2 (a5 be a 2acto& in 2o&eign exchange (a&1et illiG"idit54 + cent&al ban1 o#e&ating a 2ixed exchange &ate &egi(e i " "all5 active in the (a&1et b5 nece it5, which 1ee# (a&1et #a&tici#ant 2&o( gaining ex#e&ience in #&ice 2o&(ation and exchange &ate &i 1 (anage(ent and con t&ain inte&ban1 activit54 In ext&e(e ca e , the cent&al ban1 (a5 do(inate the inte&7 ban1 2o&eign exchange (a&1et and act a the #&i(a&5 2o&eign exchange inte&(edia&54 With a 2ixed exchange &ate, (a&1et #a&tici7 #ant have le incentive to 2o&( view on exchange &ate t&end , ta1e #o ition , o& t&ade 2o&eign exchange, which li(it 2o&eign exchange activit5 in both the #ot and the 2o&wa&d (a&1et 4 In addi7 tion, to &ed"ce the co#e 2o& #ec"lation, 2o&wa&d (a&1et activit5 tend to be di co"&aged "nde& #egged exchange &ate &egi(e 4 *he (all i'e o2 the 2o&wa&d (a&1et , in t"&n, li(it o##o&t"nitie 2o& hedging &i 1 4 *he 2ollowing te# can hel# a co"nt&5 i(#&ove the de#th and e22icienc5 o2 it 2o&eign exchange (a&1et@ J +llowing o(e exchange &ate 2lexibilit5 A2o& exa(#le, within a band a&o"nd a #egB to ti("late 2o&eign exchange activit54 +"tho&itie ho"ld al o 2o te& a en e o2 two7wa5 &i 1 in the exchange &ate6the &i 1 that the c"&&enc5 (a5 eithe& a##&eci7 ate o& de#&eciate6to enco"&age (a&1et #a&tici#ant to ta1e both ho&t and long #o ition 4 8etween .//< and :;;., t"&nove& inc&ea ed in the 2o&eign exchange (a&1et o2 co"n7 t&ie that ado#ted (o&e 2lexible exchange &ate &egi(e and declined in co"nt&ie that ado#ted le 2lexible &egi(e 4

Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

J Red"cing the cent&al ban13 (a&1et7(a1ing &ole b5 c"tting bac1 it t&ade with ban1 and it inte&vention to allow co#e 2o& othe& (a&1et (a1e& 4 *he cent&al ban1 ho"ld not t&ade with non2inancial c" to(e& 4 J Inc&ea ing (a&1et in2o&(ation on the o"&ce and " e o2 2o&7 eign exchange and on balance o2 #a5(ent t&end to enable (a&1et #a&tici#ant to develo# c&edible view on exchange &ate and (oneta&5 #olic5 and #&ice 2o&eign exchange e22icientl54 +"tho&itie ho"ld al o en "&e that in2o&(ation 5 te( and t&ading #lat2o&( #&ovide &eal7ti(e bid and o22e& G"otation in the inte&ban1 (a&1et4 J ?ha ing o"t o& eli(inating &eg"lation that ti2le (a&1et activ7 it54 I(#o&tant (ea "&e wo"ld incl"de aboli hing &eG"i&e(ent to "&&ende& 2o&eign exchange &ecei#t to the cent&al ban1, taxe and "&cha&ge on 2o&eign exchange t&an action , and &e t&iction on inte&ban1 t&adingK "ni25ing eg(ented 2o&eign exchange (a&1et K and &elaxing c"&&ent and o(e ca#ital acco"nt &e t&iction to inc&ea e the o"&ce and " e o2 2o&eign exchange in the (a&1et4 Ca#ital cont&ol ho"ld be ea ed g&ad7 "all5, howeve&, and onl5 a2te& ce&tain (ac&oecono(ic and in tit"tional #&econdition have been (et4 J Uni25ing and i(#li25ing 2o&eign exchange legi lation and avoiding 2&eG"ent, ad hoc change to the law, o a to inc&ea e (a&1et t&an #a&enc5 and &ed"ce t&an action co t 4 J I(#&oving the (a&1et3 (ic&o t&"ct"&e b5 &ed"cing (a&1et eg(entation, inc&ea ing the e22ectivene o2 (a&1et inte&7 (edia&ie , and ec"&ing &eliable and e22icient ettle(ent 5 te( 4 $evelo#ing and dee#ening the 2o&eign exchange (a&1et i (o&e co(#licated when a co"nt&5 i 2o&ced to abandon a #eg "nde& (a&1et #&e "&e and ha not had ti(e to #&e#a&e 2o& an o&de&l5 exit4 *he gove&n(ent i li1el5 to 2ace con2licting obMective 4 On the one hand, it need to ell 2o&eign exchange to #&event exce ive de#&e7 ciation4 On the othe&, to (aintain (a&1et c&edibilit5 it need to ig7 nal that it will not inte&vene to de2end a #a&tic"la& exchange &ate level4 Unde& the e ci&c"( tance , (an5 co"nt&ie have g&ad"all5 &eno"nced the cent&al ban13 (a&1et7(a1ing &ole, &e(oved ba&&ie&

>

Econo(ic I "e No4 38

to 2o&eign exchange (a&1et o#e&ation , and tole&ated g&eate& exchange &ate volatilit5, while allowing inte&e t &ate to &i e to co"nte& (a&1et #&e "&e and (onito&ing (a&1et t&an action to dete&(ine the o"&ce and di&ection o2 o&de& 2low 4

LLL
Cent&al ban1 inte&vention
Unde& c"&&enc5 #eg , o22icial #"&cha e and ale o2 2o&eign c"&7 &enc5 to b&idge the ga# between 2o&eign c"&&enc5 "##l5 and de(and at a given #&ice a&e o2ten &"le 7ba ed in that the ti(ing and a(o"nt o2 inte&vention a&e #&edete&(ined4 In cont&a t, o22icial inte&7 vention in the 2o&eign exchange (a&1et i o#tional, o& di c&etiona&5, "nde& a 2lexible exchange &ate &egi(e, altho"gh a"tho&itie till can and do inte&vene, " "all5 to co&&ect (i align(ent , cal( di o&de&l5 (a&1et , "##l5 2o&eign exchange, and acc"("late &e e&ve 4 *h" , a gove&n(ent that i hi2ting to a 2lexible &egi(e need to 2o&("late #olicie on the obMective , ti(ing, and a(o"nt o2 inte&vention4 ,i1e all othe& (a&1et , 2o&eign exchange (a&1et a&e i(#e&2ect4 Fo& exa(#le, Ehe&dingF Awhen inve to& b"5 o& ell en (a eB and E2eedbac1 t&adingF At&ading d&iven b5 #&ice (ove(ent &athe& than 2"nda(ental B (a5 &e "lt in the (i align(ent o2 a c"&&enc5 with a co"nt&53 econo(ic 2"nda(ental , with e&io" &e#e&c" ion 4 +(ong othe& thing , an ove&val"ed c"&&enc5 "nde&(ine the co(7 #etitivene o2 the co"nt&53 ex#o&t , while an "nde&val"ed exchange &ate co"ld to1e in2lation4 Mo&eove&, when a co"nt&53 ca#ital acco"nt i not 2"ll5 libe&ali'ed, o& it ca#ital (a&1et i ine22i7 cient, te(#o&a&5 hoc1 (a5 t&igge& exchange &ate volatilit5 in EthinF (a&1et 4 Polatilit5 can be #oliticall5 co tl5 beca" e the exchange &ate e&ve a a 5(bolic (ea "&e o2 a gove&n(ent3 "cce in (ac&oecono(ic (anage(ent4 +nd long7la ting (i align(ent and e&&atic exchange &ate (ove(ent can "bMect co t and inco(e #&o7 Mection in the &eal ecto& to wide (a&gin o2 e&&o&, (a1ing long7te&( #lanning and inve t(ent di22ic"lt4 Howeve&, (i align(ent a&e di22ic"lt to detect, and the&e i no con en " on a (ethodolog5 2o& e ti(ating the eG"ilib&i"(

Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

exchange &ate4 *he indicato& " ed (o t 2&eG"entl56the no(inal and &eal e22ective exchange &ate , #&od"ctivit5 and othe& co(#eti7 tivene (ea "&e , the te&( o2 t&ade, the balance o2 #a5(ent , inte&e t &ate di22e&ential , and #a&allel (a&1et exchange &ate 6 " "all5 do not enable #olic5(a1e& to a e the deg&ee o2 (i 7 align(ent acc"&atel5 eno"gh to hel# the( dete&(ine the o#ti(al ti(ing and a(o"nt o2 inte&vention4 +nd even when #olic5(a1e& detect exchange &ate (i align(ent o& de tabili'ing volatilit5, cent&al ban1 inte&vention (a5 not alwa5 co&&ect the #&oble(4 *he e(#i&ical evidence on the e22ectivene o2 inte&vention in in2l"encing the exchange &ate i (ixed, and the i(#act o2 inte&vention on the exchange &ate level a##ea& to be ho&t7lived4 E(#i&ical t"die have al o 2o"nd that inte&vention tend to inc&ea e, &athe& than dec&ea e, exchange &ate volatilit54 *h" , ho&t7te&( exchange &ate volatilit5 (a5 not wa&&ant inte&vention, e #eciall5 when it occ"& in a liG"id, o& o&de&l5, (a&1et4 Polatilit5 (a5 &e2lect the (a&1et #&oce o2 #&ice di cove&5 and #&ovide " e7 2"l ignal to #olic5(a1e& and (a&1et #a&tici#ant 4 Cent&al ban1 inte&vention i " "all5 M" ti2ied, howeve&, to cal( di o&de&l5 (a&1et 6that i , (a&1et with "neG"al n"(be& o2 ell7 e& and b"5e& o2 2o&eign exchange, &e "lting in illiG"idit54 I2 (a&1et illiG"idit5 #e& i t , it can h"&t the &eal econo(54 +ltho"gh volatilit5 that i d"e to di o&de&l5 (a&1et and that i li1el5 to lead to a col7 la# e o2 liG"idit5 i al o di22ic"lt to detect, accele&ation in exchange &ate change , widening bid7o22e& #&ead , and a ha&# inc&ea e in inte&ban1 t&ade &elative to c" to(e&7ban1 t"&nove& a&e ign to watch 2o&4 Cent&al ban1 (a5 al o have to inte&vene in the 2o&eign exchange (a&1et to "##l5 2o&eign c"&&enc5 o& b"ild "# thei& &e e&ve 4 Fi& t, (an5 cent&al ban1 have a &eg"la& "##l5 o2 2o&eign c"&&enc5 beca" e o2 inco(e on 2o&eign &e e&ve and thei& &ole a the ban1e& o2 gove&n(ent that bo&&ow o& &eceive aid in 2o&eign c"&&enc54 Second, the5 no&(all5 ta&get a ce&tain level o2 &e e&ve , &eG"i&ing the &eg"la& #"&cha e o2 2o&eign c"&&enc5 to (aintain co&e &e e&ve cov7 e&age &atio 4 + co"nt&5 (a5 need to &eeval"ate it inte&national7&e e&ve7 (anage(ent #olic5 when it (ove to a 2lexible exchange &ate

Econo(ic I "e No4 38

&egi(e4 On the one hand, the level o2 &e e&ve &eG"i&ed to (aintain a 2lexible &ate (a5 be lowe& than that &eG"i&ed to (aintain a 2ixed one4 In addition, i(#&oved "#e&vi ion o2 #&ivate ecto& 2o&eign c"&7 &enc5 ex#o "&e (a5 &ed"ce &e e&ve &eG"i&e(ent 4 On the othe& hand, the eli(ination o2 ca#ital cont&ol (a5 c&eate a need 2o& highe& &e e&ve to (aintain o& boo t (a&1et con2idence and lowe& exchange &ate volatilit5, &ed"ce the li1elihood o2 c&i e , and inc&ea e the e22ectivene o2 inte&vention, while #&oviding 2"nd 2o& the gov7 e&n(ent to inve t in longe&7te&( a et with highe& &et"&n 4 In gene&al, cent&al ban1 ho"ld be elective in thei& inte&vention and #a& i(onio" in thei& " e o2 2o&eign &e e&ve 4 *he di22ic"lt5 o2 detecting exchange &ate (i align(ent and di o&de&l5 (a&1et (ean that deci ion on the ti(ing and a(o"nt o2 inte&vention a&e "bMective and (a5 be o22 the (a&14 Mo&eove&, b5 ente&ing the (a&1et in2&eG"entl5, cent&al ban1 can convince the (a&1et o2 thei& co((it(ent to exchange &ate 2lexibilit5 and i(#&ove the #otential e22ectivene o2 the occa ional inte&vention4 When a co"nt&5 int&o7 d"ce a band a #a&t o2 a g&ad"al (ove to exchange &ate 2lexibilit5, inte&vention e#i ode (a5 be (o&e 2&eG"ent than "nde& (o&e 2lexible &egi(e K nonethele , cent&al ban1 ho"ld (ini(i'e the n"(be& o2 inte&vention and (a1e 2"ll " e o2 the exchange &ate 2lexibilit5 allowed b5 the width o2 the band4 Cent&al ban1 in (an5 advanced econo(ie A2o& exa(#le, Canada, New Qealand, and the United )ingdo(B eldo( inte&vene in the 2o&eign exchange (a&1et4 *&an #a&enc5 al o hel# b"ild con2idence in the new exchange &ate &egi(e, e #eciall5 in the a2te&(ath o2 a 2o&ced exit4 Man5 co"n7 t&ie , incl"ding the ?hili##ine and *"&1e5, i "ed tate(ent and #olic5 &e#o&t a22i&(ing that the5 we&e co((itted to a 2lexible exchange &ate &egi(e and that the5 wo"ld not inte&vene in the 2o&7 eign exchange (a&1et to ta&get a ce&tain exchange &ate level4 *he #"bli hed inte&vention #olicie o2 +" t&alia and Sweden a&e good exa(#le o2 the #olicie that need to be develo#ed and co(("ni7 cated to the (a&1et to enhance the e22ectivene o2 o22icial 2o&eign exchange o#e&ation 4 $i clo ing in2o&(ation on inte&vention with a ti(e lag can i(#&ove (a&1et t&an #a&enc5 and cent&al ban1 acco"ntabilit54 *he United )ingdo( di clo e in2o&(ation on inte&7

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Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

vention in a (onthl5 #&e &elea e, the E"&o#ean Cent&al 8an1 in a (onthl5 b"lletinK the U4S4 *&ea "&5 con2i&( inte&vention on the da5 the5 ta1e #lace and #&ovide additional detail in G"a&te&l5 &e#o&t 4 Selected co"nt&5 ex#e&ience "gge t that &"le 7ba ed inte&ven7 tion (a5 be " e2"l when the exchange &ate i not "nde& a lot o2 #&e "&e in a one7 ided (a&1et4 S"ch a #olic5 (a5 hel# co"nt&ie "##l5 2o&eign exchange o& acc"("late &e e&ve witho"t a22ecting the exchange &ate4 Event"all5 howeve&, cent&al ban1 will gain eno"gh ex#e&ience and c&edibilit5 to inte&vene on a (o&e di c&e7 tiona&5 ba i 4 R"le 7ba ed inte&vention #olicie tend to be t&an ito&5, abandoned o& (odi2ied b5 (o t co"nt&ie A2o& exa(#le, 8&a'il and CanadaB4

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+do#ting an alte&native no(inal ancho&
+ co"nt&5 exiting a #eg (" t &e#lace it with anothe& no(inal ancho& and &ede ign it (oneta&5 #olic5 2&a(ewo&1 a&o"nd the new ancho&4 While o(e cent&al ban1 (aintain 2lexible &egi(e witho"t a 2o&7 (al no(inal ancho&62o& exa(#le, in the e"&o a&ea, Singa#o&e, Swit'e&land, and the United State 6the e econo(ie enMo5 a high level o2 c&edibilit5, which (a5 be di22ic"lt 2o& develo#ing co"nt&ie to b"ild G"ic1l5, e #eciall5 i2 the5 &elied on a &igid exchange &ate ancho& be2o&e the exit o& had a hi to&5 o2 high in2lation4 *he (o t i(#o&tant 2"nction o2 a co"nt&53 (oneta&5 #olic5 i cont&ol o2 the (one5 "##l5 Ao& liG"idit5B4 *hi i e #eciall5 t&"e when co"nt&ie have exited a #eg "nde& (a&1et #&e "&e, ince a c"&&enc5 de#&eciation i li1el5 to #a&1 in2lation4 + a co"nt&5 (ove to a (o&e 2lexible exchange &ate &egi(e, the b"&den o2 (anaging liG"idit5 hi2t 2&o( inte&vention in the 2o&eign exchange (a&1et to othe& (oneta&5 #olic5 in t&"(ent , "ch a tanding 2acilitie , o#en (a&1et o#e&ation , and &e#"&cha e ag&ee(ent 4 While "ch in t&"7 (ent , along with liG"id (one5 (a&1et , a&e i(#o&tant 2o& (anag7 ing liG"idit5 "nde& an5 t5#e o2 exchange &ate &egi(e, thei& i(#o&7 tance &i e with exchange &ate 2lexibilit54

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Econo(ic I "e No4 38

*he di22ic"lt5 o2 develo#ing a c&edible alte&native no(inal ancho& ha ca" ed (an5 co"nt&ie to give "# the exchange &ate ancho& lowl5, 2o& exa(#le, b5 ado#ting a c&awling band a an inte&(edi7 ate &egi(e while the5 hi2t to anothe& no(inal ancho&, #o ibl5 ove& a long #e&iod4 *he band i " "all5 et 5((et&icall5 a&o"nd a c&awl7 ing cent&al #a&it5 and g&ad"all5 widened a the ten ion between exchange &ate and in2lation obMective i event"all5 &e olved in 2avo& o2 the latte&4 Chile, H"nga&5, I &ael, and ?oland "cce 2"ll5 (ade the t&an ition " ing c&awling band that we&e widened ove& ti(e in &e #on e to inc&ea e in ca#ital in2low 4 *hei& ex#e&ience ha 5ielded o(e " e2"l le on @ J *he na&&ow co#e 2o& exchange &ate 2lexibilit5 in the ea&l5 tage o2 the t&an ition can con t&ain the inde#endence o2 (on7 eta&5 #olic5 and #"t the b"&den o2 agg&egate7de(and (anage7 (ent on 2i cal and inco(e #olicie 4 J Re t&icting exchange &ate (ove(ent within a na&&owe& band than the one that wa #"blicl5 anno"nced can c&eate the #e&7 ce#tion o2 an i(#licit exchange &ate g"a&antee and &ed"ce the en itivit5 o2 (a&1et #a&tici#ant to exchange &ate &i 14 *wo7 wa5 exchange &ate (ove(ent a&e nece a&5 to give #a&tici7 #ant an incentive to develo# hedging in t&"(ent and (anage exchange &ate &i 14 J %ove&n(ent that (aintain two no(inal ancho& 6the exchange &ate and the in2lation ta&get6can bol te& #"blic con7 2idence in thei& co((it(ent to the in2lation ta&get b5 (a1ing it clea& that #&ice tabilit5 will be thei& 2i& t #&io&it5 in the event o2 a con2lict between the two ancho& 4 Man5 co"nt&ie (oving to 2lexible &ate &egi(e have o#ted 2o& in2lation ta&geting ove& (oneta&5 ta&geting4 + con en " ee( to be e(e&ging that an in2lation ta&get i a (o&e &eliable and e22ective no(inal ancho&4 While (oneta&5 ta&geting can e&ve a an alte&na7 tive no(inal ancho& a2te& a co"nt&5 abandon a #eg, the wea1 &ela7 tion hi# between (oneta&5 agg&egate and in2lation li(it the e22ec7 tivene o2 (one5 ta&get 4 Co"nt&ie that have (anaged o&de&l5 exit 2&o( #eg have gene&all5 ado#ted in2lation ta&geting ove& long ti(e ho&i'on , in #a&t beca" e o2 the ti(e &eG"i&ed to #"t the nece a&5 in tit"tion and (ac&oecono(ic condition in #lace, incl"ding a

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Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

cent&al ban1 (andate to #"& "e an ex#licit in2lation ta&get a the ove&&iding obMective o2 (oneta&5 #olic5K cent&al ban1 inde#endence and acco"ntabilit5K t&an #a&enc5 that #&o(ote acco"ntabilit5 in the cond"ct and eval"ation o2 (oneta&5 #olic5K a &eliable (ethodolog5 2o& 2o&eca ting in2lationK a 2o&wa&d7loo1ing #&oced"&e that 5 te(at7 icall5 inco&#o&ate 2o&eca t into #olic5 and &e #ond to deviation 2&o( ta&get K a "##o&tive 2i cal #olic5K and a well7&eg"lated, "#e&7 vi ed, and (anaged 2inancial ecto&4 Until the e #&econdition a&e e tabli hed, (an5 co"nt&ie have 2ollowed va&io" ve& ion o2 the (oneta&57ta&geting a##&oach Ata&7 geting ba e (one5, b&oad (oneta&5 agg&egate , o& ban1 &e e&ve B, e #eciall5 a2te& a di o&de&l5 exit4 Fo& exa(#le, eve&al o2 the co"n7 t&ie hit b5 the + ian c&i i ado#ted (oneta&5 ta&get i((ediatel5 a2te& exiting 2&o( #egged exchange &ate &egi(e to e tabli h a new no(inal ancho& and &e to&e #olic5 c&edibilit5 a G"ic1l5 a #o ible4 In )o&ea, the ?hili##ine , and *hailand, the (oneta&57ta&geting a##&oach laid the g&o"ndwo&1 2o& a 2ai&l5 &a#id (ove to in2lation ta&geting4 8&a'il ha 2ollowed a i(ila& #ath4 In Indone ia, howeve&, the t&an ition 2&o( (oneta&5 ta&geting to in2lation ta&geting wa lowe& beca" e the eve&it5 o2 the c&i i ha(#e&ed the co"nt&53 e22o&t to (ove ahead4

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Managing and "#e&vi ing exchange &ate &i 1
When a co"nt&5 2loat it c"&&enc5, exchange &ate &i 1 hi2t 2&o( the #"blic ecto& Athe cent&al ban1B to the #&ivate ecto&, a the 2o&(e& no longe& tand &ead5 to inte&vene at 2ixed &ate 4 Indeed, di o&de&l5 exit o2ten ha##en beca" e o2 "n(anageable i(balance in the #"blic ecto&3 balance heet4 *h" , dete&(ining the cale and co#e o2 exchange &ate &i 1 ex#o "&e in the 2inancial and non2inancial ecto& i al o 1e5 to achieving an o&de&l5 exit 2&o( #eg 4 *he #&i7 vate ecto&3 ex#o "&e to exchange &ate &i 1 can have an i(#o&tant bea&ing on the #ace o2 the exit, the t5#e o2 2lexible exchange &ate &egi(e ado#ted A2o& exa(#le, a band ve& " a 2loatB, and o22icial inte&vention #olicie 4

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Econo(ic I "e No4 38

*he eval"ation o2 exchange &ate &i 1 ex#o "&e entail detailed bal7 ance heet anal5 i 2oc" ing on the c"&&enc5 co(#o ition, (at"&itie , liG"idit5, and c&edit G"alit5 o2 a et and liabilitie deno(inated in 2o&eign c"&&encie 4 *he + ian c&i i , 2o& exa(#le, howed how "nhedged 2o&eign exchange bo&&owing b5 the co&#o&ate ecto& co"ld t"&n into (a ive lo e 2o& c&edito& ban1 and a "&ge in de(and 2o& 2o&eign c"&&enc54 Even when ban1 en "&e that 2o&eign c"&&enc5 lia7 bilitie and a et a&e (atched, the " e o2 ho&t7te&( 2o&eign c"&&enc5 2"nd to 2inance long7te&( 2o&eign c"&&enc5 loan to "nhedged c" 7 to(e& &e "lt in i'able c&edit and liG"idit5 &i 1 4 Si(ila&l5, the co&7 #o&ate and the ban1ing ecto& 3 ex#o "&e to inte&e t &ate &i 1 can li(it the cent&al ban13 abilit5 to " e inte&e t &ate , in tead o2 inte&vention in the 2o&eign exchange (a&1et, in cond"cting (oneta&5 #olic54 It can be ve&5 di22ic"lt 2o& co&#o&ation in develo#ing and e(e&ging (a&1et co"nt&ie to o227load inte&e t &ate &i 1, in #a&tic"la& when thei& a et a&e not inte&e t bea&ing and the5 have di22ic"lt5 obtaining long7 te&( 2ixed &ate 2o& thei& liabilitie , a i o2ten the ca e4 *he (anage(ent o2 exchange &ate &i 1 i co(#o ed o2 2o"& ele(ent @ J In2o&(ation 5 te( to (onito& the va&io" o"&ce o2 exchange &ate &i 1, incl"ding the o"&ce and " e o2 2o&eign c"&&enc5 2"nd , and 2o&(al &e#o&ting &eG"i&e(ent 4 Indi&ect exchange &ate &i 1 ho"ld be (onito&ed th&o"gh &eg"la& "&7 ve5 o2 the co&#o&ate ecto& o& b5 &eG"i&ing bo&&owe& to #&o7 vide in2o&(ation on thei& 2o&eign c"&&enc5 inco(e , 2o&eign debt , and hedging o#e&ation 4 J Fo&("la and anal5tical techniG"e to (ea "&e exchange &ate &i 14 Mea "&e o2 &i 1 incl"de acco"nting7ba ed (ea "&e o2 the ove&all 2o&eign c"&&enc5 #o ition and (o&e 2o&wa&d7loo1ing &i 17(anage(ent techniG"e "ch a val"e7at7&i 1 (odel and t&e te ting4 J Inte&nal &i 1 #olicie and #&oced"&e , incl"ding, a(ong othe& thing , li(it on concent&ation in 2o&eign c"&&enc5 loan , #e7 ci2ic #&ovi ion 2o& the additional c&edit &i 1 a ociated with 2o&eign c"&&enc5 lending, &eG"i&e(ent 2o& 2o&eign ea&ning o& collate&al 2o& bo&&owe& o2 2o&eign c"&&enc5, and anal5 i o2 the #otential i(#act o2 exchange &ate (ove(ent on 2o&eign c"&7

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Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

&enc5 bo&&owe& 4 +l o i(#o&tant a&e t&ong inte&nal cont&ol 6 incl"ding a w&itten #olic5 on 2o&eign exchange o#e&ation , ex#o "&e li(it , &i 17(anage(ent #&oced"&e , and a 5 te( o2 (onito&ing co(#liance whe&e 2&ont and bac1 o22ice a&e 2"ll5 e#a&ate6a well a good co&#o&ate gove&nance, incl"ding &eg"la& (onito&ing, &eview, and a##&oval o2 &i 1 #olicie and #&oced"&e b5 the boa&d o2 di&ecto& to (aintain a##&o#&iate chec1 and balance within the in tit"tion4 8an1 ho"ld enco"&age client to hedge again t exchange &ate &i 1 4 J ?&"dential &eg"lation and "#e&vi ion o2 2o&eign exchange &i 14 ?&"dential (ea "&e (a5 incl"de li(it on net o#en #o ition Aa a #e&centage o2 ca#italB, 2o&eign c"&&enc5 lending Aa a #e&7 centage o2 2o&eign c"&&enc5 liabilitie B, and ove& ea bo&&owing and bond i "ance Aa a #e&centage o2 ca#italBK li(it on the &ange o2 2o&eign exchange o#e&ation ban1 a&e allowed to #e&2o&( th&o"gh licen ing &eG"i&e(ent K ca#ital &eG"i&e(ent again t 2o&eign exchange &i 1K and the i "ance o2 &eg"lation o& g"ideline on the de ign o2 ban1 3 inte&nal cont&ol 4 Fo&eign c"&&enc5 bo&&owing b5 ecto& that do not gene&ate 2o&eign c"&7 &enc5 &even"e o& that a&e ex#o ed to volatile &et"&n wa&&ant #ecial vigilance4 Facilitating the develo#(ent o2 &i 17hedging in t&"(ent b5 li2t7 ing cont&ol on 2o&wa&d (a&1et activit5 can be a do"ble7edged wo&d4 In addition to i(#&oving &i 1 (anage(ent, it can cont&ib"te to the develo#(ent o2 the 2o&eign exchange (a&1et4 Howeve&, de&ivative can ea il5 be (i " ed6in *hailand, in .//>, 2o& exa(7 #le, inve to& " ed the( to ta1e highl5 leve&aged bet on "n " 7 tainable exchange &ate 4 Co&#o&ation and 2inancial in tit"tion 6 and the a"tho&itie that "#e&vi e the(6need to acG"i&e con ide&able o#hi tication to en "&e that "ch in t&"(ent a&e " ed #&o#e&l54 In addition, thei& " e (" t be clo el5 (onito&ed, ban1 t&ading o2 de&ivative #&od"ct (" t be tanda&di'ed and acco"nting tanda&d 2o& 2ai& val"ation and a &eliable legal 5 te( 2o& cont&act en2o&ce(ent (" t be e tabli hed, and the cent&al ban1 ho"ld #&o7 (ote (a&1et t&an #a&enc5 and high &e#o&ting tanda&d 4

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Econo(ic I "e No4 38

?ace and eG"encing

Co"nt&ie 2ace ce&tain t&ade7o22 in choo ing between a &a#id exit 2&o( a #eg and a (o&e g&ad"al (ove to a 2loating exchange &ate &egi(e4 + &a#id a##&oach involve 2ewe& inte&(ediate te# , i2 an5, between 2ixed and 2loating &egi(e than a g&ad"al a##&oach4 Fo& a co"nt&5 with a t&ong (ac&oecono(5 and a #&"dent (one7 ta&5 #olic5, a &a#id a##&oach can be a (o&e c&edible ignal o2 co(7 (it(ent to exchange &ate 2lexibilit5 than a g&ad"al a##&oach, while allowing the co"nt&5 to li(it it inte&vention in the 2o&eign exchange (a&1et and the&eb5 con e&ve it 2o&eign exchange &e e&ve 4 Co"nt&ie ee1ing g&eate& (oneta&5 #olic5 inde#endence (a5 al o be bette& o22 (oving &a#idl5, a (a5 tho e with an o#en ca#ital acco"nt6it (a5 be ha&de& to #"& "e a g&ad"al exit t&ateg5 in the #&e ence o2 la&ge and volatile ca#ital 2low 4 Howeve&, a g&ad7 "al a##&oach i #&e2e&able i2 a co"nt&5 lac1 the a##&o#&iate in tit"7 tional 2&a(ewo&1, incl"ding a dee# 2o&eign exchange (a&1et and the abilit5 to (onito& and (anage exchange &ate &i 1K "ch a co"n7 t&5 &"n a high &i 1 o2 ex#e&iencing exce ive exchange &ate volatil7 it5 i2 it (ove too G"ic1l54 *he ab ence o2 a 2"ll72ledged in2lation7ta&geting 2&a(ewo&1 a an alte&native no(inal ancho& need not #&ecl"de a &a#id exit t&ateg5, i2 the&e i a &ob" t co((it(ent to #&ice tabilit54 *he b"ild7 ing bloc1 o2 in2lation ta&geting6 "ch a 2i cal di ci#line, the (on7 eta&5 a"tho&itie 3 o#e&ational inde#endence in #"& "it o2 low in2la7 tion, c&edible te# to contain in2lation, and t&an #a&enc5 and acco"ntabilit56a&e 2"nda(ental to the "cce o2 an5 (oneta&5 #olic5 &egi(e &ega&dle o2 whethe& in2lation ta&geting i 2o&(all5 ado#ted4 So"th +2&ica exited 2&o( a 2ixed #eg to a 2loat in the ea&l5 ./8; b"t did not 2o&(all5 ado#t in2lation ta&geting "ntil :;;;4 Othe& co"nt&ie 2o&ced to 2loat in one te#62o& exa(#le, Mexico and *"&1e56" ed (oneta&5 ta&geting a an inte&i( t&ateg5 be2o&e ado#ting in2lation ta&geting4 + g&ad"al a##&oach allow the co"nt&5 to (ove towa&d a 2&ee 2loat in (ea "&ed te# 62o& exa(#le, b5 hi2ting 2&o( a 2ixed #eg again t a ingle c"&&enc5 to a 2ixed o& c&awling #eg again t a ba 1et o2 c"&7 &encie , and then to an exchange &ate band that i inc&ea ed in inc&e7 (ent 4 In H"l5 :;;<, 2o& exa(#le, China &eval"ed the 5"an and

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Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

&e#laced it #eg to the dolla& with a #eg to a ba 1et o2 c"&&encie 4 ?egging to a ba 1et o2 c"&&encie ha the advantage o2 &ed"cing the t&an (i ion o2 exte&nal hoc1 to the do(e tic econo(5 and te(7 #e&ing the exchange &ate3 ex#o "&e to the #otentiall5 e&&atic (ove7 (ent o2 a ingle c"&&enc54 *he ba 1et (a5 be co(#o ed o2 a weighted ave&age o2 the c"&&encie o2 a co"nt&53 (ain t&ading #a&t7 ne& 4 + hi2t to a c&awling #eg again t a ba 1et o2 c"&&encie can hel# a co"nt&5 (aintain it exte&nal co(#etitivene i2 it in2lation &ate a&e di22e&ent 2&o( tho e o2 it t&ading #a&tne& 4 Moving to a ho&i'on7 tal o& c&awling exchange &ate band can #&ovide g&eate& exchange &ate 2lexibilit5 and (oneta&5 #olic5 inde#endence4 While the e va&i7 ant o2 #egged &egi(e a&e ea ie& to (aintain than wide exchange &ate band and 2loat , the5 con t&ain (oneta&5 #olic5 and can be di27 2ic"lt 2o& co"nt&ie with libe&ali'ed ca#ital acco"nt to " tain4 In eithe& ca e, whethe& the exit i &a#id o& g&ad"al, each te# 2o&wa&d ho"ld en "&e two7wa5 &i 1 in exchange &ate (ove(ent 4 Ea&l5 #&e#a&ation 2o& the (ove to a 2loating exchange &ate inc&ea e the li1elihood that the exit will be "cce 2"l4 + co"nt&5 ho"ld begin to la5 the g&o"ndwo&1 2o& the exit while it till ha a #eg, ec"&ing cent&al ban1 inde#endence, i(#&oving it abilit5 to 2o&eca t in2lation, (a1ing (oneta&5 #olic5 (o&e t&an #a&ent, devel7 o#ing in2o&(ation 5 te( on 2o&eign exchange &i 1, and inc&ea ing in2o&(ation on balance o2 #a5(ent develo#(ent 4 Once it ha laid the g&o"ndwo&1, it can (ove to a econd tage, int&od"cing o(e exchange &ate 2lexibilit5 to ti("late activit5 in the 2o&eign exchange (a&1et, while it develo# the othe& tool it will need to o#e&ate the new &egi(e4 Inte&vention #olicie can be add&e ed late& in the t&an ition4 +ltho"gh #olic5(a1e& have no cont&ol ove& the #ace o2 a di o&7 de&l5 exit, the5 till need to (a1e deci ion abo"t eG"encing4 *hei& to# #&io&it5 ho"ld be to tabili'e the exchange &ateK o2ten, thi can be done b5 eli(inating the ho&tage o2 dolla& in the (a&1et and (aintaining (oneta&5 cont&ol4 ?olic5(a1e& ho"ld al o atte(#t to ignal a con e&vative (oneta&5 #olic5, altho"gh the de ign o2 an alte&native no(inal ancho& will #&obabl5 &eG"i&e (o&e ti(e4 +do#ting a 2lexible exchange &ate be2o&e libe&ali'ing the ca#ital acco"nt enable a co"nt&5 to ab o&b ca#ital acco"nt hoc1 at a

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Econo(ic I "e No4 38

lowe& co t to the &eal econo(5 than "nde& a 2ixed exchange &ate4 85 cont&a t, libe&ali'ing the ca#ital acco"nt 2i& t can hel# o22 et te(7 #o&a&5 c"&&ent acco"nt hoc1 , ex#and the &ange o2 in t&"(ent available 2o& &i 1 (anage(ent, and dee#en the 2o&eign exchange (a&1et4 +cco&dingl5, when an exchange &ate i 2loated be2o&e the ca#ital acco"nt i libe&ali'ed, cent&al ban1 inte&vention (a5 be needed to o22 et te(#o&a&5 c"&&ent acco"nt hoc1 and to li(it exce ive &eal exchange &ate volatilit54 *he ex#e&ience o2 e(e&ging (a&1et econo(ie ove& the #a t decade highlight the &i 1 o2 o#ening the ca#ital acco"nt be2o&e ado#ting a 2lexible exchange &ate4 Man5 co"nt&ie we&e 2o&ced o22 #eg a2te& "dden &eve& al o2 ca#ital 2low "nde& o#en ca#ital acco"nt A2o& exa(#le, Mexico at the end o2 .//=, *hailand in H"l5 .//>, and 8&a'il in ea&l5 .///B4 Othe& 2aced heav5 in2low and "#wa&d #&e "&e on #egged &ate and had to allow exchange &ate 2lexibilit5 to avoid ove&heating the econo(5 A2o& exa(#le, Chile and ?oland d"&ing the .//; B4 *h" , even "nde& 2avo&able econo(ic condition , o#ening the ca#ital acco"nt be2o&e int&od"cing exchange &ate 2lexibilit5 can th&eaten do(e tic liG"idit5, c&eate (ac&oecono(ic i(balance , and #&eci#itate #ec"lative attac1 4 Uganda did not libe&ali'e it ca#ital acco"nt "ntil a2te& it had co(7 #leted it (ove to a 2loatK New Qealand "cce 2"ll5 (oved to a 2loat and libe&ali'ed it ca#ital acco"nt i("ltaneo" l5K and Chile3 ca#i7 tal acco"nt libe&ali'ation (oved in #a&allel with it t&an ition to a 2loating exchange &ate, b"t ve&5 g&ad"all54

LLL
*o 2loat o& not to 2loat
It i no do"bt bette& to #lan an exit in a cal( econo(ic envi&on7 (ent4 8"t even #lanned exit do not nece a&il5 la t4 Man5 co"nt&ie have &eve& ed co"& e a2te& ado#ting exchange &ate 2lexibilit54 Eithe& (ac&oecono(ic condition o& a lac1 o2 in tit"tion o& both (a5 con7 t&ib"te to the &eve& al 2&o( a 2loat to a 2ixed &egi(e4 Fi cal do(i7 nance #la5ed an i(#o&tant &ole in the &eve& al o2 both R" ia A.//3I/<B and Pene'"ela A:;;:I;3B, while Eg5#t3 &eve& al occ"&&ed

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Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

a(id conce&n abo"t exce ive de#&eciation A:;;3B4 Othe& ob tacle to 2loating in (an5 develo#ing co"nt&ie incl"de the li(ited n"(be& o2 #a&tici#ant in the 2o&eign exchange (a&1et, #e&va ive exchange cont&ol , a wea1 technological in2&a t&"ct"&e, and "nde&develo#ed (one5 (a&1et 4 8oth 2ixed and 2loating exchange &ate have di tinct and di22e&ent advantage 4 No ingle exchange &ate &egi(e i a##&o#&iate 2o& all co"nt&ie in all ci&c"( tance 4 Co"nt&ie will have to weigh the co t and bene2it o2 2loating in light o2 both thei& econo(ic and thei& in tit"tional &eadine 4

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*he Econo(ic I "e Se&ie

..4

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.34 .=4

.<4 .04 .>4 .84 ./4 .;4

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%&owth in Ea t + ia@ What We Can and What We Cannot In2e&4 Michael Sa&el4 .//04 $oe the Exchange Rate Regi(e Matte& 2o& In2lation and %&owth! +ti h R4 %ho h, +nne7Ma&ie %"lde, Honathan $4 O t&5, and Holge& Wol24 .//04 Con2&onting 8"dget $e2icit 4 .//04 Fi cal Re2o&( *hat Wo&14 C4 Hohn Mc$e&(ott and Robe&t F4 We cott4 .//04 *&an 2o&(ation to O#en Ma&1et O#e&ation @ $evelo#ing Econo(ie and E(e&ging Ma&1et 4 Ste#hen H4 +xil&od4 .//04 Wh5 Wo&&5 +bo"t Co&&"#tion! ?aolo Ma"&o4 .//>4 Ste&ili'ing Ca#ital In2low 4 Hang7-"ng ,ee4 .//>4 Wh5 I China %&owing So Fa t! Q"li" H" and Moh in S4 )han4 .//>4 ?&otecting 8an1 $e#o it 4 %illian %4 %a&cia4 .//>4 $eind" t&iali'ation6It Ca" e and I(#lication 4 Robe&t Rowtho&n and Ra(ana Ra(a wa(54 .//>4 $oe %lobali'ation ,owe& Wage and Ex#o&t Hob ! Matthew H4 Sla"ghte& and ?hilli# Swagel4 .//>4 Road to Nowhe&e@ How Co&&"#tion in ?"blic Inve t(ent H"&t %&owth4 Pito *an'i and Ha(id $avoodi4 .//84 Fixed o& Flexible! %etting the Exchange Rate Right in the .//; 4 F&ance co Ca&a(a''a and Hahangi& +'i'4 .//84 ,e on 2&o( S5 te(ic 8an1 Re t&"ct"&ing4 Cla"dia $'iobe1 and Ce5la ?a'a&ba Rogl"4 .//84S T In2lation *a&geting a a F&a(ewo&1 2o& Moneta&5 ?olic54 %"5 $ebelle, ?a"l Ma on, Mig"el Sava tano, and S"nil Sha&(a4 .//84 Sho"ld EG"it5 8e a %oal o2 Econo(ic ?olic5! IMF Fi cal +22ai& $e#a&t(ent4 .//84 ,ibe&ali'ing Ca#ital Move(ent @ So(e +nal5tical I "e 4 8a&&5 Eicheng&een, Michael M" a, %iovanni $ell3+&iccia, En&ica $et&agiache, %ian Ma&ia Mile i7Fe&&etti, and +nd&ew *weedie4 .///4 ?&ivati'ation in *&an ition Co"nt&ie @ ,e on o2 the Fi& t $ecade4 Oleh Hav&5l5 h5n and $onal Mc%ettigan4 .///4 Hedge F"nd @ What $o We Reall5 )now! 8a&&5 Eicheng&een and $onald Mathie on4 .///4

.84 ./4

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:;4 Hob C&eation@ Wh5 So(e Co"nt&ie $o 8ette&4 ?iet&o %a&ibaldi and ?aolo Ma"&o4 :;;;4 :.4 I(#&oving %ove&nance and Fighting Co&&"#tion in the 8altic and CIS Co"nt&ie @ *he Role o2 the IMF4 *ho(a Wol2 and E(ine %U&gen4 :;;;4 ::4 *he Challenge o2 ?&edicting Econo(ic C&i e 4 +nd&ew 8e&g and Cathe&ine ?attillo4 :;;;4 :34 ?&o(oting %&owth in S"b7Saha&an +2&ica@ ,ea&ning What Wo&1 4 +n"#a( 8a ", Evangelo +4 Cala(it i , and $hane hwa& %h"&a4 :;;;4 :=4 F"ll $olla&i'ation@ *he ?&o and Con 4 +nd&ew 8e&g and Ed"a&do 8o&en 'tein4 :;;;4 :<4 Cont&olling ?oll"tion U ing *axe and *&adable ?e&(it 4 Hohn No&&egaa&d and PalV&ie Re##elin7Hill4 :;;;4 :04 R"&al ?ove&t5 in $evelo#ing Co"nt&ie @ I(#lication 2o& ?"blic ?olic54 Mah(ood Ha an )han4 :;;.4 :>4 *ax ?olic5 2o& $evelo#ing Co"nt&ie 4 Pito *an'i and Howell Qee4 :;;.4 :84 Mo&al Ha'a&d@ $oe IMF Financing Enco"&age I(#&"dence b5 8o&&owe& and ,ende& ! *i(oth5 ,ane and Steven ?hilli# 4 :;;:4 :/4 *he ?en ion ?"''le@ ?&e&eG"i ite and ?olic5 Choice in ?en ion $e ign4 Nichola 8a&&4 :;;:4 3;4 Hiding in the Shadow @ *he %&owth o2 the Unde&g&o"nd Econo(54 F&ied&ich Schneide& with $o(ini1 En te4 :;;:4 3.4 Co&#o&ate Secto& Re t&"ct"&ing@ *he Role o2 %ove&n(ent in *i(e o2 C&i i 4 Ma&1 R4 Stone4 :;;:4 3:4 Sho"ld Financial Secto& Reg"lato& 8e Inde#endent! Ma&c W"int5n and Michael W4 *a5lo&4 :;;=4 334 Ed"cating Child&en in ?oo& Co"nt&ie 4 +&5e ,4 Hill(an and Eva Hen1ne&4 :;;=4 3=4 Can $ebt Relie2 8oo t %&owth in ?oo& Co"nt&ie ! 8enedict Cle(ent , Rina 8hattacha&5a, and *oan W"oc Ng"5en4 :;;<4 3<4 Financial Re2o&(@ What Sha1e It! What Sha#e It! +bd"l +biad and + ho1a Mod54 :;;<4 304 ?&e e&ving Financial Stabilit54 %a&&5 H4 Schina i4 :;;<4 3>4 Integ&ating ?oo& Co"nt&ie into the Wo&ld *&ading S5 te(4 :;;<4 384 Moving to a Flexible Exchange Rate@ How, When, and How Fa t! R"#a $"ttag"#ta, %ilda Fe&nande', and Ce( )a&acadag4 :;;<4

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R"#a $"ttag"#ta i an econo(i t in the IMF3 We te&n He(i #he&e $e#a&t(ent4 She wa an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent when he coa"tho&ed the wo&1ing #a#e& on which thi Econo(ic I "e i ba ed4

%ilda Fe&nande' i an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent4

Ce( )a&acadag i a di&ecto& in E(e&ging Ma&1et Econo(ic at C&edit S"i e Fi& t 8o ton4 He wa an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent when he coa"tho&ed the wo&1ing #a#e& on which thi Econo(ic I "e i ba ed4

Moving to a Flexible Exchange Rate@ How, When, and How Fa t!

R"#a $"ttag"#ta i an econo(i t in the IMF3 We te&n He(i #he&e $e#a&t(ent4 She wa an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent when he coa"tho&ed the wo&1ing #a#e& on which thi Econo(ic I "e i ba ed4

%ilda Fe&nande' i an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent4

Ce( )a&acadag i a di&ecto& in E(e&ging Ma&1et Econo(ic at C&edit S"i e Fi& t 8o ton4 He wa an econo(i t in the IMF3 Moneta&5 and Financial S5 te( $e#a&t(ent when he coa"tho&ed the wo&1ing #a#e& on which thi Econo(ic I "e i ba ed4

*he IMF la"nched the Econo(ic I "e e&ie in .//0 to (a1e the IMF ta223 &e ea&ch 2inding acce ible to the #"blic4 Econo(ic I "e a&e ho&t, nontechnical (onog&a#h on to#ical i "e w&itten 2o& the non #eciali t &eade&4 *he5 a&e #"bli hed in ix lang"age 6 Engli h, +&abic, Chine e, F&ench, R" ian, and S#ani h4 Econo(ic I "e &e2lect the o#inion o2 thei& a"tho& , which a&e not nece a&7 il5 tho e o2 the IMF3 Exec"tive 8oa&d o& (anage(ent4