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The Wall Street Journal Interactive Edition -- October 20, 1997

The Outlook


Should small, developing countries dump their national currencies and adopt the currency of a larger nation?

Amid the Asian currency crisis, some monetary experts say that is one alternative such countries should consider. It is a provocative notion. After shucking off colonialism or, in some cases, military occupation, emerging nations might bristle at the idea of being subsumed by a larger power.

But in a world of mobile money, where huge hedge funds wield more capital than many countries have in foreign reserves -- some experts wonder whether developing nations wouldn't be better off pushing for monetary unification with nations with which they have close economic ties.

Some even predict that, in five years, there could be a Mexican dollar, Singapore yen and South African euro.

Michael Howell, head strategist at financial consultant CrossBorder Capital in London, likens this world of three currency zones, each anchored by a dominant economy, to George Orwell's "1984," in which the world is divided among Oceania, Eastasia and Eurasia, and where Mr. Howell says "each region has its own dominant economy and its own emerging markets."

Even if such forecasts turn out to be vastly exaggerated, one thing seems sure: At the least, Asia's turmoil could signal the death knell of the era of pegged-exchange rates, which for decades have been the foundation of developing countries' monetary systems.

Small countries that tie their currencies to that of a larger country or to a basket of currencies hope the arrangement will help them control inflation and create credible monetary policy. Yet time and again, currency pegs have proved inherently unstable in the face of speculative assaults.

Take the Thai baht, which was pegged to a basket of currencies led by the U.S. dollar. After waging a two-month war with speculators, Thailand abandoned the peg and let its currency float on July 2. The baht immediately plunged 16% against the dollar. By Friday, it was down 35%.

Since 1994, globe-trotting, fast-moving cash has also clobbered the currencies of many developing countries including Mexico, South Africa, the Czech Republic, the Philippines, Malaysia and Indonesia. To defend their currencies and, by definition, their pegs, their central banks at first usually push interest rates sky-high. That ravages weak banks, hurts corporations and potentially slows growth. And because much of their debt is short term and in foreign currencies, they get slammed once again.

"That has devastating effects on the nation's economy," says Frederic Mishkin, a professor at the Columbia University Graduate School of Business in New York.

The main weakness of pegs is that a small country's economy can become a slave to its foreign-exchange policy. "You have to devote so much of your resources just to maintain the credibility of your commitment [to the peg] that you end up with no flexibility," says Adam Posen, an economist at the Institute for International Economics in Washington.

These problems lead Barry Eichengreen, a senior policy adviser at the International Monetary Fund, to conclude that it is anachronistic for one nation to link its currency to another informally.

He says that capital has become too mobile, cross-border investment too vast, world financial markets too large, economies too closely integrated and financial technology too innovative. In his book "International Monetary Arrangements for the 21st Century," he contends that countries have to choose between two extremes: monetary unification with others or letting their currencies float freely. So far, some have chosen the float route, but some economists say the nations could find unification more appealing in the long run.

A free-floating system allows exchange-rate adjustments to occur over time and gives officials the flexibility to adjust domestic policies smoothly, instead of being pushed from crisis to crisis. And a floating currency doesn't provide speculators an easy target.

Monetary union makes life easier for exporters, importers and investors by removing the uncertainty caused by exchange-rate fluctuations. It can also damp inflation if the link is with a low-inflation country. In theory, it could work like the planned European economic and monetary union that calls for the creation of a single central bank that will issue a common currency to be used by all participating countries. Or, as with Luxembourg and Belgium's monetary union, it could involve a small nation effectively adopting the currency of a larger one and not having its own central bank.

Monetary union theoretically offers the advantages of having a currency that can be used world-wide. With a widely accepted currency, business can be conducted more efficiently and at lower cost.

To be sure, neither course is a panacea. Floating means adhering to market discipline -- a price that often persuades policy makers to shy away from letting their currencies bend with the wind. Studies indicate that excessive exchange-rate volatility can retard investment and trade.

The key to successful monetary unification is hitching your currency to that of a country with close economic ties and a similar business cycle. Otherwise, what is good monetary policy for the smaller country may not be the policy of the larger one.

The debate isn't over. But Dr. Posen says the big lesson of failed currency pegs "is you've got to go along to get along."


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