Lessons of Recent Currency Crises

Given all that has been written over the past half dozen years about the lessons of currency crises, I feel somewhat like Henry VIII's sixth wife on her wedding night: I know what is expected of me, but I am not sure I can make it that interesting. Nevertheless, let me try by focusing on lessons in two areas, namely, currency regimes and debt problems.

Currency Regimes

There is widespread dissatisfaction with the status quo on currency regimes for emerging economies on at least three counts.

First, the high vulnerability of adjustable pegs and simple crawls has been amply demonstrated during the past seven years. The crises of Mexico, Thailand, Indonesia, South Korea, Russia, Brazil, and Turkey speak loudly to the fragility of these regimes.

Adjustable peg regimes often led to complacency about currency risk and large currency mismatches. Few countries can defend a peg for long with a high interest rate defense, and a noncrisis exit to greater exchange rate flexibility has proved difficult to bring off.

The latest version of the crawl—namely the basket band crawl (or BBC regime), proposed by John Williamson (2000)—admittedly has some nontrivial advantages. Still, experience suggests that a BBC regime is not flexible enough to handle large and abrupt shifts in investor sentiment and private capital flows. When that happens, the band gets widened further and further until it is ultimately abandoned in favor of float. Moreover, recent empirical research suggests that intermediate regimes have historically yielded the highest average inflation rates and rates of monetary expansion; that is, they do not provide a good monetary anchor. ¹

Second, while less fragile than soft pegs, Argentina's experience documents that currency boards are by no means immune from speculative attacks. Just as important, currency boards do not offer a visible policy instrument to deal with recessions, since monetary policy is made abroad, concerns over debt sustainability often rule out countercyclical fiscal policy pump-priming, and the domestic economy is invariably not flexible enough to correct a large real exchange rate overvaluation without a change in the nominal exchange rate. Nor is a fiscal contraction likely to yield enough of a confidence boost (or decline in the risk premium) to be expansionary.

Dollarization, the hardest of the hard pegs, hardly looks like the solution. Yes, dollarization does away with currency mismatches. But if a dollarized emerging economy (with a debt problem) has an overvalued exchange rate, the correction will come via a decline in the domestic price level. This in turn means a higher real debt burden. In other words, dollarization does not do away with debt problems. Even more to the point, the most comprehensive review available of the performance of dollarized economies, undertaken by Sebastian Edwards (2001), concludes that dollarized economies show inferior growth performance relative to nondollarized economies, better inflation performance, and essentially no difference on either fiscal policy discipline or current-account behavior. No wonder, then, that Edwards concludes that most of the lofty claims for dollarization represent "misleading advertisement."

Third, it is known from the empirical work of Calvo and Reinhart (2000) as well as Hausmann and others (2000) that emerging economies do not float in the same way as large industrialized countries. Specifically, the former lean more heavily on interest rate policies and sterilized exchange market intervention to limit the movement in the nominal exchange rate. Moreover, this so-called fear of floating seems to be linked to the high incidence of dollar-denominated debt and large currency mismatches. In such an environment, a large depreciation could result in large-scale insolvencies and deep output losses. When floating is more de jure than de facto, emerging economies do not obtain the benefits associated with greater exchange rate flexibility. Moreover, a floating regime requires emerging economies to choose a nominal anchor for monetary policy, and the past performance of monetary targeting under (plain vanilla...