Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Globalisation and Monetary Policy

Effects of Exchange Rates & Exchange Rate Mechanism on Monetary Policy

The experience of living with capital flows since the 1970s has fundamentally altered the context of monetary policy. In particular, there is a dramatic shift in the still unsettled debate on the determinants of the exchange rate and the choice of the appropriate exchange rate regime, although the weight of opinion is clearly in favour of a flexible regime. According to conventional wisdom, it was trade flows which were the key determinants of exchange rate movements. In more recent times, the importance of capital flows in determining the exchange rate movements has increased considerably, rendering some of the earlier guideposts of monetary policy formulation possibly anachronistic. On a day-to-day basis, it is capital flows which influence the exchange rate and interest rate arithmetic of the financial markets. Capital flows have been observed to cause overshooting of exchange rates as market participants act in concert while pricing information.

For more open economies, sharp movements in the exchange rate can have significant effects on domestic inflation as well as on domestic balance sheet in view of liability dollarisation. This raises the issue of appropriate monetary policy response to exchange rate movements. Three alternative views exist on this issue. According to the first view - the strict constructionist view - monetary policy should respond to the exchange rate only to the extent that it affects inflation. The second view - flexible inflation targeter view - holds that exchange rate can also be a legitimate policy objective alongside inflation and output targets.

The third view - Singaporean view - believes that for a sufficiently open economy, stabilising inflation requires close management of the exchange rate. Managing the exchange rate, in this view, is not an objective by itself but a means to achieve the objective of low inflation. As EMEs are more exposed to the influence of the exchange rate, they may be required to accord a bigger role in policy assessment and decision-making. Although a real depreciation of the exchange rate may be helpful for external competitiveness and growth, it also increases the vulnerability from factors such as high exchange rate pass-through and liability dollarisation. There is, thus a "fear of floating" although there is some evidence that exchange rate pass-through to prices has generally tended to decline during the 1990s (see Module 4). Empirical evidence suggests that not only EMEs but even industrial economies also keep an eye on the exchange rate and often intervene in the foreign exchange market. Out of a sample of 18 countries (emerging as well as industrial countries) studied by Ho and McCauley (op cit.), 12 countries intervened in the foreign exchange market, above and beyond the impact of exchange rate on inflation.

That even industrial economies are quite concerned with exchange rate is amply illustrated by the recent experience of New Zealand. According to the Reserve Bank of New Zealand (2004), "the amplitude of the New Zealand exchange rate cycle has long been a concern. The exchange rate varies to a far greater extent than the underlying economic situation warrants. Excess exchange rate variation makes engaging in business more difficult, reducing investment and thereby restricting the opportunities for New Zealand in growth. Excessive exchange rate variability can also make the Bank's task of achieving and maintaining price stability more difficult, potentially leading to unnecessary output, inflation and interest rate variability. As inflation has been brought down and stabilised around the world and as a result economies have become more stable overall, exchange rate cycles have not noticeably diminished". Therefore, the Reserve Bank of New Zealand whose extant stance was to use foreign exchange reserves to "intervene only if the foreign exchange market became disorderly" recommended, in March 2004, that as one of its monetary policy tools, "it should have the capacity to intervene in the foreign exchange market to influence the level of the exchange rate".

The above discussion suggests that monetary authorities cannot ignore movements in exchange rates, at least in EMEs. This raises the issue: whether monetary policy reaction functions such as Taylor-type rules should be augmented to include exchange rates. According to Ball (1998), the policy instrument for an open economy should be a monetary conditions index (MCI). MCI is a weighted average of the short-term interest rate and the exchange rate. The underlying assumption of the MCI is that higher interest rates and an appreciation of the exchange rate are qualitatively equivalent, i.e., for an open economy, if the exchange rate were to appreciate, the interest rates should be lowered and vice versa to keep output growth and inflation at their desired trajectory. The use of the MCI as an indicator of market conditions, however, may be misleading since it depends upon the nature of the shocks to the exchange rates. Illustratively, in the presence of cost-push shocks, the interest rate needs to increase - and, not decrease - in combination with exchange rate appreciation to stabilise inflation expectations. Notwithstanding this debate on the usefulness of MCI, exchange rate movements remain a source of concern to the policy authorities in emerging markets.

For the majority of developing countries which continue to depend on export performance as a key to the health of the balance of payments, exchange rate volatility has had significant real effects in terms of fluctuations in employment and output and the distribution of activity between tradables and non-tradables. In the fiercely competitive trading environment, where countries seek to expand market shares aggressively by paring down margins, even a small change in exchange rates can develop into significant and persistent real effects. The heightened exchange rate volatility of the era of capital flows has had adverse implications for all countries except the reserve currency economies. The latter have been experiencing exchange rate movements which are not in alignment with their macro imbalances and the danger of persisting currency misalignments looms large over all non-reserve currency economies.

On the positive side, globalisation has contributed to sustained lowering of inflation as well as inflation expectations during the last two decades (see Module 4). At the same time, globalisation appears to hold a threat for future inflation. One such threat emerges from the US twin deficits. Fiscal as well as current account deficits in the US, at present, are close to 5 per cent of GDP. This order of current account deficit being run by the US would probably not have been funded in the past as readily as it is today. It is the increased degree of financial globalisation that has permitted the financing of such a large order of US current account deficit. However, such a large deficit may not be sustainable and, at some point of time, the US current account deficit has to narrow. As observed by Obstfeld (2004), unusually large current account deficits "should remain high on policymakers' list of concerns, even for the richer and less-constrained countries. Extreme imbalances signal the need for large and perhaps abrupt real exchange rate changes in the future, changes that might have undesired political and financial consequences, given the incompleteness of domestic and international capital markets". The threat to global inflation emerges from the adjustment dynamics that might accompany the reduction in the US current account deficit (Box IV.2). Depreciation of the US dollar would increase external demand and this would put upward pressure on aggregate demand and inflation. The concomitant monetary tightening in the US can have serious implications for the sustainability of growth not only in the US but in several developing countries. According to Ferguson (2004), however, the correction of the US current account deficit, if properly managed, need not lead to undue distress. "To minimise the harmful effects, there is a need for a coordinated and cooperative approach. The current account deficit in the US is, to a large extent, a manifestation of its large saving-investment gap which widened to a high level of 5.3 per cent in 2003. The US, therefore, will have to try to curb household and government borrowings and strengthen national savings. The Euro area continues to depend largely on external demand. It, therefore, will need to pursue some structural reforms, especially in the labour policies, to boost domestic demand. Japan also needs to continue to take some concrete measures to strengthen its financial system and reduce huge fiscal imbalances" .

The US has been a key engine of the global economic recovery since the late 1990s. Accommodative monetary and fiscal policies have enabled a strong growth in the US economy in the aftermath of the bursting of the information technology bubble. While real activity in the US has provided stimulus to activity in the rest of the world, it has been accompanied by large and growing twin deficits -fiscal as well as current account deficits. The current account deficit of the US has widened from US $ 117 billion in 1996 to an estimated US $ 631 billion in 2004 or from 1.5 per cent of GDP to an estimated 5.4 per cent of GDP. The deficit is expected to remain above five per cent in 2005. Large US current account deficits have been mirrored in huge current account surpluses and rising foreign exchange reserves in the rest of the world, mainly the Asian countries.

Existing research indicates that large current account deficits typically undergo correction when these are in excess of some threshold. For industrial economies, this threshold is estimated to be five per cent of GDP. For the US, existing studies place the threshold between 2.5-3.5 per cent of GDP and 4.5 per cent of GDP. An analysis of the three largest swings in the US current account over the past five decades shows that the exchange rate had a prominent role in these swings. Almost two-thirds of the widening of the US trade deficit from 1996 to 2003 can be attributed to appreciation of the US dollar between 1995 and 2002. In view of (i) income elasticity of US exports being higher than its imports and (ii) US GDP growth being in excess of the rest of the world, exchange rates will have a prominent role in the adjustment of the present current account imbalances. With unchanged growth rates in the US and the rest of the world, the US dollar would need to depreciate by nearly 33 per cent - equivalently, the non-US currencies would have to appreciate, on average, by 50 per cent - to balance the US trade account. According to Obstfeld and Rogoff (2004), the trade-weighted US dollar needs to depreciate, at least, by another 20 per cent. While further deepening of the international financial markets can sustain the US current account imbalances, it can only postpone the day of reckoning as the ultimate exchange rate adjustments will have to be more extreme (Obstfeld and Rogoff, op cit.).

As noted earlier, EMEs have been grappling with large surpluses on their current as well as capital accounts in the recent 3-4 years. The excess supplies in the foreign exchange markets pose threat to price stability in EMEs. Following Mundell, it is well-known that the trinity of desirable objectives, viz.¸ a fixed/ managed exchange rate (for relative price stabilisation purposes and as a credible nominal anchor), an independent monetary policy (for output stabilisation purposes) and an open capital account (for greater efficiency) can not be achieved simultaneously. Since only two out of the three desirable objectives are mutually consistent, the policy makers have to give up one of the objectives leading to what is called "policy trilemma" (Obstfeld and Taylor, 2002). Over the past century, countries have experimented with alternative monetary and exchange rate arrangements. The way out of the trilemma was provided by giving up monetary policy independence during the gold standard era (1870-1914), free movement of capital during the Bretton Woods era and exchange rate fixity in the recent decades. The impossible trinity can also be viewed as a constrained sum in which fractions are possible. That is, an independent monetary policy (1) might be combined with semi-fixity of the exchange rate (1/2) and a halfway open capital account (1/2). Capital account openness, therefore, should not be viewed as an all-or-nothing proposition and this appears to be the practice in most of the developing world.

Empirical evidence shows almost full adjustment of local interest rates to foreign interest rates during the 1990s, irrespective of the exchange rate regime, for most of the countries, with the notable exception of Germany and Japan. The speed of adjustment of domestic rates is, however, faster for pegged exchange rate regimes than under other regimes. The evidence thus suggests falling monetary independence during the 1990s, albeit with some degree of temporary monetary independence for flexible exchange rate countries. Monetary authorities attempt to overcome the constraints imposed by the impossible trinity in the short-run through sterilisation using a variety of instruments.

In a fixed exchange rate regime, excess forex inflows would perforce need to be taken to forex reserves to maintain the desired exchange rate parity. On the other hand, in a fully floating exchange rate regime, the burden of adjustment would be borne by the exchange rate. In case capital flows are persistent and large, the exchange rate may appreciate significantly with implications for external competitiveness and overall macroeconomic stability. Accordingly, in practice, the central banks intervene in the forex markets in almost all countries. At the same time, a more intensive approach to intervention may be warranted in the EMEs as capital flows in these economies are often relatively more volatile and sentiment driven, not necessarily being related to the fundamentals in these markets. Such volatility imposes substantial risks on market agents, which they may not be able to sustain or manage (RBI, 2004b).

The absorption of foreign exchange by the central banks, however, has its own limitations. Intervention purchases by the central bank result in an expansion in base money and, through the money multiplier process, in broader monetary aggregates and may spillover into domestic inflation. This may hurt external competitiveness, even with an unchanged nominal exchange rate. Thus, the objective of the monetary authority to prevent nominal appreciation would be defeated as the concomitant monetary expansion ends up with similar adverse consequences for exports and, in turn, output and employment.

It is, therefore, critical that the adverse effect of purchases of foreign currency by the central bank on monetary aggregates and inflation be offset or 'sterilised'. The classical form of sterilisation is through the use of open market operations (OMOs), that is, selling Treasury bills and other instruments to reduce the domestic component of the monetary base. Narrowly defined, sterilisation is the exchange of bonds rather than money for foreign exchange. Open market sales of government bonds (or central bank's own bills) suck out liquidity from the financial system and, thus sterilise the expansionary effect of money supply. Sterilisation is the most popular policy response and has been virtually used by all countries facing capital surges during the 1990s. It also avoids the burden on the banking system of higher reserve requirements. Moreover, by limiting the role of banking system in intermediating the flows, sterilisation operations reduce bank's vulnerability to sudden reversal of flows. Apart from government bonds/ bills, central banks in a number of countries like Chile, China, Colombia, Indonesia, Korea, Malaysia, Poland, the Philippines, Peru, Russia, Sri Lanka, Taiwan and Thailand have resorted to the issuance of their own securities to conduct open market operations for sterilisation.

The effective conduct of open market operations by the central bank as a tool for sterilisation is often constrained by the depth of the Government bond markets. This may be due to inadequate volume of Government securities for the conduct of open market operations and undeveloped/underdeveloped markets for Government securities. Many central banks have accordingly taken recourse to issuances of their own securities to absorb excess liquidity. The choice between issuing central bank securities or offering special treasury issues created specially for the purposes of monetary policy has depended mostly on institutional and market considerations.

Central bank issues have been used to conduct open market operations in Indonesia, where domestic Government debt is not allowed. In the Philippines, the central bank took the same course in the early 1980s because it did not have access to sufficient Government debt. The Bank of Korea (BoK) introduced Monetary Stabilisation Bonds (MSBs) in 1961. The Czech National Bank (CNB) issued its own debt in 1992 to mop up liquidity from the banking system. The National Bank of Poland (NBP) conducted sterilisation operations by introducing central bank securities of different maturities during 1994-97. From 1995 to mid-1997, the Bank of Thailand issued bonds to absorb excess liquidity arising from huge capital inflows from abroad and in the context of the Government's budget surplus. In 1993, the Bank Negara Malaysia began to issue Bank Negara Bills which are similar to Malaysian Government Treasury Bills. This was since treasuries issuance was dwindling in line with the shrinking Government deficit. Bank Negara Malaysia issued BNM bills equivalent to 2 per cent of GDP in 2000; the issuances have increased sharply in recent years, leading to substantial sterilisation costs (RBI 2003d). In Taiwan, the central bank issues Negotiable Certificates of Deposits (NCDs) to mop up excess liquidity from the financial system. The NCDs are issued through competitive/non-competitive bidding in various denominations with maximum maturity of three years and sold, either on outright basis or under repos. The People's Bank of China (PBC) started outright issue of central bank bills from April 22, 2003 in view of the limited Government bond holdings of the central bank.

Country experiences show that excessive reliance on central bank securities for conduct of open market operations puts a strain on the central bank's balance sheet. Costs of sterilisation mount as continuous sterilisation bids up the rates at which successive issuances can be made. This erodes the profitability of the central bank and several central banks have suffered losses - Chile (1.0 per cent of GDP per annum during 1993-98), Colombia (0.5-0.7 per cent in the early 1990s), Mexico (0.2-0.4 per cent during 1990-92) and Poland (1.0 to 1.15 per cent of GDP during 1995-97) (Ariyoshi et al 2000; RBI 2003d).

Moreover, issuance of central bank bills results in two sets of competing risk-free papers (along with government securities), with a similar yield curve (RBI, 2003d). In countries with large fiscal deficits, the problem is exacerbated by public confusion regarding the relationship between the two. Where the central bank is vested with the responsibility for public debt management, issuance of the central bank bills can potentially sharpen the trade-off for the central bank between the objectives of monetary policy and those of public debt management. It also leads to fragmentation of debt markets, which can lead to instability in the Government borrowing programme.