IX Case Studies in the Role of the Exchange Rate in Inflation-Targeting Emerging Economies

Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
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This section chronicles exchange rate management practices of selected inflation-targeting emerging economies and emerging economies with other anchors. The case studies focus on recent episodes involving tension between the inflation objective and exchange rate practices and are not meant to provide up-to-date descriptions. The case study countries were chosen to cover the spectrum of inflation-targeting regimes in which the exchange rate plays an important role (open-economy inflation targeting, inflation targeting with an explicit exchange rate band, inflation targeting with an exchange rate policy instrument) as well as the spectrum of emerging economies with other anchors.


The new central bank law strengthened Guatemala’s monetary policy framework by clarifying that price stability is a primary objective, and the Bank of Guatemala (BoG) has tried to incorporate consideration of the exchange rate into its policy analysis. At the same time, in January 2005, the BoG adopted a rule-based mechanism for intervention in the foreign exchange market, which effectively establishes the exchange rate objective. Episodes during 2005–06 with high inflation and appreciation pressures reveal potential tension between the two objectives.

Monetary and Exchange Rate Policy Framework

The BoG has established an explicit inflation goal under the framework of its monetary policy. Since 1991, the BoG’s monetary board announced an inflation goal in terms of annual consumer price index (CPI) growth for the coming year. Monetary policy is formulated to achieve this goal. The current framework is outlined below.

  • At the end of each year, the monetary board determines the monetary, exchange rate, and credit policy for the subsequent year, and presents the basic strategy in terms of both a policy goal as well as various indicative variables. The policy goal is described in the form of a CPI target for the next two years; for example, 5.5 percent ±1.5 percent was set for December 2008, and 5.5 percent ±1 percent for December 2009.
  • The monetary board decides on a policy rate, namely the seven-day certified term deposit rate of the central bank, at a previously specified monthly meeting. The decisions are based on analyses of various economic indicators as well as a comparison of the inflation forecast with the CPI target.
  • The BoG conducts monetary operations to manage systemic liquidity to ensure that money market conditions are consistent with the policy rate, thereby helping to achieve the inflation goal. Currently, weekly withdrawal operations (monetary stabilization operations) are the primary tool, given the systemic excess liquidity.

A new central bank law, enacted in 2002, strengthened Guatemala’s monetary framework. The new law clearly establishes the maintenance of price stability as a primary objective of the central bank.54 Other responsibilities and functions of the BoG are subject to the price stability objective. The law also enhances operational autonomy by introducing an executive committee that is responsible for monetary policy implementation, and transparency is improved through various measures such as a governors’ biannual report to Congress on monetary policy.

The BoG has identified the exchange rate as one of the transmission channels for monetary policy. In its assessment of monetary policy, the BoG uses a Taylor-rule-type reaction function, which incorporates an adjustment of the nominal exchange rate in addition to inflation differentials and an output gap.55 A monetary condition index—a composite index that combines an interest rate and a foreign exchange rate—is also cited in the analysis of monetary easiness or tightness. These analytical frameworks are based on the assumption that the exchange rate has an important influence on economic activity and inflation developments.

The BoG adopted a rule-based mechanism for intervention in the foreign exchange market in January 2005. The rule, integrated into the annual monetary, exchange rate, and credit policy, clarifies that the purpose of intervention is to moderate the volatility of the nominal exchange rate without affecting its tendency, while assuming that the exchange rate is determined by supply and demand conditions in the market. Initially, the rule was established only for the purchase of foreign currency, in light of upward pressure on the currency (quetzal) at that time, but it was followed by the introduction of a similar rule for intervention to address depreciation pressures. The rule provides some conditions that trigger intervention, but these are asymmetrical between cases of appreciation and depreciation; the purchase of U.S. dollars is always available as long as the quetzal has appreciated 0.5 percent more than the five-day moving average. On the other hand, sale of U.S. dollars can be undertaken only when the quetzal has depreciated below a certain level.56 Depending on the resistance threshold against depreciation, this indicates the BoG’s stronger stance of leaning against the appreciation trend.

Policy and Exchange Rate Developments in 2005–06

Experiences in 2005–06 illustrate the BoG’s attempt to deal simultaneously with high inflation and appreciation pressures. The BoG chose a policy mix of moderate monetary tightening and intervention in the foreign exchange market, which might create tension between the inflation and exchange rate objectives.

High inflation and appreciation pressures

Guatemala’s inflation rate moved well above the central bank’s target range. Higher oil prices and relatively easy monetary conditions caused high inflation, which registered over 8 percent in 2005 despite the inflation goal of 4–6 percent. In 2006, inflation declined significantly to the lower part of the range because of weak oil prices and the lagged effect of monetary tightening.57

A sharp rise in worker remittances, together with capital inflows, put upward pressure on the quetzal. The quetzal was on an appreciation trend during 2005–06. This, along with other supply-side and external demand factors, contributed in part to the trade deficit and slow export growth, leading to the authorities’ concerns about competitiveness.

The BoG’s policy responses

To contain inflation pressures, the BoG continually raised its benchmark interest rate. The leading interest rate of monetary policy was increased by a total of 170 basis points (bps), to 4.25 percent, on seven occasions in 2005, and further raised by 75 bps, to 5 percent, in 2006. These actions were based on an expected overshooting of the inflation target and aimed at moderating inflation expectations and limiting the second-round effect of the imported inflation.58 As a result, inflation decreased into the central bank’s target range toward end-2006, but short-term interest rates remained negative in real terms.

Meanwhile, the BoG intervened in the exchange market to stem the appreciation pressures according to the established rule. In 2005, when the new intervention rule was introduced, the BoG bought US$466.6 million, and in 2006 it purchased US$130.5 million. It should be noted that interventions were conducted only against abrupt appreciation, as specified in the rule stated above.59 These operations helped lead to the accumulation of foreign reserves, but at the same time appear to have been conducive to rapid money and credit expansion.


The BoG recognizes that the exchange rate is an important channel in the pursuit of the explicit inflation goals, but it faces conflicts. The new central bank law strengthened Guatemala’s monetary policy framework, clarifying price stability as a primary objective, under which the BoG tried to incorporate exchange rate considerations into its policy analysis. But, in the face of high inflation and appreciation pressures, the BoG was forced to conduct a conflicting policy combination of monetary tightening and U.S. dollar purchase interventions, resulting in still relatively easy monetary conditions.

A clear rule for foreign exchange intervention, despite increasing transparency, has complicated policy implementation. According to the current rule, interventions can be triggered automatically, based on exchange rate developments, which effectively establishes a kind of exchange rate objective. This arrangement makes unclear the role of the exchange rate in pursuit of the inflation objective, causing potential tension between the two.


Hungary, an open transition economy, adopted an inflation target with a ±15 percent exchange rate band in 2001. This reflects the importance of the exchange rate channel in a transmission mechanism and also the authorities’ planned entry into the European Economic and Monetary Union (EMU). Under the framework, the Magyar Nemzeti Bank (MNB) guides the exchange rate in line with the inflation objective by maneuvering the policy interest rate. The MNB was explicit about its preferred exchange rate target in the initial stage of the regime. However, speculative attacks and deterioration of market confidence in 2003 caused conflicts between the inflation target and exchange rate management. A preferred exchange rate was no longer announced after 2004. Furthermore, to make clear the MNB’s primary objective of price stability, the exchange rate band was abandoned in February 2008.

Monetary and Exchange Rate Policy Framework

To achieve and maintain its price stability objective, Hungary adopted: (1) an inflation target in 2001, and (2) a ±15 percent intervention band for the exchange rate. In the process of economic transition in the 1990s, the (crawling) peg arrangement succeeded in bringing down the inflation rate from 30 percent to 10 percent. However, disinflation came to a halt as a result of higher prices for imports during 1999–2000, boosting inflation expectations, which required a new monetary policy regime. The key elements adopted in 2001 were the following:

  • In agreement with the government, the MNB widened the fluctuation band of the exchange rate from ±2.25 percent to ±15 percent (May 2001), which is compatible with the European exchange rate mechanism II (ERM II). 60,61 The central parity, pegged to the euro, was Ft 276.1 per €1.62 Subsequently, the crawling peg was abandoned (October 2001). Under this exchange rate regime, the MNB was occasionally explicit about its preferred exchange rate (narrower band), but this practice was abandoned around the beginning of 2004, as discussed below.
  • The forint was declared fully convertible, and the existing restrictions on foreign exchange transactions were lifted (June 2001).
  • The MNB introduced inflation targeting (June 2001). The consumer price index targets were set jointly with the government at 7 percent ±1 percent for December 2001 and 4.5 percent ±1 percent for December 2002. Afterward, the targets were determined on a yearly basis until the end of 2006, followed by the introduction of the medium-term target at 3 percent for the period starting in 2007.63
  • The new Central Bank Act defined that the primary objective is to achieve and maintain price stability, and reinforced the central bank’s operational independence, which is consistent with European Union requirements (effective July 2001).

The MNB’s monetary council is responsible for setting the key policy rate to guide the exchange rate in line with the inflation target. The council convenes at least twice a month according to an announced schedule, and the two-week policy rate is set by a simple majority vote.64 A change in the MNB’s policy rate is aimed primarily at affecting the foreign exchange rate, which has a considerable impact on aggregate demand and inflation in Hungary.65 For example, when the council judges that developments in the exchange rate jeopardize meeting the inflation target, it raises (or cuts) the policy rate to expand (or reduce) the forint-euro interest rate differential, which in turn is supposed to stimulate an appreciation (or depreciation). At the same time, the MNB makes clear that it does not focus exclusively on changes in the exchange rate but on all factors that affect inflation.

The MNB, in principle, refrains from intervening in the foreign exchange market, although it is entitled to conduct interventions within the exchange rate band. Indeed, in the initial period of widening the band in 2001, the MNB allowed the exchange rate to appreciate strongly to find a new equilibrium. In the face of speculative attacks in early 2003, the MNB intervened in the exchange market to counteract them, but announced in May 2003 that it had ended such operations and would conduct interventions only in cases of market disturbances in the future. This effectively clarified the MNB’s intention to influence exchange rate movements mainly through changes in the policy interest rate.

The MNB provides the general public with various kinds of information about monetary policy. The monetary council announces its decision and the underlying reasons in the form of a policy statement or press release on the day of the previously announced meeting. Abridged minutes of the rate-setting meetings (that is, the second meeting of each month) are released regularly, before the next rate-setting meeting takes place. In addition, the Quarterly Report on Inflation66 presents the MNB’s inflation forecasts, which play the role of an intermediate target for the monetary framework.

Policy and Exchange Rate Developments in 2003

After a successful two-year implementation of the inflation target, speculative attacks and a deterioration in market confidence in 2003 posed challenges to the conduct of monetary policy. The MNB missed the target for the first time in 2003; year-end inflation stood at 5.7 percent, whereas the target was 3.5 percent ±1 percent.

Speculative currency attacks in early 2003

In January 2003, there was a massive inflow of speculative capital aimed at forcing a revaluation of the exchange rate band. To defend the band, the MNB lowered its key interest rate from 8.5 percent to 6.5 percent in two phases. Changes were also made to monetary policy instruments by widening the overnight interest rate corridor and putting a temporary limit on the availability of the deposit facility at the MNB. Further, the MNB intervened actively in the exchange market. As a result of these measures, the MNB succeeded in defending the currency band and fending off the speculative capital by May 2003, when the end of the currency attack was announced explicitly by the monetary council. However, the consequences were lower interest rates and a weaker exchange rate, which boosted inflation pressure during the latter part of the year.

Depreciation pressures after devaluation of the parity in June 2003

The unexpected devaluation of the exchange rate band undermined market confidence, resulting in considerable depreciation of the forint. In June 2003, at the government’s request, the MNB agreed to devalue the central parity of the band by 2.26 percent, to Ft 282.36 per €1. This was initiated as part of a series of economic policy measures, resulting in support for exporters. However, it caused considerable confusion, and rising risk premiums caused the forint to take a sharp downward turn. In order to counter these developments, the MNB raised its key policy rate by 3 percentage points, to 9.5 percent, in two stages in June. The interest rate actions, together with the government’s announcement of Hungary’s euro changeover in 2008,67 stabilized the forint rate, with marginal appreciation until October. But the market shifted its attention to imbalances in the Hungarian economy, particularly the budget and current account deficits, which fueled downward pressure on the exchange rate again in November 2003, representing a threat to the inflation target. As a result, the MNB was forced to raise the key policy rate by another 3 percentage points, to 12.5 percent, to offset the increasing risk premiums and stop the forint from depreciating further.

In the course of these developments, the MNB explicitly announced the narrower preferred range of the exchange rate apart from its wider ±15 percent band. In the policy statements and press releases, the monetary council repeatedly expressed its view that the exchange rate should stay in the (upper) range of Ft 250-260 per €1 in order for the inflation objectives to be met. This was supposed to stabilize inflation expectations by presenting the desirable exchange rate level. However, as this range became increasingly untenable in the face of strong depreciation pressure in late 2003, the announcement of the preferred range turned out to be ineffective. The narrower target was no longer announced after 2004.


In open transition economies like Hungary, the exchange rate plays an important role in inflation targeting. With a more open economy, the exchange rate channel is stronger, making it more relevant for achieving the targeted inflation rate. Moreover, during the transition process, with the authorities’ lower credibility, the exchange rate can function well as a nominal anchor to reduce high inflation rates in the absence of alternative monetary control systems. Furthermore, countries planning to enter the EMU have a particular concern about their exchange rates, which must eventually be fixed to the euro. For these countries, the exchange rate is an important factor driving monetary policy.

However, sudden changes in the market environment, characterized as risk-premium shocks, may cause tension between inflation targeting and the exchange rate consideration. Counteracting exchange market movements brings about large fluctuations in the policy interest rate. Particularly in the case of appreciation pressure, efforts to defend the exchange rate band can result in unintended monetary expansion, thereby undermining the inflation objective.

Presenting the preferred level of the exchange rate to the public makes policy intentions unclear. Although the measure is aimed at enhancing the transparency of the policy, it may deliver an ambiguous signal about whether monetary policy decisions are oriented toward the inflation target or the exchange rate objective. In addition, this can trigger speculative attacks aimed at revaluating the targeted exchange rate level. This is typically the case with narrower ranges of an announced specific target.

Recognizing this potential tension, the MNB abandoned the ±15 percent band in February 2008. The MNB judged that limiting exchange rate fluctuation under an inflation-targeting regime would not help to firmly anchor long-term inflation expectations. This move is seen as enhancing the credibility of the MNB’s inflation-targeting regime in the face of inflation rising above the target level.68


The Central Bank of Iceland (CBI) takes the exchange rate into account in its inflation-targeting regime, recognizing that the effects of its actions on inflation are significant. Because the CBI does not attempt to manage the exchange rate by aiming at a specific level, there is not much tension between exchange rate considerations and a price-stability objective. The CBI simply responds to the impact of exchange rate movements on inflation and inflation expectations in order to attain the inflation target. An episode of financial turbulence in 2006 highlights how the CBI incorporates the exchange rate in the conduct of monetary policy.

Monetary and Exchange Rate Policy Framework

Iceland introduced an inflation target in March 2001 with adoption of a floating exchange rate regime.69 The framework is outlined as follows:

  • The CBI aims at an average rate of inflation, measured as the annual increase in the headline consumer price index, of as close to 2½ percent as possible.
  • The tolerance limit is now ±1½ percent above or below the target. The upper tolerance has been narrowed step by step since introduction of the inflation target; it was +3½ percent in 2001 and +2 percent in 2002.
  • If inflation deviates by more than ±1½ percent from the target, the CBI is obliged to submit a report to the government explaining the reasons for the deviation, how the CBI intends to react, and how long it will take to reach the inflation target again in the CBI’s assessment. The report must be made public.70
  • The CBI provides an inflation forecast, projecting inflation two years into the future. The projection is outlined in its Monetary Bulletin, which is published three times a year.

The CBI’s inflation target takes priority over other objectives. The CBI cooperates with the government policies insofar as they do not conflict with the inflation target. The CBI also undertakes tasks that are consistent with its central banking functions, such as maintaining foreign reserves, promoting an effective and reliable financial system, issuing notes and coins, and regulating foreign exchange markets.71

Monetary policy is decided by the board of governors of the CBI on previously announced dates. Interest rate decisions are currently made six times a year, approximately every two months, three of which are associated with publication of the Monetary Bulletin containing the inflation forecast. Policy decisions are published on the scheduled dates, followed by a press conference by the chairman of the board.

The inflation target is to be attained through the CBI’s monetary operations, with controlling the short-term interest rate as an operating target. A main instrument is collateral loan agreements with financial institutions. Auctions of seven-day instruments are held every week, the interest rate on which constitutes the CBI’s policy rate. In addition, the CBI provides a number of facilities available for financial institutions at their discretion, which prevents excessive swings in money market rates. These include remunerated current accounts, certificates of deposit with a maturity of 90 days, and overnight loans.

Foreign exchange market intervention became rarer after the exchange rate target was abandoned in 2001. The intervention is employed only if the CBI considers this necessary in order to promote its inflation target or sees exchange rate fluctuations as a potential threat to financial stability (Table 9.1).72

Table 9.1.CBI: Exchange Rate Considerations in Monetary Policy during 2006

References to the Exchange Rate in Policy StatementsInflation Rate1

Exchange Rate2
Jan. 26 +0.25%… inflation measured slightly higher than had been forecast in December. For most of this period the króna has also been marginally weaker than forecast…. The highest real exchange rate since the 1980s and record current account deficit indicate sizable inflation pressures ahead …4.4%

Mar. 30 +0.75%The inflation outlook has deteriorated … To a significant degree this can be attributed to a substantial depreciation of the króna in recent weeks[T]he inflation outlook is correspondingly less favorable …, especially in light of the adverse effect that recent exchange rate developments have had on the prospects for attaining the inflation target…. Now the króna has depreciated sooner and faster than was generally expected. Inflation expectations have risen as a result …4.5%

May 18 +0.75%… the króna has depreciated substantially, inflation has risen, and the medium-term inflation outlook has deteriorated accordingly…. Large current account deficit … indicates a risk of further downward pressure on the króna in the months ahead. In order to moderate its effects on domestic inflation it is essential to maintain a very restrictive monetary policy stance …7.6%

July 6 +0.75%The (króna) depreciation has already contributed to soaring inflation and will keep it high over the coming months…. A less favorable exchange rate development than expected could lead to even higher inflation, requiring an even higher policy rate to rein it in.8.4%

Aug. 16 +0.50%No reference to the exchange rate.8.6%

Sep. 14 +0.50%No reference to the exchange rate.7.6%

Nov. 2 unchangedDisinflation over the past two months is partly the result of the sustained tight monetary stance …, a wider interest rate differential with the rest of the world, and an appreciation of the króna. However, … the appreciation of the króna … (is) a volatile measure and can be reversed.7.3%

Dec. 21 +0.25%Assuming that the exchange rate of the króna remains relatively stable, the outlook is for somewhat lower inflation over the early part of the forecast period… The tight monetary stance has … contributed to exchange rate stability … Inflation prospects and the monetary stance depend heavily on the króna remaining relatively strong.7.0%

Source: IMF staff.

Annual change in consumer price index in the month.

Exchange rate index of the króna on the date; Dec. 31, 1991 = 100.

Source: IMF staff.

Annual change in consumer price index in the month.

Exchange rate index of the króna on the date; Dec. 31, 1991 = 100.

The CBI recognizes the exchange rate as an important transmission channel. Inflation targeting is understood to mean that a currency appreciation contributes to lower import prices, which has a direct effect on reducing inflation. The appreciation also makes imported goods and services relatively cheaper than domestic ones, decreasing demand for domestic products, which leads to lower inflation. This indicates that monetary policy is likely to accommodate currency movements if they are associated with demand shocks. The CBI’s macroeconomic model incorporates this exchange rate channel,73 in addition to interest rate and asset price channels. The assessments of price developments and inflation forecasts that are included in the Monetary Bulletin also provide a great deal of analysis on the impact of exchange rate movements.

Recent Episode of Policy Responses to Exchange Rate Developments

In 2006, Iceland experienced turbulence in its financial markets, in particular large swings in the exchange rate, in the face of mounting inflation pressures. This episode highlights how the CBI takes exchange rate movements caused by risk-premium shocks into account when conducting its inflation target. A distinctive feature is that the CBI did not attempt to manage the exchange rate but instead responded to the impact of exchange rate movements on inflation and inflation expectations.74 The following divides the period into pre-2006 and post-2006.

Toward the end of 2005

A rapid expansion in domestic demand led to strong inflation pressures. The expansion was driven by new investment projects in the aluminum sector, introduced in late 2004. Consumption and housing demand were also promoted by active bank lending after structural changes in the mortgage market. As a result, in 2005 the current account deficit reached 16½ percent of GDP and the annual inflation rate edged up above 4 percent, the upper tolerance of the CBI’s inflation target. The economic expansion, together with favorable global market conditions, enabled Icelandic banks to extend their activities abroad, with a significant increase in foreign liabilities.

Higher interest rates caused the króna to appreciate, and it ended up at a historical high in late 2005. In response to growing inflation pressures, the CBI steadily raised its policy rate from 5.3 percent in spring 2004 to 10.5 percent at the end of 2005, inducing the currency appreciation. Indeed, monetary tightening was channeled primarily through the exchange rate, which was amplified by a large interest rate differential with the rest of the world. The real exchange rate reached its highest level since 1988. Nevertheless, bank credit continued to grow both in households and firms owing to relatively easy access to mortgage and global financing; thus, inflation had yet to be fully contained.

The CBI expressed concern about the sustainability of the appreciation of the króna. Given the large current account deficit, the CBI felt that a strong króna was unlikely to be maintained in the long run. It outlined in its Monetary Bulletin that a substantial part of the adjustment of imbalances would take the form of a króna depreciation, and it incorporated this view in its inflation forecast. The CBI concluded that a tighter monetary stance was needed for an extended period in order to meet the inflation target. Inflation targeting also emphasized that monetary policy was aimed at ensuring that the inevitable exchange rate adjustment would not result in a higher inflation rate than is compatible with the target.

Financial turbulence in 2006

Against the background of accumulating imbalances, a series of negative reports from rating agencies triggered financial turbulence in the first half of 2006. These reports, citing concerns over macro imbalances and vulnerabilities in the highly leveraged financial sector, caused a sharp depreciation of the króna by one-quarter and a fall in stock prices, also by one-quarter. Bond prices of banks fell significantly as well, hindering their access to foreign credit markets.

As the inflation outlook deteriorated owing to the króna depreciation, the CBI tightened its monetary stance sharply by raising its policy rate by 3.75 percentage points during 2006. Monetary tightening took place on seven out of eight policy decision dates, two of which were added to originally scheduled ones. Throughout these decisions, the CBI signaled a firm commitment to bring inflation back to the target after it had risen substantially. The CBI took into account the foreign exchange rate in its assessment and forecast of inflation, but did not set a specific target on the rate (Table 9.1).

In addition, the CBI enhanced communication about the economy and financial stability. In the Monetary Bulletin and annual Financial Stability Report, the CBI provided more detailed and comprehensive explanations of the economy and the financial system, which helped international audiences follow the situation in Iceland. Moreover, the CBI, in cooperation with the financial supervisory authority, strengthened monitoring of banks’ financing, liquidity, and risk management.

Although financial markets had calmed significantly by mid-2006, inflation pressures remained, calling for a sustained tight monetary stance. The real exchange rate returned to close to the 25-year average in late 2006, and the króna has been fairly stable since. However, economic activity continues to be robust in all regards, and underlying inflation is still high, forcing the CBI to maintain the higher policy rate. Because the króna began gradually appreciating again in the beginning of 2007, the CBI has been cautious about the increasing probability of an eventual depreciation of the króna, a potential risk to inflation.75


Pursuing price stability in a consistent manner is crucial for maintaining policy credibility. During the above-mentioned period, the CBI repeatedly cautioned against the idea that a tight monetary policy can be avoided by temporarily relaxing the inflation target. Such a “volte-face” policy would immediately raise inflation expectations, fuel higher wage increases, and result in a further depreciation of the króna and more inflation. The cost of such a policy is thought to be huge. On the contrary, the CBI chose to adhere to the inflation target to avoid making inflation a persistent problem.76

Setting no exchange rate target can successfully avoid tensions between exchange rate considerations and the inflation target. Even though it takes account of the exchange rate in monetary policy, the CBI does not intend to manage it. The CBI simply reacts to the impact on inflation of exchange rate developments. This consistent policy prevents discrepancies within the monetary framework.

Financial stability provides a basis for a stable exchange rate and low inflation. Episodes in 2006 and early 2008 suggest that financial vulnerability can bring about abrupt depreciation of the króna, which induces inflation pressures. Mitigating financial imbalances is an important task in order for small and open economies to be resilient to external shocks.


Kazakhstan, a booming transition economy, has had an eclectic monetary policy framework. Price stability has been the primary objective of the National Bank of Kazakhstan (NBK) since the change of policy framework in 2003, but the NBK also pays attention to exchange rate developments. Kazakhstan has sustained a very strong macroeconomic performance since the start of the decade, with an average real GDP growth exceeding 10 percent. Oil-related inflows and improved confidence in the economy led banks to increase their external borrowing and extend loans domestically. Strong output and credit growth, coupled with resistance to allowing rapid appreciation, resulted in inflation pressures. In recent years, until mid-2007, the main challenge for the NBK was to strike a balance between inflation pressures and appreciation.

The Monetary Policy Framework

The law governing the NBK states that its main goal is to ensure stability of prices in the Republic of Kazakhstan. This goal, which was introduced to the law by amendments in 2003, supported the adoption by the NBK of a new monetary policy framework, with price stability as its primary objective. In practice, the current policy framework of the NBK can be considered eclectic, using different indicators in conducting monetary policy to control inflation and rapid credit growth as well as giving attention to the exchange rate. Looking forward, the NBK announced plans to introduce an inflation-targeting regime. Preparations for full-fledged adoption of inflation targeting are under way. The NBK and the National Statistics Agency developed a set of core inflation indices, and the NBK stepped up its efforts to model and monitor macroeconomic developments.

The operational framework reflects a very low level of government debt and large oil-related foreign exchange reserves. The NBK has a limited stock of government securities to conduct monetary operations, and therefore had to issue central bank securities (NBK notes) to manage liquidity.

Economic Background

Kazakhstan has sustained a very strong macroeconomic performance since 2000. Between 2000 and 2006, annual real GDP growth has averaged over 10 percent, and per capita income reached about five times the 1999 level in dollar terms. However, growth slowed to 5½ percent in the fourth quarter of 2007. Employment has expanded steadily since 2000, and social indicators have improved. The fiscal position has remained very strong, permitting substantial increases in public expenditures, especially social and infrastructure spending, as well as an accumulation of large savings in the National Fund (NFRK) for future generations (Box 9.1). High prices for oil and gas, rapid growth of domestic consumption, and a rebound in investment were among the factors that contributed to the strong economic performance.

Nevertheless, monetary policy faces a number of challenges. Sharply rising oil revenues and capital inflows fueled inflation pressures and vulnerabilities in the banking sector. A major concern is external debt, which increased rapidly in recent years, almost all of it owed by private banks that extended loans to households and firms, with limited hedging possibilities. The very rapid growth in bank credit poses the risk of a sharp deterioration in loan quality. Containing inflation has also been a challenge for the NBK in an environment of rapid output and credit growth and large foreign exchange inflows. Inflation has been on an increasing trend since 2003, reaching 18.1 percent in March 2008. The challenge in this environment is to set appropriate monetary and exchange rate policy stances to slow the pace of bank credit growth and external borrowing and to contain inflation.

Box 9.1.The National Fund of the Republic of Kazakhstan

Faced with a surge in foreign exchange earnings from higher oil production and prices, the authorities established the National Fund of the Republic of Kazakhstan (NFRK) in 2001 to reduce the impact of volatile market prices for natural resources on the economy and to smooth the distribution of oil wealth over multiple generations. The NFRK is domiciled in the National Bank of Kazakhstan (NBK), which has the responsibility of managing its assets on behalf of the government. All NFRK assets are invested exclusively abroad. As of mid-March 2008, $22.8 billion had accumulated in the fund.

The NFRK is a special account of the Ministry of Finance of Kazakhstan with the NBK. The NBK advises the Ministry of Finance on managing the assets of NFRK. A significant portion of the fund’s reserves are under management by the world’s leading private financial institutions, to ensure the transparency and accountability of the process.

Another challenge throughout the period has been to assess the impact of money growth on the economy. As a transition economy with strong growth and macroeconomic stability, there was a steady buildup of confidence in the banking system after the late 1990s, which was reflected in strong money demand and monetization. Relying on monetary aggregates for monetary policy in such an environment is challenging. On the other hand, the lack of some of the preconditions to do this, including the lack of effective interest rate channels, made it difficult to adopt this regime in the short term. The NBK’s eclectic approach reflects these challenges.

The 2003 monetary policy framework included inflation and exchange rate objectives. The NBK treated price stability as the key monetary policy objective, but continued to closely monitor the real exchange rate of the tenge against a basket of 24 currencies of key trading partners. The NBK intervened in the foreign exchange market, mainly through purchases aimed at preventing a rapid appreciation of the tenge. In an effort to stem upward pressure on the tenge while containing money growth, the NBK supplemented its exchange market intervention with continued large-scale sterilization operations. However, as sterilization costs mounted, the increase in the NBK’s reserves was not fully sterilized. As a result, reserve and broad money growth rose beginning in 2003. Moreover, although NBK policy rates were raised in 2005, 2006, and 2007, the increases were well short of the rise in international short-term rates, and interest rates were often negative in real terms.

Policy Response to the Boom until Mid-2007

The authorities’ main concerns during the period were rapid appreciation, mounting vulnerabilities in the banking system, and inflation pressures. The authorities recognized that appreciation of the tenge was unavoidable amid high oil prices and increases in domestic production. Yet they believed that large and rapid nominal appreciation could prove disruptive. Resistance to rapid appreciation, however, brought about continued inflation pressures. Another major concern was banks’ external borrowing and rapid credit growth. A sudden stop or a reversal of flows posed the risk of funding problems for the banking system.

The NBK used a variety of tools to respond to the economic boom and rapid credit growth. Interest rates were increased by 100 basis points in 2006 and a further 100 basis points during the first half of 2007. Despite these measures, banks’ lending rates declined markedly in real terms, further fueling credit demand. During the first half of 2007, the NBK allowed a more rapid appreciation of the tenge by scaling back its interventions in the foreign exchange market.

Reserve requirements were another tool used to slow credit growth. To enhance its ability to absorb liquidity, in October 2005 the NBK broadened the coverage of required reserves to include net foreign liabilities. Reserve requirements were raised in mid-2006. Changes to the requirements were implemented in a phased manner to allow banks to adjust their balance sheets without undue disruption.

The financial position of the NBK was strengthened in 2005 to better cope with capital inflows. An amendment to the budget code enacted in mid-2005 envisaged capital injections to the NBK to cover losses related to monetary operations, including interest expenses for sterilization operations and revaluation losses resulting from tenge appreciation.

Prudential measures were implemented in response to rapid credit growth. These included bank-capital-related limits on borrowing, tighter asset-classification rules and risk weights, and stronger collateral requirements. Banks’ open foreign currency limits were reduced in early 2005, and capital adequacy requirements for market and operational risks were introduced. The risk weight for high-value property loans was raised, and the scoring system used by banks for loan classification was toughened. But the new regulations proved ineffective, partly because they appeared to be lax and were implemented too slowly.

Supervision was also strengthened. On-site inspections were intensified. Off-site supervision was strengthened and, since early 2006, banks have been required to submit additional information on their assets, contingent liabilities, and related party and holding operations. Banks are required to regularly submit stress test results—covering liquidity, credit, interest rate, exchange rate, oil, and real estate price shocks—and currency gap analyses to the financial supervisory authority.

Although these measures likely have had some impact, they have not fully addressed the authorities’ concerns. Rapid appreciation may have been avoided to some extent, but inflation has continued to rise. Despite measures to tighten liquidity, money and credit aggregates surged. External debt and credit continued to grow at a fast pace.

Recent Developments

The volatility and liquidity problems that started after the subprime mortgage crisis in August 2007 hit the Kazakhstan banking sector hard. The banking system faced difficulties in external funding, and bond spreads in international markets jumped by 150-350 basis points during July-August. Liquidity conditions in the domestic money market tightened correspondingly, with interbank rates rising by 250 basis points despite large-scale redemption of NBK notes by banks as well as nonresidents. The tenge came under pressure, but NBK intervention helped limit its depreciation against the dollar to 3½ percent from end-June to end-August. The NBK responded by providing large-scale liquidity to the banks during August-October through repurchase agreements, foreign exchange swaps, the early redemption of NBK notes, and the easing of reserve requirements. It also intervened in the foreign exchange market, with 25 percent of reserves used to cool down the market and an effective peg of the tenge to the U.S. dollar after October 2007. After rising sharply, interbank rates have eased.


Concerns about rapid appreciation cause tension with the price stability objective. Resisting appreciation through intervention fuels liquidity growth, leading to inflation pressures. In a rapid-growth environment supported by a positive terms-of-trade shock, appreciation is unavoidable. The challenge for the NBK is to assess the equilibrium rate of the real exchange rate and keep the tenge around that level, no matter how rapid the appreciation may be. Otherwise, the risk remains that adjustment of the real exchange rate will take place through inflation, instead of nominal appreciation.

Regulatory measures are not sufficient to address vulnerabilities without a complementary monetary policy. Although the regulations themselves need to be strengthened, the fact that interest rates remained low or negative in real terms in Kazakhstan throughout the period has muted the overall policy impact.


Given high financial dollarization, the Central Reserve Bank of Peru (BCRP) takes the exchange rate into account in its framework. The BCRP has tried to prevent excess exchange rate volatility to avoid the risks associated with dollarization, as long as such a policy is consistent with the inflation objective. Strong depreciation pressure on the nuevo sol and its subsequent appreciation trend during 2005–06 highlighted the interaction and potential tension with exchange rate management.

Monetary and Exchange Rate Policy Framework

To achieve its constitutional objective—preservation of monetary stability—the BCRP adopted inflation targeting in 2002. This replaced monetary targeting, because there was no longer a systematic association between inflation and the growth of the monetary base. The key aspects of the inflation-targeting regime are as follows:

  • The 2007 target was an annual inflation rate of 2 percent in terms of the CPI (for Metropolitan Lima), with a tolerance margin of ±1 percent. The central rate was reduced by 0.5 percent in February 2007, from 2.5 percent, the rate set when inflation targeting was introduced. The new target, closer to the inflation rates in Peru’s major trading partners, is expected to reinforce the BCRP’s commitment to maintain the purchasing power of the domestic currency in the long run and to help reduce financial dollarization.
  • The board of the BCRP decides on a reference rate for the interbank lending market on a previously announced date, usually at the beginning of each month. The decisions are based on forecast studies and macroeconomic simulations. To keep the interbank rates close to the reference rate, the BCRP conducts open market operations to inject liquidity into or withdraw it from the system. In addition, the BCRP provides lending and deposit facilities, which form a corridor of interbank rates.
  • The board’s decisions are immediately announced to the public along with the main reasons underlying the decisions. The BCRP also publishes an inflation report every four months, which analyzes recent inflation developments, outlines policy actions adopted by the BCRP, and presents the inflation forecast with the balance of risks. Exchange rate movements and their implications for inflation are also analyzed.

The first five years of inflation targeting were associated with good inflation control. The average annual inflation rate was 2 percent for 2002–06, indicating that inflation was within the target range. This outstanding performance apparently led to the reduction of the target rate (mentioned above).

Peru’s inflation-targeting regime and its exchange rate policy are also aimed at preventing the risks associated with financial dollarization and smoothing the way to dedollarization. Peru’s economy remains highly dollarized, although much less so in recent years, from more than 70 percent of deposits as of end-2000 to less than 40 percent as of March 2008. Financial dollarization poses risks stemming both from currency and maturity mismatches, which makes the economy more vulnerable to abrupt exchange variations, in particular an unexpected depreciation of the local currency. Inflation targeting contributes to a reduction in financial dollarization by reinstating confidence in the domestic currency. At the same time, a flexible exchange regime77 is pursued to help stabilize the real return on domestic assets and avoid abrupt exchange rate fluctuations, which facilitates the dedollarization process.78

The BCRP intervenes in the exchange market to prevent excessive volatility. In addition, purchasing foreign currencies can strengthen the BCRP’s foreign reserve position, which also enhances its ability to deal with strong depreciation pressures.79 In its interventions, the BCRP does not strive for any particular exchange rate level; it emphasizes that the elimination of volatility in the exchange rate might prevent economic agents from promoting risk management in foreign currencies. Importantly, exchange interventions are conducted in line with the inflation-targeting regime, given the priority of achieving the target.

Policy and Exchange Rate Developments in 2005–06

Strong depreciation pressures and the subsequent appreciation trend during 2005–06 highlighted the interaction between inflation targeting and exchange rate management. The BCRP addressed these market developments, taking account of risks under high financial dollarization.

Depreciation pressures during late 2005 and early 2006

Beginning in August 2005, the exchange market was subjected to depreciation pressures accompanied by an increase in the sovereign risk premium. Following an appreciation trend beginning in 2003, the nuevo sol once again weakened in August 2005, as a result of growing uncertainty about the results of the presidential election and shifts in institutional investors’ portfolios. Election-related uncertainty fueled the country risk premium increase as well. These downward currency movements ended in mid-January 2006, but volatility continued until the first round of elections in April 2006. Forward currency transactions also indicated rising expectations that the nuevo sol would deteriorate during the first several months of 2006.

To prevent the sol’s depreciation and excess exchange rate volatility, the BCRP raised the reference rates by 150 bps, to 4.5 percent, and conducted foreign exchange market interventions. The policy rate was raised six times from December 2005 to May 2006 (25 bps each month). Although the inflation rate was below the targeted level (2.5 percent) during the period, strong economic growth, together with a depreciating exchange rate, made it advisable to reduce monetary stimulation to avoid creating inflation pressures that could affect the ability to meet the inflation target in the future. The BCRP also countered the market until January 2006 through the sale of dollars (purchase of nuevos soles) and the placement of U.S. dollar-indexed certificates called readjustable certificates of deposit. These policy actions and operations were meant to check the negative impact of the excessively volatile exchange rate on economic activity in the context of heavy financial dollarization.

Appreciation trend after mid-2006

As election-related uncertainty dissipated, the appreciation of the sol resumed in mid-2006, prompting the BCRP to intervene in the opposite direction. The upward pressure was supported by the continuous favorable evolution of the external account and increasing remittances from Peruvian citizens abroad. In order to offset these pressures, the BCRP intervened in the exchange market and stepped up dollar purchase operations. This contributed to the restoration and subsequent strengthening of the BCRP’s foreign reserve position. As a result, the dollarized economy was in a better position to deal with associated risks. Meanwhile, the BCRP maintained the monetary policy reference rate at 4.5 percent until July 2007, when it began to express concern about the possibility of inflation because of the increase in domestic demand. In line with this policy stance, the BCRP sterilized excess liquidity through placements of nuevo soldenominated certificates of deposit.80


A high degree of financial dollarization increases the role of the exchange rate in the monetary policy framework. To prevent risks associated with dollarization, the authorities sought to avoid excess exchange rate volatility, particularly strong exchange rate swings, which could seriously affect the economy’s balance sheet, given still significant dollarization. Peru has effectively succeeded in achieving this objective in line with its inflation-targeting regime, while increasing the economy’s reliance on the local currency; the level of financial dollarization in Peru has decreased significantly in recent years.

As long as depreciation pressures are accompanied by inflation risks, there is little conflict between inflation targeting and exchange rate considerations, as seen between late 2005 and early 2006. However, appreciation with inflation complicates the implementation of monetary policy, because dollar purchase interventions may cause excess liquidity. To mitigate the tension, the BCRP must sterilize the monetary impact of its intervention.

Supplemental measures to promote dedollarization help prevent potential conflicts between the inflation objective and concern about a volatile exchange rate. As pointed out by the BCRP, robust financial systems and sound fiscal positions help reduce risks associated with financial dollarization.


The strong appreciation of the peso in 2006 revealed potential tension between foreign exchange interventions and the need to contain inflation pressures, complicating inflation targeting of the Bangko Sentral ng Pilipinas (BSP). Expanding sterilization operations and liberalizing capital controls have helped ease the problem to some extent.

Monetary and Exchange Rate Policy Framework

The BSP adopted an inflation target in January 2002, after abandoning monetary targeting. The primary objective of the BSP’s monetary policy is “to promote price stability conducive to a balanced and sustainable growth of the economy,” which the inflation target aims to achieve. Core elements of the framework are as follows:

  • The BSP aims for an average year-over-year change in the headline CPI. The target for a given year is announced two years in advance (a two-year target horizon) and is set by the government in consultation with the BSP. The target for 2008 was 4 percent, with a tolerance of ±1 percentage point (or 3–5 percent). For 2009, the target is 3.5 percent ±1 percentage point (or 2.5–4.5 percent).81
  • If the BSP fails to meet the inflation target, the BSP governor issues an open letter to the president to explain to the public why the target was missed, along with measures to be adopted to bring inflation toward the target. Open letters were issued January 16, 2004; January 18, 2005; January 25, 2006; January 19, 2007; and January 14, 2008.82 This suggests that the target has been missed during most of the period.
  • Acceptable circumstances under which the BSP is allowed to fail to achieve its inflation target include price pressures arising from volatility in the prices of agricultural products; natural calamities or events that affect a major part of the economy; (3) volatility in the price of oil products; and (4) significant government policy changes that directly affect prices—for example, changes in the tax structure, incentives, and subsidies.
  • The BSP publishes a quarterly inflation report with inflation forecasts and the highlights of the meeting of the monetary board to help the public better understand monetary policy developments.

Monetary policy is decided by the monetary board, which meets every six weeks on pre-announced dates. To strengthen the decision-making process, an advisory committee was established to make recommendations to the monetary board. This committee, consisting of the BSP governor and representatives of several government agencies, meets a few days before each monetary policy meeting.

The primary instruments used to achieve the inflation target are overnight repos and reverse repos, whose interest rates form the BSP’s policy rates. Other regular monetary instruments include short-term repos, outright purchases and sales of securities, rediscounting, and reserve requirements. In addition, the BSP sometimes adopts a “tiering scheme” for banks’ aggregate placements at the BSP to encourage bank lending.83 Moreover, the BSP implemented new liquidity management measures to improve capacity to absorb liquidity.84

The BSP’s foreign exchange intervention is officially limited to countering disorderly market conditions.85 The authorities took advantage of favorable market conditions to strategically build up reserves, thereby reducing vulnerability to external shocks. Over 2005– 07, absolute monthly intervention averaged 38 percent of daily foreign exchange market turnover (Edison and others, 2007).

The BSP takes the exchange rate into account when carrying out monetary policy. Although the BSP does not attempt to keep the exchange rate at any particular level, it examines the impact of exchange rate movements on price developments in its overall inflation forecasts. The BSP also assesses external competitiveness through analysis of the real effective exchange rate.86

Recent Policy Responses to Exchange Rate Developments

After hovering around a historically low level in 2004–05, the peso strengthened markedly, which complicated the BSP’s monetary policy. During this period, the BSP continued to be vigilant against risks of inflation higher than the target, which revealed potential tensions between the inflation target and exchange rate considerations.

The BSP’s policy responses in 2005

In the face of inflation pressures, the BSP tightened its policy stance. Higher inflation in 2005 was attributed to price increases in food, energy-related products, and transportation, which are outside the control of monetary policy. Nevertheless, aware of increased risks for inflation, the BSP raised its policy rates in April, September, and October 2005 by a cumulative 75 basis points. In addition to supply shocks from high oil prices and their second-round effects, the BSP pointed out risks of exchange market pressure on inflation expectations, given the likelihood of declining differentials between domestic and foreign interest rates and a possible adverse shift in investors’ sentiment. The BSP also increased reserve requirement ratios by 100 basis points in July 2005 in order to mop up excess peso liquidity.

In addition, the BSP implemented other administrative and regulatory measures to stem peso depreciation pressures. In July 2005, the Currency Risk Protection Program was revised, with the addition of a more competitive pricing mechanism. This enabled eligible corporate and other foreign exchange users to purchase foreign exchange from banks at a predetermined rate in the future, which was expected to remove a significant amount of demand from the spot market. The BSP also tightened its foreign exchange regulations in January 2006 to require any person whose transactions are in foreign currency or foreign-exchange-denominated monetary instruments to furnish information on the source and purpose of these transactions.

The BSP’s policy responses in 2006–07

Despite the BSP’s concern about depreciation, the peso appreciated significantly during 2006 and 2007. Strong dollar inflows from remittances by Filipino workers abroad as well as from portfolio and foreign direct investment were the main sources of the peso’s appreciation. The latter reflected renewed investor confidence because of a positive economic outlook in the wake of fiscal reforms and stable macroeconomic performance.

Strong foreign exchange flows presented challenges for the BSP’s monetary and exchange policy. During 2006, a series of adverse supply shocks, including from food prices, international oil prices, and reforms to the value-added tax, failed to feed into underlying inflation. The retreat of inflation to within the target band and stable interest rates contributed to continued foreign exchange inflows, leading to further appreciation pressures. Although the BSP recognized that the stronger peso helped keep the prices of imported goods down, the appreciating peso adversely affected exporters and Filipino workers abroad. Against this background, the BSP intervened in the foreign exchange market to smooth out exchange rate fluctuations and build up reserves. However, the absence of full sterilization of interventions led to peso liquidity.

To curtail potential inflation pressures, the BSP implemented measures in 2007 to strengthen sterilization and increase demand for foreign exchange. As stated above, access to the special deposit account (SDA) window was expanded to more financial institutions in May 2007 to help withdraw liquidity from the system. The SDA grew quickly and helped contain the growth of liquidity. To increase demand for foreign exchange, the authorities accelerated prepayment of external debt in December 2006.87 In addition, relaxation of foreign exchange controls on capital outflows began in April 2007, which included raising limits on banks’ foreign currency transactions to pre-Asian-crisis levels (before 1997). In late December 2007, a second round of liberalization was implemented.


The large scale of foreign exchange intervention can cause tension with the inflation target. Although appreciation can contain inflation pressures, the concerns of the BSP about excessive peso fluctuations and its goal of building up foreign reserves led to intervention and rapid growth of liquidity, which has the potential to conflict with the inflation objective.

Sterilization can alleviate the tension but may not be sustainable. Although recent sterilization efforts were successful, such operations carry quasi-fiscal costs, which are ultimately borne by the government. Thus, sterilization cannot be seen as a panacea for dealing with conflict between inflation and foreign exchange objectives.

Relaxation of capital controls on outflows can also ease the problem to some extent. However, its effects on exchange rate developments have not been verified. Moreover, this is not a direct solution when seeking to achieve balance between monetary policy objectives and exchange rate considerations.


Singapore’s monetary policy has been centered since 1981 on management of the exchange rate. The Monetary Authority of Singapore (MAS) adopts the exchange rate as an operational target by guiding a trade-weighted Singapore dollar within a policy band. This framework reflects the fact that the exchange rate is the most effective tool for maintaining price stability in the small and open Singapore economy, and indeed it has performed very well to date. However, growing capital flows have posed new challenges to this exchange-rate-centered framework.

Monetary and Exchange Rate Policy Framework

In Singapore, monetary policy is centered on the management of the exchange rate, rather than monetary aggregates or interest rates. The primary objective of monetary policy in Singapore is to promote price stability88 as a sound basis for sustainable economic growth.89 To achieve this ultimate purpose, the MAS has used the exchange rate as the operational target since 1981, as outlined below.

  • The MAS manages the Singapore dollar vis-à-vis a trade-weighted basket of currencies of Singapore’s major trading partners and competitors (S$NEER). The composition of this basket is reviewed and revised periodically to take account of changes in trade patterns, but details concerning the index are not disclosed.
  • The trade-weighted exchange rate fluctuates within a policy band. The general direction of the band is announced semiannually, but details on the slope and width are not disclosed.
  • When the trade-weighted exchange rate breaches the policy band on either side, or when there is undue Singapore dollar volatility or speculation, the MAS intervenes in the foreign exchange market by using spot or forward transactions.90 Intervention operations take the form of purchase or sale of Singapore dollars against U.S. dollars.
  • The exchange rate policy band is reviewed semiannually to ensure that it remains consistent with the economic fundamentals and market conditions, results of which are published in the Monetary Policy Statement. The MAS may change the slope of the band or shift it in response to changes in inflation pressures. Sometimes, for example, during periods of heightened volatility, the band may be widened to accommodate more volatile fluctuations in the exchange rate.91

This framework reflects the fact that the exchange rate is the most effective tool in maintaining price stability in the small and open Singapore economy. Indeed, total exports and imports are each well in excess of 200 percent of GDP. Empirical research suggests that changes in the trade-weighted Singapore dollar have a greater influence on domestic inflation and the output gap than changes in interest rates.92

Under the exchange-rate-centered framework with an open capital account, the MAS cedes control over domestic interest rates. The MAS’s money market operations are aimed at ensuring sufficient liquidity in the banking system to meet banks’ demand for reserve and settlement balances. To this end, in addition to daily market operations such as repos, foreign exchange swaps, and lending, the MAS provides an end-of-day liquidity facility, an intraday liquidity facility, and a standing facility. These facilities have helped contain interest rate volatility. In conducting its money market operations, the MAS takes into account the net liquidity impact of foreign exchange interventions in conjunction with various autonomous and other market factors. In this respect, the MAS’s foreign exchange interventions can be said to be sterilized in the broader sense that the liquidity in the system is always restored to a level sufficient to meet banks’ demand for reserves.

The MAS has made efforts to increase disclosure and enhance transparency on the policy stance and the rationale behind that stance. Recent initiatives include the publication of the Monetary Policy Statement soon after each semiannual review of monetary and exchange rate policy. This is supplemented by the release of the Macroeconomic Review, which provides the MAS’s background analysis and outlook for GDP growth and inflation for Singapore.

Policy Developments under the Exchange-Rate-Centered Framework

Policy developments since 1981

It is generally observed that Singapore’s monetary policy has stabilized inflation pressures at a low level by guiding the exchange rate flexibly along an appreciation path. This has led to low and stable inflation with prolonged economic growth. Policy developments since 1981 are summarized in Table 9.2

Table 9.2.Monetary Authority of Singapore: Policy Developments since 1981
PeriodPolicy StanceDescription
1981–85appreciationOil price shocks and high capital flows intensified inflation pressures. Appreciating the trade-weighted exchange rate by 30 percent during 1981-85 prevented the emergence of inflation.
1985–88depreciationSingapore experienced a recession, caused largely by a deterioration in export competitiveness, a cyclical downturn in electronics, and the collapse of the construction boom. The depreciation of the exchange rate by 16 percent during 1985-88 restored competitiveness.
1988–97appreciationAfter economic recovery from the recession, fear of renewed inflation prompted the MAS to guide a decade-long trend appreciation of the exchange rate.
1997–2000zero-appreciationDuring the Asian crisis, inflation eased and GDP growth stalled. The MAS eased policy by guiding the exchange rate to fluctuate within a zero-appreciation band.
2000–01appreciationAgainst the backdrop of a favorable external environment and a strong rebound of the economy, the MAS tightened policy by inducing a gradual appreciation of the exchange rate.
2001–04zero-appreciationGiven weak external demand, a protracted global electronics downturn, and subsiding inflation pressures, the MAS eased its policy stance to a neutral setting in July 2001. The policy band was centered on a zero-percent appreciation.
2004–08appreciationAgainst a more favorable growth outlook for the economy, and the risk of rising inflation pressures, the MAS shifted to a policy of modest and gradual appreciation of the exchange rate in April 2004. In October 2007, the MAS increased the slope of the policy band slightly. Further, in April 2008, the MAS shifted the policy band upward by recentering it at the prevailing level of the S$NEER.
Source: IMF staff.
Source: IMF staff.

Singapore’s monetary policy framework has proven flexible in the face of heightened market volatility and uncertainty. The flexibility is brought about by widening the policy band, which could facilitate greater exchange rate adjustments, thereby preventing adverse volatility in the real economy. One example of this flexibility was after the uncertainty caused by the Asian financial crisis. Another was soon after the September 11 terrorist attacks in the United States. In both cases, the MAS widened the policy band to allow more volatile fluctuations in the Singapore dollar.

Recent policy challenges

Strong capital flows have posed policy challenges for Singapore. As noted, the MAS has maintained a policy of modest and gradual appreciation of the Singapore dollar policy band since April 2004. Though this has contributed to the low and stable inflation environment amid robust economic growth, carrying out the policy has been complicated by appreciation pressures stemming from strong investment inflows into the region, weak U.S. dollar sentiment, and a relatively buoyant Singapore economy.

Since 2006, the trade-weighted Singapore dollar has stayed in the upper half of the policy band, and more recently it has fluctuated near its upper end. The appreciation pressures have forced the MAS to intervene in the foreign exchange market to keep the exchange rate within the policy band, as evident in the accumulation of foreign exchange reserves (to US$163 billion at end-2007 from US$116 billion at end-2005).93 In April 2008, the MAS recentered the policy band at the prevailing level of the S$NEER to mitigate inflation pressures.

Heavy intervention has built up domestic liquidity and lowered domestic interest rates. Under the MAS’s money market operation framework, as explained, the extent to which the impact of foreign exchange interventions is sterilized depends on banks’ demand for reserve and settlement balances, which in the end affects money market rates. Against expectations that the U.S. dollar will appreciate and expectations about liquidity conditions in the market, the (three-month) interbank interest rate had come down to 2.9 percent by March 2007, from 3.4 percent in September 2006. The interest rate fell further to 1.3 percent at the end of March 2008. Although the interest rate in Singapore is neither a policy instrument nor an intermediary target, the decline of interest rates has partly offset tightening monetary conditions envisaged by the strong exchange rate.


Singapore’s exchange-rate-centered monetary framework has performed very well to date. It should be noted that the framework is supported by the small size and high degree of openness of Singapore’s economy. A key condition for the framework to be viable is that the exchange rate plays a significant role in the inflation dynamics in Singapore. Under the framework, there is relatively limited tension between the inflation objective and exchange rate management.

Increased capital flows pose challenges for the exchange-rate-centered framework. Growing gross capital flows highlight the importance of the MAS’s ability to keep the exchange rate within the policy band. There have been few problems so far, but future concern cannot be ruled out. At the same time, maintaining the equilibrium value of the exchange rate within the framework might be another important issue.

South Africa

The South African Reserve Bank (SARB) allows the exchange rate to be determined in the market, but it takes into account the rate’s impact on prices in the context of inflation targeting. This strategy has worked well, with little tension between the inflation objective and exchange rate policy. However, the rand remains vulnerable to the nation’s large current account deficit, causing higher fluctuations of the exchange rate, and this calls for relatively swift and sizable policy responses, as seen in recent episodes. Furthermore, large capital flows pose new challenges to the SARB’s monetary policy.

Monetary and Exchange Rate Policy Framework

In February 2000, South Africa announced the adoption of formal inflation targeting as the monetary policy framework. The monetary policy of the SARB was already aimed at price stability, which is stipulated as its primary goal in the constitution and in the central bank law. But the SARB has relied mainly on monetary aggregates in the past, causing uncertainty among the public about the policy stance. To make monetary policy more transparent and accountable and improve coordination between monetary policy and other macroeconomic policies, inflation targeting was introduced in a more formal way.

  • The inflation target in terms of the CPIX (the overall consumer price index, excluding mortgage interest costs) is determined by the government in consultation with the SARB. Until 2003, the authorities specified the target in the form of the annual average rate of the CPIX for every calendar year.94 But in November 2003, this was replaced by a continuous CPIX target of 3–6 percent on an annual basis for the period beyond 2006. This change aimed to prevent excessive interest rate volatility and ineffective management of inflation expectations.
  • The Monetary Policy Committee (MPC) decides the policy stance by changing the repo rate, the policy rate applied to the SARB’s refinancing operations, to achieve the inflation target. Currently, a meeting is held every two months. The result of the meeting is immediately made public at a press conference and broadcast live on national television. At the MPC meetings, a large number of indicators that could affect inflation as well as other exogenous factors are monitored.
  • To fully inform the public about monetary policy implementation, the SARB publishes a number of reports, including the Monetary Policy Review twice a year, which provides its core forecast of inflation in the form of a fan chart. In addition, a Monetary Policy Forum is convened by the SARB twice a year in the major cities, at which representatives of labor organizations, business, government, and academic institutions exchange views on monetary policy and economic development.

The SARB adheres to a floating exchange regime in the context of inflation targeting. Although the exchange rate is perceived as an important transmission mechanism for monetary policy that could affect inflation and economic growth, the SARB is of the view that too much concern about exchange rate stability can induce the wrong policy response. Wide fluctuations in the exchange rate of the rand could complicate monetary policy decision making; nevertheless, South Africa opted for a flexible exchange rate regime to maintain monetary policy flexibility. The MPC therefore monitors the exchange rate from the perspective of whether and how it influences the inflation rate and inflation forecast. Indeed, most policy statements mention the exchange rate as one of the factors affecting inflation.

The SARB intervenes in the foreign exchange market only to bolster its reserve position through purchases of dollars. While allowing the exchange rate to be determined by the market, the SARB aims at creating underlying economic conditions that are conducive to exchange rate stability. For this purpose, the SARB attempted to reduce its oversold forward book (net open position in foreign currency), which caused concern and contributed to a volatile exchange rate. After achieving this goal in May 2003, the objective of the exchange operations was shifted to increase foreign reserve holdings whenever circumstances permitted.

Policy and Exchange Rate Developments in 2003 and 2006

Large fluctuations in the exchange rate of the rand have affected inflation, leading to relatively sizable monetary policy responses.

Recovery of the rand and monetary easing in 2003

After considerable depreciation until the beginning of 2002, the rand appreciated throughout 2003. The increased risk aversion of international investors created downward pressures on the rand, accelerating inflation well above the inflation target during most of 2002. The restored risk appetite toward emerging market economies, together with sound macroeconomic policy in South Africa and its improved credit ratings, changed the direction of the exchange rate and brought it back to the recovery trend. By mid-2003, the nominal effective exchange rate returned close to its end-2000 level—just before the start of the depreciation. This, in addition to other factors such as a slowdown in food price increases, contributed to lower inflation forecasts.

The SARB reduced its policy rate significantly as the inflation outlook improved. Favorable inflation projections enabled the SARB to ease its monetary policy beginnning in June 2003. The SARB cut the repo rate five times, to 8 percent by the end of the year, including at an unscheduled meeting in September, with a total reduction of the rate amounting to 550 bps. The inflation rate declined eventually within range of the inflation target in October 2003. Although the appreciation of the exchange rate somewhat affected the profitability and competitiveness of exporters, the recovery of the rand assisted materially in containing inflation, which was the basis for the SARB’s monetary easing.

Depreciation of the rand and monetary tightening

After remaining relatively stable, the exchange rate encountered depreciation pressures in 2006. In 2005, the rand was supported by high commodity prices, foreign direct investment flows, and positive economic data for South Africa, despite the growing current account deficit. However, the currency depreciated in mid-2006 amid volatility in global financial markets and uncertainty regarding the direction of U.S. interest rates. The SARB noted that a further widening of the current account deficit could trigger market concerns about its sustainability, which could have adverse impacts on the exchange rate. Along with higher oil prices and robust domestic demand, particularly strong household consumption, the rand’s depreciation led to inflation pressures through some pass-through effects on domestic prices.

In the face of upside risks to inflation, the SARB tightened monetary policy beginning in mid-2006. As inflation projections deteriorated, the SARB raised the repo rate by 50 bps at its June 2006 meeting, which was followed by a subsequent series of 50 bps increases at the August, October, and December meetings. In addition, the policy rate was increased by a total of 2 percentage points on four occasions in 2007 and by a total of 1 percentage point on another two occasions in the first half of 2008, taking it to 12 percent. These policy responses are intended to ensure that inflation, which breached the target in April 2007 for the first time since August 2003, returns to within the target range.


The SARB allows the exchange rate to be determined in the market while taking account of its impact on prices in the context of inflation targeting. In this respect, attainment of the inflation objective has not been naturally limited by the exchange rate consideration. The SARB simply accepts the currency movements without leaning against them. Consistently, interventions in the foreign exchange market are aimed primarily at strengthening the reserve positions, which is expected to be conducive to exchange rate stability.

However, the rand remains vulnerable to the country’s large current account deficit and exposure to commodity price movements. This causes concern about greater fluctuations in the exchange rate. Indeed, the rand was among the most volatile emerging currencies during the market turbulence of May–June 2006. In addition, the above episodes indicate that a large swing of the rand, at least in part, triggered relatively swift and sizable policy responses.

Large capital flows pose new challenges for the SARB’s monetary policy. The growing current account deficit has been adequately financed by capital inflows. At the same time, the large inflows are accompanied by rapid credit growth, particularly in the household sector, as well as increases in asset prices, which contribute to the risk of inflation. Therefore, monetary tightening by the SARB interacting with the exchange rate and capital flows could support sustainability of the current account deficit but bring about unexpected outcomes in domestic monetary conditions, thereby potentially complicating achievement of the inflation target.


The central bank law stipulates that the BoG’s fundamental objective is “to contribute to the creation and maintenance of the most favorable conditions for the orderly development of the national economy, for which, it will propitiate the monetary, exchange and credit conditions that promote stability in the general level of prices.”


Details such as equilibrium exchange rate and other parameters are not disclosed.


Details of the rule are reviewed every year. Under the current rule, when the exchange rate is equal to or less than the moving average in the previous five business days minus a fluctuation margin of 0.5 percent, the BoG convenes an auction to purchase U.S. dollars. On the other hand, when the exchange rate is equal to or greater than Q 7.815 per US$1, a dollar sale auction is offered when the exchange rate is equal to or greater than the five-day average plus 1 percent margin.


However, inflation recently edged up again, moving well above the upper limit of the inflation goal.


Policy statements did not mention the exchange rate developments and their impact on inflation and growth.


In 2005, no rule was prepared for the sale of U.S. dollars. As for 2006, the resistance threshold, Q 7.70 per US$1, was indeed not reached during the year, nor was the 2007 current threshold (Q 7.815 per US$1).


The ERM II is a regime under which every country planning to join the EMU has to participate for at least two years before introducing the euro. As one of the convergence criteria for the eventual adoption of the euro, the ERM II requires a currency fluctuation band of ±15 percent around the central rate against the euro. Hungary does not yet participate in ERM II.


According to the central bank law, the government, in agreement with the MNB, determines the exchange rate regime and all


This was devalued to Ft 282.36 per €1, as described below.


The medium-term target, announced in August 2005, was set at a level consistent with price stability for a longer period. The target is to be reviewed at the time of Hungary’s entry into ERM II, or after three years, whichever is sooner.


As of mid-2004, the council made an interest rate decision at its second meeting each month; it could hold an extraordinary meeting at any time to decide on changes in the rate.


The exchange rate is thought to influence prices of durables and import costs of fuels and energy, accounting for more than one-third of the consumer basket, and also indirectly to affect service prices and processed food prices. The MNB finds that exchange rate movements pass through to tradable goods’ prices very quickly.


As of 2006, the main inflation forecasts appear biannually in May and November; interim updates are issued in February and August.


In May 2004, the planned date of the euro changeover was revised to 2010.


The MNB admits that the exchange rate will continue to play an important role in influencing inflation even after removal of the ±15 percent band. It also acknowledges that the abandonment of the band constitutes a step toward the adoption of the euro, because a floating exchange rate provides better conditions to meet the nominal convergence criteria and finally to enter into the ERM.


Before introduction of the inflation target, the CBI adhered to a fixed exchange rate regime with some tolerance limits, which were gradually extended to ±9 percent early in 2000.


Three reports to the government on inflation beyond the tolerance limit have been published, dated June 20, 2001; February 18, 2005; and September 19, 2005. When the consumer price index increased beyond the tolerance limit in September 2007, a detailed report was not published, as it was deemed that the necessary explanation was already presented in the CBI’s Monetary Bulletin.


The central bank law grants the CBI authority to establish the basic exchange rate policy by saying “with the consent of the Prime Minister, the Central Bank determines the policy according to which the value of the Icelandic króna against foreign currencies is determined.”


Separately, the CBI makes a weekly purchase of $6 million in the interbank market, to meet Treasury foreign debt service needs and to strengthen the CBI’s foreign reserves. Monthly data regarding the foreign exchange market suggest that the CBI’s foreign exchange operations are limited to these regular purchases, which currently account for only about 0.5 percent of total market turnover.


In the CBI’s quarterly macroeconomic model, raising the policy rate by 1 percentage point causes immediate appreciation of the króna by 0.2 percent and leads to continuous appreciation with a peak at 0.8 percent after five quarters (Monetary Bulletin, November 2006).


The CBI appeared not to have intervened in the exchange market in this period.


In early 2008, the króna depreciated sharply, with credit spreads widening for the sovereign and the banking sectors. The currency depreciation fueled inflation pressures, pushing the CPI to a double-digit increase. In response, the CBI hiked the policy rate by 175 basis points in March and April, to clarify its determination to battle inflation.


At the same time, the CBI allowed inflation to deviate beyond the tolerance limit for more than a year. This strikes a delicate balance between maintaining the inflation target and providing some flexibility in the face of an external shock.


Peru’s exchange rate regime is currently classified as a managed float.


In addition, the BCRP points out that a high level of foreign reserves, a banking system with liquid foreign currency assets, appropriate banking supervision, and a strong fiscal position help reduce the risks involved in financial dollarization.


A portion of these purchases of dollars have served to meet the treasury’s demand for foreign currency to repay the external debt.


The BCRP explains that the sterilization operations have not led to negative effects on the BCRP financial outcome, because the interest rates on certificates of deposit have not been higher than the yield obtained on foreign reserves.


Until 2007, the target formula was a range target, for example, “4–5 percent,” but it was changed to a point target with a tolerance beginning in 2008, effectively widening the target band. This provides more flexibility to the BSP in steering inflation.


These letters outline price developments and adopted measures in the previous year and the outlook for the coming year.


Under the most recent tiering scheme (lifted in July 2007), the banks’ liquid funds placed at the BSP were given progressively lower interest rates: the policy rate for the first 5 billion Philippine pesos (PHLP), 200 basis points less for the next PHLP 5 billion, and 400 basis points less for amounts in excess of PHLP 10 billion.


Under the measure, government-owned and government-controlled corporations and trust entities are allowed to deposit with the BSP at a relatively high rate in a special deposit account.


The central bank law stipulates that the monetary board shall determine the exchange rate policy of the country.


The quarterly inflation reports of the BSP often discuss competitiveness based on real effective exchange rate developments.


In December 2006, the BSP prepaid its outstanding obligations to the IMF in the amount of US$220 million, marking its exit from the postprogram monitoring arrangement with the IMF.


The authorities do not provide any numerical target or definition of price stability.


According to the central bank law, one of the MAS’s objectives is to promote, within the context of the general economic policy of the government, monetary stability and credit and exchange conditions conducive to the growth of the economy.


The MAS explains that it will refrain from intervention as much as possible and allow market forces to determine the level of the Singapore dollar exchange rate within the policy band (Monetary Authority of Singapore, 2007).


For example, the policy band was widened during the Asian crisis of 1997–98 and after the terrorist attacks in the United States in September 2001.


Parrado (2004a) found that the trade-weighted nominal exchange rate has relatively little impact on CPI inflation initially, but becomes more influential in the medium term. Khor, Robinson, and Lee (2004) also contend that the impact of an exchange rate appreciation on GDP, exports, and CPI is considerably greater than a corresponding increase in the interest rate.


The MAS sterilized in part the net liquidity impact of its foreign exchange intervention mainly through foreign exchange swaps, leading to rapid growth of the MAS’s forward position (to US$63 billion at end-2007).


This formula entailed revision of the targets, which complicated the implementation of inflation targeting and caused uncertainty among the public. For example, the initial CPIX targets of 3–5 percent for 2004 and 2005 were revised to 3–6 percent when it became clearer that they would be missed for a fairly protracted period.

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