Exchange rate policies and crises
The severe financial crises that many emerging market economies experienced in the last decade have been attributed to many causes. One common contributing factor was the attempt to maintain “soft” pegs—exchange rates pegged in value to some other currency or basket of currencies, with some commitment by the authorities to defend the peg, but with changes in the rate possible if the exchange rate came under significant pressure. In the context of increased integration with international capital markets, it was argued, only the polar extremes—floating or fixed exchange rates supported by very strong commitment mechanisms (“hard” pegs)—can be sustained for extended periods.
Among the crises of the 1990s, the Asian financial crisis of 1997–98 played a key role in forming the perception of a vanishing middle ground for exchange rate regimes in emerging market countries. Before the crisis struck, the five Asian economies had actively managed their exchange rates, partly to promote their competitiveness—something they saw as an important ingredient in their “miraculous” economic performance. The crisis forced all of these countries to abandon their de facto exchange rate pegs, and the subsequent floats of their currencies were associated with very sharp declines and fluctuations in their values. Thus, argued analysts, if economies with exceptional macroeconomic fundamentals could not successfully manage their exchange rates in a more financially integrated world, surely other developing countries faced even bleaker prospects.
Same old policies?
More recently, however, doubts have arisen about postcrisis exchange rate policies. Several observers have suggested that these countries may have reverted to exchange rate practices similar to those of the precrisis period, in an effort to stabilize the values of their currencies against the U.S. dollar, without adopting any of the strong commitment mechanisms called for by a “hard” peg. The worry among such observers is that, in view of the vanishing scope for “soft” peg arrangements with greater international financial integration, resuming such practices may make the former crisis countries vulnerable to a repetition of the events of 1997–98. According to this view, these countries should opt for one of the extreme or polar currency arrangements that their own experience (and that of others) suggests are the only viable options if they are to remain highly integrated with world capital markets.
More flexible now?
In terms of the official IMF classification, postcrisis Indonesia, Korea, and Thailand moved to more flexible exchange rate regimes, while Malaysia moved in the opposite direction. Only the Philippines retained its precrisis exchange rate regime, classified as “independently floating.”
But a problem with classifying exchange rate arrangements is the difficulty of measuring a country’s commitment to a “soft” peg. The study asserts that commitment can be gauged in terms of the observed volatility of financial variables, such as exchange and interest rates, and changes in stocks of foreign reserves. The empirical results suggest that de facto exchange rate regimes in all five countries changed after the crisis. While no country adopted a “soft” peg with unfettered capital movements, there was no movement either to the extreme (or corner) solutions of “hard” pegs and clean floats.
In other words, these countries continued to manage their exchange rates in an active manner and thus continued to occupy the supposedly vanishing hollow middle of exchange rate policy. The study shows that—with the exception of Malaysia, which fixed its exchange rate and adopted capital controls—these countries allowed greater flexibility in their exchange rates after the crisis. However, they did not float to the same extent as the industrial countries, such as Germany (against non-EMU currencies), Japan, and the United States. The evidence shows that Indonesia, Korea, Thailand, and the Philippines both intervened in foreign exchange markets and used monetary policy to influence their exchange rates (see chart, this page).
Possible objectives of the policies
What were the postcrisis objectives of these countries? Hernández and Montiel maintain that, while the monetary authorities may have intended to smooth high-frequency exchange rate fluctuations, this could not have been their only objective. In addition, the systematic accumulation of reserves after the crisis suggests that, consistent with their long-term (export-oriented) development strategies as well as with their short-term need to reactivate their economies, they may have been trying to moderate the appreciation of their real effective exchange rates after the overshooting associated with the crisis, and seeking to accumulate a “war chest” of reserves for possible future use in defending the exchange rate (see chart, page 58).
According to the authors, the postcrisis exchange rate policies of the five countries had three common features: limited flexibility, resistance of real exchange rate appreciation, and reserve accumulation.
Evaluating the policies
The total policy packages in these countries, Hernández and Montiel observe, have been credible and perceived by the markets as sustainable. For the four countries that moved from “soft” pegs toward the flexible end of the exchange rate spectrum, allowing greater flexibility had a significant potential benefit in the postcrisis period: the absence of any explicit or implicit commitment to an exchange rate peg most likely discouraged “one-way bet” speculation by creating uncertainty about the future course of the exchange rate. At the same time, some degree of exchange rate smoothing may have helped anchor market expectations about the path of the exchange rate, which may have been particularly helpful in these countries that had recently emerged from a crisis. Thus, the authors explain, the limited exchange rate variability allowed by the four “floaters” may have represented an attempt to strike a compromise between desirable but potentially conflicting objectives in the postcrisis context.
Unlike the other countries, Malaysia opted for exchange rate stability, forgoing the objective of flexibility. If an intermediate solution within the hollow middle was chosen by the other countries, why was the same choice not made by Malaysia? The authors believe Malaysia’s choice was related to its decision not to request assistance from the IMF. Given the potential adverse effect on market sentiment of such a decision, the country may have faced a much less favorable flexibility-stability trade-off than other countries in the region.
Asian crisis countries more flexible but not like some industrial countries
Data: Authors’ calculations
Hernández and Montiel also suggest that reserve accumulation may be an important component of a natural transition to a new regime of floating exchange rates. One reason why some countries maintain large stocks of reserves is the “original sin”—the inability of agents in these economies to borrow externally in their own currencies. However, that accumulation may be a substitute for other measures (such as institutional reforms and corporate restructuring) that these countries need to take. To the extent that these measures have been absent and/or remain incomplete, reserve accumulation is best interpreted, the authors argue, as a second-best transition strategy.
Asian crisis countries built up reserve “war chest” in postcrisis period
Classifying the regimes
After looking at the five Asian crisis countries, the authors conclude that the simple classification of exchange rate regimes into “hard” pegs, “soft” pegs, and “floating” is a fiction. In practice, exchange rate regimes vary along a continuum. The crisis simply tended to propel the countries involved toward more flexibility in the postcrisis period. But this move was not uniform across the region:
Malaysia moved in the direction of greater fixity and less integration with world capital markets.
Korea and Thailand maintained or increased their integration with world capital markets and moved toward greater flexibility, but not to the pole of pure floating.
Because of domestic political uncertainties, it is not so clear that the Philippines and Indonesia truly moved into a postcrisis period during 1999-2000. But relative to the precrisis period, both countries have altered their exchange rate regimes in the direction of greater flexibility.
Lessons for other countries
Hernández and Montiel draw one tentative lesson: the middle ground between floating and a “hard” peg is probably smaller, but it still exists. It is smaller since it is far more difficult for financially integrated countries to sustain “soft” pegs, simply because capital markets will not allow domestic policy mistakes to go unpunished. But it still exists because a wide range of intermediate regimes may be both feasible and desirable, depending on country circumstances. Specifically, under postcrisis conditions, if the fragility of domestic balance sheets rules out “hard” pegs as an option (because of the strains caused by the high interest rates needed to defend the peg), the authors conclude that a dirty float designed to resist real appreciation and allow the accumulation of reserves may be more appropriate than the polar extreme of clean floating.
Copies of IMF Working Paper 01/170, Postcrisis Exchange Rate Policy in Five Asian Countries: Filling in the “Hollow Middle”?by Leonardo Hernández and Peter Montiel, are available for $10.00 each from IMF Publications Services. See page 58 for ordering information.