Introduction

Financial integration has reshaped monetary policy frameworks and transmission channels in emerging markets over the past few years. Both short-term and long-term interest rates in emerging market economies (EMEs) have become more responsive to foreign financial conditions. One important channel for the transmission of e ternal factors on monetary policy is the e change rate. !he c"rrent environment of rising inflation and c"rrency appreciation press"res in many EMEs poses a partic"lar challenge# as monetary policy now faces a more diffic"lt trade-off between price stability and e change rate stability. $ndeed# many central banks highlight the increased infl"ence of e ternal shocks in form"lating domestic monetary policy in their contrib"tions to this meeting. %gainst this backgro"nd# this paper disc"sses the motives for stabilising nominal e change rates in emerging markets& how far central banks can s"stain a target for the real e change rate over the medi"m term& how the notions of long-r"n e'"ilibri"m e change rates infl"ence monetary policy strategies& and how monetary policy frameworks and act"al decisions co"ld incorporate e change rate movements. !he disc"ssion is based on central bank papers p"blished in this vol"me and '"estionnaire responses prepared for this meeting# as well as o"r own analysis# with a foc"s on the period from ())* to early ()++. !he main findings of o"r paper are as follows. First# at least since ()),# central banks in emerging markets have been managing the val"e of their c"rrencies more actively via some combination of reserve acc"m"lation# policy interest rates and administrative meas"res. -econd# motives for infl"encing e change rates vary across ."risdictions# reflecting concerns abo"t large capital flows# "ndesired spillovers from swings in global risk aversion and long- r"n e ternal competitiveness. !hird# more active c"rrency management p"ts a premi"m on o"r "nderstanding of e'"ilibri"m e change
1

rates# notions of which are still diffic"lt to define concept"ally and empirically. Finally# policy rates and e change rate fle ibility are critical tools in addressing the challenges facing EME central banks today# b"t there is no consens"s yet on how best to incorporate e change rate movements into monetary policy frameworks. !he remainder of the paper consists of five parts. -ection ( highlights key motives for stabilising nominal e change rates. -ection / disc"sses practical limitations for central banks that aim to s"stain a target for the real e change rate over the medi"m term. -ection 0 reviews vario"s notions of long-r"n e'"ilibri"m e change rates "sed by central banks# and how they infl"ence monetary policy strategies. -ection 1 presents a simple analytical framework for disc"ssing how monetary policy frameworks and act"al decision co"ld incorporate e change rate movements. -ection 2 concl"des.

Motives for stabilising nominal exchange rates

3hy do central banks in emerging markets try to stabilise e change rates of the c"rrencies they iss"e4 %nd how valid are these motives on theoretical and empirical gro"nds4 3hether central banks in emerging markets aim to stabilise nominal e change rates depends in the first instance on the monetary policy framework and e change rate regime they have adopted.( !h"s# central banks that operate a c"rrency board or a fi ed e change rate regime# s"ch as the 5ong 6ong Monetary %"thority or the -a"di %rabian Monetary %"thority# have a legal mandate to keep the e ternal val"e of the domestic c"rrency stable. %ccordingly# they tailor their policy instr"ments to manage the e change rate against a benchmark 7 e change rate stability is simply the overriding goal of monetary policy. For other e change rate arrangements# the motives for stabilising e change rates fall into ro"ghly two broad categories8 concerns abo"t the short-term impact on macroeconomic and financial stability& and concerns abo"t the medi"m- to long-term impact on reso"rce allocation. Short-term motives. %ll central banks nat"rally incorporate iss"es of e change rate fl"ct"ations into their respective monetary policy strategies. %s noted in the 9ational Bank of :oland paper in this vol"me# central banks are "ltimately concerned abo"t e change rate movements even in a floating regime beca"se these movements infl"ence inflation. $deally# floating e change rates play a macroeconomic stabilisation role by absorbing vario"s shocks. 5owever# e perience in significant short-term emerging markets has shown all too often that rate movements that deviate from e change

f"ndamentals can also affect macroeconomic performance. %nother reason why central banks in an independent floating regime may
3

occasionally want to stabilise e change rate movements is that e change rate volatility may affect financial stability. !his may occ"r# for instance# if markets for hedging e change rate risk are "nderdeveloped# as is often the case in EMEs& in financially dollarised economies& or# more generally# in EMEs in which the financial sector is small relative to the si;e of short-term capital flows. 9ominal e change rates of emerging market c"rrencies tend to fl"ct"ate very widely# both with respect to benchmark c"rrencies s"ch as the <- dollar (=raph +) and in effective terms (%ppendi =raph %+). For instance# d"ring the crisis of ())>7),# the c"rrencies of Bra;il# 6orea# :oland and ?"ssia first weakened by 0)72)@ against the dollar (between October ())> and Febr"ary ()),) and then appreciated by ()70)@ (between March and -eptember ()),) (=raph +). -"ch large swings in e change rates may affect financial markets and the real sector# especially if they res"lt from capital inflows# sharp terms of trade swings# or other shocks that are deemed to be temporary or "nrelated to the f"ndamental determinants of e change rates./

% partic"lar concern is that e change rate fl"ct"ations will enco"rage spec"lative behavio"r on the basis of e pectations that the e change rate will contin"e to appreciate# as noted in the Bank of ?"ssia contrib"tion. Aepending on the mat"rity str"ct"re and c"rrency denomination of assets and liabilities in the economy# sharp e change rate movements co"ld res"lt in li'"idity shortages and trigger significant balance sheet effects# which may re'"ire central bank action to stabilise the system 7 for instance# by providing short-term foreign c"rrency li'"idity to the banks. Bentral banks have been also concerned that m"ch of the recent e change rate appreciation has been d"e to the wide interest rate differentials with respect to advanced economies# which is seen to res"lt largely from the contin"ation of the near ;ero policy rates in advanced economies.
4

% comparison of the pre- and post-crisis periods provides some s"pport to concerns abo"t the increased volatility in foreign e change markets. !he implied volatility (derived from foreign e change options) of emerging market e change rates has been generally higher since the start of the recovery in March ()), than it was before -eptember ())> 7 the notable e ception was the !hai baht !his s"ggests greater market "ncertainty abo"t e change rates in the near term# a concern for policymakers in emerging market economies ?ecent policy disc"ssions have highlighted one related motive for stabilising nominal e change rates8 in recent years# the demand for EME c"rrencies has proved sensitive to changes in risk aversion in international markets. !h"s# d"ring the global financial market boom from ())/ to ())*# key emerging market c"rrencies strengthened8 the Bra;ilian real by +1)@& the $ndian r"pee by almost /)@& the renminbi and other widely traded emerging market c"rrencies by +17()@ (=raph /). !he Cehman bankr"ptcy and its aftermath led to a flight from emerging market assets# and the dollar val"e of most EME c"rrencies pl"nged. !he renminbi was an e ception8 it did not fall against the dollar and rose sharply against other emerging market c"rrencies (green line in =raph /). % significant recovery in the e change rates of EMEs other than the renminbi did not start "ntil the end of the period of e treme volatility in global financial asset prices aro"nd MarchD%pril ()),. 3eighted average of fo"r widely traded c"rrencies 7 the 6orean won# the Me ican peso# the -o"th %frican rand and the !"rkish lira# based on ())1 =A: and ::: e change rates& an increase indicates appreciation of the local c"rrency& monthly averages. Over the past year# developments in ma.or international c"rrencies have again strongly affected movements in emerging market e change rates. Following a brief period of downward press"re triggered by the sovereign debt crisis in =reece in May ()+)# key emerging market c"rrencies appreciated against the <- dollar "ntil October (=raph +). $n Bra;il# Bhile# 6orea# :oland# -o"th %frica and !"rkey# the nominal
5

e change rates appreciated by +/7(/@. 5owever# since early 9ovember ()+)# the dollar has partly recovered against some ma.or c"rrencies# as the o"tlook for the <- economy improved and a new ro"nd of sovereign debt problems emerged in E"rope. ?eflecting these developments 7 and not necessarily the economic performance of emerging markets# which was fairly stable thro"gho"t the year 7 the appreciation trend of emerging market c"rrencies has reversed since 9ovember ()+) (notably in central and eastern E"rope (BEE) and 6orea)# flattened in others (Bra;il# Me ico and many %sian EMEs) and contin"ed among ma.or commodity e porters (incl"ding Bhile and -o"th %frica) (=raph +). Longer-term motives. For central banks operating managed e change rate regimes# the additional motives for e change rate stabilisation incl"de the impact of e change rate fl"ct"ations on e ternal competitiveness and the impact of possible e change rate misalignment on reso"rce allocation in the long term. %t a theoretical as well as empirical level# one can find some ."stification for concerns abo"t the impact of e change rates on e ternal competitiveness. !he demand for many emerging market e ports is fairly price elastic. !his may res"lt in the loss of market share even in the short r"n. F"rthermore# e change rate appreciation p"ts the tradable sector at a

disadvantage relative to the non-tradable sector in the home co"ntry. Aepending on the co"ntryEs initial e ternal position# this can lead relatively '"ickly to e ternal imbalances and financial instability. !he arg"ments for stabilising e change rates in order to avoid reso"rce
6

misallocation in the long term seem less pers"asive. Floating e change rates do have a tendency to overshoot their long-term trend val"es for prolonged periods (see -ection 0). !his was the case with many BEE c"rrencies d"ring the long cyclical "pswing from aro"nd ())/ to mid-())>. 5owever# whether s"ch deviations lead to potentially irreversible loss of capacity in the tradable sector 7 the so-called FA"tch diseaseG 7 is less clear. -tr"ct"ral change and shifts in comparative advantage are "ltimately driven by technical innovation# stable e change income growth and shifts in labo"r skills. Maintaining

rates or resisting e change rate appreciation will not prevent ad."stments in ind"strial str"ct"re from taking place& it may only postpone the inevitable ad."stments 7 eg the shrinking of te tile or steel ind"stries 7 at a large cost to the economy in terms of reso"rce misallocation in the long term. Moreover# a false sense of e change rate stability may lead to c"rrency mismatches in the private sector that prove very costly to "nwind# as demonstrated by the %sian crisis of +,,*7,> and the recent e perience of the Baltic states. Evidence from policy responses. :olicy moves over the past two years indicate that central banks and other policymakers in emerging markets have employed vario"s tools to infl"ence the stability of e change rates8 foreign e change intervention and reserve acc"m"lation& targeted administrative meas"res# incl"ding ta es# to dampen the inflows& and other restrictions on short-term capital inflows. One significant manifestation of EMEsE efforts to stabilise their c"rrencies has been rapid reserve acc"m"lation. %s shown in !able +# the EMEs acc"m"lated almost H+./ trillion in reserves over ()), and ()+)# reflecting aggregate c"rrent acco"nt s"rpl"ses of H00) billion in ()), and H/01 billion in ()+)# as well as net capital inflows of# respectively# H/)) billion and H(2) billion in the past two years. 3hile the aggregate e ternal s"rpl"s of emerging markets is lower today than before the crisis# the fact that it is not showing signs of d"rable
7

decline is once again raising the '"estion of global imbalances and the need for their ad."stment. %nother piece of evidence is that many inflation targeting central banks that normally do not intervene have recently fo"nd merit in foreign e change intervention. For e ample# the 9ational Bank of :oland notes in its contrib"tion that very large# b"bble-like deviations of the e change rate from levels seen as s"stainable over the medi"m term can amplify rather than absorb the shocks. $ts g"idelines for monetary policy in ()+)7++ th"s state that the floating e change rate regime does not r"le o"t foreign e change interventions sho"ld they t"rn o"t necessary to ens"re domestic macroeconomic and financial stability (9B: (()+))). !he 9ational Bank of :oland th"s intervened in %pril ()+) for the first and only time since +,,> to red"ce the volatility of the ;loty and increase the risk facing investors engaging in moment"m trading strategies. -imilarly# the Bentral Bank of Bhile has recently res"med reg"lar interventions in the foreign e change market# as the central bank estimated that a reserve b"ffer was needed to better deal with the contingency of a significant deterioration of the e ternal environment. $n %sia too# most inflation targeting central banks have e perienced noticeable reserve acc"m"lation since early ()),. % f"rther indication of attempts to stabilise e change rates comes from indicators of e change rate volatility. -ome EME central banks aim to stabilise their bilateral e change rate against a ma.or international c"rrency s"ch as the <- dollar# while others tend to manage their c"rrencies on a trade-weighted basis. By comparing volatilities of the bilateral <- dollar e change rate with that of the nominal effective e change rate# one can ga"ge the relative weight central banks p"t on the basket of c"rrencies against which they benchmark their own c"rrency. % higher ratio indicates a relatively greater basket orientation 7 some analysts also take ratios m"ch higher than +)) to indicate a relatively high basket orientation# while a ratio significantly below +)) indicates a relatively low basket orientation
8

Real exchange rate as a medium-term policy target

!he increased emphasis on managing e change rates in emerging markets in recent years presents a n"mber of operational challenges. One ."stification for this approach by policymakers has been the desire to red"ce Fe cessiveG e change rate volatility. !his ass"mes that one can reasonably estimate e cessive movements# on both the "pside and the downside. Moreover# "nderlying this ass"mption is a notion of a medi"m-term target for the real e change rate. %t least three '"estions arise8 5ow does a central bank set the target4 3hich tools co"ld it "se to achieve it4 %nd what are the constraints on maintaining the target4 -etting a target for the real e change rate over the medi"m term re'"ires a g"idepost as a reference. Many options have been proposed# each having advantages and drawbacks. One notion of the e'"ilibri"m e change rate is based on long-term economic f"ndamentals8 the ne t section will arg"e that this is diffic"lt to '"antify. Iario"s meas"res are being "sed by central banks in emerging markets# as o"r s"rvey indicates (!able ()# b"t there is s"ch as prod"ctivity no consens"s on the best f"ndamentals differentials

between tradable and non-tradable sectors in EMEs relative to advanced economies (the Balassa--am"elson effect).1 concepts are diffic"lt to operationalise. Even these well known real

Balc"lating FpermissibleG

e change rate appreciation within the Balassa--am"elson framework re'"ires a large amo"nt of high-'"ality data that are not always available in emerging market economies. One meas"re approach.0 -ome concepts are int"itively clear 7 for instance# the notion that e change rate appreciation is driven by of the challenge is that emerging market central
9

banks have yet to solve the simpler problem of correctly meas"ring wage and price changes when calc"lating real e change rates. ?egarding the tools "sed to achieve a targeted e change rate# central banks in emerging markets traditionally rely on foreign e change intervention (to infl"ence the nominal e change rate) and sterilisation (to offset the increase in banking system li'"idity res"lting from intervention). !hese techni'"es are well known# and central banks in emerging markets generally view them as effective (Mihal.ek (())1)). 5owever# the literat"re on intervention and sterilisation finds that s"ch actions entail vario"s risks and costs that event"ally affect both the ability and the willingness of central banks to resist e change rate movements. !hese incl"de val"ation losses# sterilisation costs and# in partic"lar# increased commercial bank lending res"lting from partial or ineffective sterilisation.2 :rolonged intervention can also res"lt in the

perception by the markets of a one-sided e change rate bet. $n s"ch conditions# carry trade dynamics easily arise. 3here one-sided bets acc"m"late# central banks may have an incentive to trade in a discretionary fashion on the other side. !his may help to balance the order flows# b"t it may also lead to losses for the central bank. %part from the costs of intervention and sterilisation# general macroeconomic developments can also constrain the willingness of central banks to s"stain a target for the e change rate. -ince late ()+)# for instance# growing domestic inflationary press"res have complicated trade-offs associated with intervention# meas"res to dampen capital inflows and conventional monetary policy. !he recent monetary policy environment in Bhina ill"strates this point8 even tho"gh foreign e change intervention and capital controls have been s"ccessf"l in limiting the pace and e tent of nominal c"rrency appreciation# they may not be able to s"cceed in alleviating inflationary press"res arising from the e pansion of banking sector balance sheets. !he policy alternatives are also problematic at this stage. 5igher
10

interest rates wo"ld help to rein in inflationary press"res b"t co"ld wind "p attracting additional capital inflows. %nd# an "nchanged policy mi wo"ld mean that the costs and risks associated with foreign reserve acc"m"lation wo"ld rise f"rther. Finally# controversy remains over the role of prolonged foreign e change interventions by emerging market central banks in the face of persistent global c"rrent acco"nt imbalances. One perspective is that s"ch actions impede global read."stments and even p"sh down yields on very li'"id international assets# which in t"rn compresses risk premia# inflates asset prices and lowers the perceived imperative for fiscal consolidation in advanced economies. %nother perspective is that large fiscal deficits# easy monetary policy and '"antitative easing in advanced economies aggravate EME global c"rrent acco"nt imbalances# prompting capital flows to emerging markets that res"lt in central banks "ndertaking foreign e change interventions. !hese two perspectives are not m"t"ally e cl"sive.

11

Equilibrium exchange rates and monetary policy

5ow do notions of e'"ilibri"m e change rates infl"ence monetary policy strategies in emerging markets4 %s disc"ssed in several central bank contrib"tions to this vol"me# many emerging market central banks have concl"ded that recent capital inflows and real effective e change rate appreciation are to a considerable e tent d"e to so"nder f"ndamentals in their co"ntries. !his is one of the concl"sions in the central bank papers from the B;ech ?ep"blic# $srael# the :hilippines# :oland# -o"th %frica and !hailand# among others. -everal central banks also view the si;eable growth differential between the EMEs as a whole and the advanced economies as permanent# not cyclical. -imilarly# some central banks (eg the -o"th %frican ?eserve Bank) now consider increased foreign investment in emerging market debt as str"ct"ral in nat"re. !hese considerations wo"ld imply that the e'"ilibri"m real e change rate of many EMEs has appreciated over the past few years and# hence# that the observed real effective e change rate appreciation is consistent with e'"ilibri"m dynamics. 9evertheless# commodity e porters# small open economies# and the EMEs that are closely integrated with advanced economies 7 s"ch as $srael# Me ico and central E"ropean co"ntries 7 remain more dependent on e ports and growth in developed co"ntries than the large economies of Bra;il# Bhina and $ndia. For these smaller EMEs# large real appreciation can imply a palpable decline in e ternal competitiveness. %s noted by the Bank of $srael# real e change rate misalignments that are d"e to medi"m-term deviations of the act"al e change rate from the e'"ilibri"m real e change rate co"ld res"lt in inefficient reso"rce allocation over the cycle# incl"ding "nder"tilisation of factors of prod"ction in some periods and over"tilisation in others. More solid evidence on where the e'"ilibri"m e change rate might be at a point in time wo"ld enhance the ability of central banks to assess the
12

implications of e change rate fl"ct"ations for policymaking. !o ill"strate this point# note that real effective e change rates have fl"ct"ated considerably over the past few years. $f we compare the sit"ation in early ()++ with the long-term average for the pre-crisis period from ())) to ())*# the pict"re that emerges is one of very diverse developments across EMEs (=raph 1)8 7 7 7 7 -7 strong real appreciation (0)72)@) in Bra;il and ?"ssia& s"bstantial appreciation (()70)@) in $ndonesia# the :hilippines# the B;ech ?ep"blic# and !"rkey& moderate appreciation (+)7()@) in Bhina# $ndia# -ingapore# !hailand# Bhile# 5"ngary# :oland and -o"th %frica& strong real depreciation (almost 0)@) in %rgentina& s"bstantial real depreciation (+)7()@) in 5ong 6ong -%?# 6orea and stable real e change rates compared to the ()))7)* average in different developments s"ggest that the determinants of Me ico& and %lgeria# $srael# :oland# -a"di %rabia# Malaysia# :er" and Iene;"ela. !hese very e'"ilibri"m real e change rates are likely to be fairly co"ntry-specific. 9o generalisations are possible and each central bank needs to feel its way to what the e'"ilibri"m e change rate of its c"rrency might be at a given point in time. One simple b"t cr"de meas"re of the e'"ilibri"m e change rate is the :::implied nominal effective e change rate# ie a trade-weighted basket of foreign c"rrencies eval"ated at :::.* $ts main advantage is that estimates of ::: rates are readily available and can be easily compared with trade-weighted e change rates# which most central banks typically comp"te on a monthly basis. =raph 2 shows that the :::-implied e change rate gaps can be large and very persistent. For instance# the r"pee and the renminbi were# respectively# 2)@ and 0)@ below their :::-implied e change rates in late ()+) (=raph 2# "pper left13

hand panel). %s Obstfeld and ?ogoff (()))) pointed o"t# the si;e and persistence of these gaps constit"te one of the big p";;les in international economics. One interpretation is that e change rates are s"b.ect to very weak short- to medi"m-term feedbacks from f"ndamentals in financial markets and the real economy. !he weak feedback also s"ggests that e change rates may appear to become "nanchored from economic f"ndamentals for e tended periods of time# and that these price signals from the misaligned e change rates lead to real distortions. !his e change rate disconnect perspective is confirmed in many st"dies of the predictability of e change rates8 a debate abo"t whether e change rates follow a random walk over short hori;ons is still going on (?ogoff and -travrakeva (())0))# while for long hori;ons there is some evidence of predictability of e change rates. %nother perspective abo"t the si;e and persistence of the gaps highlights the possibility of significant meas"rement iss"es. !he $nternational Bomparison :rogramme# which s"rveys prices globally# is a h"ge statistical "ndertaking to develop new# more precise international price comparisons& b"t s"ch comparisons are available only at infre'"ent intervals. 9onetheless# the res"lts of the programme raise '"estions abo"t the "se of ::: e change rates even as a ro"gh g"ide for central banks searching for an appropriate meas"re of the e'"ilibri"m e change rate. Many emerging market central banks have therefore been developing more sophisticated empirical models of e'"ilibri"m e change rates. !able %+ in the %ppendi approaches to provides a s"mmary of more than a do;en c"rrently "sed estimating e'"ilibri"m e change rates.> One "nresolved

concept"al iss"e in this literat"re is the choice of the appropriate price inde (B:$# tradable prices# "nit labo"r costs# =A: deflators). %nother is ass"mptions abo"t the nat"re of ad."stment mechanism in foreign e change markets 7 is the main driver of ad."stments "ncovered interest rate parity over long hori;ons# or
14

do internal and e ternal imbalances in EMEs play a key role4 %mong central banks attending this meeting# only $ndia# Me ico# ?"ssia# -a"di %rabia and !"rkey do not prepare estimates of long-r"n e'"ilibri"m e change rates (!able (). Of those that do# 5"ngary# 6orea and Malaysia do not p"blish their estimates beca"se they consider them to be sensitive information that co"ld be potentially disr"ptive to the foreign e change market. Most central banks report in answers to the B$- '"estionnaire that they "se a combination of behavio"ral (BEE?) and f"ndamental (FEE?) e'"ilibri"m e change rate methodologies (incl"ding the B;ech ?ep"blic# Bolombia# Malaysia# :er" and :oland) (!able (). -ingapore and !hailand combine estimates from macroeconomic balance and BEE? approaches& and 5"ngary# $srael and 6orea those from e ternal s"stainability and FEE? approaches. %lgeria# 5ong 6ong -%? and the :hilippines rely on the $MFEs three ma.or Bons"ltative =ro"p on E change ?ates (B=E?) methodologies. !he Bentral Bank of %lgeria# for instance# intervenes on the foreign e change market on the basis of inflation differentials against the ma.or trading partners and other f"ndamental indicators of the domestic economy. -everal central banks also look at the ::: estimates of e'"ilibri"m e change rates (eg Bolombia# the :hilippines and :oland). Overall# the in Bolombia# the B;ech ?ep"blic# $srael and :oland. %mong the contrib"tions to this vol"me# the paper by Bank of $srael analyses estimates of the e'"ilibri"m real e change rate of the $sraeli shekel and how they are "sed in deciding on FJ interventions. !he estimates based on a model derived from long-r"n f"ndamentals show that the $sraeli c"rrency was overval"ed in early ())>. !his prompted the central bank to start p"rchasing
15

methodology for

estimating e'"ilibri"m e change rates seems to be partic"larly well developed

foreign c"rrency# thereby probably contrib"ting to a grad"al realignment and some "nderval"ation in ()),# followed by convergence close to e'"ilibri"m in ()+). 5owever# based on an alternative approach# the real e change rate was still "nderval"ed in ()+) d"e to the relatively large c"rrent acco"nt s"rpl"s. $n Bolombia# the central bank staff ro"tinely prepare estimates of long-r"n e'"ilibri"m e change rates based on several methodologies8 :::# tradableDnontradable relative prices (Balassa--am"elson approach)# BEE? and FEE?. !he staff calc"late estimates and confidence intervals for each methodology# and assess the probability of misalignment by e amining the position of the c"rrent real e change rate or nominal effective e change rate with respect to the confidence intervals. !his information is "sed to form a ."dgment on misalignments# which is in t"rn a key inp"t in foreign e change intervention decisions. Most methodologies are comp"ted for a ::$-based# trade-weighted real e change rate inde # b"t the staff also e amine other real e change rate indices# incl"ding B:$-based indices and indices of competitiveness in third markets.

16

Table Estimation of equilibrium exchange rate Availability Algeria !es !es !es Colombia Methodologies Real e$$ec%i&e exchange ra%e 'R((R) and nominal e$$ec%i&e exchange ra%e '"((R) *i%h IM+ me%hodology as %he re$erence, Ra%es based on PPP- %radable#non.%radable rela%i&e prices- beha&ioural e/uilibrium exchange ra%e '0((R) and $undamen%al e/uilibrium exchange ra%e '+((R), 0((R- permanen% e/uilibrium exchange ra%e 'P((R)na%ural real exchange ra%e '"ATR(1)- +((R and models rela%ed %o sus%ainable real exchange ra%e 'SR(R), Also%he Czech "a%ional 0an de&elops original approachessuch as %he pricing.%o.mar e% 'dispari%y) and %he au%archy 'ie cross.border order $lo*.ad2us%ed) exchange ra%e concep%, Three approaches adop%ed by %he IM+3 %he e/uilibrium exchange ra%e approach- %he macroeconomic balance approach and %he ex%ernal sus%ainabili%y approach, +((R, R((R, R((R and +((R, 0ased on a combina%ion o$ $undamen%als and beha&ioural approaches, !es 0((R and +((R, The 0ang o Sen%ral ng Pilipinas4s mul%iple e/ua%ion model 'M(M)- *hich genera%es exchange ra%e es%ima%es based on PPP and in%eres% ra%e pari%y condi%ions, The R((R and %he IM+4s C5(R me%hodologies are also considered, The "a%ional 0an o$ Poland %a es in%o accoun% %he resul%s o$ %he In%erna%ional Comparison Programme0((R- PPI.based real exchange ra%e o$ (6R#P7"+((R and $irm.le&el da%a rele&an% in exchange ra%e misalignmen% analyses, Also- %he IM+4s C5(R es%ima%es are considered, 0ased on an o&erall assessmen% o$ %he pre&ailing macroeconomic ou%loo , 0((R, T*o me%hodologies similar %o %hose o$ %he IM+3 macroeconomic balance approach and 0((R, !es !es !es Published 1 studies "#A !es !es

Czech Republic !es

!es

!es !es Hong Kong SAR !es !es Hungary Israel Korea Malaysia Mexico Peru Philippines "o !es !es

!es !es "#A "#A

Poland

"#A !es !es

"#A !es !es

Russia Saudi Arabia Singapore Thailand Tur ey 1

!es "o

"#A indica%es in$orma%ion no% pro&ided by %he cen%ral ban 8 publica%ions are lis%ed in Appendix Table A9, Source3 Cen%ral ban responses %o %he 0IS /ues%ionnaire,

$n :oland# the central bank "ses a FEE? model to estimate the level of the real e change rate that wo"ld be consistent with the sim"ltaneo"s attainment of internal and e ternal e'"ilibria# which are defined as ;ero o"tp"t gap and the

s"stainable level of the c"rrent acco"nt. !he latter is calc"lated on the basis of a solvency criterion# ie the s"stainable level of the c"rrent acco"nt that stabilises :olandEs net foreign debt at an e ogeno"sly set level. % partic"lar feat"re of the 9ational Bank of :oland (9B:) model is that it takes into acco"nt the s"pply side performance of the :olish economy# by incorporating firm-level data relevant in e change rate misalignment analyses. !he res"lts of the model are "pdated '"arterly and are presented to the Monetary :olicy Bo"ncil., !he B;ech 9ational Bank paper in this vol"me disc"sses how meas"res of long-term e'"ilibri"m e change rates have been "sed in assessing the timing of entry to the e"ro area. Beca"se the long-term trend appreciation of the B;ech kor"na# which is driven by high prod"ctivity growth in its tradable sector# is e pected to contin"e over the ne t decade# entering the e"ro area now wo"ld imply an e pansionary shock to interest rates of +K7/ percentage points. !his co"ld lead to the boom and b"st cycle observed in co"ntries s"ch as =reece# $reland# :ort"gal and -pain before they entered the e"ro area in the +,,)s. Many central banks in EMEs have faced a more pressing iss"e over the past year8 5ow fast and how far can they allow e change rates to appreciate before a potentially "nhealthy dynamic in domestic asset markets develops4 5ere opinions clearly differ. One view# mentioned in the note by the Bank of ?"ssia# is that allowing a sharp c"rrency appreciation wo"ld create a two-way fore risk# limiting spec"lative inflows into domestic asset markets. % contrary view is that appreciation prices. $n practice# it is often diffic"lt for policymakers to be precisely g"ided in their decisions by estimates generated from models of e'"ilibri"m e change rates. Boncerns abo"t the impact of e change rate volatility on financial stability and fears abo"t the loss of e port reven"e sho"ld e change rates "ltimately overshoot factor into decisions by policymakers to resist e change rate generates e pectations of f"rther appreciation# sparking increased carry trades and aggravating an overshooting of domestic asset

appreciation by applying some combination of interest rate and e change rate policies. !his iss"e is addressed in the ne t section.

Exchange rates in monetary policy frameworks: tools targets or both!

!he preceding disc"ssion indicated that the e change rate can play two different

roles in the monetary policy frameworks of emerging market economies. First# it can be "sed as a policy tool to help achieve the inflation target and o"tp"t stabilisation. -econd# it can be a separate target of monetary policy in a way similar to the inflation target. !his section describes a simple concept"al framework that co"ld be "sed to analyse these two roles of the e change rate in monetary policy frameworks. Exchange rate as a policy tool !o the e tent that central banks can control both the policy rate and the nominal e change rate 7 for instance# in a managed floating regime with incomplete capital mobility 7 the e change rate co"ld be "sed as a tool of monetary policy. Other things being e'"al# letting the nominal e change rate appreciate wo"ld lower domestic prices of imports and help lower the import components of prod"ction costs and cons"mer prices. % special case of the "se of the e change rate as a monetary policy tool is that of -ingapore. !he Monetary %"thority of -ingapore (M%-) operates a managed floating regime with domestic interest rates largely determined by foreign interest rates and the e pected f"t"re movements of the -ingapore dollar. !o achieve price stability# M%- targets a trade-weighted val"e of the -ingapore dollar so that it appreciates when the economy is overheating and depreciates when the economy is weak. One way to concept"alise this framework is to consider an e change rate-a"gmented !aylortype r"le# following the approach of Ball (+,,,)8 where the right-hand side of e'"ation (+) incl"des three terms of a conventional !aylor-type r"le8 a constant & an inflation gap defined as the deviation of inflation from left-hand side of the e'"ation incl"des a weighted average of the policy interest rate# R# and the nominal e change rate# f# with a weight that takes on val"es between ;ero and one. 3e can think of the weight as characterising vario"s types of e change rate regimes8 a freely floating regime wo"ld be consistent with = 1& while = 0 is consistent with a -ingaporetype framework. $ntermediate val"es of wo"ld represent managed floating

regimes. E'"ation (+) th"s highlights possible trade-offs between the policy interest rate and the e change rate as monetary policy tools in EMEs. 5istorically# the central banking practice of foc"sing on an average of the policy interest rate and the e change rate was formalised at several central banks (eg the Bank of Banada# the ?eserve Bank of 9ew Lealand and -veriges ?iksbank) as a monetary conditions inde (MB$). $n the past decade# formal MB$ regimes have fallen o"t of fashion. From a theoretical point of view# Ball (+,,,) emphasises that the optimal choice of arises from consideration of the role of e change rates in determining both o"tp"t and inflation dynamics# and of the policymakersE preferences for o"tp"t and inflation variability.++ $n practice# EME policymakers rely on more pragmatic assessments when choosing the best mi of policy rates and e change rate movements. $n recent years# greater willingness to manage e change rates raises '"estions abo"t how central banks have been deciding this policy mi . !o inform the disc"ssion of this iss"e# we estimated a version of e'"ation (+) and plotted the fitted against the act"al policy rates in the %ppendi (=raph %(). E cept for some end points# the estimated policy rates fit the act"al policy rates fairly well in a n"mber of co"ntries# in partic"lar Bhile# $ndia# Malaysia# :er"# !hailand and !"rkey. For some of the others# the estimated policy rates can "ndershoot or overshoot the act"al policy rates by a large margin at times# indicating the importance of factors other than inflation# o"tp"t and e change rates. !able %( presents the coefficient estimates and test statistics for the corresponding regressions. !he coefficient estimates on inflation and o"tp"t gaps generally have the correct signs and are statistically significant. !he coefficients on the e change rate are somewhat more diverse. !he negative signs wo"ld be consistent with a trade-off between changing the e change rate and policy interest rates in determining the policy setting. Rethinking currency misalignments and monetary policy

Engel (()++) has recently arg"ed that c"rrency misalignments sho"ld play a bigger role in the setting of monetary policy. 5e derives this res"lt from a f"lly optimising model of monetary policy and shows that the appropriate loss f"nction in s"ch an economy depends on the s'"are of the inflation gaps# o"tp"t gaps and the average c"rrency misalignment. $n other words# his research s"ggests that central banks sho"ld target c"rrency misalignments (in addition to inflation gaps and o"tp"t gaps) to red"ce the inefficient reso"rce allocations associated with violations of p"rchasing power parity across economies. M"estions remain abo"t how relevant this research is for emerging market central banks. One simple way to think abo"t this iss"e more formally is by adding a misalignment variable on the right-hand side of e'"ation (+).+( -"ch a simple instr"ment r"le capt"res the notion that a central bank wo"ld "se its policy tools to stabilise inflation# o"tp"t and e change rates aro"nd the inflation target# potential o"tp"t and an appropriate meas"re of the e'"ilibri"m e change rate# respectively. $n this sense# s"ch a simple monetary policy r"le capt"res the notion of Fleaning against the windG with respect to e change rate misalignments. $t is important to note that this type of policy r"le does not imply that central banks wo"ld narrowly foc"s on e change rate deviations# as was the case with :::-based e change rate regimes in the +,>)s and +,,)s (?einhart and ?ogoff (())0)). !hose regimes did not provide a strong nominal anchor for inflation e pectations8 in the face of an inflation shock# the nominal e change rate wo"ld depreciate& this wo"ld raise import prices& and lead to f"rther ro"nds of inflation via the pass-thro"gh effect# and so on. Over the past two decades# many EME central banks have gained credibility for achieving and maintaining price stability# so it is "nlikely that the narrow :::-based e change rate regimes of the past wo"ld be seen as desirable today. $nstead# this approach highlights the m"ltiple ob.ectives that central banks wo"ld try to balance sim"ltaneo"sly. First and foremost# price stability is

important. !his does not s"ggest that central banks aim to keep inflation at the target every period& rather# central banks aim to red"ce inflation deviations 7 on either the "pside or the downside 7 over time in a way consistent with price stability. !he record for this approach to targeting inflation has been commendable in both advanced and emerging market economies (see eg Filardo and =enberg (()+))). -econd# o"tp"t stabilisation is also important. !his ob.ective can be e plicit in the central bankEs preferences# as in the case of d"al-mandate central banks s"ch as the Federal ?eserve. $t can also reflect indirectly the important infl"ence of the o"tp"t gap on inflation dynamics# as is the case in many formal monetary policy models of inflation targeting. Finally# as with inflation and o"tp"t stabilisation# central banks wo"ld not strictly target a given level of the e change rate at each point in time. ?ather# a central bank wo"ld factor in its policy decisions the desired speed at which to red"ce the misalignment of the e change rate from its e'"ilibri"m rate# along with concerns abo"t inflation and the stage of the b"siness cycle. !echnically# the speed of ad."stment in general e'"ilibri"m wo"ld reflect the central bankEs preferences and the time series behavio"r of o"tp"t# inflation# e change rates and other key macroeconomic variables. % few other comments on policy hori;ons and meas"rement "ncertainty deserve consideration. Bonventionally# the policy hori;on for

inflation and o"tp"t stabilisation is one to two years. $n cases where this is ."dged to be too short given the nat"re of shocks infl"encing the monetary policy environment 7 eg in the case of crises or other large and persistent macroeconomic shocks 7 the policy hori;on can be appropriately e tended. For e change rates# the convergence to the e'"ilibri"m val"e may be m"ch longer than for inflation and o"tp"t. $n part# this may be d"e to the fact that the determinants of e change rates# s"ch as inter-ind"stry and international prod"ctivity differentials# take several years to ad."st to their e'"ilibri"m val"es (Obstfeld and ?ogoff (())))). $n s"ch cases# central banks may prefer to

allow the e change rate to converge over a relatively long hori;on and therefore avoid strong reactions to misalignments. <ncertainties abo"t the meas"rement of e'"ilibri"m real e change rates may also infl"ence the desired speed of ad."stment. !he greater the "ncertainty# the smaller generally will be the misalignments.+/ desired reaction to e change rate

Otherwise# sp"rio"sly meas"red deviations co"ld res"lt in to

"nd"e volatility in policy actions. $f meas"rement "ncertainty is very prono"nced# one co"ld adopt a more state-dependent approach incorporating e change rate deviations into monetary policy decisions.+0 %lgebraically# one can think of an indicator f"nction that wo"ld t"rn on a misalignment term in an e tended version of e'"ation (+) only when the deviation of the e'"ilibri"m e change rate was deemed very large. !his Fsecond pillarG approach wo"ld take acco"nt of the longer-term risks# ie the risk arising from long-term reso"rce misallocations that might be associated with e change rates deviating too far for too long from reasonable estimates of e'"ilibri"m e change rates. $n practice# this wo"ld mean that the central bank may need to ad."st policy rates even tho"gh inflation and o"tp"t forecasts at conventional hori;ons appear well behaved. $n s"m# recent research p"ts a spotlight on the '"estion of whether c"rrency misalignments sho"ld play a role in monetary policy decisions generally and in EMEs partic"larly. !he relevance of relatively this research is likely to vary across economies. For closed economies# this iss"e may be relatively minor. For open

economies that face considerable deviations from the law of one price# this iss"e may be more important. Of co"rse# diffic"lties in acc"rately meas"ring misalignments and in comm"nicating with the p"blic have to be factored in. Overall# this disc"ssion raises iss"es of whether EME central banks that already target misalignments sho"ld do more# and whether those that do not sho"ld p"t greater emphasis on misalignments in the cond"ct of monetary policy.

"onclusion
E change rates have been playing an increasingly important role in the monetary policy decisions of emerging market economies in recent years. !his has reflected not only the developments d"ring the global financial crisis# b"t also feat"res of the c"rrent con."nct"re# incl"ding the impact on e change rates of volatile capital flows# low global interest rates and spillovers from changes in risk aversion in global financial markets. Bentral banks have been concerned abo"t the impact of heightened e change rate volatility on macroeconomic and financial stability# as well as on e ternal competitiveness and reso"rce allocations. %s a res"lt# many central banks are finding greater merit in stabilising e change rates than in the past. =reater attention to e change rate stability p"ts a premi"m on central banksE "nderstandi of e'"ilibri"m e change rates. 5owever# notions of e'"ilibri"m e change rates are diffic"lt to define concept"ally and empirically. $n addition# analytical work that incorporates e change rate stability considerations into standard monetary policy frameworks is still in its infancy. 9onetheless# having achieved and maintained price stability# many emerging market central banks seem likely to e tend their policy frameworks to reflect the potential role that e change rates can play as both a policy tool and a policy target.

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