Economic and Financial Crises in Emerging Market Economies

The University of Chicago Press

Copyright © 2003 National Bureau of Economic Research
All right reserved.

ISBN: 978-0-226-24109-8

Chapter One

Exchange Rate Regimes

1. Sebastian Edwards 2. Domingo F. Cavallo 3. Arminio Fraga 4. Jacob A. Frenkel

1. Sebastian Edwards

Exchange Rate Regimes, Capital Flows, and Crisis Prevention

1.1.1 Introduction

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 to propel stock market booms and to finance large current account deficits. At some point, and for a number of reasons, these funds slowed down 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 countries 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 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 crisis 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 (Summers 2000). Second, a number of analysts have argued that the imposition of capital controls-and in particular controls on capital inflows-provides an effective way to reduce 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 1.1.2 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: (a) the role of nominal exchange rates as nominal anchors; (b) the costs of real exchange rate overvaluation; (c) strategies for exiting a pegged exchange rate; and (d) the death of middle-of-the-road exchange rate regimes as policy options. In section 1.1.3 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 1.1.4 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 is 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 1.1.5 contains some concluding remarks.

1.1.2 Exchange Rate Lessons from the 1990s Currency Crises

The currency crises of the 1990s have led economists to rethink their views on exchange rate policies in emerging countries. Specifically, these crises have led many economists to question the merits of pegged-but-adjustable exchange rates, both in the short run-that is, during a stabilization program-and in the longer run. Indeed, the increasingly dominant view among experts is that, in order to prevent the recurrence of financial and currency crises, most emerging countries should adopt either freely floating or super-fixed exchange rate regimes. In this section I discuss the way in which policy thinking on exchange rates in emerging countries has evolved in the last decade and a half or so.

Nominal Anchors and Exchange Rates

In the late 1980s and early 1990s, and after a period of relative disfavor, rigid nominal exchange rates made a comeback in policy and academic circles. Based on time-consistency and political economy arguments, a number of authors argued that fixed, or predetermined, nominal exchange rates provided an effective device for guiding a disinflation program and for maintaining macroeconomic stability. According to this view, an exchange rate anchor was particularly effective in countries with high inflation-say, high two-digit levels-that had already tackled (most of) their fiscal imbalances. By imposing a ceiling on tradable prices, and by guiding inflationary expectations, it was said, an exchange rate nominal anchor would rapidly generate a convergence between the country's and the international rates of inflation. This view was particularly popular in Latin America and was behind major stabilization efforts in Argentina, Chile, and Mexico, among other countries. According to this perspective, a prerequisite for a successful exchange rate-based stabilization program was that the country in question had put its public finances in order before the program was implemented in full. This, indeed, had been the case in Chile in 1978-79 and Mexico during the late 1980s and early 1990s, when the so-called Pacto de Solidaridad exchange rate-based stabilization program was implemented (see Edwards and Edwards 1991; Aspe 1993).

However, a recurrent problem with exchange rate-based stabilization programs-and one that was not fully anticipated by its supporters-was that inflation tended to have a considerable degree of inertia. That is, in most episodes, domestic prices and wages continued to increase even after the nominal exchange rate had been fixed. In Edwards (1998c) I used data from the Chilean (1977-82) and Mexican (1988-94) exchange rate-based stabilizations to analyze whether the degree inflationary persistence declined once the nominal exchange rate anchor program was implemented. My results suggest that, in both cases, the degree of persistence did not change significantly and remained very high. I attributed these results to two factors: a rather low degree of credibility of the programs, and, particularly in the case of Chile, the effects of a backward-looking wage-rate indexation mechanism.

If inflation is indeed characterized by a high degree of inertia, a fixed-or predetermined-nominal exchange rate will result in a real exchange rate appreciation and consequently in a decline in exports' competitiveness. Dornbusch (1997, 131) forcefully discussed the dangers of exchange rate anchors in his analysis of the Mexican crisis:

Exchange rate-based stabilization goes through three phases: The first one is very useful ... [E]xchange rate stabilization helps bring under way a stabilization ... In the second phase increasing real appreciation becomes apparent, it is increasingly recognized, but it is inconvenient to do something ... Finally, in the third phase, it is too late to do something. Real appreciation has come to a point where a major devaluation is necessary. But the politics will not allow that. Some more time is spent in denial, and then-sometime-enough bad news pile[s] up to cause the crash.

An additional complication is that under pegged exchange rates, negative external shocks tend to generate a costly adjustment process. Indeed, in a country with fixed exchange rates the optimal reaction to a negative shock-a worsening of the terms of trade or a decline in capital inflows, for example-is tightening monetary and fiscal policies until external balance is reestablished. A direct consequence of this is that, as a result of these negative shocks, economic activity will decline, and the rate of unemployment will tend to increase sharply. If the country is already suffering from a real exchange rate overvaluation, this kind of adjustment becomes politically difficult. More often than not, countries that face this situation will tend to postpone the required macroeconomics tightening, increasing the degree of vulnerability of the economy. Following this kind of reasoning, and after reviewing the fundamental aspects of the Mexican crisis, Sachs, Tornell, and Velasco (1995, 71) argue that it is "hard to find cases where governments have let the [adjustment process under fixed exchange rate] run its course." According to them, countries' political inability (or unwillingness) to live according to the rules of a fixed exchange rate regime reduces its degree of credibility.

In the mid-1990s, even as professional economists in academia and the multilateral institutions questioned the effectiveness of pegged-but-adjustable rates, policymakers in the emerging economies continued to favor that type of policies. In spite of Mexico's painful experience with a rigid exchange rate regime in the first half of the 1990s, the five East Asian nations that eventually ran into a crisis in 1997 had a rigid-de facto, pegged, or quasi pegged-exchange rate system with respect to the U.S. dollar. Although this system worked relatively well while the U.S. dollar was relatively weak in international currency markets, things turned to the worse when, starting in mid-1996, the dollar began to strengthen relative to the Japanese yen. Naturally, as the dollar appreciated relative to the yen, so did those currencies pegged to it. Ito (2000, 280) has described the role of pegged exchange rates in the East Asian crisis in the following way:

[T]he exchange rate regime was de facto dollar pegged. In the period of yen appreciation, Asian exporters enjoy high growth contributing to an overall high, economic growth, while in the period of yen depreciation, Asian economies' performance becomes less impressive ... Moreover, the dollar peg with high interest rates invited in short-term portfolio investment. Investors and borrowers mistook the stability of the exchange rate for the absence of exchange rate risk.

In Russia and Brazil the reliance on rigid exchange rates was even more risky than in Mexico and in the East Asian nations. This was because in both Russia and Brazil the public-sector accounts were clearly out of control. In Russia, for example, the nominal deficit averaged 7.4 percent of gross domestic product (GDP) during the three years preceding the crisis. Worse yet, the lack of accountability during the privatization process, and the perception of massive corruption, had made international investors particularly skittish. In Brazil, the real plan, launched in 1994, relied on a very slowly moving preannounced parity with respect to the U.S. dollar. In spite of repeated efforts, the authorities were unable to rein in a very large fiscal imbalance. By late 1998 the nation's consolidated nominal fiscal deficit exceeded the astonishing level of 8 percent of GDP.

Real Exchange Rate Overvaluation: How Dangerous? How to Measure It?

The currency crises of the 1990s underscored the need to avoid overvalued real exchange rates-that is, real exchange rates that are incompatible with maintaining sustainable external accounts. In the spring 1994 meetings of the Brookings Institution Economics Panel, Rudi Dornbusch argued that the Mexican peso was overvalued by at least 30 percent and that the authorities should rapidly find a way to solve the problem. In that same meeting, Stanley Fischer, soon to become the International Monetary Fund's (IMF's) first deputy managing director, expressed his concerns regarding the external sustainability of the Mexican experiment. Internal U.S. government communications released to the U.S. Senate Banking Committee during 1995 also reflect a mounting concern among some U.S. officials. Several staff members of the Federal Reserve Bank of New York, for example, argued that a devaluation of the peso could not be ruled out. For example, according to documents released by the U.S. Senate, on 27 October 1994 an unidentified Treasury staff member commented to Secretary Lloyd Bensten that "[rigid] exchange rate policy under the new Pacto [the tripartite incomes policy agreement between government, unions, and the private sector] could inhibit a sustainable external position" (D'Amato 1995, 308).

The overvaluation of the Mexican peso in the process leading to the 1994 currency crisis has been documented by a number of postcrisis studies. According to Sachs, Tornell, and Velasco (1996), for example, during the 1990-94 period the Mexican peso was overvalued, on average, by almost 29 percent (see their table 9). An ex post analysis by Ades and Kaune (1997), using a detailed empirical model that decomposed fundamentals' changes in permanent and temporary changes, indicates that by the fourth quarter of 1994 the Mexican peso was overvalued by 16 percent. According to Goldman Sachs, in late 1998 the Brazilian real was overvalued by approximately 14 percent. Moreover, although the investment houses did not venture to estimate the degree of misalignment of the Russian ruble, during the first half of 1997 there was generalized agreement that it had become severely overvalued.

The East Asian nations did not escape the real exchange rate overvaluation syndrome. Sachs, Tornell, and Velasco (1996), for instance, have argued that by late 1994 the real exchange rate picture in the East Asian countries was mixed and looked as follows: While the Philippines and Korea were experiencing overvaluation, Malaysia and Indonesia had undervalued real exchange rates, and the Thai baht appeared to be in equilibrium. Chinn (1998) used a standard monetary model to estimate the appropriateness of nominal exchange rates in East Asia before the crisis. According to his results, in the first quarter of 1997 Indonesia, Malaysia, and Thailand had overvalued exchange rates, whereas Korea and the Philippines were facing undervaluation.


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