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Exchange rate regimes and macroeconomic stability

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edited by

Lok-Sang Ho
Lingnan University
Hong Kong

Chi-Wa Yuen
University of Hong Kong
Peking University and Wuhan University
Hong Kong


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
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Printed on acid-free paper.


List of Contributors
Assaf Razin
F oreword



Chapter 1

Lok-Sang Ho and Chi-Wa Yuen


Part 1

The Asian Currency Crisis: Responses and Policy Options


Chapter 2

Lessons from the Asian Financial Crisis, and the Prospects
for Resuming High Growth
Wing Thye Woo


Chapter 3

Financial Market Stability, Monetary Policy, and the IMF
Joseph Stiglitz

Chapter 4

The IMF Approach to the Asian Currency Crises: An
Alternative View
Charles Adams

Chapter 5

Does Asia Need a Common Currency?
Robert Mundell

Chapter 6

Recommending a Currency Basket System for Emerging
East Asia
Masahiro Kawai

Part 2
Chapter 7

Monetary Policy, Exchange Rate Regimes, and
Macroeconomic Stability
A Comparative Analysis ofExchange Rate Regimes
Naoyuki Yoshino, Sahoko Kaji and Ayako Suzuki






Chapter 8

Chapter 9

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


Chapter 10 Currency Board, Asian Financial Crisis, and the Case for
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





Understanding Crises
Chi-Wa Yuen



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
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.


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
Yum K. Kwan is Associate Professor ofEconomics at the City University of
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
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


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.


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.

Tel Aviv University and Cornell University


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.

Chapter 1

Lok-Sang Ho* and Chi-Wa Yuen t
*Lingnan University, fUniversity ofHong Kong, Peking University, and Wuhan University

The whole world is still in search of a more efficient system of
managing its monies--one that can bring greater stability to the world's
financial markets. This does seem rather strange, given that the Bretton
Woods system-itself the result of a major international effort to bring
stability to the world's international monetary system-was born in 1944
more than half a century ago, and that both the World Bank and the IMF,

institutions set up under the Bretton Woods arrangement, had access to the
brightest brains in economics.
Another equally puzzling development is that financialleconomic crises
have become deeper and more frequent over the past 25 years,
notwithstanding the rapid development of economics as a discipline and the
emergence of almost four dozen Nobel laureates in economics-including
two of our contributors Robert Mundell and Joseph Stiglitz.) The lingering
effects of the Asian Financial Crisis, which broke out in 1997, were still
affecting many countries in the region when 2001 Nobel Laureate Joseph
Stiglitz gave his speech ("Financial Market Stability, Monetary Policy, and
the IMF") to the Hong Kong Economic Association in December 2000,
when he predicted that another crisis might be looming in Argentina. The
course of events proved that he was right. The currency board system in
Argentina, reputed to have restored price stability and economic order to a
chaotic system, broke apart in January 2002, as the country defaulted on its
loans and painfully devalued the peso amid street riots.
Once again, some critics put the blame on the IMF? Others consider
the overvaluation of the peso consequent on the strength of the dollar and
especially the devaluation of the Brazilian real in 1999. 3 Still others claim
that the problem lies in Argentina's not following the orthodox currency
board model. 4
Yet still others blame Argentina's problems on its
half-hearted pro-market reforms, which have resulted in corruption and
faulty legal institutions. 5


Exchange Rate Regimes and Macroeconomic Stability

When something goes wrong, dozens of theories can be made up to
explain it. Many of these explanations, however, are cooked up after the
fact and, for that reason, may not have much predictive power. In contrast,
Stiglitz's analysis predicted the crisis, and he further predicted that the crisis
would most likely be mismanaged. His analysis thus carries weight and
deserves to be c10sely studied.
Another weighty and provocative artic1e in this volume is the one by
2000 Nobel Laureate Robert Mundel1. In his chapter on "Does Asia Need
A Common Currency?" Mundell argues that the answer to that question lies
in what is the alternative. According to hirn, the first best for the world is
to have a "common currency." If that should materialize, Asia would not
have needed aseparate common currency. But if that option is not
practical, at least for the time being, then Asia would do well to have a
common currency within the region. By a common currency Mundell does
not necessarily mean a single common currency. He believes that it will do
just fine if separate currencies "operate just like one common currency."
He also believes that the US dollar can serve as the default anchor currency,
given that neither the yen nor the RMB would work. Linking Asian
currencies to one another and anchoring them to the US dollar can be
effected, for instance, through currency boards. Mundell's advice would
certainly provoke further studies on the merit of currency board
arrangements. In this volume we have several extended studies on the
Among authors who address the currency board issue, Corrinne Ho
("Contemplating the Credibility of Currency Boards") provides an in-depth
exploration of the fundamental subject of credibility. In particular, she
makes clear distinction between the concept of "credibility-worthiness,"
which relates to the objective ability and willingness to deliver the promises
of the regime, and that of "credibility," which is the public's subjective
perception of the former. A study of the Hong Kong currency board

system shows that perception and "market sentiment" (a reflection of
"credibility-worthiness" of the policymaker and the regime. Corrinne Ho
provides an interesting perspective by examining the circumstances under
which the five major modern currency boards were introduced and their
subsequent histories in order to get a sense of how contextual factors help
shape credibility-worthiness and credibility.
The subject of credibility of the currency board arrangement is also
dealt with, but from a different, institutional arrangement angle, by Lui,
Cheng, and Kwan ("Currency Board, Asian Financial Crisis, and the Case
for Put Options") and by Alex Chan ("The Currency Board in Hong Kong:
Operational Weaknesses and a Proposed Refinement Scheme"). These



chapters, written independently and from a rather different perspective, come
to similar conc1usions, namely that the seven technical measures to
strengthen the currency board system, introduced by the Hong Kong
Monetary Authority (HKMA) in September 1998, are tantamount to a
"reserve commitment policy" or a currency "put option"-effective1y a

"convertibility insurance" for those holding Hong Kong dollars as proposed
by Merton Miller in 1998. Since the Hong Kong system is the world's
single most important currency board in practice today, the detai1ed analysis
of the operation of this system is of great value to countries pondering the
use of currency board systems in the future. The two chapters are
complementary in that the chapter by Lui et. al. is more theoretical, while
that by Alex Chan is more operational. Lui et. al. suggest that interest rate
arbitrage has been working properly until the rule-bound currency board was
eroded by central bank-like, discretionary policies pursued by the HKMA.
The de facto implementation of the put options proposal put the HKMA
back onto the rule-bound track, and interest rate arbitrage appears to be
effective again. Chan goes to great details on the operational side,
explaining how the currency board system has worked in Hong Kong during
the different historical phases of the system.
Credibility and confidence are obviously interrelated. Charles Adams
("The IMF Approach to the Asian Currency Crises: An Alternative View")
pinpoints the importance of confidence. He points out that the observed
upward pressure on interest rates may be a reflection of the collapse of
confidence and need not imply conscious monetary tightening.
"Expansionary monetary policies would have been required to avoid high
interest rates," he wrote. This position may be subject to debate, given the
literature on the monetary conditions index, which would ·look at surging
real interest rates as de facto tightening of monetary policy, other things
being equal. One will, however, have to agree with Adams that without a
convincing way to restore confidence, high interest rates will be unavoidable.
Moreover, Adams explains that the IMF's key concern was to stabilize
"badly hemorrhaging balance of payments positions," which is just another
way of saying restoring confidence. Adams points out that the IMF has
facilitated external debt restructuring in at least one of the crisis-afflicted
Asian economies, viz., Korea. Ignoring the contribution of the IMF in

restoring confidence and hence financial market stability would not have
been fair to the IMF. 6
Wing Thye Woo ("Lessons from the Asian Financial Crisis, and the
Prospects for Resuming High Growth"), a self-espoused critic of the IMF,
agrees that the role of confidence is paramount. The key, however, is what
builds confidence. "Since all five currencies (and economies) collapsed
rather than just one as expected, it seems that financial contagion is a better


Exchange Rate Regimes and Macroeconomic Stability

explanation than weak domestic fundamentals." To Woo, occasional
excessive price movements in financial markets are normal and to be
expected. "Bad things can happen to good people" and that economic
disasters, rather than "penitence for economic sins," should be dealt with
realistically, seriously, and globally. He is especially wary about the
effects of short term capital flows, and makes a plea for a coordinated effort,
both at the international level and at the regional and national levels, to
manage exchange rates.
According to Lok Sang Ho ("Bringing About Realistic Exchange Rates:
A Post-Asian Financial Crisis Perspective"), what belies the credibility of
and confidence about fixed exchange rates in general and the currency board
in particular might be the real value of the exchange rate itself. If the
exchange rate itself lacks credibility (e.g., due to excessive strength of the
anchor currency or home-grown inflation), then all the institutions,
announcements, and even strong reserves will not count. In contrast to the
stability-pain tradeoff assumed by Corrinne Ho, Lok Sang's implicit
assumption is that there is a threshold of economic pain that an economy can

endure. Pain tolerance may therefore not be relied upon indefinitely to
bring stability to the exchange rate regime. On this basis, he considers
establishing "realistic exchange rates" as an alternative, explores a
mechanism for operationalizing the concept, and offers it as an answer to the
debate over the choice between the floating and fixed exchange rates. Lok
Sang's discussion of this important subject is highly relevant to the
interesting question raised by Lui, Cheng, and Kwan, who ask whether the
Hong Kong currency board based on an exchange rate established in 1983 is
sustainable, given the much higher inflation rate in HK than in the US
(though subdued and turned into deflation after 1998). In particular, has
Hong Kong become so expensive---especially in light of the strength of the
US dollar-that it must devalue its currency to restore international
competitiveness? Lui et. al. believe that if prices and wages adjust quickly
enough, there would be no need for a devaluation, and the pain of adjustment
would be much smaller. If the institutions are there to safeguard credibility
and inspire confidence, the currency board should have no risk of being
unsustainable. In light of the fact that any overhanging debt does not
deflate with deflation, the workability of this approach in restoring
competitiveness is still open to question, and Lok Sang's call for "realistic
exchange rates" appears to deserve a closer look.
Echoing to Lok Sang's urge for the need to introduce a system offering
relatively stable real effective exchange rates that are compatible with the
need for full employment, Masahiro Kawai ("Recommending A Currency
Basket System for Emerging East Asia") argues that economies currently
operating under a US dollar peg, such as Malaysia, China, and the Hong



Kong SAR, should exit to a currency basket system before the next round of
exchange market pressure develops. The proposed currency basket system
ought to be supported by regional surveillance and financing mechanisms.
With better political and institutional support, a more robust framework of
macroeconomic and exchange rate cooperation will evolve in the region.
The validity ofKawai's argument is confirmed by the theoretical analysis of
Yoshino, Kaji, and Suzuki ("A Comparative Analysis of Exchange Rate
Regimes"), who conclude that of the three arrangements, the basket-peg, the
dollar-peg, and the free float, the basket-peg could potentially minimize the
government's policy losses under alternative policy objectives, while the
losses would always be larger under the free float than under the dollar-peg.
They have also estimated the optimal weights for the ideal currency basket.
Over all, the set of chapters contained in this volume offers interesting
perspectives which have been stimulated by the recent turns of events in the
foreign exchange market. They provide a useful reference for anyone
interested in the development of exchange rate regimes, and represent
considerable reflection and hard thinking by economists half a century after
Bretton Woods.





Forty-six economists have up till 2001 been awarded the Bank of Sweden Prize in
Economic Sciences in Memory of Alfred Nobel.
"The Argentina crisis is the result of the IMF's emphasis on tight monetary policies,"
says Rodrigo Carazo, former president of Costa Rica. "In order to service foreign
debt and satisfy foreign investments, all of the traditional public institutions have been
sold off.
This means the people of Argentina have nothing to resort to."
(Radio-Netherlands, December 28, 2001.)
The core of Argentina's problem, according to Paul Krugman, is " ... the deflationary
pressure imposed by an overvalued currency. Dollarization offers no cure; it would
end speculation against the currency, but do nothing about the underlying economic
problem." ("Argentina's Money Monomania.")
Steve Hanke and Kurt Schuler, "What Went Wrong In Argentina?" Central Banking
Journal, Vol XII, no.3, February 2002.
Brink Lindsey, "How Argentina Got Into This MessT' Wall Street Journal, January 9,
Adams' analysis is consistent with a statement made by Thomas C. Dawson, Director
of the External Relations Department of the IMF, in a letter to the editor for the Daily
Yomiuri: "Argentina's experience shows that-no matter what currency regime is
adopted, no matter how much external support is forthcoming, and no matter how
strong the personalities are-ultimately it is the confidence of the people and the
markets in the underlying strength ofnational policies that really counts."

Part 1


Chapter 2

Wing Thye Woo *
University ofCalifornia, Davis

Broadly 'speaking, there were two initial explanations /or the
unexpected nature 0/ the Asian financial crisis. The first explanation
emphasized the common. structural problems (soft rot) in the crisis Asian
countries, and the second explanation emphasized the primary roles 0/
investor panic and financial contagion. In my view, the crisis was built on
national weaknesses that were greatly magnified by a jlawed international
financial system; the initial policy recommendations from Washington,
especially to raise interest rates sharply and to close a large number 0/
financial institutions, were inappropriate, and made matters worse, not
There was tittle particularly "Asian" about the Asian financial crisis.
The more generic character 0/ the crisis became all too clear during 1998,
as the crisis spread to Russia, South Africa, and Latin America. The world
is experiencing a type 0/ global crisis that rejlects the rapid arrival 0/ global
capitalism. Long-term crisis prevention requires actions both at the
national, regional, and international levels, including a basic change 0/
strategy in exchange rate management, recognition 0/ the inherent
destabilizing risks 0/ short-term capital jlows, and the establishment 0/
regional monetary institutions.
The continued high growth 0/ the Asian economies will depend on
their ability to maintain and improve its competitiveness in a globalized

economy. Southeast Asia, in particular, is unlikely to return to the high
growth 0/ the previous 20 years, unless it not only pursues the anti-financial
crisis measures, but also strives to increase its technological capacity in


Exchange Rate Regimes and Macroeconomic Stability

order to accelerate technological diffusion to the region, and to accelerate
indigenous innovation.

The Asian financial crisis has been as puzzling as it has been
far-reaching in its consequences. The sharp region-wide plunge in output
after of the devaluation of the Thai baht in July 1997 was unexpected, land
the strong region-wide recovery in 1999 was equally unexpected. Although
the World Bank and the International Monetary Fund have long shared a
common policy framework, they were divided on the causes of the crisis,
and on what the policy advice should have been given. All across Pacific
Asia, the crisis has brought about many fundamental changes: internationally
well known conglomerates have collapsed, the banking systems are
paralyzed by large amounts of non-performing loans, and barriers to entry by
foreign financial institutions have been lowered.
During the darkest moments ofthe Asian financial crisis in 1998, it was
widely predicted that East Asia would continue to be deathly sick for the
next two to four years. While it is fortunate that the news of the (near)
death of the East Asian miracle was greatly exaggerated, this economic
earthquake remains a tragic disaster in human terms. The tremendous
destruction of weaIth and the pushing of a significant proportion of the

population in the poorer countries to below the poverty line caused political
volcanoes to erupt in several countries. New governments have emerged in
Indonesia, South Korea and Thailand; and the political leadership is split in
Malaysia. The social after-shocks of this economic earthquake were still
feit during the inaugural biennial conference of the Hong Kong Economic
Association in December 2000.
In December 2001, with the passage of now over four years since the
crisis began, we are in the position to suggest some tentative conclusions
about the causes of the crisis and the appropriateness of the policy responses
to the crisis. However, we feel that while we may now know enough about
the nature of the Asian financial crisis to ensure that future financial crises
would not inflict such severe damage again, the preventive policies that have
been discussed (and ofwhich, many are being implemented) may not return
the East Asian economies to their previous paths of sustained high growth.
The situation of the mid-income and high-income East Asian economies is
that they need to become endogenous centers of growth if their previous
high growth rates are to be maintained, and we think that more and better
coordinated public efforts are required in order to achieve this goal. This

Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth


problem appears to be particularly acute for the Southeast Asian economies
of Indonesia, Malaysia, Philippines, and Thailand.

For the economics profession, the Asian financial crisis has been
divisive and, for some economists, humbling. The International Monetary

Fund (IMF), the financial firefighter of the world, under-predicted the
severity of the output collapse in every one of its pro gram countries,2 and
then went on to under-predict the pace and strength of the economic
recovery. 3 This systematic failure in prediction by the IMF of output
behavior in the crisis countries certainly suggests an institution that neither
understood the cause of the region-wide crisis nor knew what the optimal
rescue package for these countries should have been.
It was in support of this impression of an incompetent IMF that Joseph
Stiglitz, the Chief Economist at the World Bank during the crisis, wrote in
April 2000:
"IMF experts believe that they are brighter, more educated,
and less politically motivated than the economists in the countries
they visit. In fact, .... the IMF staff.... frequently consists of
third-rank students from first-rate universities .... Quite frankly, a
student who turned in the IMF's answer to the test questions
"What should be the fiscal stance of Thailand, facing an economic
downturn?" would have gorten an F.,,4
The economics profession is certainly divided over the IMF's
performance but not in a clear-cut fashion, however. For example, among
the economists who agree with Stiglitz that the first IMF pro grams that
Indonesia, South Korea and Thailand were badly flawed, many would differ
importantly both from his reasons for why the IMF made mistakes and from
his negative assessment about the general analytical capability of the IMF.
The economics profession has shown uncharacteristic humility over its
initial judgement of the Asian financial crisis. The well-known economist,
Paul Krugman, has recorded ein his website the changes in his thinking about
the crisis, and we will use his intellectual odyssey as a convenient expository
device to capture the evolution in the economics profession's analysis ofthe
Asian financial crisis.
In March 1998, Paul Krugman opined that:


Exchange Rate Regimes and Macroeconomic Stability

"Broadly speaking, I would say that there are two approaches
to the Asian crisis .... One approach - which I would identify
mainly with Harvard's Jeffrey Sachs - regards what happened to
Asia as basically a modern, high-tech, multicultural version of a
good old-fashioned financial panic ... The important point to make
here is that a panic need not be a punishment for your sins. In
principle, at least, an economy can be "fundamentally sound" ...
and yet be subjected to a devastating run started by nothing more
than a self-fulfilling rumor. ..
"OK, as you may have guessed, I don't buy that story .. The
story I believe ... argues that the preconditions for that panic were
created by bad policies in the years running up to the crisis. The
crisis, in short, was a punishment for Asian crisis, even if the
punishment was disproportionate to the crime.
"What were these Asian crises? We hear now about 'crony
capitalism.' It's a good. phrase, and it certainly captures the spirit
of what went on in much of Asia .. The specific spirit that pushed
Asia to the brink was the problem of moral hazard in lending mainly domestic lending."s
Following his crony capitalism analysis of the crisis, Paul Krugman
(1998a) went on to deliver a defense of the IMF policies, which had been
criticized (by Jeffrey Sachs, for example) as overly deflationary. He felt
that the policies were justified because the IMF was not a true
lender-of-Iast-resort due to its limited financial capital, and because the IMF
had little choice ("the Fund must either confront crony capitalism or stay out

of the picture altogether").
However, seven months later, in October 1998, Paul Krugman (1998b)
completely reversed his assessment of the crisis in an artic1e entitled "The
Confidence Game: How Washington Worsened Asia's Crash."
Krugman's new awareness:
"When the Asian crisis struck, .. countries were told to raise
interest rates, not cut them, in order to persuade some foreign
investors to keep their money in place and thereby limit the
exchange-rate plunge... In effect, countries were told to forget
about macroeconomic policy; instead of trying to prevent or even
alleviate the looming slumps in their economies, they were told to
follow policies that would actually deepen those slumps.
" .. [To understand the perverse macroeconomic policy stance]
consider the situation from the point of view of those smart
economists who are making policy in Washington. They find

Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth


themselves dealing with economies whose hold on investor
confidence is fragile, .. The overriding objective of policy must
therefore be to mollify market sentiment. But, because crises can
be self-fulfilling, sound economic policy is not sufficient to gain
market confidence; one must cater to the perceptions, the
prejudices, and the whims of the market. ür, rather, one must
cater to what one hopes will be the perceptions ofthe market.
"In short, international economic policy ends up having very

little to do with economics. It becomes an exercise in amateur
psychology, which the IMF - whose top economist Stanley
Fischer, boasts credentials just as impressive as those of Summers
and his crew - and the Treasury Department try to convince
countries to do things they hope will be perceived by the market as
favorable. No wonder the economics textbooks went right out to
the window as soon as the crisis hit.
"Unfortunately, the textbook issues do not go away .... The
perceived need to play the confidence game supercedes the normal
concerns of economic policy. It sounds pretty crazy, and it is."
What led to Paul Krugman's startling apostasy? In a retrospective
piece in a September 1999 issue of Slate, Krugman (1999) asked:
"Where do I fit in? In the summer of 1998, I began to
reconsider my own views about the crisis. The scope of global
"contagion" - the rapid spread of the crisis to countries with no
real economic links to the original victim - convinced me that IMF
critics such as Jeffrey Sachs were right in insisting that this was
less a matter of economic fundamentals than it was a case of
self-fulfilling prophecy, of market panic that, by causing a collapse
ofthe real economy, ends up validating itself."
Several papers in the August 2000 issue of the ASEAN Economic
Bulletin reached the same conclusions as Paul Krugman finally did. Patrick
Damien Carleton, Brian Pilapil Rosario, and Wing Thye Woo (2000)
examined the currency experiences of 57 countries in the 1970-1996 period,
and found that inflationary macroeconomic policies and small stocks of
foreign reserves were reliable predictors of currency collapses. They found
that the individual probability of Indonesia, Malaysia, Philippines, South
Korea and Thailand experiencing a currency collapse in 1997 was about 20
percent, which meant that only one of these five countries should have
experienced a crisis. Since all five currencies (and economies) collapsed


Exchange Rate Regimes and Macroeconomic Stability

rather than just one as expected, it seems that financial contagion is a better
explanation than weak domestic fundamentals.
Wing Woo (2000) examined the movements of the risk premia levied
on Eurobonds issued by East Asia, and came to two conclusions. First, the
great increase in capital flows into East Asia during 1994-1996 was
accompanied by a secular decline in the risk premia. These price-quantity
movements indicate a positive shift in the supply of funds to Asia. This
verification of the existence of "irrational exuberance",6 implies that the
opposite phenomenon, investor panic, must also exist.
Second, the risk premia on Thai Eurobonds increased by 10 basis points
following the July 2, 1997 devaluation but it jumped 41 basis points upon
the implementation ofthe IMF program in August 1997, see Table 1. This
is because economic agents, both domestic and foreign, could see that the
drastically higher interest rates were crippling economic activities and would
cause the nonperforming loan (NPL) situation in Thai banks to worsen, and
hence started fleeing from financial instruments issued by Thai companies.
The IMF pro gram of deflationary macroeconomic policies and abrupt bank
closures undermined investor confidence instead of restoring it!
Table 1. Secondary Market Spreads for Eurobonds Issued by Thailand and Indonesia
(average of daily spreads, in basis points)
April 1997

January 1998

Data Source: McKibbin and Martin (1999)
Spread computed from ten-year dollar-denominated bonds issued by the govemments ofthese
countries. Their rates are first converted using Bloomberg's IRR calculations into yields,
and then compared with US dollar yields of comparable maturity

Anwar Nasution (2000) pointed out that it was important to cleanse the
financial system of insolvent banks but the Indonesian way of doing so (in
compliance with IMF conditionality) in late 1997 exacerbated the economic
cnSlS. The government should have taken over the running of the insolvent
banks in the short-run rather than have closed them down precipitously.

Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth


This way, the lines of credit to solvent borrowers would not have been
disrupted, and the confidence of the depositors unperturbed.
To sum up, in hindsight, we can say that:
investor panic was the cause ofthe Asian financial crisis/
b) tightening macroeconomic policies (particularly fiscal policy) IS an
inappropriate response to panic-induced crisis; and
c) the shutting down of the insolvent banks in Indonesia, South Korea and
Thailand should have been carried out in a manner that was sensitive to
the possibility of triggering bank runs.

There are too many valuable insights in the voluminous literature on the
Asian financial crisis for us to summarize here. 8 We have selected two of
them for discussion here because of their wide implications for economic
management. The first deep insight concerns the natural working of the
market mechanism, and the second deep insight concerns the broader context
within which the market mechanism operates.
There has long been a tradition of resistance within the economics
profession to acknowledge the phenomenon of disorderly market behavior.
The most commonly used defense against claims of speculative bubbles is
the alternative hypothesis that unstable asset prices reflect unstable
government policies. The claim is that observed flip-flop movements in
asset prices reflected rational anticipations of changes in government
policies that were not realized. This defense against the speculative bubble
hypothesis is known in the financialliterature as the "peso problem."
The truth is that the peso problem hypothesis cannot really be disproved,
even in the case where the fundamentals, ex post, were stable for a long
period of time. To see the difficulty of disproving it, suppose that agents,
after long experiences with governrnent behavior, have concluded that the
government is the chief destabilizing force, and adjusted their financial
market behavior accordingly. Ifthe government were to now cease being a
destabilizing force, the very fact that the behavioral norm of the government
had changed fits the definition of a vacillating government! There is just
no way of getting around the sophistry of a determined peso problem
The fact that financial contagion has been common in the 1990's cannot
be in serious dispute: the European Exchange Rate Mechanism crisis in
1992-1993, the Mexican and Latin American financial crisis in 1994-1995,
the Asian financial crisis in 1997-1998, the conversion of the Russian ruble

to a rubble in August 1998, and the collapse of the Brazilian real in January


Exchange Rate Regimes and Macroeconomic Stability

1999 to a more realistic level. It stretches credibility, if not also the
imagination, that all these governments coincidentally shifted to
destabilizing policies in the same decade. Herein lies the first deep insight
from the Asian financial crisis: occasional excessive price movements in
finanäal markets are normal and should not be labeled 'peso problems' in a
knee-jerk fashion.
The unpleasant truth is that "bad things can happen to good people" and
that economic disasters are not necessarily penitence for economic sins.
Crony capitalism is bad regardless of where it exists but it was not the cause
of the Asian financial crisis. Paul Volcker (1999), former Chairman of the
Federal Reserve Board, put it very well when he wrote:
"International financial crises, I might even say domestic
financial crises, are built into the human genome. When we map
the whole thing, we will find something there called greed and
something called fear and something called hubris. That is all
you need to produce international financial crises in the future. I
have not seen anything to raise any doubts about that."
The rejection of the dogmatism of the peso problem approach to
interpreting economic phenomenon leads naturally to the rejection of the
dogmatism of unreflective market bias. It is with this open-mindedness
that Zainal-Abidin (2000) assessed the controversy over the use of capital
controls in Malaysia, and found that, to be modest, one could safely say that
the capital controls have not rendered the recovery in Malaysia slower than

in the other crisis countries. However, if one chose to be less modest, one
could point out that the 1998 collapse was in Malaysia was smaller than in
Thailand and the Philippines, and that the 1999 recovery in Malaysia was
faster than in these two countries. Zainal-Abidin (2000) identified the chief
virtues of the controls to be the monetary policy independence to reflate the
economy, and the breathing room to drastically restructure the financial and
corporate sectors. The main cost of the controls was that Malaysia missed
most of the international capital that returned to the region beginning
1998:4Q. A possible cost, that is still not yet clear, may come from
concerns that a similar policy could be reintroduced prior warning, hence
resulting in a higher risk premium in the future for Malaysian-issued
The second deep insight from the Asian financial crisis is that "getting
the institutions right" is just as important as "getting the prices right" if
long-term stable growth is to be guaranteed. There were failures in both
domestic economic institutions and international economic institutions.
The most relevant domestic economic institution that was inadequate in

Lessons from the Asian Financial Crisis, and the Prospects for Resuming High Growth


pre-1997 Asia was the prudential supervision mechanism in Indonesia,
Malaysia, South Korea, and Thailand. The over-borrowing of short-term
foreign funds, and the collusive relationship between many domestic banks
and their biggest customers rendered these economies vulnerable to
exchange rate and interest rate shocks. The most relevant international
economic institution that proved inadequate during the Asian crisis was the
IMF. Its incorrect diagnosis led to wrong policy advice that worsened the

recession caused by the interaction of investor panic, excessive unhedged
short-term external debt, and fragile balance sheets ofthe domestic banks.
The sad case of Indonesia, which experienced a larger output loss and a
slower recovery compared with its neighbors, suggests that economic
viability depends on political institutions as weIl. The Indonesian outcomes
could arguably be seen as more the results from a flawed political system
rather than as the results from a flawed economic system. In the
three-decade long rule of Soeharto, he relied upon satisfactory economic
growth as the justification for his stewardship of the country.
Regularization of the political process was neglected because Soeharto
recognised such regularization as a reduction in his power. So instead of
establishing political institutions and channels to resolve important
socio-political issues about regime legitimacy, political succession,
administrative transparency, regional concerns, ethnic disputes and religious
tensions, Soeharto resorted to political manipulation, co-optation, and
occasional violence to minimize discussions of these issues. The result is
that beneath the fa<;ade of stable rule buttressed by support from the armed
forces, social dissatisfaction with the Soeharto regime was rising in step with
the expansion of the middle and professional classes, and in step with the
growth of special economic privileges to Soeharto's children, e.g. subsidised
loans from state banks, and monopoly import licenses.
As Soeharto entered into his seventies, and as his health showed signs
of decline, the tensions associated with political succession became
impossible to contain, and fissures within the army appeared. The fissures
multiplied and widened when Soeharto promoted his son-in-law, General
Prabowo Subianto, over several more senior generals to be the head of the
most powerful military command based in Jakarta (Kostrad) -- the post that
Soeharto held when he made his bid for political power in 1965. Soeharto's
increasingly tendency toward an "all-in-the-family" approach to economic
and political matters discredited hirn considerably within his core

constituencies, the army and the bureaucracy. Once the Asian financial
crisis revealed that the aging Soeharto had become an incompetent manager,
there was massive withdrawal of political support by the upper and middle
classes, and factionalism within the army and the civilian bureaucracy spun
out of control. The Indonesians, unlike the Malaysians, the South Koreans