4. Managing the Transition to Greater ER Flexibility: Overcoming Obstacles
- Mark Horton, Hossein Samiei, Natan Epstein, and Kevin Ross
- Published Date:
- May 2016
Addressing Fear of Floating
In tranquil times, exits from pegged ER regimes have involved gradual, step-by-step moves to a full float. Examples include Chile (1984–1999), Israel (1985–2005), and Poland (1990–2000).
Gradual transitions to greater flexibility are not always feasible. During shocks and crisis periods, exits from pegs may involve sharp, rapid depreciation, as in Brazil (1999), the Czech Republic (1996–97), and Uruguay (2002). Uruguay bears the most resemblance to CCA countries, given a high degree of dollarization, less developed local capital markets, and limited FX risk-management capacity at the time of transition.
A key question is how the authorities can overcome fear of floating and embrace a more modern monetary policy framework. As stressed in the IMF staff paper, “Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries,” the key is to establish greater central bank independence and the clear primacy of the inflation objective. With this in hand, self-reinforcing reforms that enhance credibility may proceed on multiple fronts—even during periods of stress.
Shifting away from multiple monetary policy objectives, establishing the preeminence of the inflation objective, and allowing greater ER flexibility call for:
- Presentation and acceptance of the case for modernization of monetary frameworks:
- – Stressing that ER rigidity may helpful to stabilize high inflation but not to adjust to shocks nor to address dollarization issues.
- – Emphasizing that if CCA governments wish to develop and enhance their private sectors and nontraditional exports—a cornerstone of strategies to confront the current shocks and diversify and strengthen growth—they must become accustomed to uncertainties and risk.
- Building an “in-country consensus” and convincing stakeholders, including at the highest levels to accept the argument.
- Stressing that moving on multiple fronts is possible even during times of stress and that reforms to money and FX markets and communication frameworks build synergies that improve the functioning of the economy in general.
- Preparing for the rigors of flexibility and recognizing the need to tolerate ER volatility and overshooting—both of which may occur in the short run. This will involve enhanced communications.
- Expanding knowledge sharing, including among CCA central banks, finance ministries, and political authorities.
Modernizing Monetary Policy Frameworks
Key steps in building and maintaining credibility and in shifting away from the ER as an intermediate target during modernization include the following (from Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries).
Building and Maintaining Credibility during the Transition
- Declare medium-term inflation objectives; define objectives as continuous point targets/ranges.
- Invest in external communications, emphasizing the medium-term inflation objective and central bank independence and accountability.
- Communicate forward; explain current situations and policy decisions relative to objectives and economic outlook. Admit and explain the target misses and plans to address them.
- Ensure consistency between the monetary policy framework and operations.
- Invest in analytical capacities.
- Focus on de facto regimes when conducting internal analysis, not the de jure one.
- Strengthen central bank legal operational independence, including by phasing out direct credit to government.
- Extend policy horizons, as forecasting capacities improve. The minimum is one year.
- Make policy decisions at pre-announced dates.
- Encourage staff participation in the policy decision-making process.
- Integrate into a single process all decision making using various instruments (for example, key policy rate, exchange rate, reserve requirements, net open position limits).
- Take active measures (even administrative) to reduce and or prevent dollarization.
- Show strong resolve to make policy more effective even in difficult times. Build consensus and start applying the principles in practice.
- Split monetary policy formulation from implementation and supervision.
- When using several instruments with a primary impact on the monetary policy stance, use them consistently; avoid using these instruments for different objectives.
Shifting Away from ERs as Intermediate Targets during Modernization Process
- Set up a high-level coordination task force with authority; increase flexibility (asymmetrically) during appreciations.
- Create functional spot and derivative FX market; support market making activity by banks, encourage the functioning of trade organizations (for example, FX club).
- Liberalize capital account at a pace that is appropriate with the country’s level of financial and institutional development.
- Keep the ER flexible in both directions, even if in a narrow corridor (minimum +/- 3 percent) to help the market develop.
- Channel the FX proceeds from the transactions with the government back to the FX market.
- Encourage government to issue local currency debt at benchmark maturities in sufficient quantities to form a yield curve and help integrate money and FX market rates and infrastructure.
- Seek greater foreign participation in domestic markets, which would increase volume and improve practices and standards of conduct.
- Hasten the resolve to implement an alternative anchor and a more effective monetary policy, especially after an ER/balance of payments crisis.
- Make an interest rate the operating target.
- Resolve the conflicts between the ER and inflation anchors consistently in favor of inflation. Gradually move the ER from being a target to being a monitoring transmission variable.
- Take a leading role in promoting good standards in hedging FX risks by the banks and the corporate sector.
Addressing Risks to Financial Sector Stability
Financial sector risk may emanate from high dollarization and balance sheet mismatches, financial, corporate, and individual. ER flexibility increases pricing volatility, and thus shifts in balance sheet valuations, and risks. Depreciation may impact banking sector profitability, nonperforming loans, and capitalization, given significant net open positions.
Effort is needed to structure comprehensive de-dollarization strategies. There is a wealth of cross-country and research experience on which to draw, be it on dollarization risks or on thinking about de-dollarization strategies and measures.15
Measures to Reduce Dollarization
Dollarization is mainly a credibility issue. It can stem from high inflation, financial repression, capital controls, ER rigidity and underdeveloped financial markets. In most cases, dollarization of deposits leads to dollarization of credits as banks try to balance FX positions. Most successful de-dollarization strategies include: (1) a sustained and credible macroeconomic stabilization; (2) liberalization that removes distortionary controls that discourage local currency use, and (3) prudential measures that reduce bank incentives to borrow and lend in foreign currencies—such as asymmetric reserve requirements and additional provisioning for currency-induced credit risks.
Market based measures de-dollarization measures may also be helpful. These include: (1) greater ER flexibility, improving central bank liquidity management (via reserve requirements, OMOs and an interest rate corridor) to make local currency more attractive (see Box 2); (2) fiscal consolidation, which reduces the need to borrow in foreign currency; and (3) and unbiased taxation of foreign currency instruments (or biased toward local currency instruments such as bonds or deposits). Public debt management which fosters the development of the local currency bond market are particularly useful to de-dollarize government balance sheets and stimulate the development of domestic financial markets and local currency investor base. If confidence in the local currency remains shallow, indexation to local prices could be used. Promotion of hedging instruments is critical.
Box 2.Active De-dollarization Strategies: Peru and Armenia
Peru: Although dollarization in Peru has declined since the introduction of the IT regime in 2001 (from around 75 percent to 35 percent today), it remains a key vulnerability. In 2015 the central bank (NBRP) implemented new measures, which mandate financial institutions to reduce their stock of dollar credit 5 percent by mid-2015 and 10 percent by end-2015 or face added RR (30 percent of the actual deviation over the target). Conditions are more stringent for dollar car loans and mortgages. To ease local currency liquidity constraints, the NBRP also created new repo facilities specifically for the expansion and conversion of loans to soles (on top of other mechanisms) and cut RR on local currency deposits. New measures complement long-standing regulations linked to FX exposure and active RR management, which have contributed to the economy’s gradual de-dollarization:
RRs: The central bank imposes higher RR on FX liabilities. This year, marginal RRs on dollar deposits have been raised to historically high levels (70 percent in June from 50 at end-2014) to discourage dollar credit, while RRs on domestic currency liabilities have been eased (6.5 percent in June from 30 percent in July 2013).
FX risk: The bank regulatory framework seeks to minimize exposure to FX risks and curb ER volatility. Banking supervision limits FX positions: long (short) open positions cannot exceed 50 percent (10) of effective equity and the absolute value of net FX derivative positions cannot be over 20 percent of effective equity. Capital requirements on banks’ FX credit to borrowers exposed to exchange risk (with revenues in local currency and liabilities in dollars) are being tightened gradually, increasing the associated credit risk weights from 102.5 in 2012 to 108 percent by 2016. This year, the NBRP ramped up restrictions to cut FX volatility by imposing additional RRs on banks that exceed certain limits on the flow and stock of FX derivative operations (excluding those carried out for hedging purposes).
Resident inflows: The central bank uses RRs on local currency deposits held by foreigners and fees on transfers of central bank-issued certificates of deposits for parties other than local financial institutions to discourage short-term speculative inflows. RRs are also applied to bank’s external debt to reduce their vulnerability to outflows.
Armenia: Financial dollarization in Armenia historically has been high, although it has experienced wide fluctuations. Dollarization rates peaked at over 80 percent in the early 2000s, before declining to below 40 percent in 2007–08. With the global financial crisis, dollarization increased again. By end-2014, around 60 percent of total deposits and private sector credit was denominated in dollars, slightly below historical averages of 65 percent. Dollarization has been closely linked to exchange rate developments and less linked to inflation developments. The Armenian authorities have a broad de-dollarization strategy in place, including both macroeconomic stabilization and specific de-dollarization measures (see also Country Report No. 15/66).
Macroeconomic stabilization: Armenia has achieved relatively low inflation, and has for a number of years implemented a comprehensive strategy to reduce macroeconomic imbalances and vulnerabilities. That said, the authorities recognize that reducing inflation volatility would help increase the credibility of the inflation targeting regime and lay a sounder foundation for de-dollarization. In addition, better communications on the sources of inflation volatility could help improve the reliability of the local currency as a store of value.
Specific de-dollarization measures: Armenia has in place a wide range of specific actions from restrictions on use of FX for certain transactions, to prudential, supervisory, and crisis management measures.
RRs: The strategy has relied significantly on differential reserve requirements (2 percent on local currency liabilities and 12 percent of dollar liabilities) and use of the local currency as the currency of denomination of RRs, and has also included measures to reduce FX liquidity risk and strengthen capital buffers.
FX risk: The authorities have also introduced: (1) higher risk weights for the calculation of credit risk for FX loans; (2) minimum liquidity ratios for FX liabilities; and (3) improved monitoring of currency mismatches.
Addressing Financial Stability Concerns
CCA central banks are rightly concerned with ER changes and risks to financial stability. In addition to high dollarization, recent IMF-World Bank Financial Sector Stability Assessments (FSSAs) have identified bank profitability and NPLs as concerns across the region, along with banking sector and loan concentration, interconnectedness, reliance on short-term funding, gaps in bank and corporate governance, nontransparent bank ownership and complex financial group structures, and gaps in the supervisory framework (for example, overvaluation of assets and collateral, doubtful quality of restructured loans, weaknesses in regulatory powers and enforcement). In addition, there are shortcomings in crisis preparedness, management, and resolution frameworks.
CCA central bank strategies and toolkits should involve some or all of the following:
- Crisis preparedness. Well-defined responsibilities, powers, and tools are needed, set out in a robust legal/regulatory regime. Agencies should have adequate resources and effective cooperation and information sharing, both domestically (with other agencies) and cross-border (with other regulators). Strong ex ante planning is important, including on contingency planning, crisis manuals and guidelines, communications, bank recovery, and resolution plans. This is enhanced by ongoing meetings, information sharing, review and stress testing, and crisis-management simulations.
- Regulation and supervision. Shortcomings should be addressed, including weaknesses in asset classification and provisioning requirements (prompt identification), risk management requirements (liquidity risk, operational risk), related party exposures, gaps in consolidated supervision (important where groups are complex), and legal protections for central bank or deposit insurance fund staff. In some countries, the situation is more serious, and includes deficiencies in statutory powers, insufficient staffing and resources, interference by government and courts, inadequate contingency planning and testing of processes and powers, and limited solvability assessments or bank-specific resolution plans.
- Domestic and cross-border cooperation and coordination. Some countries would benefit from better sharing of information on problem banks between the central bank and the deposit insurance agency, and stronger coordination among central bank, ministry of finance, deposit insurance fund. This would involve more frequent meetings at policy and technical levels, more joint analyses, and contingency plans and crisis simulation exercises to prepare possible policy responses. Clearer and more explicit roles and agreements (MOUs) that elaborate on crisis management frameworks may be needed to support possible extraordinary actions. In some CCA countries, stronger cross-border arrangements are needed, including to improve information sharing, to recognize foreign resolution actions, and to firm up planning for possible liquidity support to foreign-owned banks.
- Crisis management (LOLR/ELA). While some countries have well-articulated frameworks for emergency liquidity assistance (ELA)—covering only solvent banks and with clear interest rates and strict access/collateral rules—frameworks could be strengthened in others, including by clarifying legal and institutional arrangements (for example, collateral, government guarantees, enhanced supervision).
- Resolution/restructuring. Experience has shown that the best arrangement is to establish independent resolution authorities with clear mandates and broad powers and tools and with a focus on medium-term viability and forward-looking business plans. Some countries in the region have a broad menu of tools available, as well as framework that provides for sound escalation from corrective to rehabilitation to restructuring measures. Others need a clearer delineation of resolution and liquidation procedures in the law, enhanced authority to assume powers of decision-making bodies of the bank, refined triggers to allow for intervention at an early stage and reduce time delays, and a clearer legal and institutional framework for government involvement in crisis resolution. In some countries, gaps and deficiencies in statutory powers or interference by government and the courts are concerns.
On balance, financial stability considerations should not justify significant or prolonged efforts to support a misaligned ER, instead be addressed by enhanced macroprudential policies. With price stability as the main policy objective, CCA central banks would allow greater ER flexibility in order to absorb shocks and prevent the buildup of price distortions and currency misalignments. If financial stability concerns arise during the transition to more flexible ERs and the elimination of currency misalignments, central banks should use a second tool, such as macro- or microprudential regulation. Building up capacity in this area is paramount to supporting financial sector stability. While FX interventions may buy some breathing room, they should not become sizable and prolonged, undermining policy credibility. The situation could become more acute if financial market participants and the public understand that central bank intervention is being motivated by banking sector weaknesses.
Improving Central Bank Communications
Good central bank communications can improve the effectiveness of monetary policies. Central banks should be able to explain their views on current and future economic conditions, the rationale for their actions, and the expected and actual outcomes of these actions. In doing so, central banks can help ensure that monetary and ER policies stay credible and that market expectations are anchored, even if inflation or exchange rates deviate from targets or from an equilibrium level. Clear, open, and timely communications are the main tenets of transparent communications, as they ensure that the central bank does not withhold any meaningful information in helping the public and markets form aligned expectations, without undue delay, while making communications easy to understand.
In this context, CCA central banks should develop communication strategies and plans covering a wide range of issues. These include central bank objectives and their rationale; the monetary and exchange policy strategy—how the central bank links its actions to inflation and output outcomes; and the expected future trajectory of the key policy rate and FX interventions in meeting inflation and ER objectives. Communication is especially important during regime transitions, explaining changes in the framework and their rationale. Tailoring strategies to country specifics is vital, including central bank capacity and country communications environments. Central bank communications should be well aligned with communications by governments and finance ministries.
Progress in strengthening central bank communications may require substantial capacity development. Ideally, communications capacity should be strengthened before the process of transitioning to greater ER flexibility; however, there may be periods of pressure and volatility in the interim. If these are managed poorly, gains could be threatened. Efforts should on:
- Clarifying the central bank’s policy framework, objectives, strategy, risks and legal protection, and developing a formal communications strategy.
- Informing a wide range of stakeholders of the goals of monetary and exchange policy and of the central bank’s communications strategy. Enhancing staff and communications capacity across the range of changes (press conferences, other public and closed-door meetings, Internet, print, TV/radio, central bank websites).
- Communicating regularly—in both good and bad times—through a variety of channels and discussing risks and reactions. This should include: (1) introducing or broadening the audience of the “not-for-attribution” meetings with representatives of the business community, think tanks and government and legislative bodies; (2) organizing high-level seminars and workshops, for example, with officials from other countries with a history of inflation targeting; and (3) holding more frequent news conferences, with the chairman as the keynote speaker.
- Working to ensure that few public officials speak about monetary and exchanger rate policies and when they do, they speak on coordinated messages. Ensuring that communication on these issues happens during both times of pressures and times of calm.
- Monitoring and analyzing communications channels and adjusting the implementation of the communications strategy accordingly.
- Raising economic, financial, and consumer literacy, including by developing a cadre of journalists who understand macroeconomic and central bank issues.16
Prioritizing IMF Technical Assistance Resources
The IMF staff is ready to provide continued support to CCA central banks through TA and the Financial Sector Assessment Program (FSAP). Fund TA and FSAPs to CCA countries since 2010 highlight areas where the Fund could play an enhanced role in preparing the ground and promoting greater ER flexibility:
- CCA country authorities and IMF mission teams could strengthen TA prioritization by preparing medium-term TA strategies—in which ER related activities are prominently covered.
- TA on model building, legal reforms, and FPAS support should be part of medium-term strategies, with other organizations (for example, World Bank, EBRD, ADB) providing support in key areas (for example, capital market development, local currency bonds).
- TA should also focus on communications, IT implementation, and monetary and ER instrument and market development in order to promote pricing, trading, and risk management.
- TA related to improving financial regulation and supervision should focus on dollarization and FX-related risks, which are impediments to greater ER flexibility.
- TA could have a regional element, as the eight CCA countries face common issues and have a fairly common institutional setup and path. This would contribute to peer-to-peer learning.
- Further efforts would help enhance peer-to-peer networks related to monetary and ER market activities.
- Gaps and vulnerabilities identified in FSSAs should continue to be addressed. The Financial Sector Stability Review (FSSR), a new IMF TA instrument for low and middle income countries, can help CCA countries better design, sequence, and implement financial sector reforms.
- TA should be demand-driven to be productive and meaningful.