Download dummy report of the first meeting of the sub

Distr.
LIMITED
CS/TCM/CFAC/I/9
February, 2007
Original: ENGLISH
COMMON MARKET FOR EASTERN
AND SOUTHERN AFRICA
The First Meeting of COMESA Fiscal Affairs Committee
Port Louis, Mauritius
April 23 - 25, 2007
REPORT OF THE JOINT COMESA/IMF SEMINAR FOR SENIOR OFFICIALS
ON EXCHANGE RATES, REGIMES AND COMPUTATION:
POLICY AND OPERATIONAL CONSIDERATIONS
FOR DEVELOPING COUNTRIES
07-(rpm)
CS/TCM/CFAC/I/9
Page 1
A.
INTRODUCTION
1.
The Tenth Meeting of the COMESA Committee of Governors of Central
Banks which was held in Bujumbura, Burundi, in November 2005 approved an
Action Plan for implementation of currency convertibility, in the four sub-groups of
countries within the COMESA region. For successful implementation of currency
convertibility, the Governors agreed that there was need to build capacity of
member States in computing, analysing and monitoring developments in real
effective exchange rates. In this regard, the Governors decided that the COMESA
Secretariat should organise a workshop and seek the assistance of the IMF which
is the world expert body in this field. The IMF at the request of the Secretariat,
agreed to provide resource persons for the seminar topics.
2.
The COMESA Secretariat, therefore, jointly organised a Seminar with the
International Monetary Fund on Exchange Rates from March 27-28, 2008, in
Lusaka, Zambia. The purpose of the seminar was to build capacity of member
countries on exchange rate regimes, computation, policy and operational
considerations.
B.
ATTENDANCE, OPENING OF THE MEETING ADOPTION OF THE
AGENDA AND ORGANISATION OF WORK
3.
The Seminar was attended by officials from the Central Banks of Burundi,
Djibouti, Kenya, Libya, Malawi, Rwanda, Seychelles, Sudan, Uganda, Zambia and
Zimbabwe. The International Monetary Fund provided a team of seven (7)
resource persons for the seminar. ( List of Participants is in annex II)
Opening of the Seminar
4.
Mr. Sindiso Ngwenya, the Assistant Secretary General of COMESA made
a statement. In his statement, he pointed out that the reform measures that
member countries were undertaking had contributed to a great extent in
enhancing the implementation of the first stage of the COMESA Monetary
Integration Programme. He, however, emphasized that member countries needed
to make more effort to enhance the implementation of the next stages of the
COMESA Monetary Integration Programme namely, currency convertibility and
exchange rate union. For effective implementation, he underscored the
importance of building capacity in the determination of equilibrium real effective
exchange rates, especially in view of the establishment of the Regional Payment
and Settlement System (REPSS) which was expected to be operational soon and
the Customs Union scheduled for 2008.
5.
He also informed the seminar that the COMESA Summit of Heads of State
and Government in Djibouti last November had decided, on the basis of the
recommendation of the COMESA Committee of Governors of Central Banks, that
a COMESA Monetary Institute be established to undertake preparatory work that
CS/TCM/CFAC/I/9
Page 2
will lead to the creation of a monetary union with a single currency for the entire
region. This, he said, would pose a number of challenges in the management of
the exchange rate by member countries’ central banks as they progressed
towards the realization of this goal.
6.
In concluding his statement, Mr Ngwenya thanked the International
Monetary Fund (IMF) for having agreed to assist COMESA in organizing and
providing resource persons for the Seminar. He noted the assistance that the IMF
had already provided to COMESA in the past including an analysis of the impact
of the COMESA Free Trade Area on the revenues of the member countries; the
design of REPSS; and the holding of a workshop on the Financial Sector
Assessment Programme (FSAP). He said that COMESA cherished this
cooperation and looked forward to continued cooperation with the IMF.
7.
Mr Samuel Itam, Senior Advisor in the African Department of the IMF also
made a statement. In his statement, he noted that COMESA and IMF had a long
history of close collaboration. He encouraged participants to interact and learn
from one another. He informed the participants that the IMF was always ready to
learn what had worked and what had not. He pledged IMF’s readiness to assist in
the development effort and expressed the hope that its cooperation with COMESA
would continue in this regard.
8.
The Seminar was officially opened by Dr. Richard Chembe, Director of
Financial Markets at the Bank of Zambia, on behalf of Dr. Caleb Fundanga, the
Governor of the Bank of Zambia. In his statement, Dr Chembe emphasised the
importance of achieving equilibrium exchange rates for the consolidation of the
COMESA FTA, the creation of the Customs Union, the soundness of the financial
system and the eventual establishment of the COMESA monetary union. He
pointed out that COMESA’s interest in monetary integration toward monetary
union was motivated by its micro and macro-economic benefits that arising from
such integration. One such benefit is efficiency gains. More stable exchange
rates and lower economic uncertainty stimulate the integration of goods and
capital markets. Moreover, lower uncertainty on the riskiness of investment induce
dynamic effects, and contribute to increased intra-regional trade and faster
economic growth. Additional benefits are likely to be generated in terms of
increased macro-economic stability. He pointed out that macro-economic stability
would create a more conducive environment for long-term development, financial
integration and private sector growth, thereby not only giving a boost to the single
market, but also proving to be a vehicle for economic and political integration. He
observed that benefits, however, did not come as free lunch. In the process of
integration, countries progressively give up the possibility to set monetary policy
autonomously and lose the freedom to issue currency to finance budget deficits.
However, the benefits outweigh the costs.
CS/TCM/CFAC/I/9
Page 3
9.
Finally, Dr Chembe thanked the IMF for agreeing to jointly organise the
Seminar with COMESA and thanked the participants and resource persons for
their positive response to come and participate in the Seminar.
Seminar Programme
10
The Seminar was conducted during the following hours:
Morning
Afternoon
11.
09.00 hours
14.00 hours
-
12.30hours
17.30 hours
The Seminar Sessions were as follows:
1.
Opening;
2.
Equilibrium exchange rates: basic concepts;
3.
Analytical approaches to the determination of equilibrium exchange
rates;
4.
Empirical analysis of competitiveness
misalignment in low-income countries;
5.
Empirical models of equilibrium exchange rates for African countries;
6.
Exchange rate regime classification;
7.
Exchange rate regime choice;
8.
Experiences with moving from rigid to more flexible exchange rate
systems;
9.
Role of the foreign exchange markets in the functioning of the
exchange rate regime;
and
exchange
rate
10. Closure.
Proceedings of the Seminar
Session I. Equilibrium exchange rates: basic concepts
12.
In this session Mr. Bas Bakkar of the Policy Development and Review
Department elaborated on the basic concepts of equilibrium exchange rates. The
real exchange rate was described as a key macro-economic concept. The
following are the salient points of the presentations and discussions:
CS/TCM/CFAC/I/9
Page 4
•
•
•
The real exchange rate is an important relative price, which guides
resource allocation between domestic and foreign goods, that is tradables
and nontradables
The real exchange rate is an important factor of competitiveness. i.e, the
extent to which traded goods and services can compete with traded goods
and services of other countries, both at home and abroad (external
competitiveness) and the extent to which production of traded goods and
services is attractive relative to the production of non-traded goods and
services (internal competitiveness)
If there is a significant deviation of real exchange rates from equilibrium,
there is likely to be a misallocation of resources, with macro- and
microeconomic costs. The following are the costs:
-
Real exchange rate overvaluation may cause sustainability
problems, disorderly exchange rate adjustment, and economic
stagnation.
-
Real exchange rate undervaluation may lead to overheating and
increase in inflation.

The bilateral real exchange rate is the ratio of the domestic price level to the
price level in another country converted into a common currency. The
multilateral real exchange rate or the Real Effective Exchange Rate (REER)
is the ratio of domestic price level to the price level abroad, where abroad is
the weighted average of all other countries.

If REER appreciates, a country becomes less competitive.. The REER can
rise for two reasons.. The nominal exchange rate rises (the weighted
average of the actual exchange rates), or inflation is higher than in other
countries.. The REER is calculated using two important components: the
country weights and the cost or price indicators. As regards country weights,
the IMF calculates the weights for the CPI-based REER based on the
relative importance of trading partners and competitors in trade in
manufactures, commodities and tourism services. The country weights are
determined as weighted average of the weights for manufacture,
commodities and tourism.

The weight for manufacturing depends on how important a trading partner is
as a competitor in domestic market of the trading partner and in third
countries. Tourism weights are arrived at in a similar manner as
manufacturing weights. Commodity weights depend on a country’s shares in
global commodity trade either as exporter or importer.. Oil and energy are
excluded from the calculation of country weights.
CS/TCM/CFAC/I/9
Page 5

REERs can be calculated using many different price or cost indices namely,
consumer prices, export prices, wholesale prices, producer prices and GDP
deflators and Unit labor costs.. In practice, two most important (and
calculated by the Fund) are:Unit Labor Costs-based REER and CPI-based
REER.

One problem with CPI-based REER is Ballasa Samuelson effect.. As
countries get richer, productivity in tradable sector goes up much faster than
productivity in non tradable sector. Wages in both sectors are likely to go up.
However, at a similar rate. This implies that the relative price of non-tradable
increases as countries get richer, and that the CPI-based REER will
appreciate, but this does not reflect the deterioration of the tradable sector.

Equilibrium REER is not constant but depends on several variables which
may change over time. These are terms of trade, government consumption
expenditure, and. external debt;

If REER is higher than equilibrium REER: exchange rate overvaluation. This
will often lead to low growth and high current account deficits. If REER is
lower than equilibrium, exchange rate is undervalued. This may lead to
overheating and rapid increase in prices . This increase in prices will partly
correct the undervaluation.. It may also lead to large current account
surpluses.
13. In the subsequent discussions, the following issues were raised:




The country weights are very different from the currency weights of
exports. If 90% of your exports are denominated in dollars, this does not
mean that the country weight of the US is 90%.
Frequent revision of country weights would be desirable due to resource
constraint they are revised every ten years.
Developing countries can over heat. GDP growth could be low, but
what matters is the extent of the constraint..
Although the factors which are mentioned in the presentation are
among the ones which are most frequently investigated, there are also
a number of other factors which are relevant for the determination of
REER.
Session II:
Analytical approaches to the determination of equilibrium
exchange rates
14.
In this session, Mr. Ricci of the Research Department of the IMF
summarizes three methods for assessing medium term real exchange rate
misalignments for major advanced and emerging market countries: the
CS/TCM/CFAC/I/9
Page 6
Macroeconomic Balance approach (MB), the Equilibrium Real Exchange Rate
(ERER) Approach, and the External Sustainability (ES) Approach.1
1) The Macroeconomic Balance (MB) approach aims at assessing the
exchange rate misalignment as the real exchange rate change that would
be necessary to generate the trade adjustment that would close the gap
between the ‘appropriate’ level of the current account and the level that is
expected to prevail in the medium term.
a. The ‘appropriate’ level of the current account to GDP ratio (the CA
norm), is derived from an empirical study involving 54 countries over
the past three decades (panel estimation). The main results are
(ceteris paribus):
i. If the fiscal balance ratio to GDP, relative to trading partners,
goes up by 10 percentage points (pp), the CA norm raises by
2-3 pp.
ii. If the old-age dependency ratio, relative to trading partners,
increases by 1pp, the CA norm lowers by 0.2 pp.
iii. If the net foreign assets to GDP ratio goes up by 10 pp, the
CA norm raises by 0.2 pp.
iv. If income, relative to trading partners, increases by 10 pp, the
CA norm raises by 0.2 pp.
v. If GDP growth, relative to trading partners, goes up by 1pp,
the CA norm lowers by 0.2 pp.
vi. If the oil balance increases by 1pp, the CA raises by 0.2-0.3
pp.
b. The medium term projection of the current account to GDP ratio is
often evaluated over the next few years, when the output gap is
expected to be closed (and hence the economy is expected to be in
internal equilibrium).
c. The current account gap is the difference between the medium term
projection and the norm.
d. On the basis of the Marshall-Learner condition involving trade
elasticities, one can derive the change in the real effective exchange
rate that would close the current account gap.
1
A background study is available at http://www.imf.org/external/np/pp/eng/2006/110806.pdf
CS/TCM/CFAC/I/9
Page 7
e. The main advantage of the MB approach is that the necessary data
are generally available, while the main challenges are that one
derives only an indirect estimate of real exchange rate misalignment
and need to face uncertainty related to the derivation of the ca norm
and of the trade elasticities.
2) The Equilibrium Real Exchange Rate (ERER) approach investigates the
consistency of the real exchange rate with trend fundamentals over the
medium term. It then allows to asses the misalignment as the gap between
the actual and the equilibrium real exchange rate.
a. The equilibrium real exchange rate is derived from an empirical
study involving 48 countries over the past 25 years (panel
estimation). The main results are (ceteris paribus):
i. If relative productivity in tradables versus non-tradables
increases by 10 %, the real exchange rate appreciates by
2%;
ii. If the NFA to trade ratio goes up by 10pp, the real exchange
rate appreciates by ½ %;
iii. If the commodity terms of trade increases by 10 %, the real
exchange rate appreciates by 5%;
iv. If government consumption ratio raises by 1pp, the real
exchange rate appreciates by 2%;
v. A trade liberalization episode is associated with a real
exchange rate depreciation of 12%.
vi. If the share of administrative prices in the CPI basket declines
by 20%, the real exchange rate appreciates by 10%.
b. The main advantages of the ERER approach are that one can obtain
directly an estimate of the real exchange rate misalignment. The
main challenges are: 1) that it automatically assumes that in-sample
misalignment is zero, which may not be true if the sample is short;
and 2) that there is the usual uncertainty associated with an
econometric estimation.
3) The External Sustainability (ES) approach investigates the consistency
between the current account, growth, and the stock of net foreign assets,
on the basis of the intertemporal budget constraint. More generally, the
analysis can also involve the trade balances and the rates of return.
CS/TCM/CFAC/I/9
Page 8
a. A “benchmark” NFA position is chosen. The simplest choice is the
current stock of NFA, but other levels (medium term projection of the
stock of NFA, or target levels) can be used depending on alternative
objectives of the exercise.
b. The current account consistent with the benchmark is approximately
derived by multiplying the NFA to GDP ratio by the nominal growth
rate of GDP in dollars.
c. The current account gap is then calculated as the difference
between the current account projected in the medium term and the
current account consistent with the NFA benchmark.
d. The real exchange rate misalignment is finally derived like in the MB
approach above, on the basis of the trade elasticities.
e. The main advantage of the ES approach is that no special
econometric exercise is involved. However, it is not based on an
equilibrium relation, hence it is more useful as “consistency check”
on MB and ERER estimates, rather than an alternative. The main
additional disadvantage is that it is difficult to define an appropriate
NFA “benchmark”.
4) The final step is the overall assessment of the real exchange rate
misalignment:
a. If necessary, the misalignment estimates from each methodology
are made multilaterally consistent, so that the weighted average of
the misalignment of all countries is zero. Such weighted average
would in fact be a proxy for the world misalignment which cannot be
different from zero.
b. The overall assessment is based on the estimates derived from all
three methodologies, but country specific information is taken into
account.
Discussion on Session II
15.
There were several questions:
Question 1) can this study discuss the desirability of policies aiming at
liberalization of trade and prices?
Answer: The desirability of these polices has been shown by many studies, but
the analysis presented here cannot address such an issue. It can, however,
assess what would be the equilibrium effect on the real exchange rate of these
CS/TCM/CFAC/I/9
Page 9
policies, so that we can expect such an effect to arise and not worry when the
movement of the real exchange rate materializes.
Question 2) Can we use the CPI-based REER to compare price levels across
countries?
Answer: Unfortunately not. The CPI index is normalized and therefore is not
comparable ‘across’ countries. Hence the CPI-based REER is not comparable
across countries. However, the CPI index can be used to assess changes in
prices over time for each country (hence ‘within’ countries), so that the CPI-based
REER can be used to assess the real exchange rate appreciation/depreciation
over time ‘within countries’.
Question 3) A former method used by the IMF for assessing real exchange rate
misalignments was named PPP. Has that method been abandoned?
Answer: No. the method has been improved and renamed as ERER (the second
method above)
Question 4) This analysis has been developed for industrial countries and
emerging markets. How applicable is it to developing countries in general (and for
example to COMESA countries?).
Answer: Many of the fundamentals used in these three approaches are relevant
not only for industrial countries and emerging markets, but also for developing
countries (for example, commodity prices, fiscal variables, trade restrictions, price
controls, net foreign assets). A couple of qualifications are important mainly for
developing countries. To the extent aid flows are large, they would need to be
reflected in the fiscal variables and in the net foreign asset variables. Also, to the
extent debt reductions are expected, they would need to be included in the net
foreign asset variable.
Session III: Empirical analysis of competitiveness and exchange rate
misalignment in low-income countries
15.
In this session, Mr. Mark Lewis from the Policy Development and Review
(PDR) department of the IMF made a presentation.. He pointed out that the
notion of “competitiveness”—whether the exchange rate level, together with other
policies, is consistent with its long-term equilibrium. His discussion focused on two
aspects of the empirical analysis of competitiveness and exchange rate
misalignment in low-income countries. The first part looked at methodological
issues related to the assessment of how real exchange rates and potential
misalignments are assessed in LICs. The second part examined the broader
range of measures used to assess competitiveness, which are of particular
importance in LICs given the often weaker institutional environments. These
measures fall into several categories. Traditional measures of competitiveness
CS/TCM/CFAC/I/9
Page 10
include macroeconomic outcomes such as exports; relative price measures; and
microeconomic indicators such as specific production costs. Nontraditional
measures often focus on the quality of the business or institutional environment.
17.
The following are the salient points of the presentations:
•
Assessments of the RER are carried out by the Fund in context of its
surveillance work. These assessments include Informal assessments.
Informal assessments relay on graphical analysis to compare movements
in the CPI-based real effective exchange rate (REER) to a base year, and
are carried out for all countries.
•
Formal assessments use models to relate the REER to its macroeconomic
determinants. Methodologies include: Macroeconomic balance approach
(MB); Equilibrium REER Approach (EREER; and External Sustainability
approach (ES);
•
The EREER is the most common method of estimating RERs in LICs, uses
the following steps:
Establish “a theory” of the equilibrium relationship between RER and
fundamentals
Estimate EREER on the basis of historical data
Project medium-term values for the fundamentals
Calculate change in RER to reach equilibrium value in the medium-term
-
Nonetheless, there are important obstacles to assessing RER misalignments
in LICs. First, LIC economies have a range of structural features which make
more difficult the assessment of RERs—they are subject to (a) large and
variable capital and aid flows, posing potential appreciation pressures and
thus, need judgment of absorptive capacity; (b) terms of trade shocks and
narrow production bases; (c) evolving political and institutional environments;
and capital account and trade restrictions. These economies are also subject
to important data limitations, whereby data is often unreliable, and subject to
large margins of error, with short time series and many structural breaks.

On data issues, the consumer price index in particular has the following
weaknesses:
CS/TCM/CFAC/I/9
Page 11
-
CPI basket often not representative nationally, and often with little
link to producer costs
-
May not reflect segmented labor markets and large informal sectors
Difficult to use for cross-country comparisons given differences in
CPI basket

Other indicators might be better (e.g., Producer prices or
unit labor costs), but data may not be available
Implications of formal Assessments in LICs include the following:
-
Large standard deviations in estimates, and thus larger margins of
error when forecasting
- Difficulty in assessing estimates given shifts in fundamentals
- Risk of spurious conclusions
18.
Weaknesses in informal and formal assessments of RER misalignment
suggest the need to complement the analysis by other indicators of
competitiveness which include the following:
Macroeconomic measures, such as external sector outcomes (export
volume growth and market share, the current account balance). Relative
price measures include the internal terms of trade, which as the ratio fo
non-tradables to nontradables, is useful to assess resource allocation in the
country. Production costs are other useful measures (inlcuding
transportation, communication, and energy costs). Finally, “non-traditional”
measures include financial sector development, foreign direct investment,
and measures of institutional quality and goverance.
19.
Possible Improvements to LIC Competitiveness Assessments include the
following:
-
-
Reduce reliance on informal assessment;
More careful consideration of the fundamentals, as applied to LICs—
perhaps greater parsimony in variables;
Data improvements: strengthened surveying, recording and reporting
of macro/micro data, including institutional/capacity building for
National Statistics Agencies
Attempt to do multilateral assessments, at least for countries with
strong trade ties
CS/TCM/CFAC/I/9
Page 12
-
Subject to data limitations, consider greater reliance on methods other
than the EREER methodology for assessing RERs
More systematic treatment of “non-traditional” measures
20.
An interesting discussion ensued which focused on the following issues: (i)
how to resist the appreciation of the real exchange rate in the context of strong aid
flows; (ii) how to decide on what is the best price measure for assessing the real
exchange rate (and ensure cross-country comparability); and (iii) a further
discussion of the fundamental determinants of the RER in LICs. Mr Ricci of the
IMF also outlined how some of the CGER methodologies, which have been
developed for use with industrial countries, can be adapted for use in LICs.
Finally, there was a disucssion of whether econometric techniques based on
historical data series were valuable in light of the range of data weaknesses and
structural breaks, with one participant noting whether the respective country had
ever been in equilibrium.
Summary:
21.
A variety of methods are available to assess RER misalignment and
competitiveness in LICs. These range from informal assessments of RER
indicators, relative prices, and external sector outcomes, to formal and more
rigorous empirical methods, often relying on econometric techniques; even
indicators of financial sector development and institutional quality can be useful.
However, it is important to bear in mind structural characteristics of LIC (e.g.,
volatile terms of trade and aid flows, changes in the political and institutional
environment, and trade and capital account restrictions) as well as data limitations
(e.g, unreliable data, short time series, and many structural breaks) that can
seriously undermine the quality of notably formal assessments. It is thus important
to: (i) relay on a range of measures; (ii) give careful consideration of the limitations
of the respective measures; and (iii) take steps to strengthen the statistical base
and estimation methods.
Session IV: Empirical models of equilibrium exchange rates for African
countries
22.
In this session Ms. Elena Loukoianova of the African Department of the
IMF discussed the broad estimation techniques used and the work done at the
IMF on estimating equilibrium REER for selected Sub-Saharan African countries.
More specifically, she discussed the challenges of estimating equilibrium REER in
developing countries. She then reviewed the findings of the country studies and
highlights the particular challenges of doing econometric analysis for SSA
countries.
23.
The following are the salient points of the presentation:
CS/TCM/CFAC/I/9
Page 13
•
•
•
•
It is not easy to evaluate external competitiveness using estimated
misalignment of the real effective exchange rate (REER) for subSaharan African (SSA) countries. Among the many challenges are
inadequate or unavailable data and limited sample size.
Although some macroeconomic series, such as GDP, are available on
annual basis, the series needed may not be available on quarterly or
monthly basis. One of the most common, though not necessarily ideal,
ways to resolve this issue is to decompose an annual series into
quarterly or monthly components.
Another challenge is that because some data series go back only for 30
years or less, it is difficult to employ some econometric techniques on
an annual and even quarterly basis. This affects the choice of empirical
methods, and it certainly affects the precision and interpretation of the
results of the analysis.
The main determinants of the REER used in the studies for SSA
countries, and also identified in the recent literature for developing
countries generally, are:
a) Technological progress (proxied by real GDP or real GDP per
capita relative to trading partners) which captures productivity
measures across countries and Balassa-Samuelson effect;
b) Government consumption (fiscal policy) which is a proxy for
government demand for non-tradables;
c) Fiscal balance;
d) Investment;
e) Real interest rate differentials with trading partners;
f) The terms of trade (or world commodity prices for main export
commodities of a country);
g) Capital flows:
h) Openness to trade and the exchange system.
•
Empirical estimations of the equilibrium REER were conducted for 14
SSA countries and two regional country groups, the Central African
Economic and Monetary Community (CEMAC) and the West African
Economic and Monetary Union (WAEMU). At the end of the sample
period the REER was found to be in line with its estimated equilibrium
level in Angola, Ghana, Madagascar, Malawi, Mali, Mauritius, Tanzania,
CS/TCM/CFAC/I/9
Page 14
and both CEMAC and WAEMU; more appreciated than estimated in
Benin, Guinea, and Zimbabwe; and more depreciated than estimated in
Madagascar and South Africa. The results for Kenya are ambiguous:
the REER may have been undervalued or overvalued, depending on
the methodology and the sample period.
•
The paper also discussed the advantages and disadvantages of various
methodologies for estimating equilibrium REER. It also looks at the
challenges of estimating equilibrium REER in developing countries.
•
The paper concludes that the empirical analysis for selected SSA
countries demonstrates that estimation of a long-run equilibrium path for
developing countries poses challenges, and that any policy implications
related to competitiveness based on the results of the analysis should
be drawn with caution. This is especially true for SSA countries where
actual REER appeared to be more appreciated than its estimated
equilibrium level. In general, policy recommendations should focus on
strengthening competitiveness through continued implementation of
structural reforms. Structural impediments need to be addressed in
order to realize full benefit of achieving and maintaining equilibrium
REER. The REER is only one indicator of competitiveness. Thus, in
assessing of competitiveness of a country, other measures should be
looked at, especially when the actual REER is misaligned with its
estimated equilibrium. However, the REER seems to be one of the
measures of competitiveness that is most commonly used because it is
easily quantifiable and comparable across countries.
Summary:
24.
The empirical analysis for SSA countries demonstrates that estimation of a
long-run equilibrium path for the REER poses challenges; any policy implications
related to competitiveness based on the results of the analysis should be drawn
with caution. Most policy recommendations for SSA countries focus on
strengthening of external competitiveness through continued implementation of
structural reforms.
Discussion on Session IV
25.
The discussion of this session concentrated mainly on the issue why policy
recommendations focused almost entirely on implementation of structural reforms
and rarely suggested nominal depreciation for countries where actual REER
appeared more appreciated than its estimated equilibrium level.
CS/TCM/CFAC/I/9
Page 15
26.
Some participants had a view that nominal depreciation could be used
more often in policy recommendations if there is a potential loss of
competitiveness. However, other participants suggested that nominal depreciation
should be used very cautiously, especially if a misalignment of the REER seem to
be temporary and its magnitude is not high. Nominal depreciation only changes
prices but does not tackle problems in the real sector. Therefore, facilitation of
structural reforms is more crucial for SSA countries.
27.
Regarding the question what may hold the REER from its equilibrium path,
Ms. Loukoianova noted that a misalignment at a certain point in time does not
mean that the REER remains at that level. Typically, the REER has a meanreverting property, i.e. it converges to its equilibrium path in the medium or long
term. Also, as time passes, the equilibrium path of the REER may change
reflecting macroeconomic developments in a country. Therefore, if the REER
seems to deviate from its estimated equilibrium at a certain time, it may well be
that there is a shift of the equilibrium path of the REER. Therefore, the actual
misalignment of the REER is smaller than it seems.
Session V:
Exchange rate regime classification
28.
In this session Ms. Judit Vadasz focused on how the IMF conducts the
classification of official exchange rates. In particular, she discussed the reasons
why classification of the systems is necessary in the first place. Then she focused
on de jure and de facto classifications and the criteria based on which systems
are classified. She explained why information on official intervention is used as a
basis of classification and what role the analysis of reserves play. Finally, she
described in some detail the different regimes and what differentiates them.
29.
In particular, she stressed the following points:

As all classifications in economics, exchange regime classifications are
used to support policy-making by pointing out common characteristics.
They are also used to facilitate research and to allow for a description of
the system without resorting to lengthy explanation.

The ideal classification system should cover comprehensively all real-world
regimes. In an ideal case, relatively little overlap should occur between the
various categories, although it might no be feasible to wholly demarcate the
categories. Classification should result in consistent, transparent, and
verifiable rules, which are operationally feasible to employ. The
categorization should also be acceptable by the wider community, both
inside and outside the IMF.

The Fund is charged in Article I (iii) “To promote exchange stability, to
maintain orderly exchange arrangements among members, and to avoid
CS/TCM/CFAC/I/9
Page 16
competitive exchange depreciation.” Hence, the Fund has the obligation to
exercise surveillance over exchange regimes of the countries.

Initially, after the collapse of the Bretton Woods system, the Fund based its
classification of the regimes on de jure systems (i.e., the systems as
announced by the countries themselves). However, after the discrepancies
between legally declared and real-life exchange rate regimes became
apparent, in 1998 the Fund shifted to using the de facto operation of the
systems as the basis of the classification.

There are several underlying principles of the de facto classification
system. The first and foremost is that it does not entail a value judgment on
the appropriateness of the policies. It tries to capture the actual exchange
rate operation of the country and thus backward looking. The system is
intended to support even-handedness in the surveillance of exchange rate
policies. Classification exercises are based on inputs from within the IMF
and indirectly from the authorities.

There are several de facto classification regimes, among others the system
of Levy-Yeyati and Sturzenegger on the one hand, and Reinhart and
Rogoff on the other. The IMF is not using these systems because they
have data requirements that are very difficult to meet. Reinhart and Rogoff
has a category that is not acceptable by the Fund, while Levy-Yeyati and
Sturzenegger use cluster analysis, and hence the categories in which the
countries are put into might change even if policies did not change.

The IMF classification process is based on the identification of data and
intervention practices. Practically, the primary rate is selected and the daily
exchange rate data is recorded and compared to various foreign currencies
that have the least variation.

Intervention matters for categorization because it is the basis on which the
categories are differentiated. Intervention in this work is defined very widely
and not limited to sale and purchase of foreign or domestic currency. Other
activities (e.g., moral suasion, rationing, etc.) are also considered
intervention. There are also some types of interventions that are not
considered as a basis of reclassification (e.g., very short-run interventions
that smooth out undue fluctuations in the exchange rate).

Variations in foreign exchange reserves are used as supplementary
information if there are no reliable or detailed enough data on intervention.
These data might also be used to double-check if the exchange rate regime
is classified correctly as independently floating.

The exchange rate regimes the IMF uses can be divided into (i) hard pegs,
(ii) soft pegs, and (iii) floating regimes. Within hard pegs the Fund
CS/TCM/CFAC/I/9
Page 17
differentiates between arrangements with no separate legal tender and
currency board arrangements. Soft pegs are the conventional fixed pegs
(pegged against a single currency or against a composite), intermediate
pegs (pegs within horizontal bands, crawling pegs, and crawling bands). As
for the floating regimes, there are two categories, managed floating with no
predetermined path for the exchange rate and independently floating
regimes.
30.
The presentation was followed by a lively discussion about a couple of
country classification cases (Rwanda and Zimbabwe) and several questions on
the role of reserves in the classification procedure, on the regime COMESA
should choose if the monetary union is accomplished, and the definition of
competitive exchange rate depreciation.
31.
The presentation underlined the importance of having a proper
understanding of the actual regimes that are implemented by countries. It also
conveyed the criteria which are used by the IMF to separate one regime from
another and demonstrated that not only the quantitative indices of nominal
exchange rate developments are used, but also other elements. Most of these
other elements are quantitative, like intervention data, the evolution of foreign
exchange reserves, or developments in nominal and real effective exchange
rates. There are, however, quantitative (judgmental) elements that are also
involved in the classification, especially because the demarcation lines between
individual categories can be fuzzy.
Session VI: Exchange rate regime choice
32.
The presentation concentrated on arguments for fixing/floating and their
measurement:
a. Optimal Currency Area / Economic integration. These arguments point to a
minimum size before it is opportune to pursue an independent currency
and monetary policy and that this size is greater the more open the
economy is. Thus small open economies typically float.
b. Diversification/Terms of trade shocks. This argument highlights that
countries that are subject to real shocks are especially vulnerable to real
exchange rate misalignment and better off floating their currency to allow
quick REER adjustment.
c. Financial integration (capital mobility)/ Impossible Trinity. Financial
integration or effective capital account openness highlights the vulnerability
of countries to changing capital flows and thus supports a more flexible
regimes as buffer that absorbs such pressures.
CS/TCM/CFAC/I/9
Page 18
c. Nominal shocks/rigidities. A fixed regime helps to dampen nominal
shocks as reserves and money supply adjust through changing
imports. But the crucial underlying question in assessing the
importance of nominal or real shocks is whether prices and wages
are flexible and helps to avoid REER misalignments that could result
from shocks. Moreover, sound monetary policy monitoring systems
can counter nominal shocks.
d. Monetary policy credibility/stabilization programs. A lack of central
bank credibility or a weak central bank may require a more easily
observed or a more simple nominal anchor, which usually means a
fixed (or crawling) exchange rate as nominal anchor.
e. Fear of Floating. The risk of balance sheet effects (foreign currency
mismatches leading in a crisis to bankrupt banks or corporations) is
an argument in favor of a floating exchange rate as it forces the
private sector to pursue better risk management.
f. Institutional and historical considerations. Choices are made in a
specific context. Political will e.g. in currency unions can help with
the introduction of policies that support a specific regimes and thus
make it more desirable then otherwise would be the case.
Session VII: Experiences with moving from rigid to more flexible exchange
rate system
33.
The presentation highlighted experiences with exits. Orderly exits (that is
those that did not took place under crisis or pressure conditions) are relatively
more durable, potentially suggesting that preparation pays off. In addition,
countries that first adopt a band have been more successful, while oil exporters
were particularly unsuccessful in exiting especially if they did not adjust their fiscal
balances following the exit.
34.
The presentation focused on preparations in four areas:




Developing the foreign exchange market.
Formulating intervention policies
Establishing a new nominal anchor
Building capacity to manage & regulate exchange rate risks
35.
For a successful transition to a float, the following four ingredients are
generally needed:
(i)
a deep and liquid foreign exchange market;
CS/TCM/CFAC/I/9
Page 19
(ii)
(iii)
a coherent intervention policy;
an appropriate alternative nominal anchor; and (iv) adequate
systems to review and manage public and private sector exchange
rate risk.
36.
There are four key aspects of developing a deep and liquid foreign
exchange market:
(i)
reducing the central bank’s market-making role;
(ii)
increasing the information flows in the market;
(iii)
eliminating (or phasing out) regulations that stifle market activity; and
(iv)
improving the market microstructure. In addition, what is also
generally needed is the emergence of two-way risk in the exchange
market: Market perceptions that the exchange rate can both
appreciate or depreciate help foster better risk management
expertise and minimize destabilizing trading strategies.
37.
Formulating an intervention policy requires resolving difficult trade-offs,
which are examined in some detail in the paper. On the one hand, there are
several legitimate reasons for intervention, notably to:
(i)
correct misalignment;
(ii)
calm disorderly markets; and
(iii)
accumulate reserves or supply foreign exchange to the market. On
the other hand, misalignment is hard to detect and intervention is
often hard to time. In addition, smoothing short-term fluctuations
may stifle a nascent market and the useful signals generated in the
market. Intervention can send confusing signals about policy
intentions; recent empirical studies indicate some skepticism about
the success of intervention and “smoothing short-term fluctuations.”
38.
Moving away from a fixed exchange rate requires a new and credible
nominal anchor. Nowadays, the recommended alternative nominal anchor is
often inflation targeting. Such an alternative is not established overnight, but
requires extensive preparation. There are considerable benefits to developing the
critical elements of a reliable monetary policy framework. These include:
(i)
priority to price stability over competing objectives;
CS/TCM/CFAC/I/9
Page 20
(ii) operational independence of the central bank;
(iii) transparency and accountability in the conduct of monetary policy; and
(iv) a capacity to forecast inflation and undertake policy actions consistent
with maintaining price stability. Until the conditions for inflation targeting are
met, many countries have followed other forms of monetary targeting when
moving to a floating regime.
39.
The move to a floating rate transfers exchange rate risk from the public
sector to the private sector, but also places stress on public sector entities with
foreign exchange liabilities. To support an orderly exit (or help prevent a disorderly
one), it is beneficial to start improving systems to manage foreign exchange risk
early. Risk management systems have three components:
(i)
information systems for monitoring risks;
(ii)
formulas and analytical techniques to measure exchange rate risk;
and
iii)
internal risk policies and procedures, such as limits on concentration
in foreign currency loans.
40.
In addition the presentation showed the importance of have complementary
strategy in two areas.
 A clear communication strategy to build credibility and support sound price
discovery in the FX market and thereby reduce exchange rate volatility and
the risk of misalignment
 Building complementary markets (FX derivatives, money and bond
markets).
Pace of exit and sequencing of exchange rate flexibility and capital account
liberalization
41.
In practice, the pace at which relevant institutions can be built is a main
determinant of how early preparations for an orderly exit need to commence. Early
preparations for an exchange rate float (especially in the time consuming areas of
building an alternative nominal anchor and better risk management systems) can
be useful in their own right and bolster the ability to exploit what may turn out to be
narrow windows of tranquility. A fast pace of exit in general has benefits in that it
signals purpose and determination, thereby enhancing the credibility of monetary
policy.
42.
On sequencing, experience, especially in emerging market economies, has
highlighted the risks of opening capital accounts before floating the exchange rate,
CS/TCM/CFAC/I/9
Page 21
and especially the risk of sudden outflows. The order of liberalization, notably the
use of asymmetric liberalization (such as liberalizing longer-term capital flows
first), can help ensure a smooth transition to a float, and help avoid large
exchange rate swings and overshoots.
Session VIII:
Role of the foreign exchange markets in the functioning of
the exchange rate regime
43.
Ms. Judit Vadasz from the IMF made a presentation on how to develop
foreign exchange markets in developing countries. The presentation focused on
shallow markets because most developing countries are yet to build liquid
markets. The presentation explained the characteristics of shallow markets and
then moved on to the role and possibility of intervention in shallow markets.
Several issues were raised about the best ways to proceed in building more liquid
markets. The presentation concluded with five case studies that comprised of
abstract representation of various problems clusters countries with shallow
markets face.
In more detail, Ms. Vadasz’s presentation focused on the following issues:
44.

There is no definition of shallow markets, but there are several
characteristics that these markets express. Thus, annual foreign exchange
turnover in these markets is low, typically below 60 percent of the GDP.
There is usually a lack of forward markets and in most cases of other
derivative markets. There are too few market participants, also because of
concentration in the banking system; price discovery or its efficiency is
limited. Exchange rates in shallow markets exhibit little variation. The type
of system is used is typically auction. In most of these systems the central
bank plays a dominant role, both as a channel of demand and supply and
as a technical intermediary.

As for the type of exchange rate regimes, these countries have, these are
mostly countries with no separate legal tender, with conventional pegged
arrangements; or managed floating. This is also the case in Africa.

The mechanisms for determining nominal exchange rates in shallow
markets could be done either with or without fixings in auctions typically, as
an intermediate step before building out properly functioning interbank
markets.

Acutions are widely used in countries with single large exports, especially if
the exports are conducted through a few (state-owned) companies.
Auctions are in principle a transparent method of price determination, but if
there are only a few participants, the authorities or large
exporters/importers can easily influence the auctions. Auction participants
CS/TCM/CFAC/I/9
Page 22
might also collude. Another disadvantage of auctions is they could easily
lead to multiple exchange rates that introduce distortions in the economy.

The road to building a more liquid interbank market necessitates action
from the central bank. Thus the central bank should reduce its own role in
the market (i.e., it should intervene less); lift the exchange restrictions still
in place; remove surrender to the central bank; and eliminate other tight
controls. The central bank should also refrain from moral suasion. The
other important role for the central bank is to give its assistance to market
development. In this role the central bank should play a leading role in
guiding the market; should help in developing market infrastructure; set up
rules and regulations, but eliminate all that are superfluous; and foster bank
competition.

In transiting to less rigid regimes, the auctions with be replaced with an
interbank market; the trading terms of the central bank should be changed,
including the minimum amount that can be traded with the central bank; all
central bank guarantees should be eliminated; market makers should be
selected; and supervisory rules should be implemented.

The five case studied that were used focused on providing ideas what to do
while facing the following situations: (i) The interbank market is illiquid
because the central bank is at the center of the foreign exchange
distribution process due to surrender requirement to the central bank; (ii)
The foreign exchange market is dominated by a state-owned bank that
channels foreign exchange from the main state-owned exporting company;
(iii) Limited number of banks leads to collusion that undermines marketmaking; (iv) Foreign exchange business is segmented between an official
and a parallel market; and (v) Imbalances in foreign exchange flows hinder
the emergence of a continuous interbank foreign exchange market.
45.
The presentation underlined the importance of the central bank’s activities
in building a properly functioning, deep foreign exchange market that is necessary
for the efficient pricing of foreign exchange. Starting from shallow markets, the
usual road to achieve this passes through auction systems and reaches its climax
in a smoothly functioning inter-bank market, on which the central bank plays only
a very limited direct role. Throughout the steps needed to achieve liquid markets,
the central bank should play an active role, but at the same time has to limit its
own activities to achieve the desired result. The case studies demonstrated that
even if a country faces problems with market functioning, there are certain steps
that could be taken.
Closure of the Seminar
CS/TCM/CFAC/I/9
Page 23
46.
Mr. Samuel Itam, Senior Advisor in the African Department of the IMF,
thanked all the participants for their active participation in the Seminar. He urged
them to apply what they had learned in the Seminar and to serve as technical
resource persons for decision makers in their countries. He informed the
participants that the International Monetary Fund believed in shared views and
understanding and did not believe in imposing policy prescriptions, but benefited a
great deal from the experience of its member countries. He thanked, once again,
the COMESA Secretariat for the logistical arrangements and the resource persons
for their excellent presentations.
47.
Mr. Mark Lessit of the Central Bank of Kenya moved a vote of thanks on
behalf of all the participants. He reminded the participants that the Seminar was
held in accordance with the decision of the COMESA Committee of Governors of
Central Banks who saw the importance of capacity building in the analysis and
computation of exchange rates as COMESA moved to deeper stages of monetary
integration. He noted that the Seminar had been very successful and informative
and that it would, no doubt, enable the participants to refine their methodology of
computing and analyzing exchange rates and to become competent advisors to
their policy makers. He underscored the importance of holding similar seminars as
COMESA progressed towards monetary union.
48.
Finally, Mr. Lessit thanked the IMF team for their excellent presentations,
and the COMESA Secretariat for organizing the Seminar and for the excellent
logistical arrangements. He wished all participants safe journey back home.
49.
In closing the Seminar, Dr. Charles L. Chanthunya, Director of Trade,
Customs and Monetary Affairs, expressed sincere thanks, on behalf of the
Secretary General of COMESA, Mr. Eratus J.O. Mwencha, to the IMF for having
responded positively to COMESA’s request to provide technical assistance for
conducting the Seminar. He added that it was remarkable that the IMF had
brought a team of seven (7) resource persons to the Seminar which showed the
readiness of the IMF to assist COMESA. He stated that as COMESA progressed
to deeper monetary integration, a number of issues would come up which would
require the advise and assistance of the IMF. COMESA would, therefore, continue
to count on the assistance of the IMF. He said that he was confident that the
Seminar had enhanced the knowledge of the participants and that they would be
competent advisors to policy makers in the member States. He asked the IMF to
produce a friendly readable booklet on the proceedings of the Seminar so that
others could gain the same knowledge that had been imparted to the Seminar
participants.
50.
Finally, he wished all participants a happy Easter and safe journey back
home.