Policy Responses to Currency Crises: Issues and Options for Turkey

Valuable lessons can be learned from the exchange rate, monetary, and fiscal responses to the recent currency crises in Asia and Latin America. Policy tradeoffs in response to speculative attacks are grim. No matter what governments do, the costs are high. The less costly response to a speculative attack depends on the nature of the shock, the economy’s initial conditions, and the balance sheets of banks, firms, and the government.

Defending the currency

In determining whether to defend the exchange rate, policymakers need to assess the size of the shift in foreign finance and the responsiveness of capital flows to changes in interest rates. If the shift is small and capital flows are very responsive to changes in interest rates, the cost of defending the currency (measured by loss in output and employment) could be small relative to the loss of stability if the peg were abandoned. If the shift is large enough that high interest rates will have to be maintained for an extended period, however, policymakers might want to let the exchange rate go in order to avoid a protracted recession.

The structure and composition of debt held by banks, firms, and the public sector also affect the decision to defend the exchange rate. If most debt is held in foreign currency, depreciation can lead to bankruptcies and a decline in output. If depreciation leads to inflation and the speed of response of inflation to nominal depreciation is important, there is a strong case in favor of defending the currency.

Allowing the Exchange rate to float.

Policy makers choose to stop defending the currency for several reasons. First, if the currency is defended and interest rates rise, output can fall, increasing the risk that borrowers will default on their debt. Higher interest rates may thus decrease the expected rate of return on domestic assets and force depreciation. Second, higher interest rates are likely to have an adverse effect on debt service. If high interest rates increase the fiscal deficit, leading to a larger expected devaluation in the future, policymakers may have difficulty maintaining the fixed rate. Third, if some investors are not interest sensitive and decide to leave the country because of a panic, much higher interest rates will need to be maintained to convince the remaining interest-sensitive foreign investors to stay and maintain the exchange rate.

If policymakers choose not to defend the currency following a crisis (or losses of international reserves force the collapse of the currency), they will have to choose between adopting a floating exchange rate regime or returning to a fixed exchange rate regime at the new depreciated level of the currency. There is no evidence that under normal circumstances fixed exchange rates contribute to financial stability. In fact, some evidence suggests that fixed rates, particularly those maintained by currency boards, contribute to financial sector instability in general and bank runs in particular. In general, then, allowing the exchange rate to float is the appropriate policy.

A new monetary framework should be developed following adoption of a flexible exchange rate regime.

Adoption of a flexible exchange rate regime will impose the need for a new monetary framework and a new nominal anchor. If the country does not have the preconditions for inflation targeting, the central bank can use a combination of instruments to create a new monetary framework.

The framework can include the standard elements of ceilings on net domestic assets and floors on net international reserves. These limits must be consistent with the use of reserves to meet current account needs. To keep inflation and exchange rate depreciation in check, the central bank will have to tightly constrain the implicit expansion of base money.

The most difficult problem is setting monetary policy during the first few weeks following the collapse of the exchange rate, when financial market conditions and expectations are likely to remain unsettled. Trying to run monetary policy by targeting a monetary aggregate works poorly on a day-to-day basis. It is possible to devise a system in which the central bank sets an inter-bank interest rate between a ceiling and a floor, allows this rate to change daily in response to market pressures, and adjusts this rate in a manner consistent with keeping the monetary aggregates within the projected quarterly limits. Longer-term monetary targets must be consistent with the day-to-day policy.

The substantial depreciation of the currency after a speculative attack implies that during the months following the collapse of the currency, inflation can increase sharply (as a result of one-time adjustments in many prices). This temporary increase in inflation implies a substantial reduction in real interest rates on debt denominated in domestic currency. To offset, at least partially, this near-term effect, it is appropriate for policymakers to raise nominal interest rates temporarily to avoid further depreciation and the danger of igniting a spiral of depreciation and inflation. To the extent that nominal interest rates rise by less than inflation, the government’s fiscal position will improve modestly.

As financial conditions stabilize, nominal and real interest rates will fall. Trying to reduce interest rates too quickly, however, is likely to adversely affect more lasting progress.

Fiscal policy should be tightened in response to speculative crises, but it should not be too contractionary if a tight monetary policy is also adopted.

A new exchange rate will be sustainable only if it is perceived to be fiscally responsible. For this reason, speculative crises need to be followed by restrictive fiscal policies. But fiscal policy should not be too contractionary. If interest rates are kept high to avoid speculation and inflation following the collapse of the exchange rate, policymakers may want to avoid excessive expenditure cuts, which could lead to more contraction and lower tax revenues, making it more difficult to service the public debt. A privatization program might not improve the budget, but it could be effective in enhancing credibility, at a lower cost to the economy than a large fiscal contraction.

Sufficient time must be given to achieve the goal of moving the debt/GDP ratio to a sustainable level. A program that attempts to force the convergence of the debt/GDP ratio to its desirable long-run level too quickly could fail to achieve its goals, thereby reducing the policymaker’s credibility. If the program has to start by overshooting the interest rate in order to avoid a very sharp economic contraction, then fiscal policies should not be overly restrictive. As interest rates fall, part of the fiscal problem will be mitigated as the economy recovers; further expenditure cuts will slowly bring the economy back to a more balanced fiscal stance. Credibility will be enhanced if fiscal reform is perceived to be sustainable and leading to fiscal balance in the medium run rather than based on unsustainable expenditure cuts and tax increases in the near run.