Exchange Rates, Currency Crisis and Monetary Cooperation in Asia (review)

In many respects, the Asian crisis of the late 1990s acted as a very important circuit-breaker in the areas relating to the policies of international macroeconomics and finance. We saw large, persistent and (as it turned out) unsustainable flows of foreign capital into the region during the years leading up to the crisis. This, and the associated increase in the mobility of capital being processed by the structures, institutions and governance landscapes of the time, arguably made the international financial system vulnerable.

This volume by Ramkishen Rajan and coauthors frames the debate essentially around these vulnerabilities. The first part of the book — generally encompassing Part 1 — and Chapters 4 and 5 in the second part are devoted to something of an examination of these vulnerabilities. The latter sections of the book present an assessment of what can be done; and indeed what has been done to date to mitigate against the incurrence of such vulnerabilities in the future.

What are these vulnerabilities? There are several and there is a large and diverse literature detailing how the crisis came about, what the problems were and how policy-makers might go about fixing them. In my view, the volume covers the following three to various degrees:

The first relates to exchange rate regime choice and, in particular, the set of intermediate exchange rate regimes employed in the region prior to the crisis. It is widely acknowledged that most countries — especially those ultimately most affected — had employed soft pegs to their exchange rates. The prevailing literature at the time had warned against these regimes, arguing that they are inherently crisis-prone. The reason for this is that, under this regime choice, central banks were either unable or unwilling to defend their peg in the face of a speculative attack on the currency. Much of the policy debate after the crisis centred on the so-called bi-polar view, which suggested that exchange rate regimes are better off (in the sense that they can best withstand attack) if they are either fully fixed (for example, a currency board or dollarization), or fully floating (e.g., an inflation target).

Chapter 1 (with Alice Ouyang and Thomas Willett), Chapter 8 (with Jie Li) and Chapter 9 (with Reza Siregar and Graham Bird) also discuss an issue that is essentially a consequence of a fixed exchange rate; the accumulation of foreign reserves, the costs and benefits of this accumulation and the subsequent sterilization of the monetary effects of the reserve inflow. In fact, a pleasing addition to the empirical literature on sterilization is the employment of a central bank loss function that provides explicitly for a pegged regime. In previous work, this was merely an assumption. Rajan (with Victor Pontines) takes up the issue of exchange rate regime directly in Chapter 11 with their discussion of the merits of an Asian Currency Unit. The authors wonder about the suitability of such an arrangement at this time. I believe this to be quite reasonable. The issue of fear of floating, arguably quite prevalent in the region, is not really ameliorated — while individual currency variation ceases, the common currency may well float, leaving trade and finance flows vulnerable. An associated change in institutional structures is also needed. Chapter 5 also discusses the role of the exchange rate regime as a crisis-mitigation tool, mainly from the perspective of reducing capital flight.

A second vulnerability relates to openness and the exposure of domestic economic conditions to foreign ones. Intuitively, more open economies tend to pass more of the effects of external conditions through to domestic conditions than less open economies. Indeed this has a bearing on the exchange rate regimes in the region, as mentioned above, and the desire to keep exchange rates managed to some extent (fear of floating). Chapters 2 and 3 (both with Amit Ghosh) deal with the issue of pass-through generally and also in the particular cases of Korea and Thailand and the chapters examine the effects of exchange rate changes...