September 8 1997: Gerard Baker: Pegged back by orthodoxy

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Gerard Baker: Pegged back by orthodoxy
MONDAY SEPTEMBER 8 1997
Gerard Baker For years, emerging market governments have been exhorted by their counterparts in the industrialised world to follow the hallowed tenets of modern economic orthodoxy if they wanted to join the rich countries' club.

The pursuit of price stability through sound monetary policy and fiscal rectitude was invariably the overriding condition those governments recommended, and imposed on the importunate through the offices of the International Monetary Fund.

For many of the emerging countries, one particular policy aimed at producing price stability was the centrepiece of IMF-prescribed doctrine: fixed exchange rates. Pegging national currencies to the dollar or a trade-weighted basket of foreign currencies was often the primary provision of IMF-approved programmes in Latin America and Asia, and more recently in eastern Europe.

Now, in the wake of the financial turmoil that has swept south-east Asia in the last three months, economists and policymakers are beginning to rethink this axiom of IMF orthodoxy.

It seems that not only might fixed exchange rates not be a precondition of stability, they might actually have provoked the financial crises, or at the very least substantially exacerbated them. That was the near- consensus of economists, finance ministry officials, central bankers and politicians last month at the annual symposium of the Kansas City Federal Reserve in Jackson Hole, Wyoming.

Though most present attributed the causes of the recent problems to a range of the usual suspects - lax banking supervision, inadequate disclosure of information, irresponsible fiscal policies - most also agreed that adherence to fixed exchange rate regimes was a critical contributor that probably needed to be jettisoned if future crises were to be avoided.

It was widely accepted that for some countries, especially those with an intractable inflationary problem, fixing exchange rates might still be the quickest and most effective means of restoring monetary order. The externally delivered shock of, in effect, hitching an inflation-ravaged monetary policy to the growth of money supply in the US was often sufficient to crush inflationary pressures, even if it was at the cost of a collapse in demand.

But in a well-received paper by Frederic Mishkin, an economist with the Federal Reserve Bank of New York and one of the leading authorities on monetary policy, the conference heard that there are special characteristics of emerging countries that now make fixed exchange rates highly dangerous.

Professor Mishkin drew an important distinction between the nature of financial crises in industrialised countries and those in emerging ones. The central difference stems from the structure and the denomination of countries' debt.

In industrialised countries, where inflation risks are perceived to be relatively small, most debt is of relatively long maturity and denominated in the host currency.

But in emerging countries, where there is a much shorter track record of sound monetary policy, investors prefer the security of shorter-dated debt and, more importantly, like to lend in a reserve foreign currency, usually the dollar. Investors are thus relieved of the exchange rate risk, should the emerging market government prove incapable of holding its fixed exchange rate against the dollar.

For emerging markets with fundamentally sound banking systems the fixed-rate regime is not necessarily inherently destructive. But when banking problems emerge, the constraints imposed by a fixed exchange rate mean currency storms can translate quickly into full-blown economic typhoons.

Consider the unfolding of a financial crisis. If the exchange rate comes under pressure, perhaps because of concerns about the health of the banking system, the government is forced to raise interest rates to defend the currency, a policy that further damages the banking sector.

As Professor Mishkin pointed out, in emerging markets this effect is much more severe because of the high proportion of short-term debt in total borrowings - a rise in short-term interest rates becomes almost immediately an shock to demand.

If the peg is abandoned, however, equally damaging problems arise. With a high proportion of dollar-denominated debt, a sudden devaluation of the currency raises dramatically the costs of debt servicing, dampening demand and weakening the balance sheets of banks and non-financial institutions alike.

This is essentially what happened in both the Mexican peso crisis of 1994-95 and the Thai difficulties this summer. Though the immediate causes were different - in the former, fears of sovereign debt problems; in the latter, domestic banking difficulties - the development of the crises were similar.

The special characteristics of emerging market economies' debt means devaluation or the abandonment of a fixed-rate regime precipitates a much greater economic downturn than is the case in industrialised countries: Professor Mishkin pointed out that whereas a country like Britain ultimately benefited from its foreign exchange crisis in 1992, an emerging market country like Mexico experienced a depression after its trauma.

The analysis leaves only one practical problem unanswered: how does a country extricate itself from a fixed exchange rate policy if it is no longer seen as appropriate?

Though several of the south-east Asian countries have now abandoned their pegs under pressure, no-one seems to have come up with what is termed a good "exit strategy" from a fixed rate regime. As soon as the possibility is even considered in public, it precipitates a run on the currency.

It seems countries have no alternative but to stick with the policy until it is blown apart in a frenzy of activity on the foreign exchanges - hardly a recipe for financial stability.

The Causes and Propagation of Financial Instability: Lessons for Policymakers, by Frederic Mishkin, Federal Reserve Bank of New York.

© Copyright the Financial Times Limited 1997
"FT" and "Financial Times" are trademarks of The Financial Times Limited.

		Gerard Baker: Pegged back by orthodoxy MONDAY SEPTEMBER 8 1997 For years, emerging market governments have been exhorted by their counterparts in the industrialised world to follow the hallowed tenets of modern economic orthodoxy if they wanted to join the rich countries' club. The pursuit of price stability through sound monetary policy and fiscal rectitude was invariably the overriding condition those governments recommended, and imposed on the importunate through the offices of the International Monetary Fund. For many of the emerging countries, one particular policy aimed at producing price stability was the centrepiece of IMF-prescribed doctrine: fixed exchange rates. Pegging national currencies to the dollar or a trade-weighted basket of foreign currencies was often the primary provision of IMF-approved programmes in Latin America and Asia, and more recently in eastern Europe. Now, in the wake of the financial turmoil that has swept south-east Asia in the last three months, economists and policymakers are beginning to rethink this axiom of IMF orthodoxy. It seems that not only might fixed exchange rates not be a precondition of stability, they might actually have provoked the financial crises, or at the very least substantially exacerbated them. That was the near- consensus of economists, finance ministry officials, central bankers and politicians last month at the annual symposium of the Kansas City Federal Reserve in Jackson Hole, Wyoming. Though most present attributed the causes of the recent problems to a range of the usual suspects - lax banking supervision, inadequate disclosure of information, irresponsible fiscal policies - most also agreed that adherence to fixed exchange rate regimes was a critical contributor that probably needed to be jettisoned if future crises were to be avoided. It was widely accepted that for some countries, especially those with an intractable inflationary problem, fixing exchange rates might still be the quickest and most effective means of restoring monetary order. The externally delivered shock of, in effect, hitching an inflation-ravaged monetary policy to the growth of money supply in the US was often sufficient to crush inflationary pressures, even if it was at the cost of a collapse in demand. But in a well-received paper by Frederic Mishkin, an economist with the Federal Reserve Bank of New York and one of the leading authorities on monetary policy, the conference heard that there are special characteristics of emerging countries that now make fixed exchange rates highly dangerous. Professor Mishkin drew an important distinction between the nature of financial crises in industrialised countries and those in emerging ones. The central difference stems from the structure and the denomination of countries' debt. In industrialised countries, where inflation risks are perceived to be relatively small, most debt is of relatively long maturity and denominated in the host currency. But in emerging countries, where there is a much shorter track record of sound monetary policy, investors prefer the security of shorter-dated debt and, more importantly, like to lend in a reserve foreign currency, usually the dollar. Investors are thus relieved of the exchange rate risk, should the emerging market government prove incapable of holding its fixed exchange rate against the dollar. For emerging markets with fundamentally sound banking systems the fixed-rate regime is not necessarily inherently destructive. But when banking problems emerge, the constraints imposed by a fixed exchange rate mean currency storms can translate quickly into full-blown economic typhoons. Consider the unfolding of a financial crisis. If the exchange rate comes under pressure, perhaps because of concerns about the health of the banking system, the government is forced to raise interest rates to defend the currency, a policy that further damages the banking sector. As Professor Mishkin pointed out, in emerging markets this effect is much more severe because of the high proportion of short-term debt in total borrowings - a rise in short-term interest rates becomes almost immediately an shock to demand. If the peg is abandoned, however, equally damaging problems arise. With a high proportion of dollar-denominated debt, a sudden devaluation of the currency raises dramatically the costs of debt servicing, dampening demand and weakening the balance sheets of banks and non-financial institutions alike. This is essentially what happened in both the Mexican peso crisis of 1994-95 and the Thai difficulties this summer. Though the immediate causes were different - in the former, fears of sovereign debt problems; in the latter, domestic banking difficulties - the development of the crises were similar. The special characteristics of emerging market economies' debt means devaluation or the abandonment of a fixed-rate regime precipitates a much greater economic downturn than is the case in industrialised countries: Professor Mishkin pointed out that whereas a country like Britain ultimately benefited from its foreign exchange crisis in 1992, an emerging market country like Mexico experienced a depression after its trauma. The analysis leaves only one practical problem unanswered: how does a country extricate itself from a fixed exchange rate policy if it is no longer seen as appropriate? Though several of the south-east Asian countries have now abandoned their pegs under pressure, no-one seems to have come up with what is termed a good "exit strategy" from a fixed rate regime. As soon as the possibility is even considered in public, it precipitates a run on the currency. It seems countries have no alternative but to stick with the policy until it is blown apart in a frenzy of activity on the foreign exchanges - hardly a recipe for financial stability. The Causes and Propagation of Financial Instability: Lessons for Policymakers, by Frederic Mishkin, Federal Reserve Bank of New York.


		© Copyright the Financial Times Limited 1997 "FT" and "Financial Times" are trademarks of The Financial Times Limited.