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The
Asian crisis resulted from massive capital inflows
that were predominantly short-term. Such inflows
caused a country to be excessively exposed to
short-term and massive foreign liabilities. The
paper deals with the issue of how to manage massive
capital inflows by considering three different
policy instruments. The first policy instrument
is associated with an appropriate exchange rate
regime, which may reduce excessive total capital
inflows and/or avoid a sharp reversal of capital
flows (Section I). The second policy instrument
refers to capital controls, which may reduce total
and/or short-term capital inflows (Section II).
The third policy instrument relates to measures
to reduce excessive currency and maturity mismatches
through strengthening the banking sector and developing
capital markets, which also leads us to the appropriate
sequencing of capital account liberalization (Section
III).
I. Exchange Rate Regime
Currently, a large number of monetary authorities
face a trilemma: the impossibility of simultaneously
achieving exchange rate stability, full financial
integration, and monetary policy independence
(Lamberte, 1999). If a country attempts to achieve
exchange rate stability and monetary policy independence,
it needs to introduce capital controls. If a country
attempts to promote full financial integration
and monetary policy independence, it needs to
adopt a flexible exchange rate regime. If country
attempts to achieve exchange rate stability and
full financial integration, the very rigid fixed
exchange rate, such as the currency board system
or a currency union, can only be achieved by abandoning
monetary policy independence. As a result, it
has become more difficult to single out the most
appropriate exchange rate regime under capital
account liberalization
. It is generally argued that the choice of
an appropriate exchange rate regime depends on
which regime minimizes fluctuations in output,
consumption, domestic price level, or some other
macroeconomic variable 〔Aizenman (1992) and Caramazza
and Aziz (1998)〕. For example, a fixed exchange
rate regime is preferable if disturbances are
monetary (e.g., changes in the demand for money
and shocks that affect the price level). This
is because a proportional change in the prices
of all goods and services does not change their
relative prices and thus the use of an exchange
rate as an expenditure-switching policy is not
needed. By contrast, a flexible exchange rate
regime is desirable if disturbances are predominantly
real (e.g., changes in tastes or technology that
affect the relative prices of domestic goods or
imported goods). This is because a frequent change
in the relative prices may make it necessary to
use the exchange rate as a policy tool to adjust
the economy in response to the disturbances. Frankel
(1999) made the case for a fixed exchange rate
regime if a country is subject to many internal
disturbances while supporting a flexible exchange
rate regime if a country is exposed to many external
disturbances.
While considering an appropriate exchange rate
regime based on the types of disturbances is a
useful theoretical exercise, in reality it is
difficult to distinguish various disturbances
by type and hence to determine their relative
importance. Therefore, this section examines advantages
and disadvantages of fixed, flexible, and middle-ground
exchange rate regimes from a number of different
aspects. This section also discusses the feasibility
of the so-called two corner solutions─a free float
regime or a significantly rigid fixed exchange
rate regime such as a currency board system, dollarization,
and a common currency union─in the context of
Asian emerging-market economies.
1. Fixed Exchange Rate Regime
The fixed exchange rate regime─particularly, a
regime known as a "fixed-but-adjustable" exchange
rate regime was the most popular regime among
emerging-market economies and developing countries
before the Mexican and Asian crises (Edwards and
Savastano, 1999).1 Under this regime, a monetary
uthority fixes the nominal exchange rate but is
allowed to adjust the parity if monetary and fiscal
policies become inconsistent with the parity.
The fixed exchange rate regime also includes a
truly fixed exchange rate regime, a basket peg,
a currency board system, a currency union, and
dollarization. While there are some differences
among these exchange rate regimes (e.g., a degree
of a monetary authority's commitment to sustaining
a fixed exchange rate parity, a country to which
seignorage accrues, the capacity of a monetary
authority to act as a lender of last resort),
they share some common features under the framework
of a fixed exchange rate regime. Thus, this subsection
focuses on advantages and disadvantages that are
commonly observed under a fixed exchange rate
regime.
Advantages
There are four major advantages with respect
to a fixed exchange rate regime. The first and
the most important advantage in the context of
Asian emerging-market economies is that a fixed
exchange rate regime reduces transactions costs
and exchange rate risks, which encourages trade
and investment. Since the exchange rate is the
most important price in the market of tradable
goods and services under an open economy, volatility
of the exchange rate may badly disrupt these markets.
In addition, for an economy with imperfectly developed
financial markets, exchange rate volatility becomes
a serious problem as the exchange rate is often
affected by changes in portfolio adjustments.
This problem is aggravated by the limited hedging
possibilities in a poorly developed financial
market and also by the fact that long-term investment
projects are difficult to hedge financially (Cooper,
1999). Of course, a firm even without hedging
opportunities is able to mitigate the effects
of exchange rate volatility by simply shifting
its purchases and sales in response to price signals
(Rogoff, 1998). Moreover, a consumer can offset
the effects of exchange rate volatility by changing
demand toward products of different countries.
Such adjustments, however, generally take time.
It is well known that the volatility of nominal
and real exchange rates is much greater under
a flexible exchange rate regime than under a fixed
exchange rate regime. Ghosh et al. (1996) showed,
based on the date for 1960-90 and 145 countries,
that investment rates were higher by 2 percentage
points of GDP under a fixed exchange rate regime
than under a flexible exchange rate regime. With
regards to real exchange rate volatility, Hausmann
and Gavin (1995) reported a negative association
between real exchange rate volatility and the
aggregate investment-GDP ratio, using a large
sample of developing countries. Similar results
were demonstrated by Aizenman and Marion (1995),
Bleaney (1996), Ramey and Ramey (1995), Bell and
Campa (1997), Serven and Solimano (1993), Pindyck
and Solimano (1993), and Serven (1998).
Second, a fixed exchange rate is desirable for
a country with high pass-through from the exchange
rate to prices. This is true particularly when
a country is concerned about inflation. Hausmann,
Panizza, and Stein (1999) identified the impact
of pass-through for an emerging-market economy
on its decision not to let the exchange rate float
freely. An emerging-market economy tended to have
a higher pass-through, thereby making it concerned
about movements in the exchange rate. They also
found that an economy with high pass-through tended
to have large foreign reserves in order to be
able to defend the exchange rate.2 Such economies
include Indonesia, India, and the Philippines
in the case of Asia; and Colombia, Dominican Republic,
Guatemala, Mexico, and Paraguay in the case of
Latin America and Caribbean countries.
The third advantage, although relatively less
important for low-inflationary Asian economies,
is that a fixed exchange rate regime provides
a credible nominal anchor for monetary policy
and eliminates an inflationary bias if a strong
monetary discipline is to be demonstrated 〔Frankel
(1999) and Bergstein et al. (1999)〕. As fixing
the exchange rate goes further toward fixing the
entire price level, the regime is likely to be
credible and thus is likely to succeed in reducing
inflationary expectations particularly in a small
open economy.
Furthermore, a fixed exchange rate regime provides
a more suitable nominal anchor for emerging-market
and developing countries than a flexible exchange
rate regime, provided that inflation in the anchor
country is low and stable. Also, the use of the
fixed exchange rate regime as an anti-inflation
policy is often regarded as superior to monetary
targeting of inflation targeting.3 Finally, a
single currency peg promotes the expansion of
trade transactions with a dominant trade partner
〔Masson et al. (1999) and Sachs (1998)〕. Frankel
(1999) reported a positive impact of a single
currency peg on trade, which in turn increased
the correlation in incomes between countries.
In particular, if traded goods constitute a large
part of the economy, exchange rate uncertainty
is a serious issue and thus a fixed exchange rate
regime becomes an option. This advantage is generally
not applicable to Asian countries whose trade
partners are diversified.
Disadvantages
By contrast, there are at least six disadvantages
with respect to the adoption of a fixed exchange
rate regime. The first disadvantage that appears
important for Asian countries is that a country
will often find it difficult to sustain a fixed
exchange rate regime when the banking sector is
structurally fragile. The rapid credit expansion
financed by foreign funds often creates a lending
boom, thereby raising asset prices and encouraging
more collateralized lending activities. With insufficient
supervision and regulations, this can lead to
banks' excessive exposure to specific domestic
assets and to foreign-currency denominated liabilities,
Given this situation, a shift in market sentiment
can cause a collapse of the bubble and a sharp
depreciation, leading to large bank losses and
a deterioration of banks' balance sheets. This
raises the likelihood of a banking crisis, which
might be avoided if the authority could provide
adequate liquidity support to viable banks.
A fixed exchange rate regime limits monetary
policy independence and thus limits the authority's
ability to bail out ailing banks. As a result,
a banking crisis might not be avoided. Therefore,
to what extent a policy of providing liquidity
support is important for an economy depends on
the soundness of the banking system.4 This disadvantage
appears important in Asia, because the banking
sector remains not only dominant but also structurally
weak, so that liquidity support may be necessary
to prevent the frequent occurrence of banking
crises.
Second, a fixed exchange rate regime limits
downside risks from shorting a domestic currency
and thus intensifies speculative pressures in
just one way toward depreciation without fear
of possible appreciation. This situation is pronounced
especially in a bear market for a domestic currency
created by a slow-down of capital inflows 〔Folkerts-Landau
et al. (1997), Bergsten et al. (1999)〕. The more
rigid the exchange rate, the smaller the perceived
downside risks involved in shorting the domestic
currency. Moreover, the downside risks are smaller
than those from selling equities short, as a shortening
of equities entails not only the costs of borrowing
but also the risk that equity prices may rise
rather than drop.
Third, a fixed exchange rate regime, if facing
massive capital inflows, is likely to generate
an overvaluation of the currency or a misalignement,
raising the current account deficit and reducing
foreign reserves. Gavin and Hausmann (1996) found
that unsustainable exchange rate pegs contributed
more to the relatively high volatility of growth
rates in Latin American developing countries over
the past two decades than any other factor. Furthermore,
Kaminsky and Reinhart (1999a) reported that a
sharp real exchange rate appreciation typically
preceded a banking crisis. This is because a real
appreciation is likely to lower the profitability
of the tradables sector. In addition, a real appreciation
is often associated with a high real domestic
interest rate, which encourages residents to denominate
their borrowing in foreign currencies and thus
expose themselves to a large foreign exchange
rate risk (Goldstein and Turner, 1996).
However, Caramazza and Aziz (1998) questioned
the above argument. They claimed that misalignments
are equally likely under either fixed or flexible
exchange rate regimes. During 1975-96, for example,
exchange rates depreciated on average by about
25％ per a year and nearly half of the countries
under examination were under a flexible exchange
rate regime.
Fourth, a fixed exchange rate regime generates
moral hazard among foreign investors if the regime
is perceived to be credible. In this case, the
regime takes the form of an implicit guarantee
and a source of moral hazard by promoting unhedged
currency borrowing and skewing capital flows toward
the short end (Mishkin (1996), Obstfeld (1998),
and Buiter and Sibert (1999)).
Fifth, a monetary authority needs to hold ample
foreign reserves that can be used for defending
the parity. Thus, a monetary authority is required
to accumulate foreign reserves by limiting the
expansion of domestic assets
. Sixth, the rigidity of the nominal exchange
rate requires a country to increase the downward
flexibility of real wages in the labor market,
if serious domestic recession caused by overvaluation
of the exchange rate is to be avoided and flexible
and sustainable fiscal policy is to be maintained.
Basket Peg
There is growing support for a currency basket
peg rather than a single currency peg. The main
reason is that it reduces the volatility of the
nominal and real effective exchange rates for
a country with diversified trade patterns against
various currency areas. This regime makes sense
for countries with trade patterns that are highly
diversified geographically, as is the case in
Asia (Frankel, 1999). Thus, the choice depends
on the degree of concentration of trade shares
and the currencies in which external debt is denominated.
Furthermore, the basket peg induces a monetary
authority to hold diverse foreign reserves used
for market intervention and thus is likely to
make it easier for a monetary authority to improve
foreign reserve management through portfolio diversification.
The counter-argument is that a basket peg removes
the microeconomic and informational benefits of
maintaining a constant single exchange rate that
is relevant for price comparisons and economic
transactions (Masson et al., 1999). Also, in practice,
many countries adopting this regime keep the weights
secret and adjust the weights or the level so
frequently that the formula cannot be precisely
inferred (Frankel, 1999). Thus, the regime is
less transparent than a single currency peg. If
a basket peg is regarded as an option in Asia,
the weight of the yen should be increased. For
this purpose, the need for promoting the internationalization
of the yen will become a serious issue in the
near future.5 Meanwhile, the increase in the weight
of the yen in the basket and the use of the yen
as an intervention currency may increase demand
for the yen as a reserve currency. Lamberte (1999)
stressed that both Japan and other Asian economies
will benefit from such a move by reducing dependence
on the US dollar and providing Asian countries
easier access to the Japanese capital market.
Also, this would enable monetary authorities to
diversify foreign reserve assets and to reduce
country risk and encourage firms to benefit from
increased access to hedging instruments.
2. Flexible Exchange Rate Regime
The flexible exchange rate involves a free float
regime and a dirty float regime. A free float
regime refers to regime where the value of foreign
exchange is determined in the market. In reality,
there is no country that has adopted a pure float
regime. A dirty float regime allows occasional
intervention by central banks in foreign exchange
markets. This regime is observed in a number of
countries including Canada, Japan, and the United
States. This subsection illustrates the pros and
cons commonly observed under the framework of
a flexible exchange rate regime. Advantages
A series of currency crises─including the ERM
crisis in 1992-93, the Mexican crisis with the
Tequila effect in 1994-95 and the Asian crisis─have
strengthened the view in support of a flexible
exchange rate regime. There are four advantages
with respect to a flexible exchange rate regime.
First, a country is able to have independent monetary
policy. And self-fulfilling panics are relatively
easily handled or can be obviated entirely under
a flexible exchange rate regime owing to the larger
capacity of the central bank to act as a lender
of last resort for domestic banks (Sachs, 1998).
Second, a flexible exchange rate regime is likely
to avoid a free fall that gives rise to a sharp
increase in foreign debt when denominated in domestic
currency, while generating a free float. In particular,
when a country is forced to float its exchange
rate under massive speculative attacks and if
its banking sector is structurally fragile being
faced with double mismatches, the exchange rate
is likely to incur a free fall rather than a free
float. A free fall occurs through a downward spiral
of the balance sheets of financial institutions
and firms. This deepens a crisis and adversely
affects economic growth, export growth, and investment
growth. These problems could be mitigated, to
begin with, by adopting a flexible exchange rate
regime. This is because a reversal of capital
outflows gives rise to a depreciation, reducing
the likelihood of gaining from one-sided bets.
Third, a flexible exchange rate regime allows
an exchange rate to move in response to market
forces and various disturbances. This generates
an exchange rate risk, thereby encouraging private
economic agents to recognize and prudently managing
unhedged foreign borrowing. As a result, the regime
may discourage excessive unhedged foreign borrowing
and hence lessen a currency mismatch. Fourth,
it is often said that a flexible exchange rate
regime generally does not require ample foreign
reserves compared with a fixed exchange rate regime.
This is because speculative short-selling activities
of a domestic currency are lessened. However,
there appears no empirical evidence so far that
supports this argument.
Disadvantages
There are at least four disadvantages with respect
to a flexible exchange rate regime. First, a country
in need of foreign financing has to face a foreign
exchange risk in the absence of adequate hedging
instruments. In general, most emerging-market
economies can issue international bonds only in
foreign currencies. Hausmann, Panizza and Stein
(1999) showed that most emerging-market economies
had no ability to borrow in their own currencies
with the exception of South Africa, Poland, Greece,
and the Philippines that had some, but limited,
ability to do so. The lack of markets for currency
futures and options reflects the unwillingness
by non-residents to hold the domestic currency.
Also, few countries organize derivative markets
in currencies other than hard currencies.
Second, Furman and Stigliz (1998) warned that
even a flexible exchange rate regime is not necessarily
a very capable one to cope with capital inflows.
If an investor anticipates an appreciation, he/she
may invest more in the country under the expectation
of a further appreciation rather than reducing
investment with perceived exchange rate risks.
An increase in capital inflows leads to nominal
and real appreciation, which discourages exports,
shifts resources away to the non-tradable goods
sector, and causes a lending boom. As a result,
a trade deficit expands and foreign reserves drop.
Third, Cooper (1999) stressed that a broad,
diversified financial market based on the domestic
currency may not be developed under a flexible
exchange rate regime provided that substantial
capital movements take place and that an exchange
rate widely fluctuates. When residents face constant
fluctuations in the real value of domestic assets
because of such volatility, they may raise incentives
to invest in more stable and liquid foreign assets
in foreign capital markets. As a result of this
direct competition between domestic and foreign
assets, domestic financial markets are unlikely
to develop owing to the limited ability to offer
assets comparable or competitive with foreign
assets.
Fourth, even a flexible exchange rate regime
may require a country to hold a sufficient amount
of foreign reserves. This is contrary to the general
view described above. Indeed, a flexible exchange
rate regime requires a monetary authority to hold
sufficient foreign reserves to offset the excessive
volatility of the exchange rate. The volatility
arises from the thinness of domestic foreign exchange
markets, inflationary expectations caused by the
lack of credibility over monetary policy, and
the underdevelopment and incompleteness of financial
markets. However, it should be emphasized that
even in developed countries, exchange rate volatility
is also significant despite great successes in
their battles against inflation (Rogoff, 1998).
3. Two-Corner Solutions
In recent years, the world has been paying increasing
attention to the so-called 'two corner' solutions:
a free float exchange rate regime as one corner
and a currency board, dollarization, common currency
union as the other.
Free Float
A free float regime allows the exchange rate
to vary freely in the market and thus enables
the economy to absorb various disturbances. As
a monetary authority rarely undertakes intervention,
ample foreign reserves are not required. A free
float regime, however, gives rise to high exchange
rate nominal and real exchange rate volatility,
which may distort resource allocation.
Currency Board
Notwithstanding a number of arguments against
a fixed exchange rate regime in general, there
is strong support for a currency board system─a
more rigid fixed exchange rate regime. This is
because a currency board system helps a monetary
authority to enhance credibility over monetary
and fiscal policy by limiting the issuance of
a domestic currency up to the increase in foreign
reserves and thus minimizes their role as a lender
of last resort. Also, the regime maintains legal
constraints on monetary policy and leaves no scope
for altering the parity. Since a currency board
system requires a monetary authority to maintain
a strong commitment to maintaining stable macroeconomic
policy, investors' confidence on the sustainability
of the regime improves and thus speculative currency
attacks decline.
Ghosh et al. (1996) showed that a more rigid
fixed exchange rate regime was associated with
significantly better inflation performance (lower
inflation and less variability). Based on data
for 1960-90 and 145 countries, an average rate
of inflation was 7％ under a fixed exchange rate
regime, 13％ under an intermediate exchange rate
regime, and 17％ under a flexible exchange rate
regime.
Nevertheless, it should be stressed that a currency
board system is feasible only under certain conditions.
The system fits a country in which investors have
deep-rooted distrust of discretionary monetary
policy after experiencing a history of hyperinflation
(Eichengreen, 1999a). In addition, Eichengreen
pointed out the flexibility of factor markets
and deep-seated public support for the exchange
rate regime as conditions for the successful implementation
of a currency board system. Moreover, a currency
board system is suitable only for a small open
economy with sufficiently large reserves 〔Chang
and Velasco (1998), Lamberte (1999), and Sachs
(1998)〕. Particularly, such an economy should
have a strong financial system and strict fiscal
and monetary discipline. This is because limited
capacity is given to a monetary authority to function
as a lender of last resort, as seen in Argentina
in 1995. In addition, there are a number of
problems associated with the system. First, Edwards
(1999b) stressed the exit problem as a disadvantage
of a currency board system. A country may find
it difficult to exit from the system since such
an action may be regarded as a sign of loosening
monetary and fiscal discipline. Second, Bergsten
et al. (1999) emphasized a contradiction built
in the system. A currency board system helps a
monetary authority to increase its credibility
in the beginning. However, once the credibility
is achieved, resultant capital inflows push the
currency upward and lead to an overvaluation.
This deteriorates a current account deficit and
for this reason, the system loses its credibility.
Third, recent episodes exemplified in Hong Kong,
China and Argentina suggest that a currency board
system does not necessarily function as a measure
to increase investors' confidence and thus lower
speculative attacks. Hamada (1999) pointed out
that a currency board system is subject to volatile
interest rate fluctuations, which would adversely
affect the country's economic growth unless guarding
measures are undertaken. The volatility of the
domestic interest rate increases because it is
nearly proportionally affected by a change in
the foreign interest rate of the anchor country
as a result of a decline in the exchange rate
risk.
Dollarization and Common Currency Union
In line with the arguments for a currency board,
some academicians support dollarization and a
common currency union as another type of rigid
fixed exchange rate regimes.6 Dollarization maximizes
credibility since the regime leaves no scope for
surprising the public (Edwards and Savastano,
1999). One of the differences between a currency
board system and dollarization is that seignorage
accrues to the country introducing the currency
board in the former while it accrues to the United
States in the latter.
Eichengreen and Hausmann (1999) supported dollarization
as an acceptable solution in order to eliminate
foreign currency exposure risk and exchange rate
volatility. They argued that if an incomplete
financial market, not the lack of prudential risk
management, makes it difficult for domestic banks
to hold domestic-currency denominated liabilities
and to borrow in the long term, banks will face
double mismatches (Eichengreen and Hausmann call
this situation "original sin".) In this situation,
both fixed and flexible exchange rate regimes
are problematic since if the currency deprecates,
a currency mismatch would cause bankruptcies.
On the other hand, if the country defends the
peg by selling foreign reserves and raising interest
rates, a maturity mismatch would precipitate defaults
on short-term domestic debts. The only solution,
therefore, is to realize dollarization or a common
currency union (e.g., the EMU) in order to remove
a currency mismatch. A maturity mismatch could
also be reduced because it becomes easier to issue
long-term bonds in US dollars with the greater
willingness of foreigners to lend in long maturities.7
Sachs (1998) argued that a common currency union
is supported for the same reasons as applied to
a flexible exchange rate regime. Namely, a common
central bank under a union could play the role
of a lender of last resort for the whole union
in the same manner that a national monetary authority
provides liquidity support for problematic banks.
On the other hand, Sachs (1998) did not support
dollarization due to the limitation of the monetary
authority to act as a lender of last resort. In
a dollarized economy, the banking sector generally
has US dollar or US dollar-indexed assets and
liabilities. As the maturities of US dollar liabilities
are generally shorter than those of the assets,
a maturity mismatch prevails in the banking sector.
When the banking sector faces liquidity problems,
a monetary authority finds it difficult to act
as a lender of last resort. This is because it
needs to provide foreign exchange, not its own
domestic currency, in the event of a precipitous
withdrawal of US dollar balances. Under a bank
run, a monetary authority often finds that it
has no choice but to freeze the withdrawal of
US dollars and ends up converting US dollar-denominated
balances into the domestic currency by accompanying
a confiscation to some extent. In addition, Edwards
(1999b) does not support dollarization due to
the exit problem.
4. Middle-Ground Exchange Rate Regime
The middle-ground exchange rate regime refers
to a crawling peg, a floating regime within a
band, a crawling band, and a sliding band. This
subsection emphasizes pros and cons of these regimes.
Crawling Peg
A crawling peg regime has been losing support
in recent years. A crawling peg regime adjusts
its parity periodically based on past inflation
differences and is usually not allowed to fluctuate
beyond a narrow range in order to maintain a constant
real exchange rate. In the 1960s and 1970s, this
regime was popular among Latin American countries
as a tool to stabilize accelerating inflation.
However, it has become apparent nowadays that
the regime does not work in the medium to long
term as a nominal anchor on the grounds that inflation
continues to run at a high rate. For this reason,
a country must demonstrate commitment to sound
fiscal and monetary policy in order for a crawling
peg regime to be perceived by the market as credible.
In general, the regime is regarded less credible
than a fixed exchange rate regime. The shortcoming
of a crawling peg regime is that it gives rise
to inflationary inertia due to its backward-looking
nature and thus may cause monetary policy to lose
its role as nominal anchor (Edwards and Savastano,
1999). Furthermore, the regime is not flexible
enough to accommodate changes in the equilibrium
real exchange rate because of its limited possibility
and infrequency to adjust the parity. One variant
of the regime is to adjust the nominal exchange
rate by a pre-announced rate that is set deliberately
below ongoing inflation. This regime causes a
real appreciation and thus expresses the country's
commitment to containing inflation. As a result,
the regime is likely to guide the public's expectation
and to achieve a limited amount of credibility.
However, the regime is not sustainable, as with
a fixed exchange rate regime, unless sound macroeconomic
performance is sustained and fiscal policy is
supportive.
Floating within a Band
A floating regime within a band (so-called "target
zone") gives more flexible policy options for
a country than a crawling peg. The nominal exchange
rate is allowed to fluctuate within a band although
the central parity is fixed either to a single
foreign currency or a basket of foreign currencies.
The width of the band varies; in the case of the
ERM, the band was originally ±2.25％. This regime
helps a country to guide the public's expectations
because some rigidity of the exchange rate reduces
monetary policy independence. At the same time,
this regime helps the economy to absorb various
disturbances to economic fundamentals.
However, the regime ends up working like a fixed
exchange rate regime and may trigger speculative
currency attacks if the exchange rate moves to
the ceiling or floor of the band (Edwards and
Savastano, 1999). This situation is likely to
occur when massive capital inflows take place.
Thus, a choice of the band must be not too narrow
in order to prevent speculative attacks but also
not too wide in order to maintain credibility
of the exchange rate regime. This problem was
evident in the ERM crises in 1992-93, Mexico in
1994, Indonesia before August 1997, and Russia
before August 1998.
Adjustable Basket (REER) Peg with a Band
In recent years, the middle-ground exchange
rate regime has been losing popularity while the
growing attention has been given to two corner
solutions. Nevertheless, the middle-ground exchange
rate regimes should not be dismissed given the
existence of important tradeoffs between credibility
and flexibility. Bergsten et al. (1999) and Yoshitomi
and Shirai (2000), for example, proposed an innovative
form of the crawling basket peg regime with a
band. Namely, a country should stabilize the real
effective exchange rate at a predefined level
that is compatible with balanced medium-and long-term
economic development, redefine the reference parity
on a regular basis, and peg the domestic currency
to a basket of currencies. The new approach suggests
that the real effective exchange rate should be
allowed to appreciate against the reference parity
during economic overheating.
By contrast, when confronting downward exchange
rate pressure, a monetary authority should assess
whether the parity is sustainable and apply a
credible, transparent, and gradual mechanism.
Any doubt about the sustainability calls for timely
readjustments including the change in the parity
itself. The authority should then defend the sustainable
parity in a flexible way (e.g., no hikes in the
domestic interest rate at an unbearable level
and a concurrent protection of foreign reserves).
The domestic interest rate can be aligned transparently
to a foreign interest rate, augmented with a well-defined
risk premium that takes into account the characteristics
of a country until the domestic currency regains
its reference parity.
This innovative approach differs from the conventional
crawling peg regime in that it pegs a method for
adjusting the exchange rate. In contrast, the
conventional approach crawls the exchange rate
based on inflation differentials and allows for
conducting monetary policy as long as the exchange
rate fluctuates with the band (to be continued).
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----------------------------------------------
* Dean, Asian Development Bank Institute, Tokyo,
Japan.
** Visiting Scholar, Asian Development Bank Institute
and Associate Professor of Economics, Keio University,
Tokyo, Japan.
1 This regime was widely used in the Bretton Woods
era when the capital account was
not fully convertible.
2 As a result, an economy with high pass-through
tends to face smaller volatility of
the exchange rate. However, the results did not
show any correlation between pass-
through and the level of reserves for a country
with low pass-through.
3 For the discussions
over monetary targeting and inflation targeting,
see Frankel
(1999), Edwards (1993), Ghosh et al. (1996),
IMF (1997), Little et al. (1993), and
Yoshitomi and Shirai (2000).
4 Sachs, Tornell and Velasco (1996) found that
a weak banking system proxied by a
previous lending boom was the best leading indicator
for whether a country was hit
by the Tequila effect in early 1995.
5 The Council on Foreign Exchange and Other Transactions
(1999), whose mandate
was given by the Ministry of Finance, provided
comprehensive recommendations
in order to promote the internationalization
of the yen. Major impediments are
inadequate environmental and infrastructures
in financial and capital markets that
help increase market depth in the short-term
financial markets and facilitate
investment in Japanese government bonds by overseas
investors. Therefore, the
Council stressed a shift of Japan's repo market
from a cash-collateralized system
adopted in the United States and Europe, an introduction
of a five-year interest-
bearing government bond to be used as a medium-term
benchmark issue, an
adoption of the Separate Trading of Registered
Interest and Principal of Securities
program, and an improvement of the settlement
system.
6 East Timor adopted dollarization after the independence
in 1999. While the rupiah,
the baht, and the Portuguese escudo, and the
Australian dollar are currently in
circulation besides the US dollar, the US dollar
is expected to eventually become
the dominant currency with the rupiah serving
as an alternative for retail trade.
Ecuador, which faced a 70％ depreciation against
the US dollar, an inflation rate of
60％, and an unemployment of 17％ over the past
12 month, decided to replace its
domestic currency, sucre, with the US dollar
in January 2000 in order to restore
investors' confidence. However, the government
was overthrown in a military-
backed coup within days. New President Noboa
stated that he would continue with
dollarization. Panama officially dollarized in
1903. Argentina released a report
spelling out the possibility of completing full
dollarization in January 1999.
7 Eichengreen and Hausmann (1999) point out the
following effects of dollarization:
a removal of all scope for an independent monetary
policy, the limited capacity for
a monetary authority to act as a lender of last
resort, a removal of double
mismatches , increased willingness of foreigners
to lend, a reduction in the level
and volatility of interest rates, moderated severity
of business cycles, and a
strengthening of the stability of financial systems.
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