For the growing number of emerging market countries that have adopted or are considering implementing more flexible exchange rate regimes, the development of the foreign exchange (forex) market and official intervention policies is essential. A sufficiently liquid and efficient forex market allows the exchange rate to respond to market forces and minimizes instances and durations of unwarranted volatility and deviations from equilibrium.

Besides, whereas the timing and amount of forex intervention are largely determined by factors out of control of the central bank under fixed regimes, intrusion becomes discretionary under a flexible regime, creating the need to widen policies on the objectives, timing, and amounts of intervention. Exchange rate rigidity itself hinders the development of forex markets. In a fixed exchange rate environment, market participants have less incentive to form views on exchange rate trends, take positions, or trade forex, which keeps them from gaining experience in price formation and exchange rate risk management and constrains interbank activity.

A sense of two-way risk created by exchange rate variability encourages market participants to take short and long positions. Thus, an important step to develop the forex market is to gradually increase exchange rate flexibility, possibly within a band around a peg. In fact, forex market turnover grew between 1998 and 2002 in emerging market countries that adopted more flexible exchange rate regimes but declined from an already lower base in countries with less flexible regimes.

Emerging market countries have taken other measures to improve the depth and efficiency of their forex markets. Some of these measures include reducing the central bank?s market-making role, eliminating regulations that stifle market activity, unifying and simplifying forex legislations and facilitating the development of risk-hedging instruments in the economy. Although emerging markets announce greater exchange rate flexibility, many are reluctant to actually allow a floating currency. Central banks often intervene, in their view; to correct exchange rate misalignments, contain volatility and calm disorderly markets.

However, the emerging market countries advocate several reasons why interventions should be selective and parsimonious. Some of these grounds include detection problems, disorderly markets and the effectiveness of intervention.

Transparency in intervention policies also helps to build confidence in the new exchange rate regime, especially in the aftermath of crisis-driven transitions. Many countries, among them the Philippines and Turkey, issued statements and published policy reports affirming their commitment to a market-determined exchange rate and confirming that intervention will be conducted to target an exchange rate level.

Moreover, a public commitment to the objectives of intervention enables market scrutiny of and accountability for the central bank?s forex operations. Mere examples embrace Sweden and Australia. In sum, the development of the forex market and official intervention policies are important to support a more flexible exchange rate regime.

Forex market development and exchange rate flexibility are mutually reinforcing: there is no better way to prepare for operating a flexible exchange rate regime than to introduce some flexibility in the first place. In the same vein, monetary authorities can facilitate market development by reducing their presence in the market, formulating clear and transparent intervention objectives, and intervening selectively and parsimoniously.

<B>Nitish Benimadhu

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