The East Asian Financial Crisis - Implications for Exchange Rate Management

Abstract

Although inappropriate exchange rate policies are not a root cause of the financial crisis in East and Southeast Asian countries (Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand) such policies have contributed to the crisis. By the early 1980s, all of the affected countries had moved away from the old policy of pegging to the US dollar toward more flexible exchange rate regimes of basket-pegging or managed "dirty" float. But the extensive intervention policies of the central banks meant that exchange rates were de facto pegged to the dollar. It is argued that the de facto dollar peg policy contributed to vulnerability in two ways. First, the strengthening of the dollar vis¬a-vis the yen after mid-1995 led to an appreciation of the affected currencies and, thereby, to a loss of export competitiveness and cur-rent account pressures. Also by increasing the relative profitability of the nontradable sector, the fixed exchange rate encouraged in-vestments in real estate. By contrast, the dollar peg policy served well during 1985 to mid-1995, when the dollar weakened against the yen and fueled export-led growth in East Asia. Second, low ex-change rate variability and the predictable pattern of exchange rates under the de facto pegged regime reduced foreign exchange risk for the debtors and creditors and led to large surges of short-term capi-tal held in unhedged positions. Presently, all of the affected countries have adopted a policy of managed "dirty" float where the exchange rate is essentially de-termined by market forces albeit with sporadic central bank intervention. This note addresses issues such as: What would be an optimal exchange rate regime for these countries in the medium term? Should they be more rule-based? These issues are relevant not only for the affected countries but also for those that are vulner¬able to the forces of globalization.