Ebook Exchange Rate Regimes, Capital Flows And Crisis Prevention
The emerging markets financial crises of the 1990s had remarkable similarities. Attracted by high domestic interest rates, a sense of stability stemming from rigid exchange rates, and what at the time appeared to be rosy prospects, large volumes of foreign portfolio funds moved into Latin America, East Asia and Russia. This helped propell stock market booms and helped finance large current account deficits. At some point, and for a number of reasons, these funds slowed down and/or were reversed. This change in conditions required significant corrections in macroeconomics policies. Invariably, however, adjustment was delayed or was insufficient, increasing the level of uncertainty and the degree of country risk. As a result, massive volumes of capital left the country in question, international reserves dropped to dangerously low levels and real exchange rates became acutely overvalued. Eventually the pegged nominal exchange rate had to be abandoned, and the country was forced to float its currency. In some cases Brazil and Russia are the clearest examples, a severe fiscal imbalance made the situation even worse.
Recent currency crises have tended to be deeper than in the past, resulting in steep costs to the population of the counties involved. In a world with high capital mobility, even small adjustments in international portfolio allocations to the emerging economies result in very large swings in capital flows. Sudden reductions in these flows, in turn, amplify exchange rate and/or interest rate adjustments and generate overshooting, further bruising credibility and unleashing a vicious circle. Two main policy issues have been emphasized in recent discussions on crises prevention: First, an increasing number of authors have argued that in order to prevent crises, there is a need to introduce major changes to exchange rate practices in emerging economies. According to this view, emerging economies should adopt “credible” exchange rate regimes. A “credible” regime would reduce the probability of rumors-based reversals in capital flows, including what some authors have called have called “sudden stops.” These authors have pointed out that the emerging economies should follow a “two-corners” approach to exchange rate policy: they should either adopt a freely floating regime, or a super-fixed exchange rate system. Second, a number of analysts have argued that the imposition of capital controls and in particular controls on capital inflows provides an effective way for reducing the probability of a currency crisis.
The purpose of this paper is to analyze, within the context of the implementation of a new “financial architecture,” the relationship between exchange rate regimes, capital flows and currency crises in emerging economies. The paper draws on lessons learned during the 1990s, and deals with some of the most important policy controversies that emerged after the Mexican, East Asian, Russian and Brazilian crises. I also evaluate some recent proposals for reforming the international financial architecture that have emphasized exchange rate regimes and capital mobility. The rest of the paper is organized as follows: In section II I review the way in which economists’ thinking about exchange rates in emerging markets has changed in the last decade and a half. More specifically, in this section I deal with four interrelated issues: (1) The role of nominal exchange rates as nominal anchors. (2) The costs of real exchange rate overvaluation. (3) Strategies for exiting a pegged exchange rate. And (4), the “death” of middle-of the-road exchange rate regimes as policy options. In Section III I deal with capital controls as a crisis-prevention device.
In this section Chile’s experience with market-based controls on capital inflows is discussed in some detail. Section IV focuses on the currently fashionable view that suggests that emerging countries should freely float or adopt a super-fixed exchange rate regime (i.e. currency board or dollarization). In doing this I analyze whether emerging markets can adopt a truly freely floating exchange rate system, or whether, as argued by some analysts, a true floating system in not feasible in less advanced nations. The experiences of Panama and Argentina with super-fixity, and of Mexico with a floating rate are discussed in some detail. Finally, section V contains some concluding remarks.
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