FOREIGN EXCHANGE MARKET
Economic literature suggests that, at an aggregated level,the adoption of more flexible exchange rate regimes inEmerging Market (EM) countries has been associatedwith greater monetary policy independence. EM countrieswith exchange rate anchors are generally associated withpegged regimes. Here, the exchange rate serves as thenominal anchor or intermediate target of monetary policy.Around 27 per cent of the EM countries followedexchange rate anchors at the end of April 2006 (Table).When the exchange rate is directly targeted in order toachieve price stability, intervention operations areunsterilised with inter-bank interest rates adjusting fully.In Singapore, while pursuing a target band for theexchange rate is the major monetary policy instrument,the central bank’s decision on whether to steriliseintervention is made with reference to conditions in thedomestic markets
.In other regimes, where the exchange rate is not themonetary policy anchor, any liquidity impact ofintervention that would cause a change in monetaryconditions is generally avoided. Most foreign exchangeoperations are sterilised. Interventions may also be usedin coordination with changes in monetary policy, givingthe latter a greater room for manoeuvre. For example,where a change in monetary policy is unexpected,surprising the market can erode confidence or destabilisethe market. Intervention may help minimise the costs ofsurprising financial markets, allowing monetary policygreater capacity to move ahead of market expectations.Around 17 per cent of the EM countries have adoptedmonetary aggregate target, most of which are associatedwith managed floating exchange rate regimes. In the caseof a monetary aggregate target, the monetary authorityuses its instruments to achieve a target growth rate for amonetary aggregate (reserve money, M1, M2,
.), andthe targeted aggregate becomes the nominal anchor orintermediate target of monetary policy.Around 43 per cent of the EM countries have adoptedinflation targeting as their monetary policy regime, wherechanges in interest rates are the principal instrumentsof monetary policy. Inflation targeting involves the publicannouncement of medium-term numerical targets forinflation with an institutional commitment by the monetaryauthority to achieve these targets. Here, intervention
Box VI.1Exchange Rate Regimes and Monetary Policy in EMEs
becomes important when movements in the exchangerate inconsistent with economic fundamentals threatento push inflation outside the target band. However, wherethe exchange rate is responding appropriately to a “real”shock, it may be necessary either to acknowledge theexpected departure from the inflation target for someperiod of time or to offset the shock by altering monetarypolicy. Most of the countries with inflation targeting asthe monetary policy regime have adopted independentfloating as the exchange rate policy. Empirical evidencesuggests that most emerging economies that moved toa free float, introduced full-fledged inflation targeting onlyafter a transition. There are other EM countries,
Algeria, India, Romania, and Russia, which have noexplicitly stated nominal anchor, but rather monitorvarious indicators in the conduct of monetary policy. Insome of the EM countries, coordinating these policiesmay be more difficult because foreign exchangeoperations are not the responsibility of the monetaryauthority. In such instances, the maintenance of a closedialogue between the respective authorities is importantin avoiding any conflict arising between monetary andexchange rate policies.
EMEAP Study on Exchange Rate Regimes, June 2001.
Table: Monetary Policy Framework - April 2006
BulgariaArgentinaBrazilEcuadorChinaChileEgyptIndonesiaColombiaHong KongTunisiaCzech RepublicMalaysiaUruguayHungaryVenezuelaKoreaMoroccoMexicoHungaryPeruPhilippinesPolandSouth AfricaThailandTurkey
Annual Report on Exchange Arrangements andExchange Restrictions, 2006, IMF.
number of Asian countries contributed to the regionalfinancial crisis in 1997-98. Since the Asian financialcrisis, several Asian economies have adopted moreflexible exchange rate regimes except for Hong Kong,which continued with its currency boardarrangement, and China, which despite someadjustments, virtually maintained its exchange ratepeg to the US dollar. After experiencing some