Exchange Rate Regimes, Monetary Policy and Capital Restrictions in Asia

This section describes exchange rates, monetary policy rules and capital control or restriction in select Asian countries. This is important to understand the monetary transmission mechanism and policy reactions since international monetary policy transmission and most policy options are endogenously determined by the institutional arrangements in each country.

2.1 Exchange Rate Regimes

Before the 1997 Asian financial crisis, most East Asian currencies were pegged to the US dollar with different degrees of fixity. After the crisis, however, affected countries tended to move toward freer-floating exchange rate regimes and to liberalize capital and foreign exchange markets. In addition, other emerging economies that had previously chosen relatively fixed exchange rate regimes also moved toward less fixed regimes.

In the meantime, some have argued that when the crisis subsided, some countries moved toward a less flexible exchange rate system due to difficulties in maintaining a floating exchange rate regime. Indeed, there is growing recognition that the exchange rate regime a country declares often differs from its operational regime (Calvo and Reinhart 2002), Even though crisis-hit countries in East Asia including the Republic of Korea (hereafter Korea), Indonesia, Thailand, as well as non-crisis countries such as Singapore and Taipei,China, officially announce free-floating exchange rate regimes, most of them actually have a substantially less flexible exchange rate than is officially announced, due to a fear of floating.

The International Monetary Fund (IMF) exchange rate classification has had a long history of comprehensive and frequent updating. The original IMF exchange rate regime classification categorized members' exchange rate regimes based on their official announcements. From 1975 to 1998, depending on their own official declaration of the degree of exchange rate flexibility, countries' exchange rate regimes were classified into three basic categories— pegs, limited flexibility (usually within a band or cooperative arrangement), and greater flexibility (managed or free floats)—that were further divided into 15 subcategories. However, the IMF classification did not reflect the true exchange rate regime of a specific country, as exchange rate regimes often differed from what the authorities officially declared them to be.

Recognizing this problem, the IMF moved to a more de facto classification system in January 1999. The new system combines available information on exchange rate and monetary policies and formal or informal policy intentions with data on actual exchange rate and reserves movements to reach a judgment on the actual exchange rate regime (IMF 1999). The new system classifies exchange rate regimes into eight categories: a regime with no separate legal tender, currency boards, conventional fixed (pegged against a single currency or a basket of currencies), pegged exchange rates within horizontal bands, crawling pegs, crawling bands, managed floating with no predetermined path for the exchange rate, and finally, independent floating. In response, Levy-Yeyati and Sturzenegger (1999) raised a question on the old IMF de jure classification. They constructed a de facto classification based on data on exchange rates and international reserves from all IMFreporting countries over the period of 1974 to 2000, which they believed provided a meaningful alternative for conducting an empirical analysis of exchange rate regimes. They used three variables related to exchange rate behavior: exchange rate volatility, volatility of exchange rate changes, and volatility of reserves. In line with the de facto classification, Reinhart and Rogoff (2004) attempted to build a non-arbitrary de facto classification, a socalled natural classification. They employed extensive data on market-determined parallel exchange rates, and found that there was a gap between de facto and de jure exchange rate regimes.

Ogawa and Yang (2008) have also investigated the degrees of exchange rate flexibility in Asia. In theory, fixed exchange rate regimes require volatility in reserves, but zero or nearzero volatility in exchange rates. Therefore, the index should be zero or near-zero. On the other hand, free-floating regimes are characterized by substantial volatility in exchange rates with stable reserves. The index for free-floating regimes should be close to 1.

As indicated in Table 1 [ PDF 16.6KB | 2 page ], East Asian exchange rate regimes seem to move toward more flexible exchange rate arrangements both in terms of de jure and de facto classifications after the Asian crisis. However, various exchange arrangements still coexist in the region, from a hard peg (currency board) in Hong Kong, China a fixed regime in the People's Republic of China (PRC) and Malaysia, relatively flexible regimes in Korea, Thailand, and Indonesia, to mostly free-floating in Japan.

2.2 Monetary Policy

Monetary policy is related to exchange rate regimes. As most emerging Asian economies have moved toward more flexible exchange rate regimes, most monetary policies in the region have changed to allow more monetary autonomy, with inflation-targeting policies as an example. According to Stone and Bhundia (2004), after the 1990s, the number of East Asian countries using the fixed exchange rate policy decreased while the number of countries using the inflation-targeting policy increased rapidly. This change has contributed to the stability of prices worldwide and the transition of emerging markets' exchange rate systems from fixed rate to elastic floating rate.

However, East Asian countries still have a variety of monetary policy frameworks. According to Stone and Bhundia (2004), Indonesia, Philippines, Thailand, Korea, and Japan all follow the inflation-targeting framework, even though they differ somewhat in their exchange rate regime. More specifically, based on their IMF classification (IMF various issues) , the Philippines, Korea, and Japan have independently floating exchange rate regimes while Indonesia and Thailand have managed floating exchange rate regimes. Malaysia follows a fixed exchange rate arrangement and does not have an explicitly stated nominal anchor for its monetary policy, but rather monitors various indicators. The PRC targets a monetary aggregate and has a de facto conventional crawling peg exchange rate arrangement. Singapore manages the exchange rate as an intermediate target, a monetary policy framework that has been in place since the early 1980s. Singapore's high import rate and its role as a price-taker in the international markets make Singapore highly susceptible to imported inflation. Thus, Singapore considers the exchange rate to be a more effective tool than the interest rate for stabilizing inflation. This monetary policy framework, however, is considered a variant of inflation targeting (Table 2 [ PDF 73.7KB | 1 page ]). Despite having different monetary policy frameworks and exchange rate regimes, countries in the region have generally been able to keep inflation under control even during the crisis years.

2.3 Capital Restrictions

Capital controls for limiting capital flows are a common tool to mitigate the adverse effects of external shocks in emerging market economies. While capital controls can take a variety of forms, for countries that have substantially liberalized the capital account, more market-based controls—such as the Chilean unremunerated reserve requirement imposed on capital inflows—have been the predominant option in recent years. Thailand adopted this measure in December 2006, but encountered a severe side effect of rapidly falling stock prices, suggesting that designing and implementing capital inflow control is not an easy task. To these economies, returning to the days of draconian capital controls or recreating a system of extensive administrative controls is no longer an option.

Evidence on the effectiveness of capital inflow controls is mixed. Country experiences suggest that the best market-based controls can be expected to lengthen the maturity of inflows; such controls can have little impact on volume. The effectiveness of capital control measures tends to weaken over time as agents in the markets find ways to circumvent them. At the same time, capital controls can produce adverse effects: they tend to increase domestic financing costs, reduce market discipline, lead to inefficient allocations of financial capital, distort decision-making at the firm level, and can be difficult and costly to enforce. To the extent that capital controls are effective only for relatively short periods of time, such measures might be used at the time of surges of inflows rather than as a permanent measure. But again, effective implementation is not an easy task. Administering capital controls requires highly competent country regulatory authorities as they must constantly look out for unwanted flows—often disguised—entering through other channels.

Countries with significant capital controls have tried easing restrictions on capital outflows in a limited manner to reduce net capital inflows. Easing restrictions on capital outflows is expected to generate some capital outflows, reduce the size of net capital inflows, and hence mitigate the upward pressure on exchange rates. This is the policy that used to be pursued by many emerging market economies in Asia during the capital surges of early 2000s. As these measures are expanded, it must be kept in mind that a more liberal capital outflow policy could invite more capital inflows. Thus, to be effective, these measures need to be combined with other measures, such as strengthening financial sector supervision.

Asia shows a varying degree of capital account openness as the selected Chinn-Ito index in Table 3 [ PDF 15.1KB | 1 page ] illustrates. Kaminsky and Schmukler (2003) also constructed a graded index of financial reforms. This index has three components: domestic financial sector liberalization (DFS), especially of interest rate and credit controls; capital account liberalization (KA); and the openness of the equity market to foreign investment (SM). Table 4 [ PDF 15.1KB | 1 page ] also displays selected the Kaminsky and Schmukler index.

As indicated in both indexes, most Asian countries have shown a gradual liberalization of capital account transactions since the 1990s. One interesting exception is Malaysia, which took serious capital controls after the Asian crisis to mitigate the adverse effects of capital flows. In general it is fair to say that Singapore and Japan as the most liberalized economies in capital account. Indonesia, Philippines, Thailand, and Korea are in the middle in terms of Asian capital restrictions. The PRC is the most restricted in the index.

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