- R. Johnston, and Mark Swinburne
- Published Date:
- September 1999
During the past decade, most economies have become more open, as evidenced by the increase in world exports of goods and services as a share of GDP from about 18 percent in 1987 to about 23 percent in 1997. Likewise, international flows of direct and portfolio investments expanded substantially. In developing countries, net direct and portfolio investment inflows as a share of GDP increased from about 2 percent in 1987 to 5 percent in 1997. The daily turnover in major foreign exchange markets more than doubled between 1989 and 1995 to reach $1.26 trillion.
One of the principal forces driving the growth of international trade and investment was the liberalization of financial transactions, including the deregulation of financial markets, the removal of controls on international capital movements, and the liberalization of trade and exchange controls. A review of trends through July 1997 in the use of controls on payments and transfers for current international transactions and capital movements (Sections II and III) indicates that most IMF member countries continued to liberalize these controls, and that the process has accelerated since 1990. A key indicator of the progress is the number of IMF members that have accepted Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement (71 since the beginning of 1993) bringing the total to 145 in June 1998. Although some exchange and capital controls were reintroduced in the context of the Asian crisis, such controls concerned a few countries and were mostly short-lived.
The trends in trade and investments and the liberalization of exchange restrictions and capital controls are compared in Figure 1. During the 1990s, a relatively rapid liberalization of exchange controls on invisible transactions and liberalization of controls on capital movements coincided with the rapid growth of capital flows, which outstripped the growth of international trade. For industrial countries, cross-border transactions in bonds and equities now far exceed total international trade. For developing countries, net foreign capital inflows exceed the annual increase in exports.1
Figure 1.Trends in Trade, Capital Flows, and Exchange and Capital Controls
1Average for selected industrial economies, including Canada, France, Germany, Italy, and the United States.
Technological and financial innovation has also shaped the evolution of the international exchange and payments systems. Advances in computers, communications, and electronically based payment technologies have reduced the costs of collecting, processing, and executing transactions, and thus fostered the development and integration of financial markets. Furthermore, advanced computer technologies have been instrumental in devising complex pricing strategies for new financial products (especially options) that have expanded hedging and investment opportunities and broken down barriers between financial instruments and markets. Investment strategies have increasingly included an international dimension aimed at diversifying portfolio risks and increasing rates of return, while corporate strategies have evolved toward relying more on foreign investment, exports, “outsourcing,” and international alliances.
Technological and financial innovation has, in turn, created a demand for a more liberal and sophisticated international exchange and payments system. It has also increasingly rendered obsolete distinctions between various types of financial institutions, instruments, and transactions and weakened the effectiveness of administrative controls (Section II). As a consequence, the focus has shifted from the authorization of exchange transactions to broader surveillance and supervision of markets. Greater emphasis has been given to fostering the development of sound financial institutions and to promoting transparency as a basis for informed private market decision making. Likewise, in prudential regulation, the tendency is to rely less on quantitative limits for controlling risks and more on oversight of the internal capacity for risk management and public disclosure.
The forces of globalization, liberalization, and innovation have also exerted an important influence on the exchange rate arrangements of member countries (Section IV). There has been a trend by member countries to adopt more flexible market-based exchange rate arrangements. In part, this has reflected moves toward currency convertibility and tensions between economic objectives. The increasing volumes of capital movements, which may respond to interest rate and exchange rate policies, have required greater coordination of monetary and exchange rate policies. In most cases, the policy response to capital inflows has involved allowing more flexibility in exchange arrangements. Nevertheless, some countries have subordinated monetary policies to the maintenance of exchange rate pegs as part of their programs of stabilization and structural reform, or in the context of regional integration initiatives. More rigid forms of pegged arrangements that require the strongest commitment to the exchange rate peg (such as currency unions and currency boards) have been more resilient in the face of increased capital flows than, for example, conventional pegs to single or baskets of currencies.
Exchange rate arrangements have generally become more market based, with much greater reliance on interbank markets to coordinate the supply and demand for foreign exchange (Section IV). In the major markets, the relative importance of traditional dealing in spot and forward exchange is, if anything, declining, as other markets, not least in derivatives, have grown rapidly. The adoption of electronic matching systems in the major markets and moves toward a single currency in Europe has resulted in some refocusing of exchange trading toward emerging currencies. This has reinforced the trends in emerging foreign exchange markets toward more market-based exchange arrangements. Among developing countries, there has also been a continued decline in reliance on multiple exchange rate systems and significant progress with the development of forward exchange markets.
Overall, further progress toward the establishment of a multilateral exchange and payments system consistent with the purposes of the IMF has been significant.2 This continuing progress has required the IMF, in its turn, to review and update its monitoring techniques and the advice it provides to members on exchange systems, particularly in the context of assisting members on the liberalization of their capital accounts (Section III). The IMF has expanded its information on international exchange and payments systems to include the regulations affecting capital movements, and proposals are being developed to make the database available on the Internet. In advising on reforms of exchange systems and the liberalization of the capital account, the IMF has increasingly adopted an integrated approach that emphasizes the linkages between liberalization and the need for sound financial markets and institutions, the implementation of indirect monetary control, the adoption of appropriate macroeconomic and exchange rate policies, and the development of prudential safeguards to address the specific risks involved in capital flows. Work has been intensified on designing the precise operational sequencing of reforms to the capital account and coordinating it with broader financial sector reforms.
The IMF classifies members’ exchange rate arrangements on the basis of countries’ official descriptions of the arrangements; however, considerable ambiguity exists in the present classification scheme. In many cases, the actual exchange arrangement practice differs from the official classification, raising issues for transparency, as well as for analysis and research. This has become a more critical issue in an environment where consistency of monetary and exchange rate policies are a key concern in avoiding excessive short-term capital flows. As a consequence, IMF staff have developed additional indicators of exchange rate arrangements (Section IV), and this study presents a revised classification scheme that combines monetary and exchange rate indicators and takes account of members’ actual exchange rate policies.