Shackles for the Sheqel? - What Israel can learn from Europe's fashion
The European Monetary Union (EMU), a group of countries which on January 1, 1999 started using a common currency instead of their individual national currencies, is sometimes held up as a shining example-which Israel should strive to imitate-of how to manage the exchange rate. This might be the case, but conclusions drawn from European experience require further analysis.
To date, eleven countries have joined the EMU; Greece is due to join at the beginning of 2001, and other countries, for example Poland and the Czech Republic, are progressing along the path towards membership. Much can be learned about the European attitude to so-called exchange-rate stability from the developments in these countries’ exchange-rate regimes prior to their joining the EMU-particularly as such stability was set as one of the conditions for acceptance into the Union.
The process of stabilizing exchange rates in the EMU member countries was strewn with obstacles, and it underwent a fundamental transformation as it progressed. It started with an exchange-rate band with a width of 4.5 percent being set for each currency, but at the beginning of the 1990s it transpired that this regime did not ensure exchange-rate stability. As economic problems grew, mainly those related to theheavy cost which the rehabilitation of East Germany imposed on the united Germany, a situation arose in which massive central bank intervention in the foreign-exchange market was required to keep the exchange rate within the limits of the band. Such massive intervention means lack of exchange-rate stability. This lack of stability was a catalyst in leading to greater flexibility in Europe’s exchange-rate regime in 1992 and 1993.
The only country which kept the 4.5 percent exchange-rate band was Holland, which even in those two problem years maintained exchange-rate stability. The other countries, however, set bands with widths of 30 percent, or even temporarily abolished the bands, as did Italy, for example, readopting a band with 30 percent width only two years prior to the formation of the currency union. In 1998, in the approach towards unification, Italy’s exchange rate converged to the middle of the band-a rate which had been determined as the conversion rate for the Italian lira. Its stabilization at that level, however, was the not the outcome of intervention by Italy’s central bank, but of the widespread belief that that would be the exchange rate prevailing on January 1, 1999. Italy, which had made great efforts in the economic sphere, achieved genuine economic stability, and in particular, exchange-rate stability, without actually relying on the exchange-rate band.
The lesson to be learnt from the early 1990s-that an exchange-rate band affords psychological assistance, whereas what actually yields stability is an economic policy which includes setting acceptable fiscal and monetary targets-was well absorbed in Europe. Thus, when exchange-rate bands were considered for countries which are currently candidates for membership of the EMU, they were made as wide as possible or completely abolished. For example, when Greece’s membership from January 1, 2001 was decided upon some months ago, the euro/drachma exchange rate on that date was also determined. Until then, however, the value of the drachma will move within a band with a 30 percent width, capital flows into and out of Greece will affect the exchange rate, and Greece’s central bank has not undertaken to defend the exchange
rate under all conditions.
The situation regarding the exchange-rate regime of countries which are candidates for EMU membership and about whose membership the Union has agreed in principle is no less interesting. Those countries-Poland, the Czech Republic, and others-are in the midst of major efforts to attain economic stability. Poland, for example, abolished its exchange-rate band some months ago, although its width was 25 percent, and in the Czech Republic, too, the band no longer exists. In other words, these countries abandoned the use of an exchange-rate band, recognizing that doing so was the right way to achieve exchange-rate stability.
What about Israel? The exchange rate was the main variable in the Economic Stabilization Program of 1985, and not without reason. Stabilization of the exchange rate the way it was achieved in Israel was one of the major factors in reducing inflation from 400 percent a year to 18–20 percent, but at that point the influence of the exchange rate waned, and it failed to make a further contribution towards pricestability.Since the beginning of the 1990s the reduction of inflation has been achieved to a arger
and larger extent by a regime of inflation targets. In the last few years the exchange rate has in effect floated freely, while a degree of price stability and financial stability has prevailed which has not been seen for many years.
Financial stability is in part the result of a floating exchange rate, as it prevents “hit and run” investments by residents and nonresidents, since in such a regime anyone trying to profit in the short run from interest-rate differentials must consider that his entry into and exit from the market will affect the exchange rate, making such activity less profitable. In addition, a floating exchange rate leads the public towards responsible management of foreign-currency assets and liabilities, as they internalize the risk inherent in a mismatch between these assets and liabilities.
The main lessons to be drawn from the financial crises of the 1990s, headed by the severe crisis in East Asia, is the importance of financial stability in all its components-the fiscal and the monetary aspects, the rate of exchange, and the banking system. What is needed to maintain financial stability in Israel currently is even greater
flexibility in the exchange-rate regime, allowing monetary policy to be devoted to price stability and financial stability, and not to the defense of any particular arbitrary limits imposed on the exchange rate.
It is sometimes argued that in effect the exchange-rate band is constantly growing wider by 4 percent a year, so that one might think the regime is becoming more flexible in any case. Yet that is not so: the lower limit of the band is rising by 2 percent a year. As inflation in Israel is currently lower than that in the US, the existing band will sooner or later restrict the free movement of the exchange rate. What is required in order to move forward in this sphere-and clearly a decision on this matter has to be taken-is to bring about the gradual abolition of the band by setting a negative slope for the lower limit. Such a change will not have a major effect over the next few months, but in the longer term the band would become so far distant from the actual exchange rate that it could eventually be abolished without arousing any of the concerns currently felt by some policy makers. If such a path is chosen, it would be advisable to fix a timetable at the outset, for instance, setting January 1, 2003 as the date when the exchange-rate band regime would be totally abolished, and disappear from Israel’s economic vocabulary.