Exchange rate regimes and macroeconomic stability

Lok-Sang Ho and Chi-Wa Yuen Part 1 The Asian Currency Crisis: Responses and Policy Options Chapter 2 Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth W

EXCHANGE RA TE REGIMES AND MACROECONOMIC

STABILITY

EXCHANGE RATE REGIMES AND MACROECONOMIC

STABILITY

edited by

Lok-Sang Ho

Lingnan University Hong Kong

edited by Lok-Sang Ho and Chi-Wa Yuen

ISBN 978-1-4613-5365-2 ISBN 978-1-4615-1041-3 (eBook)

DOI 10.1007/978-1-4615-1041-3

Copyright@ 2003 Springer Science+Business Media New York

Originally published by Kluwer Academic Publishers in 2003

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Lok-Sang Ho and Chi-Wa Yuen

Part 1 The Asian Currency Crisis: Responses and Policy Options

Chapter 2 Lessons from the Asian Financial Crisis, and the Prospects

for Resuming High Growth

Wing Thye Woo Chapter 3 Financial Market Stability, Monetary Policy, and the IMF

Joseph Stiglitz Chapter 4 The IMF Approach to the Asian Currency Crises: An

Alternative View

Charles Adams Chapter 5 Does Asia Need a Common Currency?

Robert Mundell Chapter 6 Recommending a Currency Basket System for Emerging

East Asia

Masahiro Kawai

Part 2 Monetary Policy, Exchange Rate Regimes, and

Macroeconomic Stability

Chapter 7 A Comparative Analysis ofExchange Rate Regimes

Naoyuki Yoshino, Sahoko Kaji and Ayako Suzuki

Chapter 8 Bringing about Realistic Exchange Rates: A Post-Asian

Lok Sang Ho Chapter 9 Contemplating the Credibility of Currency Boards 145

Corrinne Ho Chapter 10 Currency Board, Asian Financial Crisis, and the Case for

247

251

LIST OF CONTRIBUTORS

Charles Adams is Assistant Director at the IMF's Regional Office for Asia and the Pacific During 2000/2001, he was on a one-year leave of absence at the Asian Development Bank, where he was a senior economic advisor He has held various positions during his nineteen-year career at the Fund including in the Research, Asia and Pacific, and Policy Development and Review departments

Alex W.H Chan is Assistant Professor in the School of Economics and Finance of the University of Hong Kong His research interests are the areas of derivative valuation, investments, risk management, and exchange rate systems

Leonard K Cheng, Ph.D (California-Berkeley), is Professor and Head ofthe Department of Economics at the Hong Kong University of Science and Technology His research fields are international economics, foreign direct investment, market structure, and technological innovation and imitation

Corrinne Ho is an economist in the Monetary and Economic Department of the Bank for International Settlements Prior to joining the BIS, she was

a student and lecturer at Princeton University Her fields of interest include exchange rate, monetary policy and economic institutions Lok Sang Ho is Director of the Centre for Public Policy Studies, Lingnan University, Hong Kong and Hon Research Fellow at the Chinese University of Hong Kong He has been President of the Hong Kong

Economic Association since 1999 His Kluwer book, Principles 01

policy issues

Sahoko Kaji holds a Ph.D in economics from the Johns Hopkins University She has been Professor of Economics at Keio since 1999 She had published in leading economic journals on international economic issues such as financial crisis and the EMU

Masahiro Kawai is Deputy Vice Minister for International Affairs at Japan's Ministry ofFinance since July 2001 He was formerly Chief Economist

of the World Bank's East Asia and Pacific Region, and prior to April

1998, Professor of Economics at the Institute of Social Science of the University of Tokyo He holds a Ph.D in economics from Stanford University

Yum K Kwan is Associate Professor ofEconomics at the City University of HongKong

Francis T Lui, PhD (University of Minnesota) is Professor of Economics and Director of Center for Economic Development at the Hong Kong University of Science & Technology His research interests include endogenous growth, population economics, social security, corruption, and exchange rate regimes

Robert Mundell is University Professor ofEconomics, Columbia University

He is the 1999 Nobel Laureate in Economic Science

Joseph E Stiglitz is the 2001 Nobel Laureate in Economics and Professor of Economics, Business, and International Affairs at Columbia University Ayako Suzuki received her BA in economics from Keio University in 1994 She received her MPhil in International Finance from the University of Glasgow in 1998 and is now enrolled in the doctoral programme at the Department ofEconomics at the Johns Hopkins University

Wing Thye Woo, Professor of Economics, University of California, Davis, specialises in open-economy macroeconomics, and economic growth, and has expertise in the economies of China, India, Indonesia, Iran, Korea, Malaysia, Mongolia, Taiwan, and Vietnam He is also the Director of the East Asia Pro gram of the Earth Institute at Columbia University

Naoyuki Y oshino holds a Ph.D in economics from Johns Hopkins University He had been Assistant Professor at the State University of New Y ork at Buffalo and Visiting Scholar at the Massachusetts Institute of Technology He is now Professor of Economics at Keio

University He coauthored with Thomas Cargill a book The Postal

Saving System and the Fiscal Investment and Loan Program in Japan

(Oxford University Press, 2002)

List ofContributors ix Chi-Wa Yuen, a Chicago PhD and a macroeconomist, is currently teaching

at the University of Hong Kong, Peking University, and Wuhan University With Jacob Frenkel and Assaf Razin, he is co-author of

Fiscal Policies and Growth in the World Economy, a popular graduate

text in open-economy macro

The Asian crisis of 1997-1998 could be viewed as a watershed in our macroeconomic thinking concerning exchange rate regimes, the functioning

of il).ternational institutions, such as the IMF and the World Bank, and international contagion of macroeconomic instability from one country to another In the now famous annual meeting ofthe IMF and the World Bank held in Hong Kong in September 1997, shortly after the outbreak of the Asian crisis, officials of the international institutions pushed for the deregulation of capital flows, as an obligation of any member of the IMF This position, seemingly a bureaucratic inertia, was in disregard to the nature

of the balance of payments problems that the country could be subject to, or the soundness and credibility of its financial institutions

Old issues were subject to renewed inteHectual scrutiny Should crisis-stricken countries raise interest rates? On the one hand, raising interest rates could restore monetary balance by strengthening domestic currency

On the other hand, by raising the interest rate the central bank places pressures on financial intermediaries and firms with heavy loads of short-term debt and thus can weaken the exchange rate

This fine book offers perspectives on this debate from the viewpoints of two Nobellaureates, an IMF economist, and Asian economists It contains a selection of papers, mostly chosen from the bi-annual meetings of the Hong Kong Economic Association that took place in December 2000 It contributes interesting new ideas to the ongoing inteHectual debate on the role of domestic monetary authorities and international institutions in reducing the likelihood of international financial crises, as weH as the problems associated with various exchange rate regimes from the standpoint

of macroeconomic stability

AssafRazin Tel Aviv University and Cornell University

ACKNOWLEDGMENTS

The editors and the Hong Kong Economic Association acknowledge with thanks the support from the Hong Kong Institute for Monetary Research, the Bank of East Asia, and the Asian Development Bank in making the First Biennial Conference of the Hong Kong Economic Association possible Most of the articles included in this volume were first presented in that Conference We also thank Blackwell Publishers for permission to reproduce articles by Stiglitz and by Mundell earlier published

in Pacific Economic Review, and Palgrave for permission to include an article by Lok Sang Ho largely adapted from a chapter first published in Twenty First Century W orld Order and the Asia Pacific, edited by James C Hsiung

INTRODUCTION

Lok-Sang Ho* and Chi-Wa Yuent

*Lingnan University, fUniversity ofHong Kong, Peking University, and Wuhan University

The whole world is still in search of a more efficient system of managing its monies one that can bring greater stability to the world's financial markets This does seem rather strange, given that the Bretton Woods system-itself the result of a major international effort to bring stability to the world's international monetary system-was born in 1944 more than half a century ago, and that both the World Bank and the IMF, institutions set up under the Bretton Woods arrangement, had access to the brightest brains in economics

Another equally puzzling development is that financialleconomic crises have become deeper and more frequent over the past 25 years, notwithstanding the rapid development of economics as a discipline and the emergence of almost four dozen Nobel laureates in economics-including two of our contributors Robert Mundell and Joseph Stiglitz.) The lingering effects of the Asian Financial Crisis, which broke out in 1997, were still affecting many countries in the region when 2001 Nobel Laureate Joseph Stiglitz gave his speech ("Financial Market Stability, Monetary Policy, and the IMF") to the Hong Kong Economic Association in December 2000, when he predicted that another crisis might be looming in Argentina The course of events proved that he was right The currency board system in Argentina, reputed to have restored price stability and economic order to a chaotic system, broke apart in January 2002, as the country defaulted on its loans and painfully devalued the peso amid street riots

Once again, some critics put the blame on the IMF? Others consider the overvaluation of the peso consequent on the strength of the dollar and especially the devaluation of the Brazilian real in 1999.3 Still others claim that the problem lies in Argentina's not following the orthodox currency board model 4 Yet still others blame Argentina's problems on its half-hearted pro-market reforms, which have resulted in corruption and faulty legal institutions.5

2 Exchange Rate Regimes and Macroeconomic Stability

When something goes wrong, dozens of theories can be made up to explain it Many of these explanations, however, are cooked up after the fact and, for that reason, may not have much predictive power In contrast, Stiglitz's analysis predicted the crisis, and he further predicted that the crisis would most likely be mismanaged His analysis thus carries weight and deserves to be c10sely studied

Another weighty and provocative artic1e in this volume is the one by

2000 Nobel Laureate Robert Mundel1 In his chapter on "Does Asia Need

A Common Currency?" Mundell argues that the answer to that question lies

in what is the alternative According to hirn, the first best for the world is

to have a "common currency." If that should materialize, Asia would not have needed aseparate common currency But if that option is not practical, at least for the time being, then Asia would do well to have a common currency within the region By a common currency Mundell does not necessarily mean a single common currency He believes that it will do just fine if separate currencies "operate just like one common currency."

He also believes that the US dollar can serve as the default anchor currency, given that neither the yen nor the RMB would work Linking Asian currencies to one another and anchoring them to the US dollar can be effected, for instance, through currency boards Mundell's advice would certainly provoke further studies on the merit of currency board arrangements In this volume we have several extended studies on the subject

Among authors who address the currency board issue, Corrinne Ho ("Contemplating the Credibility of Currency Boards") provides an in-depth exploration of the fundamental subject of credibility In particular, she makes clear distinction between the concept of "credibility-worthiness," which relates to the objective ability and willingness to deliver the promises

of the regime, and that of "credibility," which is the public's subjective perception of the former A study of the Hong Kong currency board system shows that perception and "market sentiment" (a reflection of

"credibility") is indeed often quite independent of the

"credibility-worthiness" of the policymaker and the regime Corrinne Ho provides an interesting perspective by examining the circumstances under which the five major modern currency boards were introduced and their subsequent histories in order to get a sense of how contextual factors help shape credibility-worthiness and credibility

The subject of credibility of the currency board arrangement is also dealt with, but from a different, institutional arrangement angle, by Lui, Cheng, and Kwan ("Currency Board, Asian Financial Crisis, and the Case for Put Options") and by Alex Chan ("The Currency Board in Hong Kong: Operational Weaknesses and a Proposed Refinement Scheme") These

chapters, written independently and from a rather different perspective, come

to similar conc1usions, namely that the seven technical measures to strengthen the currency board system, introduced by the Hong Kong Monetary Authority (HKMA) in September 1998, are tantamount to a

"reserve commitment policy" or a currency "put option"-effective1y a

"convertibility insurance" for those holding Hong Kong dollars as proposed

by Merton Miller in 1998 Since the Hong Kong system is the world's single most important currency board in practice today, the detai1ed analysis

of the operation of this system is of great value to countries pondering the use of currency board systems in the future The two chapters are complementary in that the chapter by Lui et al is more theoretical, while that by Alex Chan is more operational Lui et al suggest that interest rate arbitrage has been working properly until the rule-bound currency board was eroded by central bank-like, discretionary policies pursued by the HKMA

The de facto implementation of the put options proposal put the HKMA

back onto the rule-bound track, and interest rate arbitrage appears to be effective again Chan goes to great details on the operational side, explaining how the currency board system has worked in Hong Kong during the different historical phases of the system

Credibility and confidence are obviously interrelated Charles Adams ("The IMF Approach to the Asian Currency Crises: An Alternative View") pinpoints the importance of confidence He points out that the observed upward pressure on interest rates may be a reflection of the collapse of confidence and need not imply conscious monetary tightening

"Expansionary monetary policies would have been required to avoid high interest rates," he wrote This position may be subject to debate, given the literature on the monetary conditions index, which would ·look at surging

real interest rates as de facto tightening of monetary policy, other things

being equal One will, however, have to agree with Adams that without a convincing way to restore confidence, high interest rates will be unavoidable Moreover, Adams explains that the IMF's key concern was to stabilize

"badly hemorrhaging balance of payments positions," which is just another way of saying restoring confidence Adams points out that the IMF has facilitated external debt restructuring in at least one of the crisis-afflicted Asian economies, viz., Korea Ignoring the contribution of the IMF in restoring confidence and hence financial market stability would not have been fair to the IMF 6

Wing Thye Woo ("Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth"), a self-espoused critic of the IMF, agrees that the role of confidence is paramount The key, however, is what builds confidence "Since all five currencies (and economies) collapsed rather than just one as expected, it seems that financial contagion is a better

4 Exchange Rate Regimes and Macroeconomic Stability

explanation than weak domestic fundamentals." To Woo, occasional excessive price movements in financial markets are normal and to be expected "Bad things can happen to good people" and that economic disasters, rather than "penitence for economic sins," should be dealt with realistically, seriously, and globally He is especially wary about the effects of short term capital flows, and makes a plea for a coordinated effort, both at the international level and at the regional and national levels, to manage exchange rates

According to Lok Sang Ho ("Bringing About Realistic Exchange Rates:

A Post-Asian Financial Crisis Perspective"), what belies the credibility of and confidence about fixed exchange rates in general and the currency board

in particular might be the real value of the exchange rate itself If the exchange rate itself lacks credibility (e.g., due to excessive strength of the anchor currency or home-grown inflation), then all the institutions, announcements, and even strong reserves will not count In contrast to the stability-pain tradeoff assumed by Corrinne Ho, Lok Sang's implicit assumption is that there is a threshold of economic pain that an economy can endure Pain tolerance may therefore not be relied upon indefinitely to bring stability to the exchange rate regime On this basis, he considers establishing "realistic exchange rates" as an alternative, explores a mechanism for operationalizing the concept, and offers it as an answer to the debate over the choice between the floating and fixed exchange rates Lok Sang's discussion of this important subject is highly relevant to the interesting question raised by Lui, Cheng, and K wan, who ask whether the Hong Kong currency board based on an exchange rate established in 1983 is sustainable, given the much higher inflation rate in HK than in the US (though subdued and turned into deflation after 1998) In particular, has Hong Kong become so expensive -especially in light of the strength of the

US dollar-that it must devalue its currency to restore international competitiveness? Lui et al believe that if prices and wages adjust quickly enough, there would be no need for a devaluation, and the pain of adjustment would be much smaller If the institutions are there to safeguard credibility and inspire confidence, the currency board should have no risk of being unsustainable In light of the fact that any overhanging debt does not deflate with deflation, the workability of this approach in restoring competitiveness is still open to question, and Lok Sang's call for "realistic exchange rates" appears to deserve a closer look

Echoing to Lok Sang's urge for the need to introduce a system offering relatively stable real effective exchange rates that are compatible with the need for full employment, Masahiro Kawai ("Recommending A Currency Basket System for Emerging East Asia") argues that economies currently operating under a US dollar peg, such as Malaysia, China, and the Hong

Kong SAR, should exit to a currency basket system before the next round of exchange market pressure develops The proposed currency basket system ought to be supported by regional surveillance and financing mechanisms With better political and institutional support, a more robust framework of macroeconomic and exchange rate cooperation will evolve in the region The validity ofKawai's argument is confirmed by the theoretical analysis of Yoshino, Kaji, and Suzuki ("A Comparative Analysis of Exchange Rate Regimes"), who conclude that of the three arrangements, the basket-peg, the dollar-peg, and the free float, the basket-peg could potentially minimize the government's policy losses under alternative policy objectives, while the losses would always be larger under the free float than under the dollar-peg They have also estimated the optimal weights for the ideal currency basket Over all, the set of chapters contained in this volume offers interesting perspectives which have been stimulated by the recent turns of events in the foreign exchange market They provide a useful reference for anyone interested in the development of exchange rate regimes, and represent considerable reflection and hard thinking by economists half a century after Bretton Woods

3 The core of Argentina's problem, according to Paul Krugman, is " the deflationary pressure imposed by an overvalued currency Dollarization offers no cure; it would end speculation against the currency, but do nothing about the underlying economic problem." ("Argentina's Money Monomania.")

4 Steve Hanke and Kurt Schuler, "What Went Wrong In Argentina?" Central Banking Journal, Vol XII, no.3, February 2002

5 Brink Lindsey, "How Argentina Got Into This MessT' Wall Street Journal, January 9,

2002

6 Adams' analysis is consistent with a statement made by Thomas C Dawson, Director

of the External Relations Department of the IMF, in a letter to the editor for the Daily Yomiuri: "Argentina's experience shows that-no matter what currency regime is adopted, no matter how much external support is forthcoming, and no matter how strong the personalities are-ultimately it is the confidence of the people and the markets in the underlying strength ofnational policies that really counts."

Part 1

THE ASIAN CURRENCY CRISIS: RESPONSES AND POLICY OPTIONS

LESSONS FROM THE ASIAN FINANCIAL

CRISIS, AND THE PROSPECTS FOR RESUMING HIGHGROWTH

Wing Thye Woo *

University ofCalifornia, Davis

Abstract

Broadly 'speaking, there were two initial explanations /or the

emphasized the common structural problems (soft rot) in the crisis Asian

investor panic and financial contagion In my view, the crisis was built on national weaknesses that were greatly magnified by a jlawed international financial system; the initial policy recommendations from Washington,

financial institutions, were inappropriate, and made matters worse, not befter

There was tittle particularly "Asian" about the Asian financial crisis

as the crisis spread to Russia, South Africa, and Latin America The world

regional monetary institutions

their ability to maintain and improve its competitiveness in a globalized economy Southeast Asia, in particular, is unlikely to return to the high

crisis measures, but also strives to increase its technological capacity in

10 Exchange Rate Regimes and Macroeconomic Stability order to accelerate technological diffusion to the region, and to accelerate indigenous innovation

1 INTRODUCTION

The Asian financial crisis has been as puzzling as it has been far-reaching in its consequences The sharp region-wide plunge in output after of the devaluation of the Thai baht in July 1997 was unexpected, land the strong region-wide recovery in 1999 was equally unexpected Although the W orld Bank and the International Monetary Fund have long shared a common policy framework, they were divided on the causes of the crisis, and on what the policy advice should have been given All across Pacific Asia, the crisis has brought about many fundamental changes: internationally well known conglomerates have collapsed, the banking systems are paralyzed by large amounts of non-performing loans, and barriers to entry by foreign financial institutions have been lowered

During the darkest moments ofthe Asian financial crisis in 1998, it was widely predicted that East Asia would continue to be deathly sick for the next two to four years While it is fortunate that the news of the (near) death of the East Asian miracle was greatly exaggerated, this economic earthquake remains a tragic disaster in human terms The tremendous destruction of weaIth and the pushing of a significant proportion of the population in the poorer countries to below the poverty line caused political volcanoes to erupt in several countries New governments have emerged in Indonesia, South Korea and Thailand; and the political leadership is split in Malaysia The social after-shocks of this economic earthquake were still feit during the inaugural biennial conference of the Hong Kong Economic Association in December 2000

In December 2001, with the passage of now over four years since the crisis began, we are in the position to suggest some tentative conclusions about the causes of the crisis and the appropriateness of the policy responses

to the crisis However, we feel that while we may now know enough about the nature of the Asian financial crisis to ensure that future financial crises would not inflict such severe damage again, the preventive policies that have been discussed (and ofwhich, many are being implemented) may not return the East Asian economies to their previous paths of sustained high growth The situation of the mid-income and high-income East Asian economies is that they need to become endogenous centers of growth if their previous high growth rates are to be maintained, and we think that more and better coordinated public efforts are required in order to achieve this goal This

problem appears to be particularly acute for the Southeast Asian economies

of Indonesia, Malaysia, Philippines, and Thailand

2 THE CRISIS IN HINDSIGHT

For the economics profession, the Asian financial crisis has been divisive and, for some economists, humbling The International Monetary Fund (IMF), the financial firefighter of the world, under-predicted the severity of the output collapse in every one of its pro gram countries,2 and then went on to under-predict the pace and strength of the economic recovery 3 This systematic failure in prediction by the IMF of output behavior in the crisis countries certainly suggests an institution that neither understood the cause of the region-wide crisis nor knew what the optimal rescue package for these countries should have been

It was in support of this impression of an incompetent IMF that Joseph Stiglitz, the Chief Economist at the World Bank during the crisis, wrote in April 2000:

"IMF experts believe that they are brighter, more educated, and less politically motivated than the economists in the countries they visit In fact, the IMF staff frequently consists of third-rank students from first-rate universities Quite frankly, a student who turned in the IMF's answer to the test questions

"What should be the fiscal stance of Thailand, facing an economic downturn?" would have gorten an F.,,4

The economics profession is certainly divided over the IMF's performance but not in a clear-cut fashion, however For example, among the economists who agree with Stiglitz that the first IMF pro grams that Indonesia, South Korea and Thailand were badly flawed, many would differ importantly both from his reasons for why the IMF made mistakes and from his negative assessment about the general analytical capability of the IMF The economics profession has shown uncharacteristic humility over its initial judgement of the Asian financial crisis The well-known economist, Paul Krugman, has recorded ein his website the changes in his thinking about the crisis, and we will use his intellectual odyssey as a convenient expository device to capture the evolution in the economics profession's analysis ofthe Asian financial crisis

In March 1998, Paul Krugman opined that:

12 Exchange Rate Regimes and Macroeconomic Stability

"Broadly speaking, I would say that there are two approaches

to the Asian crisis One approach - which I would identify mainly with Harvard's Jeffrey Sachs - regards what happened to Asia as basically a modern, high-tech, multicultural version of a good old-fashioned financial panic The important point to make here is that a panic need not be a punishment for your sins In principle, at least, an economy can be "fundamentally sound" and yet be subjected to a devastating run started by nothing more than a self-fulfilling rumor

"OK, as you may have guessed, I don't buy that story The story I believe argues that the preconditions for that panic were created by bad policies in the years running up to the crisis The crisis, in short, was a punishment for Asian crisis, even if the punishment was disproportionate to the crime

"What were these Asian crises? We hear now about 'crony capitalism.' It's a good phrase, and it certainly captures the spirit

of what went on in much of Asia The specific spirit that pushed Asia to the brink was the problem of moral hazard in lending -mainly domestic lending."s

Following his crony capitalism analysis of the crisis, Paul Krugman (1998a) went on to deliver a defense of the IMF policies, which had been criticized (by Jeffrey Sachs, for example) as overly deflationary He felt that the policies were justified because the IMF was not a true lender-of-Iast-resort due to its limited financial capital, and because the IMF had little choice ("the Fund must either confront crony capitalism or stay out

of the picture altogether")

However, seven months later, in October 1998, Paul Krugman (1998b) completely reversed his assessment of the crisis in an artic1e entitled "The Confidence Game: How Washington Worsened Asia's Crash." In Krugman's new awareness:

"When the Asian crisis struck, countries were told to raise interest rates, not cut them, in order to persuade some foreign investors to keep their money in place and thereby limit the exchange-rate plunge In effect, countries were told to forget about macroeconomic policy; instead of trying to prevent or even alleviate the looming slumps in their economies, they were told to follow policies that would actually deepen those slumps

" [To understand the perverse macroeconomic policy stance] consider the situation from the point of view of those smart economists who are making policy in Washington They find

themselves dealing with economies whose hold on investor confidence is fragile, The overriding objective of policy must therefore be to mollify market sentiment But, because crises can

be self-fulfilling, sound economic policy is not sufficient to gain market confidence; one must cater to the perceptions, the prejudices, and the whims of the market ür, rather, one must cater to what one hopes will be the perceptions ofthe market

"In short, international economic policy ends up having very little to do with economics It becomes an exercise in amateur psychology, which the IMF - whose top economist Stanley Fischer, boasts credentials just as impressive as those of Summers and his crew - and the Treasury Department try to convince countries to do things they hope will be perceived by the market as favorable No wonder the economics textbooks went right out to the window as soon as the crisis hit

"Unfortunately, the textbook issues do not go away The perceived need to play the confidence game supercedes the normal concerns of economic policy It sounds pretty crazy, and it is."

What led to Paul Krugman's startling apostasy? In a retrospective

piece in a September 1999 issue of Slate, Krugman (1999) asked:

"Where do I fit in? In the summer of 1998, I began to reconsider my own views about the crisis The scope of global

"contagion" - the rapid spread of the crisis to countries with no real economic links to the original victim - convinced me that IMF critics such as Jeffrey Sachs were right in insisting that this was less a matter of economic fundamentals than it was a case of self-fulfilling prophecy, of market panic that, by causing a collapse ofthe real economy, ends up validating itself."

Several papers in the August 2000 issue of the ASE AN Economic

Bulletin reached the same conclusions as Paul Krugman finally did Patrick

Damien Carleton, Brian Pilapil Rosario, and Wing Thye Woo (2000) examined the currency experiences of 57 countries in the 1970-1996 period, and found that inflationary macroeconomic policies and small stocks of foreign reserves were reliable predictors of currency collapses They found that the individual probability of Indonesia, Malaysia, Philippines, South Korea and Thailand experiencing a currency collapse in 1997 was about 20 percent, which meant that only one of these five countries should have experienced a crisis Since all five currencies (and economies) collapsed

14 Exchange Rate Regimes and Macroeconomic Stability

rather than just one as expected, it seems that financial contagion is a better explanation than weak domestic fundamentals

Wing Woo (2000) examined the movements of the risk premia levied

on Eurobonds issued by East Asia, and came to two conclusions First, the great increase in capital flows into East Asia during 1994-1996 was accompanied by a secular decline in the risk premia These price-quantity movements indicate a positive shift in the supply of funds to Asia This verification of the existence of "irrational exuberance",6 implies that the opposite phenomenon, investor panic, must also exist

Second, the risk premia on Thai Eurobonds increased by 10 basis points following the July 2, 1997 devaluation but it jumped 41 basis points upon the implementation ofthe IMF program in August 1997, see Table 1 This

is because economic agents, both domestic and foreign, could see that the drastically higher interest rates were crippling economic activities and would cause the nonperforming loan (NPL) situation in Thai banks to worsen, and hence started fleeing from financial instruments issued by Thai companies The IMF pro gram of deflationary macroeconomic policies and abrupt bank closures undermined investor confidence instead of restoring it!

Table 1 Secondary Market Spreads for Eurobonds Issued by Thailand and Indonesia (average of daily spreads, in basis points)

Anwar Nasution (2000) pointed out that it was important to cleanse the financial system of insolvent banks but the Indonesian way of doing so (in compliance with IMF conditionality) in late 1997 exacerbated the economic cnSlS The government should have taken over the running of the insolvent banks in the short-run rather than have closed them down precipitously

This way, the lines of credit to solvent borrowers would not have been disrupted, and the confidence of the depositors unperturbed

To sum up, in hindsight, we can say that:

a) investor panic was the cause ofthe Asian financial crisis/

b) tightening macroeconomic policies (particularly fiscal policy) IS an inappropriate response to panic-induced crisis; and

c) the shutting down of the insolvent banks in Indonesia, South Korea and Thailand should have been carried out in a manner that was sensitive to the possibility of triggering bank runs

3 INSIGHTS FROM THE CRISIS

There are too many valuable insights in the voluminous literature on the Asian financial crisis for us to summarize here.8 We have selected two of them for discussion here because of their wide implications for economic management The first deep insight concerns the natural working of the market mechanism, and the second deep insight concerns the broader context within which the market mechanism operates

There has long been a tradition of resistance within the economics profession to acknowledge the phenomenon of disorderly market behavior The most commonly used defense against claims of speculative bubbles is the alternative hypothesis that unstable asset prices reflect unstable government policies The claim is that observed flip-flop movements in asset prices reflected rational anticipations of changes in government policies that were not realized This defense against the speculative bubble hypothesis is known in the financialliterature as the "peso problem."

The truth is that the peso problem hypothesis cannot really be disproved, even in the case where the fundamentals, ex post, were stable for a long period of time To see the difficulty of disproving it, suppose that agents, after long experiences with governrnent behavior, have concluded that the government is the chief destabilizing force, and adjusted their financial market behavior accordingly Ifthe government were to now cease being a destabilizing force, the very fact that the behavioral norm of the government had changed fits the definition of a vacillating government! There is just

no way of getting around the sophistry of a determined peso problem believer

The fact that financial contagion has been common in the 1990's cannot

be in serious dispute: the European Exchange Rate Mechanism crisis in 1992-1993, the Mexican and Latin American financial crisis in 1994-1995, the Asian financial crisis in 1997-1998, the conversion of the Russian ruble

to a rubble in August 1998, and the collapse of the Brazilian real in January

16 Exchange Rate Regimes and Macroeconomic Stability

1999 to a more realistic level It stretches credibility, if not also the imagination, that all these governments coincidentally shifted to destabilizing policies in the same decade Herein lies the first deep insight

from the Asian financial crisis: occasional excessive price movements in

finanäal markets are normal and should not be labeled 'peso problems' in a knee-jerk fashion

The unpleasant truth is that "bad things can happen to good people" and that economic disasters are not necessarily penitence for economic sins Crony capitalism is bad regardless of where it exists but it was not the cause

of the Asian financial crisis Paul Volcker (1999), former Chairman of the Federal Reserve Board, put it very well when he wrote:

"International financial crises, I might even say domestic financial crises, are built into the human genome When we map the whole thing, we will find something there called greed and something called fear and something called hubris That is all you need to produce international financial crises in the future I have not seen anything to raise any doubts about that."

The rejection of the dogmatism of the peso problem approach to interpreting economic phenomenon leads naturally to the rejection of the dogmatism of unreflective market bias It is with this open-mindedness that Zainal-Abidin (2000) assessed the controversy over the use of capital controls in Malaysia, and found that, to be modest, one could safely say that the capital controls have not rendered the recovery in Malaysia slower than

in the other crisis countries However, if one chose to be less modest, one could point out that the 1998 collapse was in Malaysia was smaller than in Thailand and the Philippines, and that the 1999 recovery in Malaysia was faster than in these two countries Zainal-Abidin (2000) identified the chief virtues of the controls to be the monetary policy independence to reflate the economy, and the breathing room to drastically restructure the financial and corporate sectors The main cost of the controls was that Malaysia missed most of the international capital that returned to the region beginning 1998:4Q A possible cost, that is still not yet clear, may come from concerns that a similar policy could be reintroduced prior warning, hence resulting in a higher risk premium in the future for Malaysian-issued Eurobonds

The second deep insight from the Asian financial crisis is that "getting the institutions right" is just as important as "getting the prices right" if long-term stable growth is to be guaranteed There were failures in both domestic economic institutions and international economic institutions The most relevant domestic economic institution that was inadequate in

pre-1997 Asia was the prudential supervision mechanism in Indonesia, Malaysia, South Korea, and Thailand The over-borrowing of short-term foreign funds, and the collusive relationship between many domestic banks and their biggest customers rendered these economies vulnerable to exchange rate and interest rate shocks The most relevant international economic institution that proved inadequate during the Asian crisis was the IMF Its incorrect diagnosis led to wrong policy advice that worsened the recession caused by the interaction of investor panic, excessive unhedged short-term external debt, and fragile balance sheets ofthe domestic banks The sad case of Indonesia, which experienced a larger output loss and a slower recovery compared with its neighbors, suggests that economic viability depends on political institutions as weIl The Indonesian outcomes could arguably be seen as more the results from a flawed political system rather than as the results from a flawed economic system In the three-decade long rule of Soeharto, he relied upon satisfactory economic growth as the justification for his stewardship of the country Regularization of the political process was neglected because Soeharto recognised such regularization as a reduction in his power So instead of establishing political institutions and channels to resolve important socio-political issues about regime legitimacy, political succession, administrative transparency, regional concerns, ethnic disputes and religious tensions, Soeharto resorted to political manipulation, co-optation, and occasional violence to minimize discussions of these issues The result is that beneath the fa<;ade of stable rule buttressed by support from the armed forces, social dissatisfaction with the Soeharto regime was rising in step with the expansion of the middle and professional classes, and in step with the growth of special economic privileges to Soeharto's children, e.g subsidised loans from state banks, and monopoly import licenses

As Soeharto entered into his seventies, and as his health showed signs

of decline, the tensions associated with political succession became impossible to contain, and fissures within the army appeared The fissures multiplied and widened when Soeharto promoted his son-in-law, General Prabowo Subianto, over several more senior generals to be the head of the most powerful military command based in Jakarta (Kostrad) the post that Soeharto held when he made his bid for political power in 1965 Soeharto's increasingly tendency toward an "all-in-the-family" approach to economic and political matters discredited hirn considerably within his core constituencies, the army and the bureaucracy Once the Asian financial crisis revealed that the aging Soeharto had become an incompetent manager, there was massive withdrawal of political support by the upper and middle classes, and factionalism within the army and the civilian bureaucracy spun out of control The Indonesians, unlike the Malaysians, the South Koreans

18 Exchange Rate Regimes alid Macroeconomic Stability

and the Thais, did not have the option of expressing their outrage at gross incompetence through the ballot box, and so they expressed their outrage in the only form available to them a social explosion that deepened and prolonged the economic meltdown

The Indonesian experience is consistent with the controversial hypothesis that socio-political development must accompany economic development in order to maintain social stability, a primary prerequisite for continued economic growth If the hypothesis is true, then the political transition away from 'strongman rule' that had occurred in South Korea and Taiwan must also occur in the remaining authoritarian states in Bast Asia where democracy has been slighted as a mechanism for resolving social tensions The case for the expansion of democratic political institutions is thus based not only on moral ground but also on pragmatic, long-term economic considerations A specific implication of this disturbing hypothesis is that continued political stability in China will require the fourth generation of leaders that will assume power in 2002 to continue introducing creative reforms to co-opt the emerging new social forces, a process that entered into a new phase in 2001 when Jiang Zemin proposed that capitalists

be permitted to join the Communist Party of China

We have so far mentioned only a subset of the institutions that have to

be appropriate and in place in order to promote economic growth The efficient working of the market mechanism necessitates the presence of infrastructural institutions like modem corporate governance; well-defined, transparent bankruptcy procedures; protection of intellectual property rights; and prudential supervision of the financial sector Furthermore, only if an efficient, objective legal system is already firmly in place, can democratic political institutions and the infrastructural institutions of the market work to their full potential

To summarise, because the severity of the output collapse was caused

by external and internal factors (like instability in the behavior of international banks and inadequate prudential supervision of domestic banks), it is optimal that reforms be implemented at the international level as well as at the country level Countries should go beyond just increasing their individual resilience to external shocks to acting in concert to restructure the international environment that created the shocks and exacerbated their effects

4 THINKING LOCALLY, AND ACTING GLOBALLY

The first required action on the international front is for the United Nations to immediately constitute a working group on international capital

flows, including representatives of the developed countries, the developing countries, the major international institutions as weH as private-sector observers, to report, within one year, on improvements in the oversight and regulation of cross-border capital flows The working group should develop, in conjunction with the Bank of International Settlements (BIS), new prudential ratios that are appropriate for the volatile conditions of emerging markets; and, a more timely and more informative reporting system of cross-border lending, hedge fund activities, and derivatives transactions The working group should also develop, in conjunction with the largest international accounting firms, global accounting standards for financial institutions

The second required action is to restructure the IMF to improve its performance, and to limit the scope of its activities Grave flaws in the IMF's procedures and policy recommendations are obvious from the failure

of each of the IMF' s major packages in 1997-1998 to meet its targets; and from the fact that many of the programs (for example, Korea, Russia, and Brazil) collapsed within weeks of their approval It is very significant to note that the default premium for Thai Eurobonds started rising dramatically only after the signing of the IMF adjustment package on August 5, 1997 The IMF package of closing many finance companies abruptly to restructure the financial sector in order to restore growth, and, of raising interest rates to defend the exchange rate produced exactly opposite to what was intended Output and the baht plunged much more than anticipated by the IMF, see Lane, et al (1999)

It is hence quite incredible that the IMF then went on to apply the same failed programs to Indonesia in October 1997 and Korea in December 1997, producing the same disastrous results in both cases The IMF had not only exceeded its technical competence in its handling of the Asian financial crisis, it had also, as pointed out by Feldstein (1998), exceeded the mandate given to it by the international community There was just no need to insist

on eliminating domestic subsidies, and terminating monopolies in order to improve the balance of payments situation for a country This microeconomic restructuring of pro gram countries is tantamount to intrusion into the internal politics of a country We therefore welcome the recent establishment of an external board to review the IMF's policy advise to developing countries, and the IMF's structural adjustment programs in the poorest countries

Reform of the IMF should also include amending the IMF voting powers to give greater representation to developing countries, which, after all, constitute eighty-five percent of the world's population, and which bear the burden of failed IMF strategies The functioning of the IMF Executive Board should be over-hauled, including: public hearings; opportunities for

20 Exchange Rate Regimes and Macroeconomic Stability

outside parties to submit evidence to the Board; and solicitations of professional opinions by the Executive Board from beyond the IMF staff The third required action is to end monopoly position of the IMF as the sole international arbiter of monetary affairs There is no justification for its present monopoly status because the IMF is not (and cannot) be a true international lender of last resort An Asian monetary fund would reflect the pragmatic dictum that one should always seek a second opinion when it comes to considering a major operation on the economy It has been claimed that the existence of two lenders (monetary funds) would result in competitive lending that would cause both lenders to weaken their conditionalities This point cannot be correct however as long as the regional fund is not set up to lose money With explicit incentives for responsible financial fiduciary, the Asian monetary fund would be interested only in diagnosing the economic situation correcdy than in automatically assuming a position opposite to that of the IMF in order to show its independence

The Association of Southeast Asian Nations (ASEAN) has agreed to explore the possibilities of mutual surveillance and pooling of foreign reserves to head off financial contagion We recommend that this ASEAN initiative be supplemented by a reorientation of the functions of the Asian Development Bank (ADB) ADB should cut back on a large part of its traditional function of infrastructure financing (which has been rendered obsolete by the globalization of financial markets) and focus more on the activities of a monetary fund

The fourth required action on the international front is to establish an international bankruptcy system to accelerate an orderly workout of international debts when a developing country falls into an extreme indebtedness crisis This means that debt relief often needs to be an integral component of "rescue" packages in order to encourage creditor-debtor bargains to stretch out loans, convert debts to equity, and occasionally a permanent write down of claims Private creditors should bear the major burden for renegotiating the timing and repayment terms on existing debts when a financial crisis emerges After all, the over-Iending

by international banks enabled the Asian financial crisis

Since it will clearly take an extended period to establish an international bankruptcy court, even if there is political consensus internationally to do so, Barry Eichengreen' s (1999) proposal of setting up "standing committees of creditors" is an excellent stopgap measure The introduction of other standard procedures in domestic bankruptcy proceedings like the automatic stay provision (to prevent grabbing of assets before resolution of bankruptcy in domestic court), and the debtor in possession provision (to enable the firm to continue to obtain working credit while the domestic

bankruptcy process takes place) - into the writing of contracts for Eurobonds would be a great improvement over the present situation

5 PUTTING OWN HOUSE IN ORDER

Governments must enhance their supervision of all financial institutions, and enforce BIS-style prudential ratios on the financial institutions Financial institutions should be required to quickly adopt intemationally accepted accounting standards, and to file more frequent reports on their portfolios and their exposure to sectoral and currency risks, in order to allow better oversight by shareholders and the regulatory bodies The ownership structure of the banking sector in emerging economies should be diversified

to include foreign ownership, in order to reduce the risks of systemic banking collapse, and to generate demonstration effects to the domestic banks regarding efficient operations and prudent risk management

Institutional reform beyond the financial sector include ensuring a well-defined, transparent, fast-functioning bankruptcy system that could handle many cases of debt workup in an orderly fashion; an incorruptible, efficient judiciary process for commercial disputes; and a corporate govemance system where the rights of the minority shareholders are protected These three mechanisms are absolutely crucial for preventing capital flight ("asset grabbing") when firms show signs of financial stress There is unlikely to be a single exchange rate regime that is optimal for all countries, or maybe even for any country over time The optimal exchange rate regime depends at least on the economic structure, type of shock, and societal preferences over tradeoffs among outcomes like unemployment, inflation, and income distribution From the viewpoint of discouraging speculative attacks on a currency, the ultimate solution would

be dollarisation because then there would no longer be an exchange rate to defend A credible currency board arrangement would also achieve this objective and, at the same time, allow the country to collect an interest income on its foreign reserves The problem, however, is how to maintain the credibility of a permanent peg because even the Hong Kong dollar was attacked during the Asian financial crisis

The interesting part of the Hong Kong experience is that it demolishes the conventional depiction of the currency board being a passive intermediary that swaps the Hong Kong dollar for the U.S dollar on demand, and vice-versa In August 1998, the Hong Kong Monetary Authority (HKMA) defended the currency peg by taking an open position against the speculators by undertaking large-scale purchases of domestic equities The dominant verdict about this unconventional intervention by HKMA is that it

22 Exchange Rate Regimes and Macroeconomic Stability

broke the speculative attack and restored order to the financial markets The unambiguous message from this episode is that a currency board has to

be ready to sometimes implement extraordinary measures in order to convince the market about the credibility of the peg Although the 1998 episode may not be enough to definitively falsify the alleged virtue of the currency board being an automatic foolproof mechanism that works best when left alone, at the minimum, it certainly shows that leaving this mechanism on automatic pilot can result in very high interest rates for a much Ion ger period

The more general and more important point is not whether a currency board can survive any speculative attack at all but the cost of surviving such

an attack Take the case of a drop in foreign demand that requires the real exchange rate be depreciated in order to preserve external equilibrium Since the nominal exchange rate is fixed, domestic prices would have to decline, and a decline in the general price level is usually accompanied by a temporary increase in unemployment This reasoning implies that the ideal candidate for a currency board regime is a country with very flexible labor markets and flexible product markets Under a currency board, countries with wages that are set by long-term contracts, which are indexed against inflation, are likely to suff er prolonged unemployment when an adverse negative shock OCCUfS

The theoretical predictions just discussed are borne out by recent experience The predicted tradeoff (generated by a negative external shock) between exchange rate depreciation and price deflation is supported when

we compare Hong Kong and Argentina two economies with CUrrency boards with Singapore and Brazil respectively, see Table 2 In response

to the competitive gains of most East Asian and Latin American economies from the 1997-1999 depreciation of their currencies, the consumer price indices of Hong Kong and Argentina have declined continually in the 1999-2001 period, and are predicted to decline further in 2002 ifthe nominal pegs are maintained The output consequences of the price deflation in Hong Kong and Argentina are also in accordance with oUf theoretical priors: Hong Kong, famous for its economic flexibility, had positive growth in 1999-2000, while Argentina, well-known for its economic sclerosis, had negative growth in 1999-2000.9

The experiences ofthe fOUf countries in Table 2 supports the wisdom of depreciating the CUrrency in response to negative external shocks - whether real or financial The negative capital account shock of 1997-1998 caused output in Hong Kong and Brazil to decline in 1998, and output in Argentina

to decline in 1999-2000, but the negative capital ac count shock did not cause output to decline in Singapore in the 1998-2000 period The difference between Singapore and these other three countries is that Singapore

depreciated its currency alm ost 20 percent between July 1997 and December

1998, and these other countries had no, or very little, devaluation.10

Table 2 Comparison of Growth and Inflation under Currency Boards and Adjustable Pegs

projected projected

1996 1997 1998 1999 2000 2001 2002 HongKong

GDP growth, % 4.5 5.0 -5.3 3.0 10.5 -0.2 2.6 CPI growth, % 6.4 5.7 2.8 -4.0 -3.8 -1.5 -0.9 Units ofDomestic 7.73 7.74 7.75 7.76 7.79 7.80 7.80 Currency per US$

Singapore

GDP growth, % 7.6 8.5 0.1 5.9 9.9 -3.4 -0.5 CPI growth, % 1.4 2.0 -0.3 0.0 1.4 1.1 0.9 Units of Domestic 1.41 1.49 1.67 1.70 1.72 1.79 1.78 Currency per US$

Argentina

GDP growth, % 5.5 8.1 3.8 -3.4 -0.5 -2.2 -1.0 CPI growth, % 0.2 0.5 0.9 -1.2 -0.9 -0.8 -0.6 Units ofDomestic 1.00 1.00 1.00 1.00 1.00 1.00 1.00 Currency per US$

Brazil

GDP growth, % 2.8 3.2 -0.5 0.8 4.2 1.6 2.0 CPI growth, % 15.8 6.9 3.2 4.9 7.0 6.7 6.5 Units ofDomestic 1.01 1.08 1.16 1.81 1.83 2.40 2.88 Currency per US$

CPI = consumer price index

Data are from the relevant country reports of the Economic Intelligence Unit (EIU) The projected numbers for 2001 and 2002 are from the November 2001 issues

When the negative export shock from the V.S recession hit the

em erging markets in 2001, only Brazil had positive growth that year, and it

is noteworthy that Brazil was the on1y economy that had significant currency depreciation that year.ll Because Argentina maintained its currency board system despite the pro10nged recession and sustained capital flight, the new negative export shock in 2001 brought the economic crisis in Argentina to a higher level With the unemployment rate at almost 17 percent, and with bank deposits nearly 20 percent lower than a year ago, Argentine depositors started bank runs in 1ate November 2001 On December 1, 2001, the government limited cash withdrawals to $250 a week for three months, mandated that travelers cou1d only take up to $1,000 out of the country, required that new bank loans be in U.S dollars, and ordered banks to pay 10wer interest rates on Peso-denominated deposits than on VS$-denominated

24 Exchange Rate Regimes and Macroeconomic Stability

deposits.12 The last two steps put Argentina on the road to dollarisation This crisis shows no signs of resolution as this chapter is going to press One natural question is whether Argentina can (or, will) follow the HKMA example of taking an open position opposite to that of the speculators, and hence calm the financial markets We think the reason why Domingo Cavallo, the Argentine Economy Minister, has not already mounted a HKMA-style rescue operation is that it was unlikely to have worked Unlike Hong Kong, the public finance of the Argentine state is in poor shape and getting worse, and the Argentine state is a net debtor to its own citizens and to the rest of the world Since Argentina does not even have the means to service its external debt, Argentina certainly does not have enough financial resources to convince speculators that they could not break the peg Herein, we may have an important reason for why HKMA was able to calm the currency markets in August 1998 The survival of the Hong Kong currency board was due not to the HKMA intervention being bold, unconventional, and unexpected, but to its large financial resources, and to the perceived readiness of China to commit its enormous reserves to defending the Hong Kong dollar

It is now alm ost conventional wisdom that, with open capital accounts, the choice of exchange rate regime is constrained by the corner solutions of a hard peg (e.g dollarisation, currency boards) or a free float The key hypothesis behind this bipolar view is that the combination of an explicitly adjustable peg regime and an open capital account makes the currency a tempting target for speculators, and is hence unviable in the long run This hypothesis has its basis in the observed "hollowing out of the middle of the

distribution of exchange rate regimes, with the share of both hard pegs and floating gaining at the expense of soft pegs" (Fischer, 2001, pp 22) Given this new intellectual background, and given the obvious preference of the four Asian crisis countries for a predictable exchange rate as evidenced

by the pre-crisis fixity of the Thai, Malaysian, and South Korean (in declining order of the hardness of the peg) currencies, and the crawling peg

of the Indonesian Rupiah, it is quite surprising that none of the four Asian crisis countries has adopted the currency board system in the wake of the cnSlS We suspect that the special circumstances behind the survival ofthe currency board in Hong Kong may have contributed to why none of these four countries have embraced the currency board arrangement

The post-1998 exchange rate management in the four Asian crisis countries appears to support the "corner solution" perspective Compared

to the pre-crisis period, Indonesia, South Korea, and Thailand have been allowing their currencies to move more freely in response to foreign exchange market pressure These three countries still intervene substantially occasionally because they see the shallowness of their foreign

exchange rates as a cause of excessive exchange rate volatility Malaysia is the only country that has returned to an adjustable peg, but it has done so with a significant difference from the pre-crisis situation, Malaysia now stands ready to re-impose capital controls to defend the peg

Given the increasing applicability of the bipolar view of viable exchange rate regimes, and the special circumstances of Hong Kong that have made its output performance so different from that of Argentina, we think that the typical emerging economy should in general pursue flexible exchange rate arrangements (e.g wide crawling bands, open floats) Flexible exchange rates will reduce the severity of capital flight because investors who panic and wish to send their funds out must now take into account that their actions could drive down the value of the currency and reduce the amount of foreign exchange that they would receive

We do not, however, equate flexible exchange rates with the withdrawal of the state from capital account management We in fact recommend that governments reduce short-term capital inflows through a combination of capital controls and taxes on capital inflow (e.g a Tobin tax) Short-term foreign borrowing by domestic banks should be tightly limited as

a matter of prudential policy But while controls on short-term capital inflows may be advisable in many countries, we hold that controls on capital

undermine government credibility and provide an inducement towards irresponsible policies

As a practical operational rule, the government should always maintain foreign reserves that exceed the amount of outstanding external short-term debt This operational rule is important because if the external short-term creditors do panic, the country will be able to pay them off and hence avert a more general panic.13 The first corollary of this rule is that a country should impose controls to limit the amount of external short-term debt to the size of its foreign reserves The second corollary is that a country should stop defending its exchange rate with sales of foreign exchange when its foreign exchange reserves stock has fallen to the level of its external short-term debt Its policy options at that point could be a combination of actively encouraging the reduction of external short-term debt, float the currency or defend the currency by other means

The suggestions that we made above about exchange rate management cannot be immutable to vast changes in international economic and political relations For countries that wish to forge even deeper economic integration among themselves in the form of a free trade area, then coordinated exchange rate management becomes desirable Ifthe free trade area were to advance to an economic union with free labor mobility and greater institutional harmonization, then a common currency could be the

26 Exchange Rate Regimes and Macroeconomic Stability

optimal form of exchange rate coordination And, if eventual political integration were the common goal, then the existence of a common currency would promote this political agenda

6 THE PROSPECTS OF RETURNING TO

in Southeast Asia Southeast Asia needs to have an additional engine of growth if it is to continue to grow at 7 percent a year

In order to see what the new engine of growth for Southeast Asia ought

to be, we must recognize the centrality of technological changes in long-term economic growth.14 Robert Solow has shown that, conceptuaIly, the only way for GDP per capita to keep on increasing is through continual technological improvements, and that, empiricaIly, the bulk of the increase

in GDP per capita can be attributed to technological improvements If we look at Asia, we see that with the exception of Japan, Taiwan and Korea, the technology that Southeast Asia has been using has been developed outside of the region Southeast Asia must do what Japan, Korea and Taiwan have succeeded doing

This transition to endogenous growth is a difficult thing to accomplish, however Most of technological innovation is concentrated in only a few countries: the top 10 countries account for 90% of the patents in the world, and the top 20 countries account for 99% of the patents The world can be divided the world into 3 types of countries according to technical capacity: a) the technologicalleaders, which are 20 countries that have 12% of the world's population,

b) the technology users like China, and Southeast Asia, which have 50% ofthe world's population,

c) the technologically excluded, which encompass Africa and the poorest Asian countries, and have about one-third ofthe world's population

There are two ways for a country to enhance its technological capacity and get new cutting edge technology The first way is to have the ability to innovate indigenously The second way is to have the ability to obtain technology transfer from elsewhere, e.g technological diffusion via foreign

direct investment The Global Competitiveness Report 2000 published by

the World Economic Forum has an overall ranking of 59 countries according

to technological capacity This technological capacity index is determined

by averaging two other indices, the "indigenous innovation index" and the

"technology transfer index."

It is instructive to see the national ranking in the two component indices and in the overall technology index Southeast Asia refers to the averaged ranking of Indonesia, Malaysia, Philippines, and Thailand

Indigenous Innovation Index USA

Finland Germany Switzerland Japan Singapore Taiwan South Korea HongKong Southeast Asia

Ireland Luxembourg Taiwan South Korea HongKong Southeast Asia

USA Finland Singapore Ireland Germany Japan Taiwan

Overall Technology Index

Korea HongKong Southeast Asia

28 Exchange Rate Regimes and Macroeconomic Stability

Southeast Asia clearly has a lot of work to do in enhancing its technological capability Of course, the growth rate of a country depends

on a number of other important factors beside technological capacity For example, the story of the Soviet Union is the story of world-class accomplishments in basic scientific research but of abysmal performance in applied scientific research, and, hence, in overall economic growth The fundamental problem in the former Soviet Union was the absence of a market economy, which meant that there were grossly inadequate incentives

to mobilize people to translate basic research into commercial applications For market economies, factors like economic openness, adequacy of infrastructure, efficiency and incorruptibility of the government, quality of financial institutions, and astuteness in macroeconomic management are of fundamental importance in economic growth The general low ranking of Southeast in these other dimensions along with its low ranking in technological capacity help explain why it has performed quite poorly in the final index for growth competitiveness for the 59 countries The high rankings that Hong Kong has in these other dimensions (e.g 1 in trade openness, 4 in sophistication of financial markets) boosted its overall ranking despite being ranked 30 in technology level Specifically:

Growth Competitiveness Index in 2000

Average ofthe Southeast Asia 4 34

Clearly, while Southeast Asia should boost its technological capacity by focusing on applied research, it also needs people at the frontier of research

It means that there should be more investment in higher education and not in airplane factories The establishment of linkages between the universities

and the business sector should be fostered, and the establishment öf state-owned factories be stopped

We should be clear that our suggestion that aggressive technology policies be adopted in Southeast Asia is compatible with our acceptance of the comparative advantage principle, and the importance of pursuing market-compatible economic policies When the inherited factor endowment of a country consists largely of unskilled labor, it is indeed a mistake to use industrial policies to ensure that the chief export of the country is technology-intensive goods It is not amistake, however, to use policies to increase human capital formation and to enhance technology transfers from abroad so that the country will begin to export more goods that are technology-intensive It would require a simplistic ideological view of what's a laissez-faire economy in order to ignore the US$90 billion

in the US government budget that's targeted to increase the technological capacity of the United States

NOTES

* This paper is based on the presentations at the Panel on Monetary Issues in the Asia Pacific Region, and the Panel on New Challenges and Opportunities in Asian Economic Development during the inaugural biennial conference of the Hong Kong Economic Association held on December 14-16, 2000 This paper draws upon ongoing work of the Asian Competitiveness Project of the East Asia Program at the Center for International Development, Harvard University I am most grateful to Professor Ho Lok Sang for his insightful comments on an earlier draft

I For example, see the empirical investigation in Woo, Carleton and Rosario (2000)

2 Lane, Ghosh, Hamann, Phillips, Schulze-Ghattas and Tsikata (1999), and IMF (1997)

3 IMF (1998)

4 Stiglitz (1999)

5 Krugman (1998a)

6 A term coined by Alan Greenspan in December 1996 to describe the U.S stock market

It is important to note that assumption of rational expectations (in the Muthian sense of model-consistent expectations) does not rule out the possibility of speculative bubbles, see Woo (1987) for a discussion of several types of rational bubbles, and empirical evidence oftheir existence

7 A point also made by Montes (1998), McKibbin (1998) and Chang (1999)

8 See, for example, Delhaise (1999), Eichengreen (1999), Garran (1998), Jomo (1998), McLeod and Garnaut (1998), Woo, Sachs and Schwab (2000) and World Bank (1998)

9 Note that the immediate lowering of inflation in 1998 and the much larger price deflation in Hong Kong compared to Argentina in 1998-2001 supports the conventional view that Hong Kong has more flexible markets than Argentina Part of the larger price deflation in Hong Kong, especially in 1998, could be due to the depressing effect of the Tenant Purchase Scheme (introduced in December 1997) on house prices, see Ho (2001)

30 Exchange Rate Regimes and Macroeconomic Stability

10 Brazil recovered after it devalued in early 1999, and Hong Kong's deep deflation - a reflection of its structural flexibility was able to induce recovery

11 Singapore would most likely still have experienced a recession in 2001 even if it had depreciated its currency by the same amount as Brazil This is because the negative export shock was focused on semiconductors, and they dominated Singaporean exports but not Brazilian exports This difference in export structure also explains why Singapore's recession is so much more severe than Hong Kong's

12 "Argentina Restricts Bank Withdrawals," Washington Post, December 2, 2001; "Last Tango: Long Hailed as Hero, Reformer in Argentina Sees His Dream Sour," Wall Street Journal, December 4,2001; and "Argentine Economy Minister Tries to Maintain Optimism," New York Times, December 6,2001

13 This may explain the extremely high statistical significance of the (short-term debt/reserves) variable in predicting financial crisis in all the probit specifications estimated in Radelet and Sachs (1998)

14 We are not denying that an important key to maintaining economic success is for a country to tighten its belt to raise its saving rate and increase the rate of capital accumulation A high saving rate is a good thing to have However, we know from the Nobel prize winning theoretical analysis of Robert Solow that a higher saving rate will raise the long-run GDP per capita, but this long-run GDP per capita will stay at this new level and not increase any further unless the saving rate is raised continually The point is that each saving rate is associated in a positive relationship with a particular level of steady-state GDP per capita

Garran, Robert, 1998, Tigers Tamed: The End ofthe Asian Miracle, University ofHawaii

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International Monetary Fund, 1998, World Economic Outlook and International Financial Markets: Interim Assessment, December

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The New Republic, October 5

Krugman, Paul, 1999, "Capital Control Freaks: How Malaysia Got away with Economic Heresy," Slate, September 27; also posted on http://wed.mit.edu/krugmanlwww/

Lane, Timothy, Atish Ghrosh, Javier Hamann, Steven Phillips, Marianne Schulze-Ghattas and

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December

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Lessons," ASEAN Economic Bulletin, Vol 17, No 2, August, pp 148-162

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Volcker, Paul, 1999, "A Perspective on Financial Crises," in Jane Sneddon Little and

Giovanni Olivei (ed.) Rethinking the International Monetary System, Federal Reserve

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Vol 17, No 2, August, pp 120-134

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August, pp 135-147

There are three central questions that I want to address today The

first is what is the role of monetary policy in economic performance and

of monetary policy in response to the Asian Financial Crisis was worse than ineffective: it exacerbated the economic downturn and, worse still, contributed to global economic instability

Second, I want to go from this description of what was wrong with the

economy of the crisis, trying to understand the behavior of the institutions responsible for formulating the policies I would argue that we have spent too little time thinking about the behavior of the international economic and financial institutions, given the important role that they play today in the global economy

I am going to argue that the IMF changed the mandate from Keynes' original conception Keynes was one of the conceptual founders of the IMF

He believed, or at least hoped, that such an institution would contribute to global stability, not to global instability What I am going to argue is that it has changed its mandate from focusing on global financial stability and providing liquidity to countries facing economic downturns-in order to sustain their economy at as dose to full employment as possible-to pursuing an agenda that reflected the special interests of the financial community In its worst manifestation it has become-if not the bill collector of the advanced industrial countries-an institution at least to enhance the likelihood that the creditors will be repaid How do we explain