Journal Issue

2. ER Policy Advice

Mark Horton, Hossein Samiei, Natan Epstein, and Kevin Ross
Published Date:
May 2016
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IMF ER Policy Advice and Rationale7

IMF ER policy advice for CCA countries—both oil exporters and importers—has been to move toward greater ER flexibility. This has been combined with recommendations to modernize monetary and ER policy frameworks, develop and deepen capital markets, and improve macroprudential supervision. These actions would support implementation of independent monetary policy and operations, based on a well-defined interest rate instrument. ER advice has been supported by calls to ensure fiscal sustainability and to promote structural reforms to make CCA economies more open, diversified, regionally and globally integrated, and competitive.

The rationale for advocating ER flexibility is that CCA countries are small, relatively open economies that are subject to frequent and persistent external shocks. The ongoing oil and commodity price shock and slower growth in Russia and China point to the need for adjustment, including of the ER for all countries in the CCA.

Adopting greater flexibility would allow the ER to play its natural shock-absorbing role by facilitating the adjustment of relative prices. Flexibility would also limit the rundown of central bank reserves, as well as preserve export competitiveness, thus helping prevent large current account imbalances. Greater flexibility may also help absorb the fiscal impact of lower hydrocarbon-related revenues, provided that expenditures are not raised in domestic currency, while reducing the necessity of excessive offsetting monetary policies. Absent this flexibility, domestic prices would bear the burden of adjusting misalignments in real ERs, or direct fiscal measures would be needed. Such price adjustments take time and may impose more far-reaching economic consequences. In addition, more flexible ERs, together with credible monetary and ER frameworks, supported by an effective interest rate instrument and deeper domestic financial markets, would make monetary policy more effective and help reduce dollarization.

This advice implies that a series of “step” devaluations in countries with more firm ER pegs may be less optimal than allowing more flexibility. Step devaluations may not restore balance, as they could increase expectations of further devaluation and instability. However, equilibrium could be regained if the step devaluation was accompanied by greater ER flexibility (subject to adequate institutional capacity) and measures that increase confidence in the currency, including strong communication (that is, greater clarity on the central bank’s key objectives and policy response). Changes in fiscal, monetary, or structural policies could also eliminate ER imbalances, regardless of the ER regime. However, this requires time and consensus and the result would not be market driven.8 On the speed of introducing greater ER flexibility, recommendations should consider the state of institutional capacity and the size of buffers.9

For example, in Turkmenistan—as in the Gulf Cooperation Council (GCC) countries—buffers may be large enough to maintain an ER peg. However, where buffers are limited, staff’s advice has been to introduce greater flexibility, together with bolstering the monetary policy framework and operations. In particular, staff has stressed the need to enhance the use of interest rate instruments, strengthen coordination with the government regarding debt issuances, and improve communications to build confidence and credibility in new, floating ER regimes.

A call for greater flexibility does not imply adoption of a fully floating ER immediately, with no future FX intervention. ER policy and operations should address two issues: first, misalignment of real effective ERs from their medium-term equilibrium levels and second, ER management in a post-adjustment steady-state. In the post adjustment period, there may be a need for some intervention for smoothing to prevent sharp, disorderly ER moves in thin markets. There may also be a need for FX purchases to build or rebuild reserve buffers. In addition, as noted, some countries may have sufficient reserve buffers and sufficiently flexible fiscal, labor market, and structural policies to maintain pegs, including at new parity levels. Countries that opt to maintain fixed ERs need to ensure such flexibility, to allow for effective and credible internal adjustment processes to emerge (for example, as in Latvia and Hong Kong SAR). One issue is that the continued FX intervention may undermine the clarity of monetary and ER policy frameworks. As such, it will be important for central banks to be clear on frameworks and operations in communications, especially on FX interventions. But the aim should be greater flexibility in a modernized policy and operational framework.

Macroeconomic Policy Advice Under Current Conditions

In support of greater ER flexibility, staff’s advice to CCA countries on macroeconomic policies under current conditions has included the following:

  • Monetary conditions may need to be tightened in the short term, both to limit ER pressures and, where necessary, to address emerging signs of inflationary pressures. In tightening policies, care should be taken not to be seen as supporting a particular ER level, while central banks should be mindful of increasing economic and financial strain.
  • Fiscal policy should aim to smooth the impact of shocks in the near term where buffers allow and where spending is efficient and short-term tax measures are well targeted. Policies should also ensure public finances are on a sustainable footing in the medium term.
  • In the financial sector, stepped-up monitoring of banks is needed, including through measures to ensure adequate banking sector liquidity, provisioning, and capital, especially where balance sheet risks stem from sizable dollarization and an already-high level of nonperforming loans.

Monetary Policy Modernization in Support of Greater ER Flexibility

While the transition to a more flexible ER regime may take time, modernization of policy frameworks and improvements in institutions should commence now (Box 1). The centerpiece of monetary policy modernization is a shift toward the primacy of the inflation objective to help anchor inflation expectations and establishment and use of an interest rate instrument as an operational target to support policy implementation. Fortifying central bank decision-making processes and de facto independence is also needed. Even in CCA countries that have made progress toward full inflation targeting, there is scope to bolster communications and enhance transparency and accountability. A positive supply shock should be followed by higher output, lower domestic interest rates, lower prices, and a real exchange rate depreciation (Clarida and Galí 1994). However, the effect on the nominal exchange rate is ambiguous (Borghijs and Kuijs 2004).10

When the foreign economy is subject to a symmetric supply shock, the foreign interest rates should also fall in response to the domestic supply shock. (Note that this does not in any way imply that domestic shocks cause foreign interest rate responses.)

Box 1.Modernizing Monetary Policy Frameworks

The October 2015 IMF report on Evolving Monetary Policy Frameworks in Low-Income Countries provides useful guideposts in the monetary policy modernization process:

The central bank needs a clear mandate to purse price stability, and it should follow a forward-looking strategy that promotes that goal while fostering macroeconomic and financial stability.

An explicit, numerical inflation objective is the cornerstone for monetary policy actions and communications. It anchors inflation and provides a clear benchmark for performance.

Tradeoffs may arise, but the primacy of the price stability objective should allow central banks more room to take other objectives into account in their policy decisions.

There is a need for a clear and unified framework within which to evaluate monetary policy and ER interventions. Analytical capacity should be strengthened, especially inflation forecasting capabilities.

The operational functioning of money and FX markets need to be strengthened, with an expanded set of instruments (for example, derivatives), and modern trading platforms and clearing mechanisms.

Monetary policy implementation should be based on the use of a specific short-term interest rate instrument. This reduces market interest rate volatility, promotes financial market development, and enhances the transmission of monetary policy.

In general, an interest rate–based operational framework would announce a target for a market rate (for example, overnight or seven-day interbank rate) or attach the policy rate to a central bank instrument. An interest rate corridor, open-market operations (OMOs), a robust short-term liquidity forecasting framework, as well as a functioning interbank market are essential. Monetary quantities (reserve or broad money) would lose their operational focus—although they could still play an indicator or cross-check role.

Modernization can proceed simultaneously on multiple tracks. Once a clear mandate and minimum central bank operational independence are established, reforms can proceed on many fronts, with greater ER flexibility helping provide a stimulus for interbank and FX market development. Attention should be paid in the near term to clarifying and communicating the policy framework and modernization process, to strengthening monetary and exchange operations and ensuring that they are consistent with the framework, and to addressing financial sector concerns, if any. Clear central bank communications are critical to guide the process.

ER Adjustment

CCA authorities have recognized the need to adjust to the new economic environment, including the role that ER flexibility might play. In practice, all CCA currencies have adjusted in response to the shocks. However, many countries have faced major difficulties in the adjustment process, including in implementing a flexible ER regime, due to a range of economic and political economy considerations.

Without the ER changes that have taken place, macroeconomic outcomes in CCA countries may have been more negative. With fundamentals having deteriorated, ERs would have become increasingly overvalued, with a loss of competitiveness and worsening trade and current account balances. While inflationary pressures may have been more contained, given the lack of pass-through from ER changes and depressed demand, internal price adjustment would likely have been more painful and more FX reserves would have been used. It should be noted that the benefits of the ER changes—for example, a stronger fiscal balance, higher non-oil exports, domestic substitution of imports—are likely to take time to materialize and will require both discipline on budgetary spending and structural reforms, especially on the business environment.

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