How, within its broad responsibilities, the IMF assists its members in choosing an exchange arrangement and implementing exchange rate policy
David Burton and Martin G. Gilman
Exchange rate policy is of more than academic interest to many people. After all, the exchange rate—a key price in any economy—affects the cost of imported goods and the profitability of export industries, influencing the rate of inflation, output, and employment. The choice of exchange arrangement—that is, whether the exchange rate is pegged, floating, or something in between— also influences the extent to which an economy is affected by booms and recessions abroad and defines the scope for independent monetary policy at home.
It is not surprising, therefore, that exchange rate policy has long been a controversial subject, no less so in recent years when practical questions about exchange rate policy have come to the fore. Eastern European countries have introduced new exchange systems as part of their radical programs of structural reform. Participation in the Exchange Rate Mechanism of the European Monetary System has expanded, with the members seeing advantages in exchange rate stability. And many African and Latin American countries have been questioning inflation-linked devaluations, which often seemingly lead to ever higher rates of inflation in the absence of sound domestic policies.
At the center of the debate sits the IMF, which, under its founding Articles of Agreement, shoulders major responsibilities in this area. It is charged with:
• overseeing the international monetary system in order to ensure its effective operation;
• ensuring that members collaborate with it and other members to assure orderly exchange arrangements and promote a stable system of exchange rates; and
• helping to establish an unrestricted multilateral payments system; indeed, the IMF is endowed with jurisdictional responsibility for limiting the use of exchange restrictions by member countries.
This article attempts to clarify these extensive responsibilities, as well as to explain how the IMF assesses the appropriateness of exchange rate policy and formulates its policy advice. As developed and developing countries alike ponder how best to conduct exchange rate policy, the IMF is finding that there is no single policy prescription—rather, advice must be tailored to fit the policy priorities and institutional realities of the country concerned.
Evolution of arrangements
Although exchange rate policy cannot be viewed in isolation from other macroeconomic policies, narrowly defined, it concerns the way in which the domestic currency price of foreign currency is determined. From the time of the establishment of the IMF until 1973, the international monetary system was based on par values—the original Bretton Woods system. With a few exceptions, member countries maintained a par value for their currencies in terms of gold, either directly or indirectly through a peg to the US dollar. Under this system, a par value could only be changed if, after consultation with the IMF, it was established that exchange rate action was necessary to correct a “fundamental disequilibrium.”
With the breakdown of the Bretton Woods system, as a result of growing financial strains and external imbalances, the world moved to what has become known as a system of “generalized floating.” This implies that there is no numeraire, or anchor, for the system as a whole, a role previously played by gold. Even so, individual countries are free to peg their currencies to any other currency or basket of other currencies, such as the IMF’s Special Drawing Right (SDR), or to allow the exchange rate to vary according to market forces or some other type of adjustment mechanism. The freedom of IMF members to choose their exchange arrangement was formally authorized in the Second Amendment to the IMF’s Articles in 1978. At the same time, the amended Articles emphasized the need for member countries to direct their economic and financial policies at fostering orderly underlying economic conditions, orderly economic growth, and reasonable price stability—all seen as essential for maintaining a stable exchange rate system.
Since the mid-1970s, there has been a tendency among member countries to adopt or maintain exchange regimes that in principle allow greater flexibility. While currency pegs accounted for 82 percent of the arrangements in 1975, they declined to 72 percent in 1983, and 66 percent in 1990 (these include the CFA franc zone and the Common Monetary Area—both in Africa—and the Eastern Caribbean Central Bank). The growing category of countries maintaining more flexible arrangements embraces a wide variety of schemes. Most of them follow a “managed” float (i.e., the authorities adjust the rate periodically in a discretionary manner), although the actual flexibility of the rates ranges from those that behave as if they were pegged to those where the nominal rate can appreciate or depreciate relatively freely. Other types of flexible arrangements include: (1) the EMS, where members’ rates are pegged to each other but the system floats independently against outside currencies; (2) independent floats, such as those followed by Japan and the United States, where the official exchange rate is determined essentially by the market with only very limited efforts at management or intervention; and (3) adjustment of the rate according to a predetermined set of indicators, as is done by Chile and Madagascar.
One complication, however, is that a large number of developing country members —about 40 in 1990—maintain dual or multiple official exchange markets (among industrial countries, Belgium and Luxembourg terminated their long-standing dual market in May 1990). In addition, parallel exchange markets, which differ in the extent to which they are officially tolerated, exist in about 70 member countries where access to the official exchange market is restricted. To the extent that a significant proportion of external transactions take place at parallel exchange rates, the classification of the official arrangement may in some cases thus be misleading.
Role of the IMF
Member countries are obligated to notify the IMF of their choice of arrangement, information that is then used as part of the bilateral and multilateral surveillance process. The IMF’s Executive Board regularly devotes sessions to exchange rate policy, with discussions tending to focus on developments in industrial countries. Exchange rate developments are also analyzed in the semi-annual World Economic Outlook, which provides the basic analytical framework for the IMF’s review of the world economy and the exchange system as a whole and which is discussed by the Executive Board. On the national level, the main vehicle for surveillance is the Article IV consultation, a sort of annual check-up for member countries, which usually concludes with an Executive Board discussion of the country’s economic situation and policies, with particular attention given to exchange rate policy. The Board’s views are then conveyed to the member’s Government in the form of a summing up by the Chairman of the Executive Board as well as by its Executive Director.
The advice provided by the IMF, in terms of the appropriateness of exchange rate policy, reflects not only the diverse economic structures and varied exchange arrangements of members but also the IMF’s overall objectives: (1) to help promote orderly growth and reasonable price stability in individual member countries; (2) to help members correct maladjustments in their balance of payments; and (3) to promote the expansion of world trade, as a means of helping to create favorable conditions for sustained economic growth and high employment in member countries.
Viewed from this broader perspective, exchange rate policy has to be judged in the context of a comprehensive analysis of a country’s economic situation. Such an analysis allows the IMF to assess the consistency of exchange rate policy with a country’s external and domestic policy goals. And it makes possible an evaluation of whether a country’s exchange rate policy can be maintained without the imposition or the tightening of exchange (and trade) restrictions, which would impede the international free flow of goods and capital and tend to distort relative prices and reduce economic efficiency, thereby adding to inflationary pressure at home.
While assessments cover a broad range of policies and have devoted increasing attention to structural issues, they typically focus on the stance of fiscal and monetary policy, because over the years, the IMF has found that disciplined domestic financial policies are the necessary prerequisite for the maintenance of relatively stable exchange rates and the avoidance of restrictions. A review of recent individual consultations with members suggests that assessments of exchange rate policy, broadly defined, are more likely to be unfavorable in cases with relatively large fiscal deficits and/or rapid credit expansion. In this setting, unsustainable balance of payments deficits are likely to emerge, which without policy correction, would lead to the intensification of exchange restrictions, the emergence of a parallel exchange market, rising inflation, and a depreciating exchange rate in some combination, depending on the nature of the exchange arrangement.
The IMF’s exchange rate policy advice roughly falls into four general areas:
Choice of exchange arrangement. While economic theory provides some general principles on which to base a choice of an optimal exchange arrangement, these are difficult to apply in practice as they depend on both the policy objectives of the authorities and the nature of the shocks to which the economy is prone. (For a detailed discussion, see publication listed in box.) There is also an important unresolved issue as to whether a pegged rate, by providing a visible nominal anchor, is more conducive to the maintenance of financial discipline than a more flexible arrangement. Indeed, the available evidence suggests that both flexible and pegged rates can be consistent with price stability.
In general, therefore, IMF staff have abided by a member country’s preferred arrangement, and tailored their overall policy advice accordingly. For example, in countries where a particular exchange arrangement may rule out changes in the exchange rate (e.g., members of a currency union), the burden of any external adjustment required must fall on budgetary and monetary policies, incomes policy, and structural measures that would help to contain costs and improve competitiveness. Where an exchange rate change is possible, the staff may recommend that appropriate financial policies be used in combination with an exchange rate depreciation to achieve an improvement in the balance of payments.
In some cases, the economic and institutional circumstances and policy priorities of a country may suggest a particular exchange arrangement. For example, a pegged exchange rate as a nominal anchor may be attractive when reducing inflation is particularly important, whereas greater exchange rate flexibility may be necessary if international reserves are at a low level and strengthening the balance of payments is a top priority. The role played by such considerations is illustrated by the different exchange rate policies adopted by Eastern European countries that have recently embarked on radical reform programs.
In Poland, for example, in late 1989, when the stabilization and reform program was being formulated, price increases were spiralling out of control, making the reduction of inflation a top priority. At the same time, a substantial proportion of domestic financial assets were denominated in US dollars, reflecting the erosion of the zloty’s value. Initially, the authorities devalued the zloty, as a way of ensuring adequate competitiveness in light of price and trade liberalization. But then the exchange rate was pegged to the US dollar, as it appeared that such an arrangement—supported by restrained monetary and fiscal policies—could be effective in providing a nominal anchor for prices and restoring confidence in the domestic currency. In May 1991, after inflation had been substantially reduced, the zloty was devalued by 14 percent and pegged to a basket of five currencies.
The use of a pegged exchange rate as a nominal anchor was feasible in Poland’s case because its international reserves were at a reasonable level when bolstered by the availability of a secondary line of defense in the form of a $1 billion stabilization fund, provided by a group of countries to help support the reform effort. Yugoslavia followed a similar approach in late 1989 when, as part of its adjustment program, the dinar was pegged to the deutsche mark. Czechoslovakia also adopted a similar exchange rate strategy in early 1991, as part of its radical reform program, pegging to a basket of currencies after an initial devaluation, even though its reserve position was somewhat less strong.
By contrast, Bulgaria and Romania, both of which embarked at the start of 1991 on bold reform programs supported by IMF arrangements, adopted flexible exchange rate systems. In both countries, the choice of a floating rate—Romania also temporarily maintained a pegged rate for certain transactions—was conditioned by the very low level of international reserves at the start of the program, the limited availability of external financing, and, given the extent of the distortions to be removed under the program, major uncertainties about what would be a sustainable exchange rate.
While the IMF recognizes that a variety of flexible exchange rate systems may be appropriate in certain circumstances, there has been growing concern that policies, which target the real exchange rate—adjusting the nominal exchange rate to offset any deviation of domestic inflation from that in partner countries—may leave an economy without a nominal anchor and could lead to high inflation, particularly if financial policies are lax. The objective of real exchange rate targeting is to preserve competitiveness, thereby protecting the balance of payments. But a danger is that the targeted level for the real exchange rate may be too low—it is difficult to know what the equilibrium real exchange rate should be, especially as it is affected by many domestic and foreign shocks—with a nominal depreciation resulting principally in higher prices. The higher prices in turn may trigger a further depreciation of the exchange rate under the real rate rule, possibly leading to a spiral of rising inflation and further depreciations. To the extent that increases in the money supply can be fueled by a balance of payments surplus, such a spiral could arise even with non-accommodative credit policies. Similar problems can arise if exchange rate policy aims to limit the differential with a parallel exchange rate to less than a target amount.
Appropriateness of a particular rate under a pegged or managed arrangement. In evaluating pegged exchange rate systems, the question frequently arises whether an adjustment to the level of the peg is needed, especially in cases where a country has a current account deficit too large to be financed on a sustained basis. The assessment generally depends on the magnitude of the required reduction in the deficit and on the downward flexibility of prices and wages. An improvement in the current account usually requires a reduction in the relative price of nontraded to traded goods, which is difficult to achieve without a depreciation in the exchange rate if wages and prices are sticky downwards.
Generally, where the imbalance is relatively small, the IMF advises that reliance should be placed on fiscal and monetary policy to reduce domestic demand relative to output, thereby restoring a sustainable balance of payments position free of restrictions on current account transactions. However, where the needed cut in the balance of payments deficit is relatively large, and especially when the flexibility in prices and wages is judged to be limited, an exchange rate depreciation may be recommended—again in the context of disciplined financial policies—so as to limit the cost of the decline in domestic absorption in terms of its adverse effect on output and social dislocation. A depreciation can achieve this by helping to switch demand from imported to domestically produced goods and to encourage export production. Experience with adjustment programs over the years suggests that an exchange rate depreciation is indeed effective in cushioning output and does not support the argument that a devaluation is on balance contractionary.
Prevailing exchange rate regimes and their frequency
(The number of countries in each category at end-March 1991 is shown in parentheses 1)
Peg: single currency (46). The country links its exchange rate to the value of a major currency—usually the US dollar or the French franc—but does not change the rate frequently. About one half of all developing countries have such an arrangement.
Peg: currency composite (40). A composite, or basket, is usually formed by the currencies of major trading partners to make the pegged currency more stable than if a single-currency peg were used. Currency weights may be based on trade, services, or major capital flows. About one fourth of all developing countries have composite pegs.
Flexibility limited vis-a-vis single currency (4). The value of the currency is maintained within certain margins of the peg. This system is currently used by four Middle Eastern countries.
Flexibility limited: cooperative arrangements (10). This applies to countries in the exchange rate mechanism (ERM) of the European Monetary System (EMS) and is a cross between a peg and a float; EMS currencies are pegged to each other, but float otherwise.
More flexible; adjusted to indicator (5). The currency is adjusted more or less automatically to changes in selected indicators. A common indicator is the real effective exchange rate that reflects inflation-adjusted changes in the currency vis-à-vis major trading partners. This category also includes cases where the exchange rate is adjusted according to a preannounced schedule.
More flexible: managed float (22). The central bank sets the rate, but varies it, sometimes frequently. Adjustments are judgmental, usually based on a range of indicators, such as international reserves, the real effective exchange rate, and developments in parallel exchange markets.
More flexible: independent float (27). Rates are market-determined. Most developed countries have floats—partial for the EMS countries—but the number of developing countries included in this category has been increasing in recent years.1The list excludes Democratic Kampuchea, for which no current information is available. For members with dual or multiple exchange markets, the classification is according to tlie major market.
Even though a devaluation may help to sustain output, it invariably has implications for income distribution. In particular, while an exchange rate depreciation typically raises the earnings of the rural poor engaged in export production, it may also lower the real incomes of the urban poor employed in the production of nontradables, at least in the short run. Given that some poverty groups may be hurt by a devaluation as well as by other adjustment measures, the IMF strongly encourages its members to take steps to protect the poor, for example by targeting subsidies and social expenditures on them.
Removal of exchange restrictions. A central element of the IMF’s mandate is promoting currency convertibility—essentially, the unrestricted use of a country’s currency for international transactions, allowing it to be freely exchanged for foreign currencies (see “Heading for Currency Convertibility,” by Martin Gilman, Finance & Development, September 1990). But it should be noted that this concept, as defined in the Articles of Agreement (Article VIII), is a limited one: members are obliged to maintain financial convertibility (the absence of limitations on the making of payments and transfers), but not commodity convertibility (the absence of restrictions, such as quotas and bans, on the underlying transactions). In addition, the IMF’s concept applies almost exclusively to current transactions. Nevertheless, the IMF also advocates freedom for capital transactions and encourages its members to undertake trade liberalization, as trade restrictions have similar effects to exchange restrictions and can dilute the benefits of currency convertibility. Countries are allowed to maintain, on a transitional basis, exchange restrictions that were in place when they joined the IMF (Article XIV status). New restrictions are subject to the IMF’s temporary approval under Article VIII, but members are expected to remove them as soon as circumstances permit.
As it has turned out, most industrial country members achieved current account convertibility by the beginning of the 1960s; in fact, only Greece remains under the transitional Article XIV arrangements. A large number of developing countries have also moved to dismantle restrictive exchange systems: by the middle of 1991, 70 members had adopted Article VIII status, including, most recently, countries such as Cyprus, Indonesia, Korea, Portugal, Swaziland, Tonga, and Turkey. Moreover, many members have adopted bold economic adjustment programs in which the dismantling of restrictions and the opening of the economy to foreign competition played a key role.
This experience shows that certain preconditions must be established for moves toward convertibility to have a reasonable chance of success. These include: (1) a realistic exchange rate; (2) appropriately disciplined monetary and fiscal policies; (3) an adequate level of international reserves; and (4) the elimination of most price controls. The first three are necessary to ensure that the removal of restrictions does not lead to an unsustainable weakening in the balance of payments and possibly a reversal of the move to current account convertibility. The fourth is necessary to ensure that convertibility results in greater efficiency via an alignment of the structure of domestic relative prices with those prevailing in the world market.
Technical assistance in designing or modifying systems. Advice in this area can be either policy oriented or operational. The former focuses on the choice of appropriate exchange rate policy, the type of exchange arrangement (including the exchange control regime), the level of the exchange rate and its compatibility with the stance of other macroeconomic policies, and the sequencing of steps to move from one regime to another. Operational assistance concentrates on the actual operation of a given exchange system, as well as the practical modalities, including institutional and administrative machinery, of putting a new regime into place.
The provision of technical assistance can take a number of forms, often simply a part of the routine annual consultations. But for many developing countries, in particular, the bulk of exchange rate assistance comes through specially designed IMF programs. One of these is run by the IMF’s Central Banking Department, which provides resident experts to central banks and fields short-term missions to address specific operational problems, especially where significant exchange system reforms are being pursued. Recent examples of this type of assistance include Bulgaria, Czechoslovakia, Ghana, Nigeria, Peru, the Philippines, Poland, Romania, and Sri Lanka.
The other program is run by the IMF’s Exchange and Trade Relations Department, often in conjunction with the Central Banking Department, usually in the context of the design or implementation of an adjustment program that is supported by an IMF arrangement. Such policy-oriented technical advice has been recently provided to Bulgaria, Egypt, Guyana, Jamaica, Mongolia, Romania, Uganda, and Venezuela. In some of these cases, where problems arose with the functioning of interbank exchange markets already in place, the assistance was diagnostic and prescriptive. In other instances, such as Egypt and Uganda, the task was to help modify existing exchange arrangements in a way that was compatible with a medium-term adjustment program and the sequencing of other reforms. In the formerly centrally planned economies, the purpose was to help put in place a system that could function effectively, while rapid structural reforms, including price and trade liberalization, were being implemented.
The IMF has been mandated global responsibilities for the international monetary system, which make the conduct of exchange rate policies of all its members—creditors and borrowers—a central focus of its activities. With the objective of promoting an open and nondiscriminatory international monetary system, the IMF and its staff continuously monitor and analyze exchange rate developments in a multilateral context and bilaterally with each member country and provide advice and technical assistance on all aspects of exchange rate policy. The IMF does not offer a single best exchange rate policy prescription, but rather tailors its advice to country circumstances. In doing so, it has found that disciplined financial policies are the essential prerequisite for stable exchange rates and the avoidance of exchange restrictions.