Main Themes. ⢠Most countries exit from pegs under stress and is therefore ... bank as the LOLR and MMOLR. â Risk of
Lessons Learned from Countries that Experienced Difficulties in the Transition from Fixed to Float David Vavra
Kyiv, May 2017
Main Themes • Most countries exit from pegs under stress and is therefore better to be prepared • Successful transitions require – a deep and liquid foreign exchange market – a coherent intervention policy – an appropriate alternative nominal anchor, e.g. Inflation under Inflation Targeting – adequate systems to review and manage public and private sector exchange rate risk
• The room for effective capital flow regulation gradually evaporates after the float – deepen the financial markets – strengthen financial system supervision and regulation – strengthen macroeconomic policy management 2
OVERVIEW OF MAIN ISSUES
3
Flexibility is gaining ground among developed economies • Advanced Countries: Exchange Rate Regimes, 1991, 1999, 2006 (Fischer, 2008) , and 2012 90%
1991
Percent of total countries
80%
1999
70%
2006
60%
2012
50% 40% 30% 20% 10% 0% Hard-peg
Intermediate
Float
Source: 2012 advance countries list is from World Economic Outlook, April 2013
4
… while EMEs increasingly face only two options: float or peg • Emerging Market Countries: Exchange Rate Regimes, 1991, 1999, 2006, and 2012 60%
50%
1991 1999
40% 2006 2012
30%
20%
10%
0% Hard Peg
Intermediate
Floating
Source: Emerging markets is SPR department official list
5
Yet exits are often disorderly Figure 2. Exits by Exchange Rate Regime, 1990–2002 160 Number of Exits
140
Orderly exits
120
Crisis-driven exits
100 80 60 40 20 0 Total
6
Source: IMF
From hard pegs, From horizontal From managed fixed and and crawling floats crawling pegs bands
… mostly triggered by external forces Figure 3. Exchange Rates Against the US$ 90 100 110 90 130
80 150
70 170
60
190
210
Angola
Kazakhstan
Azerbaijan
230
Sources: Bloomberg, Datastream and IMF staff calculations.
7
Nigeria
Russia
Saudi Arabia
Commodity price index
50
40
… aggravated by domestic macroeconomic imbalances
8
Source: CNB
Fixed exchange rate regimes • Easy to operationalize and manage in the short-term • Long-term costs in terms of – Higher macroeconomic volatility – Higher dollarization and financial sector vulnerability to FX risks – Lower stabilizing power of domestic central bank as the LOLR and MMOLR – Risk of disorderly adjustments and high interest rates
9
Exchange Rate rate flexibility • Difficult to implement and manage • If well managed, then long-term benefits in terms of – Lower interest rates – Lower macroeconomic volatility – Lower dollarization – Flexibility and insurance in terms of the LOLR and MMLR 10
Lesson #1 Pegs often lead to higher long-term exchange rate volatility
11
01-01-15
12 Source: NBG
30-07-15
23-07-15
16-07-15
09-07-15
02-07-15
25-06-15
18-06-15
11-06-15
04-06-15
28-05-15
21-05-15
14-05-15
07-05-15
30-04-15
23-04-15
16-04-15
09-04-15
02-04-15
26-03-15
19-03-15
12-03-15
05-03-15
26-02-15
19-02-15
12-02-15
05-02-15
29-01-15
22-01-15
15-01-15
08-01-15
Stable FX?
1.3
1.25
1.2
1.15
1.1
1.05
1
Stable FX? 2.2000
2.0000
1.8000
1.6000
1.4000
1.2000
1.0000
GEL
13
Source: NBG
KZT
Lesson #2
Pegs do not guarantee nominal stability
14
… and similar is true for output growth or financial sector stability 35 Ukraine Україна
Poland Польща
30 25
Czech. Чехія Rep.
20 15 10 5
0 -5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: Bloomberg
1
Lesson #3
Most peg exits are unprepared (and under stress), and well sequenced reforms are needed for success
16
Key ingredients of a successful move to flexibility A coherent/ consistent interventio n policy
A wellfunctioning FX market
Supportive macroecon omic and structural policy mix
Greater exchange rate flexibility Systems to monitor/ma nage FX risk
17
A credible alternative nominal anchor
Capacity to implement the new MP framework
Key ingredients of a successful move to flexibility A coherent/ consistent interventio n policy
A wellfunctioning FX market
Supportive macroecon omic and structural policy mix
Greater exchange rate flexibility Systems to monitor/ma nage FX risk
18
A credible alternative nominal anchor
Capacity to implement the new MP framework
Lesson #4 Alternative monetary policy regime with inflation as the new nominal anchor
19
Principles of Effective Monetary Policy* • Price stability as the overriding objective • Medium-term inflation objective as the basis for policy actions and communication • Operational independence, mandate and accountability towards the objective • Clear and effective operational framework aligning market conditions with the policy stance • Transparent forward-looking monetary policy strategy that – reflects the monetary transmission mechanism. – bases policy actions on an assessment of implications for the economy and financial stability
• Transparent communication about policy objectives and 20 actions * Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries; IMF Policy Paper; October 23, 2015
Inflation Targeting Regimes as a particularly successful example • Price stability as the overriding objective • Medium-term inflation objective as the basis for policy actions and communication • Operational independence, mandate and accountability towards the objective • Clear and effective operational framework aligning market interest rates with the policy stance and a flexible ex rate • Transparent forward-looking monetary policy strategy that – reflects the monetary transmission mechanism. – bases policy actions on an assessment of implications for the economy and financial stability
• Transparent communication about policy objectives and 21 actions * Evolving Monetary Policy Frameworks in Low-Income and Other Developing Countries; IMF Policy Paper; October 23, 2015
Operationalizing the inflation objective under IT Headline Inflation, % yoy
Inflation targeting adoption is officially confirmed in the Monetary Policy Guidelines for 2017 and medium term
50
(approved by the NBU Council) Inflation targets for 2017-2020 are irrevocable
40
30
Inflation targets 20
12%±3 pp 10
8%±2 pp
5%±1 pp
6%±2 pp
Dec 2016: 12.4%
0 2015
2016 Source: NBU
2017
2018
2019
2020 22
Lesson #5
Inflation as the new nominal anchor
23
Expectations are effectively anchored on the target 8 7 6 5
36-month ahead expectations
Inflation
4 3 2 1 0 -1
24
Source: CNB
Lesson #6
Interest rate based policy
25
Predictable movements of less volatile market interest rates up to 72
35
up to 49
NBU policy and Overnight Interbank rates, % pa
30
25
20
15
10
5
0 2007 26 Source: NBU
2008
2009
Key policy rate
2010
2011
Overnight loans
2012
2013
2014
Minimum term CDs
2015
2016
2017
Overnight interbank
Lesson #7
Flexible exchange rate with an intervention strategy, consistent with the regime and well communicated
27
Importance of FX interventions has increased after the crisis, also for ITers • After the crisis the use of FX interventions has intensified in both developed and emerging markets – 20 out of 30 pure inflation targeting regimes regularly intervene on the forex market (and 16 out of 18 countries EME ITers
• FX interventions as a systematic instrument to support a flexible exchange rate is an accepted paradigm now 28
Tasks accumulation of international reserves smoothing out the functioning of the FX market Supporting the transmission of the key policy rate as the main monetary policy instrument
Principles FX Strategy is consistent with Inflation targeting and floating ER NBU insists in minimizing the role of FX intervention as policy tool NBU does not counteract fundamental trends, only smooths their effects Criteria of banks’ participation are open and transparent Source: NBU
Forms • • • •
FX auctions single-rate interventions request for quotations targeted interventions
FX interventions Strategy
Communications the NBU maintains a reasonable level of transparency while disclosing information about its intentions to conduct FX interventions and their outcomes 29
Key ingredients of a successful move to flexibility A coherent/ consistent interventio n policy
A wellfunctioning FX market
Supportive macroecon omic and structural policy mix
Greater exchange rate flexibility Systems to monitor/ma nage FX risk
30
A credible alternative nominal anchor
Capacity to implement the new MP framework
Lesson #8 Exchange rate flexibility should come in stages to stimulate the development of the FX market and FX risk management tools
31
2.0
Aug-90
Apr-90
Jan-90
32 Source: Bank of Israel
Aug-01
Apr-01
Jan-01
Sep-00
Jun-00
Feb-00
Oct-99
Jul-99
Mar-99
Nov-98
Aug-98
Apr-98
Dec-97
Aug-97
May-97
Upper band
Jan-97
3.0
Sep-96
Jun-96
Feb-96
Oct-95
Jul-95
Mar-95
Nov-94
Aug-94
Apr-94
Dec-93
Sep-93
May-93
Jan-93
Oct-92
Jun-92
Feb-92
Nov-91
Jul-91
Mar-91
Dec-90
From Fixed Peg to a Float in Israel
6.5 6.5
6.0 6.0
5.5 5.5
5.0 5.0
4.5
Midpoint rate 4.5
4.0 4.0
3.5 3.5
Currency basket 3.0
2.5 Lower band 2.5
2.0
Lesson #9
Balanced net open FX positions and developed risk management instruments before significant flexibility
33
5/7/1996 27-09-1996 20-12-1996 14-03-1997 6/6/1997 29-08-1997 21-11-1997 13-02-1998 8/5/1998 31-07-1998 23-10-1998 15-01-1999 9/4/1999 2/7/1999 24-09-1999 17-12-1999 10/3/2000 2/6/2000 25-08-2000 17-11-2000 9/2/2001 4/5/2001 27-07-2001 19-10-2001 11/1/2002 5/4/2002 28-06-2002 20-09-2002 13-12-2002 7/3/2003 30-05-2003 22-08-2003 14-11-2003 6/2/2004 30-04-2004 23-07-2004 15-10-2004 7/1/2005 1/4/2005 24-06-2005 16-09-2005 9/12/2005 3/3/2006 26-05-2006 18-08-2006 10/11/2006 2/2/2007 27-04-2007 20-07-2007 12/10/2007 4/1/2008 28-03-2008 20-06-2008 12/9/2008 5/12/2008 27-02-2009 22-05-2009
Direct and Indirect FX Risks
0.65
0.55
Deposits
0.45
Loans
0.35
0.25
0.15
Implicit IT 2002 - 2005
34 Source: CBRT
Full-fledged IT
Financial Dollarization in Turkey
0.05
Source: CBRT
Key ingredients of a successful move to flexibility A coherent/ consistent interventio n policy
A wellfunctioning FX market
Supportive macroecon omic and structural policy mix
Greater exchange rate flexibility Systems to monitor/ma nage FX risk
35
A credible alternative nominal anchor
Capacity to implement the new MP framework
Lesson #10 Better exit from a position of strength and well prepared
36
Prudent fiscal, willing to resolve systemic banking issues Public Sector Deficit, UAH bn, and Public Debt, % of GDP
Consolidated Budget Balance, % GDP 4
"+" surplus
240
100
180
75
120
50
60
25
2 0 -2 -4 -6 Cyclical balance Structural balance w/o NBU Primary balance Total balance
-8 -10 2011
2012
2013
2014
2015
2016
2017
Source: MFU; NBU staff estimates
0
2018
2019
0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Bank recapitalization & other (incl. VAT) Naftogaz General government deficit Public debt, % of GDP (RHS)
37
Lesson #11 Reforms must be broad and well-sequenced both inside and outside the central bank
38
Broad reforms inside the bank
39 Source: NBU
Monetary policy
Shift from over discretionary policy to rule-based policy, from pegged to floating exchange rate. The decision-making process and monetary policy implementation are based on the inflation targeting practices. Enhanced independence of central bank and avoidance of fiscal dominance.
Banking system rehabilitation
Diagnostic study (AQR + stress test) for the top 60 banks (over 98% of the sector assets) accomplished, bank recapitalization progress is significant. Country’s largest bank nationalized (after failing to fulfil capitalization program) to prevent system-wide contagion and secure financial stability. Detailed related-party lending diagnostics completed, banks are implementing relatedparty loan unwinding plans. Ultimate beneficiary owners of all Ukrainian banks identified and legalized.
Banking system supervision
Risk-based supervision concept being implemented. Early-warning system put in place to identify bank problems in a timely manner. New regulation on credit risk assessment approved, new rules enacted since 2017 after a trial period over Sep-Dec 2016. Anti money-laundering policies have been enhanced, about 10 banks closed for moneylaundering practices. Basel-compliant capital and liquidity rules currently being developed.
NBU transformation
Overhaul of the organizational structure: strengthening core functions, downsizing noncore functions, optimizing regional presence. Roles of internal committees enhanced.
Sequencing of pillars of a new monetary policy regime Effective MP implementation based on interest rate Effective market based intervention strategy Monetary policy based on strong analytical and forecasting capacities Effective communication strategy 40
Well sequenced with market developments
Intervention Policies
Development of FX Market
Building up FX Risk management and regulation
Credible Monetary anchor, capacity building
Stage 1:
Stage 2:
Stage 3:
Stage 4:
Fixed peg
Limited exchange rate flexibility
Considerable exchange rate flexibility
Float
41
adapted from IMF WP/04/126
… and with the liberalization of capital flows liberalization
42
Exchange Rate Flexibility and Capital Account Liberalization • There are risks to opening the capital account before exchange rate flexibility is allowed – Opening capital account may potentially destabilize domestic liquidity conditions, create macro-economic imbalances, precipitate currency attacks – Pegged/intermediate regimes found to be more crises prone for countries open to capital flows
• Allowing exchange rate flexibility before eliminating controls on capital flows helps to: – Absorb better the real effects of capital flows – Avoid short-term speculative capital inflows by reducing perceptions of low FX risks 43
Basket Peg w ith +/- 0.5 % Band
Monetary Policy Operational Capacity
+/- 7.5 % Band
Managed Float
Exchange rate regime
Free Float
140
Repo operations
Interest rate targeting
Early stage of a corridor system Public support and communication
Official IT
FX risk management Limits on open FX and positions in place regulation
Corridor system finalized Forecasting capacity IT capacity improved
130
Limits on short open positions
Intervention strategy a standard instrument
Credit Inflow FDI, Portfolio, Securities Inflow s liberalized had been permitted
Account at CNB for privatization revenues
Capital inflow liberalization
The Czech Republic
Source: “Operational Aspects of Moving To Greater Exchange Rate Flexibility: Lessons from Detailed Country Experiences”, Occasional Paper, no. 256
2001M5
2001M1
2000M9
2000M5
2000M1
1998M9
1998M5
1998M1
1997M9
Most remaining outflow s liberalized
1997M5
1997M1
1996M9
1996M5
1996M1
1995M9
1995M1
1994M9
1994M5
1994M1
1993M9
1993M1
1993M5
44
Intervention volumes published
Other transactions liberalized
FDI and some other outflow s liberalized, especially during last quarter of 1995
Capital outflow liberalization
1995M5
110
100
FX market
1999M9
Intervention policies
Bank-client market liberalized, derivative market rapid boom
1999M5
120
Fee on FX transactions w ith CB
1999M1
Obstacles on forw ards relaxed; surrender requirements relaxed
FX risk incorporated into capital requirements
CONCLUSIONS
45
• Move to flexibility from a position of strength • The regime change should be part of a comprehensive policy strategy change, including supportive fiscal policies and banking sector reforms
• Gradual transition to float through more flexible pegs allows time to prepare for orderly exits in terms of policy reforms and capacity building • Preparation can take time, risking being forced out of the peg by markets • Take advantage of the mutually reinforcing link between flexibility and – building inflation-oriented and interest-rate-based policy framework – risk management and market development
• Gradually removing asymmetries in the openness of the 46 capital account support FX flexibility
Recommendations • Since operational capacity takes time to build, preparation should start early • Some exchange rate flexibility should be allowed at an early stage to reinforce the operational “pillars” • If already open to capital flows, countries should be prepared for a quick pace of exit • Exchange rate flexibility should be embraced prior to fully liberalizing the capital account • It is important not to wait too long and to let the 47 market inflict the exit
David Vavra Managing Partner
[email protected] www.ogresearch.com