EXCHANGE RA TE REGIMES AND MACROECONOMIC STABILITY EXCHANGE RATE REGIMES AND MACROECONOMIC STABILITY edited by Lok-Sang Ho Lingnan University Hong Kong Chi-Wa Yuen University of Hong Kong Peking University and Wuhan University Hong Kong SPRINGER SCIENCE+BUSINESS MEDIA, LLC Exchange Rate Regimes and Macroeconomic Stability 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 Softcover reprint of the hardcover 1st edition 2003 AlI rights reserved No part of this work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, microfilming, recording, or otherwise, without the written permission from the Publisher, with the exception of any material supplied specifically for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work Permission for books published in Europe: permissions@wkap.nl Permissions for books published in the United States of America: permissions@wkap.com Printed on acid-free paper CONTENTS List of Contributors Assaf Razin F oreword Acknowledgments Vll Xl xm Chapter Introduction Lok-Sang Ho and Chi-Wa Yuen Part The Asian Currency Crisis: Responses and Policy Options Chapter Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth Wing Thye Woo Chapter Financial Market Stability, Monetary Policy, and the IMF Joseph Stiglitz Chapter The IMF Approach to the Asian Currency Crises: An Alternative View Charles Adams Chapter Does Asia Need a Common Currency? Robert Mundell Chapter Recommending a Currency Basket System for Emerging East Asia Masahiro Kawai Part Chapter Monetary Policy, Exchange Rate Regimes, and Macroeconomic Stability A Comparative Analysis ofExchange Rate Regimes Naoyuki Yoshino, Sahoko Kaji and Ayako Suzuki 33 55 61 77 105 107 vi Chapter Chapter Exchange Rate Regimes and Macroeconomic Stability Bringing about Realistic Exchange Rates: A Post-Asian Financial Crisis Perspective Lok Sang Ho Contemplating the Credibility of Currency Boards Corrinne Ho 133 145 Chapter 10 Currency Board, Asian Financial Crisis, and the Case for 185 Put Options Francis T Lui, Leonard K Cheng and Yum K Kwan Chapter 11 The Currency Board in Hong Kong: Operational Weaknesses and a Proposed Refinement Scheme Alex W.H Chan 215 Postscript 247 Index Understanding Crises Chi-Wa Yuen 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 Public Policy Practice, reflects his wide interest in a wide spectrum of 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 viii Exchange Rate Regimes and Macroeconomic Stability 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 Yoshino holds a Ph.D in economics from Johns Hopkins University He had been Assistant Professor at the State University of New York 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 FOREWORD 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 World Order and the Asia Pacific, edited by James C Hsiung The Currency Board in HK: Operational Weaknesses and a Proposed Rejinement Scheme 239 some "preventive measures" to avoid the public panic sale Chan and Chen (2001) analyze the feasibility of implementing the reserve commitment policy to prevent the public panic sale under different foreign reserve levels and different government's characteristics, e.g economic fundamental and government's determination in maintaining the currency board Under certain conditions, for a government with strong determination to maintain its currency board (even if it is unobservable) and reasonably high foreign reserve (even if it is less than M3 money supply), the reserve commitment policy can effectively prevent the public panic sale 4.2.4 Lower Transaction Costs/or Arbitrage Activities The proposed scheme can lower trans action costs of arbitrage activities through broadening the currency board operation from banknote transactions to electronic payment transactions Under the proposed scheme, a government has to provide a limited amount of exchange rate insurance, which is settled through the electronic payment system If the market exchange rate of HK$ is weaker than the official fixed exchange rate, banks can participate in cash arbitrage activities (to buy HK$ from the foreign exchange market at the market exchange rate, and sell it to the HKMA at the official fixed exchange rate) through the electronic settlement system with very low trans action costs Sufficiently low transaction costs can effectively encourage banks to eliminate even small deviation of market exchange rate from the official exchange rate Hence, the currency board can operate more efficientiy 4.2.5 A Rule-Based Platform to Stabilize the HK$ Exchange Rate and Liquidity The proposed US$LAF (or HK$ put option) arrangement provides an automatic adjustment mechanism to stabilize the market exchange rate without affecting the inter-bank liquidity As banks are induced to absorb the HK$ selling pressure, the HKMA does not have to step in the foreign exchange market to take any direct intervention Hence, the HK$ inter-bank liquidity will not be squeezed Consider the example in section 3.2.2 for the operation of RTGS If no market players want to purchase the HK$2B (from clients of Bank A and Bank B) at the prevailing "market" exchange rate, Bank A and Bank B have to offer the HK dollars at a lower exchange rate to attract some potential buyers in the market This small depreciation of HK$ will induce some market players, e.g Bank C, to take an arbitrage profit from the discrepancy between the market exchange rate and the official fixed exchange rate 240 Exchange Rate Regimes and Macroeconomic Stability through exerclsmg the HK$ put option Or equivalently, through the US$LAF arrangement, market players can take arbitrage profit through (1) borrowing a US$ loan, (2) purchasing the HK$2B from (c1ients of) Bank A and Bank B, and (3) repaying the US$ loan by an equivalently amount HK$ (calculated by the official fixed exchange rate) at the maturity date As this arbitrage process will not induce any change in the HK$ inter-bank liquidity, the HK$ interest rate can remain quite stable even under capital outflOW 14 Under the proposed rule-based platform, the HKMA does not have to play any active role in monitoring the HK$ exchange rate or intervening the market Hence, the inter-bank liquidity squeeze and domestic interest rate spikes can be avoided On the other hand, the government' s foreign reserve holding will drop if banks exercise the HK$ put option (or borrow US$ from US$LAF but repay HK$ at maturity) to withdraw US$ reserve from the Exchange Fund (currency board) However, this result of losing foreign reserve under capital outflow is in fact consistent with the implication of a rule-based currency board operation 4.3 Practical Implications of the Proposed Scheme 4.3.1 ADefault Risk Free Arrangement - - US$LAF The major idea for US$LAF, HK$ put option, and structured note are exactly the same They are just different ways of implementing the same rationale It may be easier to explain the idea through the HK$ put option or the structured note However, in consideration of the actual implementation, the US$LAF has an exc1usive merit over the HK$ put option and the structured note - - the US$ LAF arrangement is free from default risk Banks holding the HK$ put options or structured notes issued from the HKMA are still bearing the default risk because the HKMA may be unable to honor HK$ put options or structured notes under some extremely worse situations (if all foreign reserve is lost) However, banks participating in the US$LAF not bear this default risk as they can obtain the US$ loan at the beginning of the loan period At the maturity date of US$ loan, they have an option to choose their repayments in US dollar or in an equivalent amount of HK dollar calculated by the official fixed exchange rate Hence, the embedded put option under the US$LAF arrangement must be honored without any default risk The Currency Board in HK: Operational Weaknesses and a Proposed Rejinement Scheme 241 4.3.2 Total Commitment under Control ofthe HKMA The amount of HK$ put option issued to the banking system is fully controHed by the HKMA Under the proposed US$LAF arrangement, banks are required to use Exchange Fund Bills and Notes as collateral to obtain the US$ loan embedded with the HK$ put option Hence, the maximum issuance of HK$ put options is limited to the amount of outstanding Exchange Fund Bills and Notes, which is under the control of HKMA 15 Certainly, a larger amount of commitment can generate a stronger signal to the public; however, astronger signal is more costly because it creates a greater inflexibility to the govemment's future policy The optimal choice ofreserve commitrnent level is considered in Chan and Chen (2001) 4.3.3 HK$ Put Option not a Toolfor Speculative Attack A major concern of using the proposed insurance scheme is whether the HK$ put option will be used as a tool for speculative attack Chan and Chen (1999) provide an analysis to compare the implications from the HK$ put option and a typical defending tool - forward contract Based on the well-known "put-call parity" relationship in the option pricing theory, they conclude that speculators will not use put options to attack a currency because a put option is a more costly instrument for speculative attack, compared with the typical currency forward contract Empirically, their conc1usion is weH supported by the tactics of speculators Both the currency forward contracts and currency option contracts have been available in the foreign exchange market for a long time However, in practice, speculators are used to attack a currency by forward contracts, but not option contracts Obviously, speculators clearly understand speculation costs of different financial instruments They know that the HK$ put option is not a good choice for them 242 Exchange Rate Regimes and Macroeconomic Stability Table Comparison between Different Defense Strategies Short Position in Short Position in US$ Forward US$ Call Option (*) Through US$ LAF Loss ofUS$ [1] Value at Risk Loss ofUS$ Reserve Reserve und er the worst situation Built-in Weaker [2] Stronger deterrent against (compared with US$ speculative forward) incentives Centrally planned [3] Defense To induce the Mechanism market to bytheHKMA [4] Publicly known After the It is the HKMA's arrangement implementation of discretion to defend HK$ link US$LAF, it is a publicly known by forward arrangement This contracts or not commitment shows government's determination to maintain the currency board to society (*J The US$ call option is equivalent to the HK$ put option Comment Roughly the Same US$ Call is better The market can better HKMA's commitment can enhance the public confidence on the HK$ exchange rate link A rule is better than discretion 4.3.4 Differences between HK$ Put Options Issued by the HKMA and by Private Investment Banks As mentioned before, currency options have been available in the foreign exchange market for a long time What are the differences between HK$ put options issued by the HKMA and by private investment banks? There is no effect on stabilizing HK$ from the issuance of HK$ put options by private investment banks Suppose a client purchases a HK$ put option from an investment bank, the client will have less incentive to seIl HK$ to reduce his HK$ devaluation risk exposure because the HK$ put option can hedge against his devaluation risk exposure However, an investment bank selling HK$ put option is to earn the service fee for synthetically creating the option, but not to speculate the market movement Hence, the investment bank will follow the "dynamic hedging" technique in the option theory of finance to synthetically replicate the HK$ put option through selling some HK$ to hedge against its exchange rate risk from shortselling the HK$ put option In other words, firstly, the issuance of put options by investment banks transfers the exchange rate risk from option holders to option writers (investment banks) And then option writers seIl HK$ to reduce their HK$ devaluation risk exposure This is just a typical The Currency Board in HK: Operational Weaknesses and a Proposed Refinement Scheme 243 risk management process of investment banks Consequently, the overall selling pressure on HK dollar is not reduced On the other hand, the issuance of HK$ put options from the government (HKMA) will have two major distinctive effects The first one is a direct effect As a government's key objective of issuing put option is to stabilize the HK$ exchange rate and enhance the public confidence on currency board, it does not carry out the dynamic hedging process to seIl HK$ as the private investment banks As a result, the overall selling pressure on HK$ can be reduced through the govemment' s issuance of put option The second one is an indirect effect As a govemment is an insider for its future policy and the issuance of HK$ put option is a costly commitment for its future policy, this explicit irrevocable commitment can signal the government's future policy and strong determination on maintaining the currency board to the public Hence, the public confidence on currency board can be strengthened This indirect effect is even more important than the direct effect CONCLUSION The Asian financial cnSlS m 1997/1998 revealed the operational weaknesses of the currency board system in Hong Kong Instead of operating as a rule-based system, it heavily relied on the discretion of HKMA During the times of capital outflow, the HKMA had to make a decision for the trade-off between maintaining its foreign reserve holding and maintaining the stability of HK$ inter-bank liquidity In October 1997, the HKMA chose the first option, which resulted in inter-bank liquidity squeeze and high interest rates that "forced" banks to seIl their US$ holding to the HKMA for the HK$ liquidity As a result, the HKMA did not lose any foreign currency reserve; but the public confidence on HK$ was shaken and the Hong Kong's economy was seriously damaged An institutional arrangement deviating from the rule-based discipline of standard currency board put the HKMA in a position to make more and more discretionary interventions A misunderstanding in the function of foreign reserve holding made the HKMA take a wrong choice The function of foreign reserve in a currency board system is to be a shock absorber to protect the domestic economy from damages of extern al shocks A currency board with higher foreign reserve holding means that this shock absorber can absorb a greater extern al shock Therefore, the public confidence on the domestic currency is stronger However, it seemed that the HKMA had considered accumulating foreign reserve holding as the ultimate objective, rather than as a tool to achieve its ultimate goal - - to protect the Hong 244 Exchange Rate Regimes and Macroeconomic Stability Kong economy As a result, the shock absorber was not used and the foreign reserve holding did not drop when the society experienced a large external shock More importantly, the economy was seriously hurt because of the malfunction of shock absorber Fortunately, Hong Kong had a very strong economic fundamental and solid banking system It could survive and recover quickly after the damage At any rate, the key for Hong Kong's successful defense of HK$ during the Asian financial crisis in 1997/1998 is its strong economic fundamental and solid banking system, but not the unused shock absorber - - Hong Kong's currency board system and its huge foreign reserve After experiencing the painful damage on Hong Kong's economy, the HKMA eventually took positive actions to improve the existing currency board system On September 5, 1998, the HKMA announced the seven technical measures to improve the operation of currency board system The seven measures basically smoothed the operation of the currency board, however had not yet solved the public confidence problem In the morning of September 14, 1998, banks in Hong Kong were aggressively selling the HK$ to the HKMA because of a market rumor that the prevailing exchange rate for "Convertibility Undertaking Arrangement" would be adjusted imminently Eventually, the HKMA announced that the official exchange rate for "Convertibility Undertaking Arrangement" would be unchanged for at least the next six months The guarantee was the key to enhance the public confidence on the exchange rate; and after this announcement, banks stopped selling HK$ and capital flowed back to Hong Kong The HKMA's measures introduced in the September of 1998, inc1uding the seven technical measures and the exchange rate guarantee on September 14, 1998, are theoretically equivalent to the proposed foreign reserve commitment policy The "Discount Window" and the removal of restriction on repeated borrowing by the Exchange Fund Bills and Notes are the ideas for the introduction of a rule-based liquidity injection mechanism in the US$LAF proposal The overall effect of "Convertibility Undertaking Arrangement" and the guarantee for no change of official exchange rate for convertibility undertaking is equivalent to a foreign reserve commitment policy or a HK$ put option The empirical evidence on September 14, 1998 c1early supports the theoretical prediction from Chan and Chen (2001) that a government with strong determination to maintain currency board can effectively enhance the public confidence on currency board through some explicit foreign reserve commitments The Currency Board in HK: Operational Weaknesses and a Proposed Refinement Scheme 245 NOTES 10 11 12 13 14 I would like to thank Nai-fu Chen, Corrinne Ho and especially Merton Miller for their helpful eomments on earlier versions of this paper I am also grateful to the financial support from Hong Kong RGC earmarked research grant HKU7137/00H The author ean be reached at the School of Eeonomics & Finance, Faculty of Business and Economics, University of Hong Kong, Pokfulam Road, Hong Kong (Tel: (852)-28578510, Email: alexchan@econ.hku.hk) Information is obtained from the web-site and annual reports of Hong Kong Monetary Authority and local newspapers in Hong Kong The Hong Kong Monetary Authority (HKMA) was established on April 1993 by merging the Office of the Exchange Fund with the Offiee of the Commissioner of Banking On Oetober 23, 1997, the HKMA sent a memorandum to all banks in Hong Kong about a warning for repeatedly borrowing through LAF [From the web-site of HKMA (http://www.info.gov.hk/hkma/eng/press/1997/971023e.htm)] "The Hong Kong Monetary Authority (HKMA) would like to remind lieensed banks that it does not eneourage repeated borrowings by lieensed banks through the Liquidity Adjustment Facility (LAF) Each licensed bank must organise their Hong Kong dollar funding prudently and not be overly dependent upon the LAF for last resort liquidity support In order to discourage licensed banks from repeated borrowings from LAF, penal LAF offer rates different from the advertised LAF offer rate will be deterrnined on a case by case basis and at the absolute discretion of the HKMA for repeated borrowers These will be communicated to the individuallicensed banks eoncemed." See the press release from HKMA at web-site: [http://www.info.gov.hk/hkma/eng/press/1998/980905e.htm] See the press release from HKMA at web-site: [http://www.info.gov.hk/hkma/eng/press/1998/980914e.htm] See Seetion for explanation and evidence See Figure HKMA purchased the HK$ from banks on Oetober 21 and 22, 1997 and generated the liquidity squeeze on October 23, 1997 Before the introduction of "Seven Teehnical Measures" in September 1998, there was no rule-based mechanism to seil HK$ to the HKMA through the electronic payment system at the offieial fixed exchange rate The currency board arrangement was only confined to buy and seil "Certifieate of Indebtedness" or equivalently HK$ banknotes See Hong Kong Monetary Authority (1995) for their implications At the beginning, the HKMA exercised its discretion to purehase the HK$ from the inter-bank market And then, at the end, the HKMA exercised its discretion to inject liquidity in HK$ market through purchasing US$ from the inter-bank market See Chan and Chen (1999) Also the senior government officials have to bear higher politieal costs or political pressure from the public Certainly, if the capital outflow is larger than the sum of Aggregate Balance in the banking system and the amount of reserve commitment, the interest rate rise and the liquidity squeeze will also happen 246 15 Exchange Rate Regimes and Macroeconomic Stability Similarly, the HKMA has full control over the amount of issuance of HK$ put options, structured notes, or other forms of exchange rate insurance schemes REFERENCES Chan, Alex, and Nai-fu Chen, 1999, "An Intertemporal Currency Board," Pacific Economic Review, Vol 4, No 2, pp 215-232 Chan, Alex, and Nai-fu Chen, 2001, "A Theory of Currency Board with Irrevocable Commitments," Working Paper, The University ofHong Kong Hong Kong Monetary Authority, 1995, Money and Banking in Hong Kong, Hong Kong Jeanne, 0., 1997, "Are Currency Crises Self-fulfilling? A Test," Journal 01 International Economics, Vol 43, pp 263-286 Miller, Merton H., 1998, "The Current Southeast Asia Financial Crisis," Pacific-Basin Finance Journal, Vol 6, pp 225-233 Obstfeld, M., 1986 "Rational and Self-fulfilling Balance of Payments Crises," American Economic Review, Vol 76, pp 72-81 Obstfeld, M., 1996, "Models of Currency Crises with Self-fulfilling Features," European Economic Review, Vol 40, pp 1037-1047 Yam, Joseph, 1998, "A Modem Day Currency Board System," Hong Kong: Hong Kong Monetary Authority Postscript UNDERSTANDING CRISES Chi-Wa Yuen University 0/ Hang Kong, Pe king University, and Wuhan University Most of the essays contained in this volume attach a significant role to the choice of exchange rate regimes by a country as a determinant of its macroeconomic performance and of its likelihood of being subject to an economic crisis As a matter of fact, most crises that have occurred around the world in the recent decades seem to be related to currency values in one way or another This is perhaps the reason why theoretical models built prior to the onset of the Asian financial crisis (AFC) - so-called "first-generation" (based on fundamentals ;i la Krugman 1979) and "second-generation" (based on self-fulfilling expectations ;i la Obstfeld 1996) models-are models of currency crises, and why, at the beginning of the AFC following the collapse of the Thai baht and the Korean won, it was misconceived as just another currency crisis (ofthe self-fulfilling variety) As the crisis unfolded, however, it became obvious that, unlike currency crises, the AFC arose more from banking and financial problems in the process of financing business investment than from exchange rate problems Since then, quite a few theories-so-called "third generation" models-have been proposed to understand its sources and consequences, viz., moral-hazard-driven investment (Krugman 1998), financial fragility (Chang and Velasco 2000), and balance-sheet implications of currency depreciation (Krugman 1999) (See also Kaminsky and Reinhart 1999 for a related discussion of the twin crises.) As Krugman (2002) argues, balance-sheet effects are now widely believed to be the most crucial element behind the AFC In particular, if firms are highly leveraged with debt denominated in foreign currency, then anything that triggers a massive capital outflow will result in a depreciation of the domestic currency and thus an increase in the firms' debt burden As a result, the net worth ofthe firms will be reduced, limiting their ability to borrow funds to finance their 248 Exchange Rate Regimes and Macroeconomic Stability new investment The resulting investment and output collapse will validate the capital flight and make the crisis self-fulfilling Any balance sheet has two sides: assets and liabilities While third-generation models stress the liability side as a constraint on the firm's ability to invest, Krugman (2002) has also examined how the asset side can exert a similar constraint in what he calls a fourth-generation model of the crisis yet to occur In particular, in the presence of an imperfect capital market, the firm' s ability to borrow funds to finance its investment would depend on the value of the collateral it can provide, which depends in turn on whether there are enough other firms expected to invest as well Any decline in confidence would cause a drop in asset prices, hence a fall in the values of collaterals, leading to a collapse in investment and output that validates the fall in confidence and asset prices and renders the crisis self-fulfilling To make things even worse, the output collapse could lead to deflation (in both asset prices and goods prices), making it more burdensome for the firm to service its debt This is especially likely to take place in an economy facing a liquidity trap as in the case of Japan, where the nominal interest rate is already close to the zero-bound and cutting the interest rate would not be a viable monetary policy option to avert the crisis The commonalities and differences among the first three generations of crisis models are succinctly summarized by Krugman (2002): " In the original crisis models a currency crisis was something that was deserved, predictable, and harmless That is, it was caused by the government' s pursuit of contradictory and unsustainable policies; given this, it had to happen, and indeed had to happen at a particular time; and since it only made the fundamentals visible, the crisis did not actually damage the economy With the second-generation models it becomes much less clear that the crisis is deserved, and it becomes unpredictable, though it is still mostly harmless With the third-generation models, crises become a clearly bad thing-IargeIy because they are no longer mainly about monetary policy Indeed, , the depreciation of the nominal exchange rate becomes more a symptom than a fundamental aspect ofthese crises " In fact, the fourth-generation model is a lot like its third-generation cousins except that domestic asset prices replace the exchange rate as a key linkage in financial crises-so that these crises can occur even in closed economies According to the logic of these models, the govemment may sometimes be able to something to prevent some of these crises But the policy measures that are called for would in general be model-specific and vary Understanding Crises 249 from case to case First-generation crises can, for instance, be eliminated through better and more consistent coordination of policy actions among different branches of the government-either forcing the fiscal authority to adopt contractionary actions to contain its growing deficits or allowing the monetary authority to abandon the fixed exchange rate regime More generally, it requires correction (strengthening) of the "wrong" (weak) fundamentals that spark off the crises In the case of second-generation crises, solutions to the inflation bias familiar from the monetary policy literature-viz., appointment of a conservative central banker, imposition of a reputation al constraint on or design of an incentive contract for the central banker, and inflation targeting - can help alter the private sector's devaluation expectations and thus prevent self-fulfilling attacks on the country's currency (see Yuen 2002) In the case of third-generation crises of the balance-sheet type, a large-scale fiscal expansion that offsets the investment collapse can rule out the crisis equilibrium Alternatively, a temporary sharp monetary tightening mayaiso the job (but at the expense of a drop in output) by supporting the value of domestic currency, hence altering people's depreciation expectations For that matter, imposing capital controls as a temporary emergency measure may work as weIl In the case of fourth-generation crises, while a sufficiently large temporary fiscal expansion can eliminate the bad equilibrium, monetary expansion of the conventional type cannot In the presence of a liquidity trap (or zero nominal interest rate), monetary policy in the form of inflation or price level targeting is needed to create inflation expectations in the private sector so as to drive the real interest rate below zero to stimulate real activities The differences across the various generations of crisis models point to " the somewhat disheartening fact that each wave of crises seems to elicit a new style of model, one that makes sense of the crisis after the fact " (Krugman 2000) In asense, it means that all unhappy families are different, to the extent that each requires aseparate case study But while such ad hoc modelling approach has strong explanatory power (because that is precisely what it is designed for), it lacks generality and predictive power -making it difficult to design common preventive measures to avoid the crises After all, what is so special about crises? In what sense are they different from depressions over a business cycle? For progress in scientific discovery, what we need is to identify the empirical regularity behind these crises In other words, it is probably more useful to think of crises as being all alike (rather than all different) and try to document their common patterns -so-called stylized facts-for the sake of economic explanation and prediction 250 Exchange Rate Regimes and Macroeconomic Stability By maintaining that "business cycles are all alike" in terms of comovements across macro variables, Lucas (1977) has revolutionized thinking about business cycle modelling and stimulated the development of real business cycle (RBC) models In principle, one could also apply a similar stochastic dynamic general equilibrium approach to the analysis of crises, focusing on the statistical properties (e.g., amplitudes, comovements, and persistence and phase shifts) of the major macro aggregates over the depression phase of the business cycle This approach has recently been applied by Cole and Ohanian (1999) to analyze the Great Depression They find the period 1929-1939 to be unique in the sharp decline (1929-1933) and a slow recovery (1934-1939) in economic activity that conventional shocks can hardly explain This suggests that the approach can usefully be employed to distinguish unique events from more familiar ones, before we decide whether the crisis in question is special enough to deserve scrutiny by developing a new, unconventional approach REFERENCES Chang, Roberto, and Andres Velasco, 2000, "Financial Fragility and the Exchange Rate Regime," Journal o/Economic Theory, Vol 92, pp 1-34 Cole, Harole L., and Lee E Ohanian, 1999, "The Great Depression in the United States from a Neoclassical Perspective," Federal Reserve Bank 0/ Minneapolis Quarterly Review, Vol 23, Winter, pp 2-24 Kaminsky, Graciela, and Carmen Reinhart, 1999, "The Twin Crises: The Causes of Banking and Balance of Payments Problems," American Economic Review, Vol 89, pp 473-500 Krugman, Paul, 1979, "A Model of Balance of Payments Crises," Journal 0/ Money, Credit, and Banking, Vol 11, pp 311-325 Krugman, Paul, 1998, "Bubble, Boom, Crash: Theoretical Notes on Asia's Crisis," mimeo, January Krugman, Paul, 1999, "Balance Sheets, the Transfer Problem, and Financial Crises," International Tax and Public Finance, Vol 6, pp 459-472 Krugman, Paul, 2002, "Crisis: The Next Generation?" in Elhanan Helpman and Efraim Sadka (eds.), Economic Policy in the International Economy: Essays in Honor 0/Assa/Razin, Cambridge University Press, forthcoming Lucas, Robert E., Jr., 1977, "Understanding Business Cycles," Carnegie-Rochester Series on Public Policy, Vol 5, pp 7-29 Obstfeld, Maurice, 1996, "Models of Currency Crises with Self-fulfilling Features," European Economic Review, Vol 40, pp 1037-1048 Yuen, Chi-Wa, 2002, "Solutions (?) to the 'Devaluation Bias': Some Preventive Measures to Defend Fixed Exchange Rates against Self-fulfilling Attacks," in Elhanan Helpman and Efraim Sadka (eds.), Economic Policy in the International Economy: Essays in Honor 0/Assa/Razin, Cambridge University Press, forthcoming INDEX "beggar-thy-self' policies, 38, 49 apparent crises, 134 Argentina, I, 5,22,23,24,25,29,30,35, 38, 52, 83, 146, 154, 162, 163, 164, 165,167,168,169,171,174,179, 180, 181, 186,212 ASEAN, 13,20,31, 74, 78, 87, 90, 92, 95, 98,99,103 Asian currency and economic crisis, 107 Asian Currency Crises, v, 3, 55 Asian Financial Crisis, v, vi, 1,2,3,4,9, 31,33,60, 133, 134, 135, 185, 186, 189,190,208,209,232,235 automatic adjustment mechanism, 190, 192,205,217,220,223,224,235, 236,239 balance sheet, 17, 140, 152, 175,248 bankruptcy probability, 39 basket-peg, 5, 107, 108, 109, 111, 112, 115, 116, 119, 124, 126, 127 bipolar view, 24, 25 Bretton Woods, 1, 5, 64, 183 bubble, 15,29, 139, 140 Bulgaria, 28, 84, 154, 162, 163, 164, 165, 167, 170, 174, 177, 179, 181, 183 capital controls, 16,25,44, 138,249 capital market liberalization, 34, 36, 38, 47,48,52 China, viii, 4, 18,24,26,50,63,68,69, 73, 74, 75, 77, 81, 83, 87, 91, 92, 93,94,96,97,157,168,177,181, 183, 184, 188, 193,211 circumstances, 2, 24, 25, 36, 41, 43, 57, 58, 113, 148, 152, 153, 162, 166, 17~ 173, 185, 189, 199 circumstantial factors, 145, 147, 157, 168, 172 commitment, 3, 44, 57, 68, 69, 77, 92, 96, 99, 102, 149, 151, 152, 156, 160, 161,162,166,170,171,172,173, 176,186,197,200,212,216,217, 224,236,237,238,239,241,242, 243,244,245 competition-neutral exchange rate, 141, 142 confidence,3,4,5, 13, 14, 15,40,41,43, 57,60, 68, 135, 137, 152, 158, 163, 165, 16~ 16~ 173, 17~ 17~ 189, 190,192,193,195,197,198,208, 209,211,216,219,220,224,226, 233,235,236,237,238,242,243, 244,248 contagion, xi, 13,37,38,52,98, 102, 134, 138 context, 2,15,145, 147, 148, 152, 153, 162,163,172,173,177 contextual factors, 2, 148 credibility, xi, 2, 4, 16,21,22,25,42, 134, 145, 146, 147, 148, 149, 150, 151, 152, 153, 155, 156, 160, 162, 163, 167,168,169,172,173,174,176, 177,185,186,187,197,202,203, 205,208,209 credibility-worthiness,2, 145, 147, 148, 155, 156, 160, 162, 167, 168, 169, 173,177 crises, 1, 12, 13, 16,34,35, 52, 59, 60, 69, 102, 108, 127, 133, 134, 135, 138, 143,145,150,171,172,179,181, 247,248,249,250 currency basket, 5, 69, 77, 78, 79, 80, 81, 82,85,86,87,88,90,91,94,95, 96,98,99, 100, 101, 102, 103, 107, 111, 112, 127, 181 currency basket arrangement, 79, 99 currency board, 1,2,4,21,22,23,24,69, 78,81,97, 100, 145, 146, 147, 148, 149, 150, 151, 152, 153, 154, 155, 156, 157, 158, 159, 160, 162, 163, 164,165,166,167,168,169,170, 171,172,173,174,175,176,177, 178,179,180,181,182,185,186, 187, 18~ 189, 190, 191, 192, 194, 198,199,209,210,211,212,215, 216,217,219,220,221,223,224, 226,231,233,235,236,237,238, 239,240,242,243,244,245 252 Exchange Rate Regimes and Macroeconomic Stability David Hume, 64 de facta US dollar-peg system, 91 default probability, 39, 40 defendable rates, 135 devaluation, 1,4, 10, 14,23,37,38,39, 47,49,68,69,96,116,122,134, 135, 137, 138, 160, 171, 172, 180, 18~ 188, 18~ 19~ 193, 19~ 195, 198,200,202,203,205,208,209, 224,226,233,237,242,249 discretion, 3, 146, 149, 150, 159, 161, 174,175,176,177,178,181,185, 186, 189, 191,202,205,211,216, 217,231,232,233,235,242,243, 245 discretionary, 149,216,218,233 disguised currency crisis, 134, 135 distributional effects, 46 dollar peg, 4, 77, 91, 96, 97, 99, 107, 115, 123, 188,212 dollar-peg, 5, 78, 85, 87, 91, 92,108,109, 111, 112, 116, 122, 124, 126, 127 East Asian currency crisis, 78, 87 endogenous growth, viii, 26 equilibrium exchange rate, 40, 130 Estonia, 82, 154, 162, 163, 164, 165, 167, 170,171,174,177,179,180,181, 183,186 euro, 62,63,65,66,67, 70, 71, 73, 75, 77, 78,79,80,86,87,88,90,94,95, 96,98,99,101,164,171,181 European Central Bank, 66, 70, 72 European Union, 65, 66, 78, 94, 95 Exchange Fund, 158, 159, 178, 180, 187, 189,199,213,217,218,219,220, 221,223,229,231,232,233,234, 236,240,241,244,245 exchange rate insurance, 200, 239, 246 external balance, 133, 141 external debt restructuring, 3, 55, 58, 59, 60 Federal Reserve, 16, 30, 31, 53, 70, 72, 250 Finance One, 137 financial contagion, 3, 9, 14, 15,20 financial crises, xi, 10, 16,34,55,56,60, 146,187,248 fixed exchange rates, 4, 64, 67, 69, 107, 115,126,133 floating, 4, 24, 63, 73, 78, 80, 81, 93, 94, 95, 100, 102, 108, 111, 112, 115, 116, 120, 124, 126, 127, 135, 158, 164, 179, 180 floating exchange rate, 133, 135, 141, 143, 144 Friedman, 71, 182 fundamentals, 4, 13, 14, 15,93, 135, 137, 138, 140, 144, 158, 168, 186, 194, 195,247,248,249 Germany, 27, 62, 154 globalization, 20, 26, 61, 63 governance,18,21,42,50,51,61 government intervention, 36, 37 growth competitiveness, 28 HKMA, 3, 21, 24, 158, 159, 160, 161, 178,179,182,185,186,187,189, 190, 191, 192, 194, 195, 196, 197, 198,199,200,201,202,203,205, 206,208,211,212,216,217,218, 219,223,229,230,231,232,233, 235,236,239,240,241,242,243, 244,245,246 Hong Kong, 3, vi, vii, viii, ix, xi, xiii, 1,2, 4,5,10,21,22,23,24,25,27,28, 29,30,68,69,72,73,74,75,77, 81,82,87,88,91,94,96,97,102, 103, 134, 135, 136, 137, 141, 142, 143, 14~ 154, 156, 157, 158, 159, 160, 161, 162, 163, 164, 166, 168, 169,170,172,173,174,176,177, 178,180,181,182,184,185,186, 187, 18~ 189, 190, 191, 192, 193, 194,195,197,198,199,200,201, 202,208,209,210,211,212,213, 214,215,216,217,218,219,220, 224,226,229,230,232,233,234, 235,236,237,243,244,245,246, 247 Hong Kong Monetary Authority, 3, 21, 69, 136, 158, 184, 185, 186, 199, 211,213,214,216,217,229,230, 234,245,246 Hysteresis, 42 IMF, v, vii, xi, 1,3,5, ll, 12, 13, 14, 17, 19,20,29,31,33,34,35,36,37, 38,39,40,41,42,43,44,46,47, 48,49,50,51,52,53,54,55,56, 57,68,69,70,72,79,80,81,85, 100, 137, 138, 144, 154, 165, 167, 169,170,177,179,180,181,183, 196,212 IMF's mandate, 50 Index indigenous innovation, 10, 27 inflation, 4, 13,21,22,29,37,42,47, 52, 60,65,67,69,70,72,74,85,86, 91,95, 120, 133, 137, 138, 142, 143, 149, 152, 154, 163, 165, 167, 170,175,176,177,179,180,181, 188,211,249 integration, 25, 61, 65, 66, 72, 75, 79, 100, 102,164 Intellectual Incoherence, 36, 53 interest rate arbitrage, 3, 185, 186, 190, 193,196,205,216,220,224,235 interest-rate defense issue, 56 internal balance, 57, 141 international bankruptcy system, 20 International Monetary Fund, 10, 11,30, 31,52,60,63,67,79,100,103, 104, 144, 183 investor panic, 9, 14, 15, 17, 57 Japan, viii, 26, 27, 28, 62, 63, 67, 68, 69, 70,72,73,74,77,78,79,80,86, 87,90,91,92,93,94,95,96,99, 101, 102, 103, 104, 107, 109, 111, 112, 115, 119, 129, 130, 131, 135, 139, 140, 141, 142, 144, 193,248 Korea, viii, 3,10,11,13,15,17,18,19, 24,26,27,28,31,39,42,44,46, 48,58,69,74,84,87,88,90,93, 96,99, 102,247 liberalization, 34 linked exchange rate, 141, 143, 157 liquidity trap, 248, 249 Lithuania,84, 154, 162, 163, 164, 165, 167,168,170,171,172,174,177, 179,180,181,182,183,186 10ss function, 108, 109, 111, 112, 113, 116,119,124, 125, 126, 127 Malaysia, viii, 4,10,11,13,16,17,24, 25,27,28,30,31,44,45,46,54, 69,73,74,77,84,87,89,90,93, 96,99,102,135,138,144 monetary policy, vii, 3, 16,33,35,43,52, 56,57,59,69,70,71,93,97,146, 147, 149, 153, 163, 164, 166, 168, 174,180,181,248,249 moral hazard, 12, 46, 47 mutual surveillance, 20 net creditor, 62, 139 253 New Economy, 61, 62 optimal weight, 5, 107, 108, 109, 111, 112,113,114,115,116,118,119, 126, 127 peso problem, 15, 16 policy objective, 5, 107, 108, 109, 111, 113,114,116,124,127,192 political turmoil, 41 put options, 3, 185, 186, 187, 189, 194, 195,196,197,198,200,201,202, 204,205,208,209,211,212,236, 240,241,242,243,246 reversal of capital inflows, 56 R}JB, 2, 68, 72, 74,97,211 rule-based, 147, 150, 152, 156, 189,206, 216,217,223,231,235,236,240, 243,244,245 rules, 54, 69, 73, 97, 135, 146, 149, 154, 155,156,160,162,166,169,170, 175, 176, 186, 189,202,205,208, 233 self-fulfilling expectations, 247 signalling, 40, 42 Singapore, 22, 23, 27, 28, 30, 69, 83, 87, 88,90,91,96,101,102,112,130, 135, 138, 177 speculators, 21, 24, 47, 69, 97, 157, 159, 160, 176, 192, 196, 197, 198, 199, 200,210,241 structured notes, 186,216,236,237,240, 246 super-chapter 11,44, 54 technology transfer, 27, 29, 61 Thailand, 10, 11, 13, 14, 15, 16, 17,24, 27,28,31,45,46,69,83,87,90, 91,96, 101, 102, 109, 112, 115, 11~ 11~ 12~ 13~ 138 trade-offs, 43, 45, 48, 162 transparency, 17, 51, 97, 162, 178 true currency crisis, 134, 135 two-corner solution approach, 78, 94 United States, 28, 29, 34, 39, 45, 48, 49, 50,61,62,65,67,69,70,74,78, 91,93,94,95,99,104,217,250 weak financial institutions, 40 yen-dollar exchange rate, 109, 114, 119, 139 ... Policy, Exchange Rate Regimes, and Macroeconomic Stability A Comparative Analysis ofExchange Rate Regimes Naoyuki Yoshino, Sahoko Kaji and Ayako Suzuki 33 55 61 77 105 107 vi Chapter Chapter Exchange. .. 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 INTRODUCTION... 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