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«Do Currency Regimes Matter in the 21st Century? An Overview Hiroshi Fujiki and Akira Otani This paper selectively reviews the recent literature on ...»

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Calvo (2000) also points out that dollarization provides a cushion for sharp relative price changes in comparison with a flexible exchange rate. If prices and wages are sticky, the nominal profit of firms will change slowly. Thus, firms would be more willing to repay debt and might facilitate a more orderly recontracting of debt under Keynesian-type recession. Calvo (2000) admits the cost of losing the LLR function. However, adding international banking, as can be seen in Panama, would be a solution.32 An alternative to dollarization is not a textbook-style free flexible exchange rate system but a closely managed flexible rate system, because the lack of credibility of central banks would mean a managed float with a lot of intervention, or inflation targeting with less credibility.33 If this regime is a realistic alternative, dollarization might make sense.

2. Is unilateral dollarization the solution?

Corbo (2001) discusses the advantages and disadvantages of dollarization in the Americas. He points out that potential benefits of dollarization are low inflation, the elimination of currency risk and its associated risk premium, low transaction costs of using the currency, lower relative price volatility of tradable goods with dollarized economies and thus a larger amount of foreign trade with those economies, and the

31. Calvo and Reinhart (2000) illustrate why large exchange rate swings are feared when access to international credit may be lost.

32. Calvo (2000) evaluates Panama’s system as follows: “In Panama, banks are subject to minimal reserve requirements and there is no institution in charge of LOLR operations. Seemingly, the de facto LOLR has been a large American bank..... The country has suffered only minor tremors from Tequila and other recent financial crises.”

33. Calvo and Reinhart (2002) find that economies that say they allow their exchange rate to float mostly do not do so. Relative to committed floaters such as Japan, the United States, and Australia, observed exchange rate volatility is small.

60 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview elimination of currency mismatch in foreign liabilities. He suggests the main cost is that, in the presence of nominal rigidity in the labor market, real depreciation is hard to achieve, and thus a real negative shock, such as a terms of trade shock, would lead to serious unemployment.

Consider economies with poor records of monetary stability, in which currency substitution is high, or economies in which a substantial part of trade in goods and capital flows occurs with the United States. Corbo (2001) suggests that the benefit of dollarization would outweigh the cost of dollarization in such economies, if labor markets are flexible and the appropriate institutions support the financial system. He suggests that many Central American economies satisfy this condition, while in large economies, except for Argentina, their choices are not clear.

Edwards (2001a) admits that the argument made by Calvo and others in favor of dollarization goes beyond the scope of the static theory of optimum currency areas.

However, he warns that their policy recommendations are based on very limited empirical and historical evidence in very small economies. He examines a small group of economies that live under a so-called dollarized monetary system,34 and finds that those nations have (1) had significantly lower inflation, (2) grown at a significantly lower rate, and (3) had similar fiscal deficits and current account balances compared with non-dollarized economies. In the case of Panama, he points out its success in achieving lower inflation, but behind these achievements it has failed to maintain fiscal discipline and has been helped by the IMF programs quite often. He also shows that external shocks in the form of terms of trade disturbances and current account balance reversals have had larger negative effects on Panama than on non-dollarized economies.

Edwards (2001b) stresses that the credibility of hard pegs is not automatic. At a minimum, an economy needs to address key structural issues such as fiscal solvency, appropriate preparation for exercising the LLR function,35 a solid banking sector, and a sufficiently high quantity of dollar reserves in the case of a currency board.

Based on the information available while this paper was written, the experience in Argentina suggests that even a currency board cannot work if the economy does not follow a prudent fiscal policy. Another lesson is that an economy’s choice of currency regime should take into account those of their key trading partners.36 The combination of low inflation and market liberalization in the early 1990s did not result in fast and sustained productivity growth that exceeded the rise in real wages, which could have preserved Argentina’s competitiveness under the currency board (Feldstein [2002]).

34. These economies are the following very small economies: Andorra, Kiribati, Liberia, Liechtenstein, the Marshall Islands, Micronesia, Monaco, Nauru, Palau, Panama, San Marino, and Tuvalu.

35. For example, one may wonder if the private banks alone could adequately handle a sudden increase in demand for dollars by citizens in a dollarized economy. Such a demand shock, if large enough, could be transmitted to the U.S. financial market.

36. Given the devaluation of the peso, Hausmann (2002) recommends establishing an independent central bank with a price stability mandate, to increase the jobs in agriculture, industry, and tourism, stimulate foreign demand, lower tariffs, and reestablish financial stability. Sachs (2002) wonders if Argentina’s history of monetary instability makes the benefit from devaluation questionable, and thus dollarization would still be preferable.

61 B. A Common Currency Area for the Americas in the Future The recent movement toward a floating exchange rate may not be the end of the discussion on the currency regime in the Americas. For example, Dornbusch (2001) argues that Mexico would benefit from the immediate introduction of a currency board to deepen economic integration with the United States. Corbo (2001) states that the type of monetary arrangement which would be more appropriate for the Southern Cone Common Market (MERCOSUR) as a whole is an open question.

However, in the long run, Corbo (2001) states that interest in moving toward currency areas in Latin America will increase, as the experience of the euro becomes clear. In this case, as Salvatore (2001) suggests, the United States might have a negative interest in the expansion of the dollar area. Suppose many Latin American economies succeed in reducing the rate of inflation to a level as low as that of the United States in the future. In such a situation, the U.S. government might benefit from dollarization in the Americas because of the increases in seigniorage and trade flows. At the same time, massive use of the dollar in the Americas, especially in large economies, might make the monetary management task of the Federal Reserve Board (FRB) harder in terms of gearing its policy exclusively toward the U.S. economy.

And if this difficulty were to raise doubts regarding the credibility of the dollar, it could well result in a sudden shift from the dollar to the euro, producing large-scale financial turmoil (Salvatore [2001]).37 V. The East Asian Experience At the beginning of the 1990s, many East Asian economies experienced high-speed economic growth. There were many economic discussions regarding the keys of success in the East Asian economies, such as World Bank (1993). Krugman (1994) was a notable critic of this success, although what he expected was a slowdown of Asian growth based on lower estimates of total factor productivity growth in this region computed by Young (1995), rather than a meltdown of the financial system in some economies in this area.

Since the East Asian crisis, a large amount of literature has been published on this topic (see, for example, Corsetti et al. [1999a] for an overview of economic fundamentals and the debate regarding this experience). Economists started to complain about many features of the economic environment in this region, for example, crony capitalism, weak banking sectors, inadequate sequencing of capital account liberalization, the lack of a legal basis in these economies, and so on, as well as about the de facto dollar peg employed in some economies. Since the bipolar view in the Asian context is motivated by the twin crises, in this section we will review a variety of models of the twin crises and policy debates. We will then move on to the issue of an Asian currency area.

37. One may object to this view because U.S. monetary policy did not show so much external concern during the dollar-standard era. An important assumption here is that the euro becomes another important international currency and the use of the dollar prevails throughout the Americas.

62 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2002 Do Currency Regimes Matter in the 21st Century? An Overview A. Twin Crises and Policy Debates: What’s New?

A variety of research papers have tried to explain the twin crises and subsequent policy debates following the East Asian crisis.

Many economists have focused on moral hazard as the common source of the over-investment, excessive external borrowing, and current account deficits that led to the twin crises (see, for example, Corsetti et al. [1999b], Krugman [1998], and Schneider and Tornell [2000]). Among the sources of moral hazard, some economists complain that the involvement of the IMF in Mexico might have allowed foreign investors in East Asian economies to expect that the Fund would help them. Such concerns led to extensive discussions regarding the role of the IMF (see, for example, Meltzer Commission [2000]).

Excessive investment based on bank lending requires a new way of thinking about the policy response to a crisis. The IMF often suggests a temporary sharp tightening of monetary policy to support the exchange rate, followed by gradual loosening once confidence seems to have been restored. Does this cure make the disease worse?

Furman and Stiglitz (1998) argue that high interest rates in highly leveraged economies can drive the exchange rate in an unintended direction. This is because such an operation would put local banks in jeopardy and make the economic situation worse.

Krugman (2000) gives an intuitive explanation why a low interest rate policy may not help such a crisis-hit economy using a slightly modified Mundell-Fleming framework (Figure 2). In the commodity market, a currency depreciation will increase net exports and domestic output in the ordinary case. Suppose that the Figure 2 Krugman (2000) Model

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63 adverse balance-sheet effects, for example, an increase in the domestic value of debt denominated in foreign currency due to depreciation, were to be sufficiently strong in the crisis. Then, the negative wealth effect due to the balance-sheet problem would generate a commodity market equilibrium condition S-shaped curve (the SS curve in the figure) against the nominal exchange rate. The asset market equilibrium condition would be the downward-sloping AA curve in the figure. Given the domestic GDP, if the monetary authority leans against the exchange rate movement, we can suppose AA is downward sloping. Thus, there are two locally stable equilibria.

Suppose a lower interest rate policy and a depreciation of nominal exchange rate were made. If this were done at around the good equilibrium in Figure 2, then the standard remedy would work. However, consider a situation where self-fulfilling capital flight or a political crisis occurs. Then, the economy might jump toward the crisis equilibrium, rather than the good equilibrium in the figure. Facing the risk of moving toward the crisis equilibrium, the central bank would be reluctant to loosen monetary policy because such a decision would only ensure that the crisis equilibrium materializes. Alternatively, if the central bank tightened, at least temporally, to persuade the market that the currency was strong, a sufficiently severe short-run shock would produce lasting effects, as in the Indonesian experience. Thus, the traditional policy response in a recession would reach a dead-end.

Another group of economists considers the role of liquidity during a banking crisis and its relationship with exchange rate regimes (see, for example, Chang and Velasco [2000, 2001]). Caballero and Krishnamurthy (2001) make an important distinction between domestic liquidity constraint and international liquidity constraint. The standard Mundell-Fleming model approximates an external shock either as a rise in the country premium or international interest rates based on interest parity condition.

In other words, it assumes that unlimited funds are available from abroad at a high but fixed price. Thus, distressed firms with good collateral would be helped by foreign funds at constant but high interest rates. Reductions in the domestic liquidity constraint due to a lower interest rate policy would also be helpful for these distressed firms. However, Caballero and Krishnamurthy (2001) argue that if the international liquidity constraint and domestic liquidity constraint are simultaneously binding, a domestic low interest rate policy would mainly affect the domestic relative price of the limited amount of international liquidity within this crisis-hit economy. Thus, a low interest rate policy during the crisis might bring about a sharp overshoot in the exchange rate depreciation without substantial gain in terms of real activity.

B. A Common Currency Area in Asia in the Future In East Asia, based on the IMF classification as of March 31, 2001, we see hard-peg economies (Hong Kong), conventional fixed exchange rate economies (Malaysia), managed floating with preannounced exchange rate target economies (Singapore), and independent float economies (Korea, Indonesia, the Philippines, and Thailand).

Before the East Asian crisis, most of these were de facto dollar-peg economies.

Currently, exchange arrangements in the East Asian economies are diversifying.

However, it still makes sense to pose the following question: what is a desirable exchange rate regime for the Asian economies, including a common currency area?

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