Chapter

I Overview

Author(s):
Barry Eichengreen, Inci Ötker, A. Hamann, Esteban Jadresic, R. Johnston, Hugh Bredenkamp, and Paul Masson
Published Date:
August 1998
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In a world of increasing capital mobility and broadening and more diversified trade, many (but not all) developing and transition economies are likely to find it desirable to move from relatively fixed exchange rate regimes to regimes of greater exchange rate flexibility. This paper suggests why, and considers strategies that countries may consider for such a move. It reinforces this discussion with a review of experience from the past two decades with alternative exchange rate regimes. The paper also identifies policies that can facilitate the transition to greater exchange rate flexibility for countries that wish to pursue this option.

In general, it is found that countries can make a successful transition to a more flexible exchange rate regime without substantial economic disruption if they make the regime shift during a period of calm in the foreign exchange market or when there is upward pressure on the exchange rate. The chances of success are also importantly enhanced by replacing the exchange rate anchor for monetary policy with a clear commitment to low inflation, which can be reinforced by granting operational independence to the central bank to pursue this objective. Institutional reforms that assure greater discipline and transparency of fiscal policy are also important, as are efforts to strengthen the soundness of the financial sector.

For countries that need to exit from a relatively fixed exchange rate regime in the presence of substantial downward pressure in the foreign exchange market, the chances of a smooth transition are generally not good. A significant loss of policy credibility attendant upon such an exit is virtually unavoidable, and an economic crisis of greater or lesser proportions is likely to ensue. The situation, nevertheless, can be improved if the exit from the old regime is combined with a firming of monetary and fiscal policies, which is typically needed to reduce the external payments imbalance and to restore policy credibility. Orderly transitions to greater exchange rate flexibility, and even more so, transitions in a crisis, can be facilitated by urgently reinforcing the anti-inflation credibility of monetary policy, improving fiscal discipline and transparency, and addressing problems in the financial sector.

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