FRBSF Economic Letter
99-37; December 17, 1999
 Economic
Letter Index
Is There a Case for an Asian Monetary Fund?
Currency crises are troubling events. They tend to spread from country
to country in a region, leaving the hardship of recession--and, consequently,
the risk of protectionism--in their wake. Currently, the problems of currency
crises are addressed by assistance from the International Monetary Fund
(IMF), which arranges rescue packages on a case by case basis. The recent
financial crises in Asia stimulated interest in an analogue to the IMF
that would be region-specific, namely, an Asian Monetary Fund.
This Economic Letter reviews the causes and consequences of
currency crises as well as their tendency to be contagious. It argues
that an Asian Monetary Fund could be a useful institution for stabilizing
Asian economies during currency crises, while promoting economic cooperation
in the region.
What causes currency crises?
Economists generally think about currency crises using either of two
theoretical models of speculative attacks. The first model focuses on
inconsistencies between a country's external commitments, such as a fixed
or pegged exchange rate, and its internal economic fundamentals. For example,
a government that is running a fiscal deficit might pressure its central
bank to help finance the budget by printing money. This creates inflation
and a current account deficit, which may lead investors to doubt the exchange
rate peg. Speculators eventually mount an attack--that is, they demand
foreign reserves in exchange for the domestic currency. To defend the
peg, the monetary authorities sell off foreign exchange reserves. When
the reserves fall to a certain point, the government is faced with a choice:
should it break its external promise (to keep the exchange rate fixed)
or keep its internal political constituents happy (by not raising taxes
or cutting spending)? Governments usually choose internal objectives over
external constraints; that is, there is a currency crisis. A model like
this works well in helping to understand the breakdown of inflationary
economies, like Russia in 1998. But such models don't help understand
recent crises in Asia. Most Asian countries had admirable monetary and
fiscal policies that were viewed as being sustainable.
The second model views currency crises as shifts between different monetary
policy equilibria; here speculative attacks can be self-fulfilling
even against countries with sound policies. In these models, market speculators
initiate attacks based on their beliefs about the willingness
of policymakers to resist pressure on the exchange rate. When markets
perceive that conditions, such as high unemployment or a weak banking
system, compromise the central bank's willingness to defend the currency
peg by raising interest rates, speculative attacks are more likely to
succeed. This is the sort of framework that economists use to understand
the Asian crises.
Not all countries are vulnerable to such attacks. For example, a stable
government presiding over a strong economy is an unlikely target because
it would not succumb to such pressures. But experience shows that even
moderate levels of financial and macroeconomic weakness leave a country
exposed to self-fulfilling attacks. Furthermore, a country that is healthy
before the attack does not stay healthy afterwards.
For example, banking sectors with large unhedged foreign liabilities are
usually bankrupted if the domestic currency depreciates sharply. Unless
the country receives external assistance quickly, this results in a credit
crunch, which, in turn, causes a recession. Of late, external assistance
has not arrived in time to prevent the recessions.
The causes and consequences of currency
crisis contagion
One striking feature of recent waves of currency crises is that they
have been regional. For example, once a country had suffered
a speculative attack--Thailand in 1997, Mexico in 1994, Finland in 1992--its
neighbors were disproportionately likely to be attacked. Why do currency
crises seem to be contagious? Glick and Rose (1998) show that currency
crises tend to spread contagiously among countries that are linked by
international trade. For example, once Thailand had floated the baht,
its main trade competitors, Malaysia and Indonesia, were suddenly at a
competitive disadvantage and so were themselves likely to be attacked.
That is, currency crises tend to follow international trade patterns;
since trade is regional, currency crises tend to be regional.
One does not want to carry this argument too far. Macroeconomic and financial
influences are not irrelevant. Still, the brute fact remains that currency
crises tend to be regional.
What are the consequences of this contagion? Currency crises are usually
associated with massive disturbances to international trade, for a number
of reasons. One of the most important is that countries that devalue tend
to suffer recessions. The recessions associated with currency crises tend
to lead to sharp falls in imports, which are the most important reasons
that the payments imbalances are reversed. But a fall in one country's
imports is a fall in another country's exports. Thus, currency crises
tend to disrupt trade flows.
These disruptions are extremely worrying. They foster politically dangerous
trade imbalances, thereby creating an environment that may engender protectionist
measures that distort and stifle trade. And if there's one thing economists
agree on, it is that free trade is good.
Is there a case for an Asian Monetary
Fund?
The main argument for a regional monetary fund is this: since trade tends
to be regional, the region loses disproportionately from trade disruptions
caused by currency crises. Therefore the region should try to
prevent the spread of these crises.
These issues are important now, and they are likely to grow in importance.
Only the naive believe that there will not be financial crises in the
future. In recognition of this fact, we have created institutions to alleviate
their costs. The International Monetary Fund (IMF) was created to alleviate
the costs of international financial crises. Article I (ii) of the Articles
of Agreement states that its purpose is "to facilitate the expansion and
balanced growth of international trade." Thus, one of its chief goals
is to provide assistance to countries experiencing short-term international
payments imbalances. By smoothing out these fluctuations, the IMF tries
to reduce protectionist tendencies.
Since efforts to liberalize trade are likely to continue, as they have
for the past 50 years, the regional nature of trade is likely to grow
further. More importantly, the mobility of international financial capital
is likely to continue growing dramatically. While capital mobility does
have advantages, it carries dangers with it: it is likely to make future
crises more disruptive and more frequent.
For several reasons, an Asian Monetary Fund (AMF) seems plausible. To
begin with, bailout packages are already arranged on a regional basis.
For example, in the Mexican bailout package of 1995, the U.S. was a major
participant. And while there were many reasons for the U.S. to be involved,
one of the key reasons was to underwrite the recently signed North American
Free Trade Agreement. Similarly, the European Union is currently engaged
in a historic endeavor of monetary unification. One of the biggest payoffs
to the monetary union--and an officially stated objective--is defending
the single European market by eliminating "competitive devaluations."
Indeed, most bailout packages in Asia of late have been regional, since
the IMF does not possess sufficient resources to put together rescues
unilaterally. In each of the recent Asian packages, bilateral components
were larger than the direct IMF contribution. While putting together packages
on an ad hoc basis has worked of late, in other facets of public policy,
we would consider this "seat of the pants" approach to policymaking problematic;
policymakers operating without a formal framework can be capricious.
It would not be hard to raise the initial capital. In 1997, Japan organized
a group of Asian countries that volunteered to head up an AMF and offered
$100 billion as initial capital. This is a small fraction of the almost
$1 trillion in international reserves that Asian countries currently hold.
Furthermore, an AMF could fill the void of economic leadership in Asia.
Though it might seem natural for Japan to be the unilateral leader, Japanese
aggression in the early part of the twentieth century combined with severe
domestic economic problems has made it more difficult for Japan to assume
this role. And there is the issue of an appropriate role for China. A
simple way around this politically charged issue would be to delegate
regional financial affairs to an AMF. Indeed, the creation of an AMF could
play a role in promoting regional cooperation and trust. There are remarkably
few issues on which China, Taiwan, and Japan agree; the AMF is one.
In other spheres of international relations we have both global and regional
institutions. There are both global (e.g., UN-sponsored) and regional
(e.g., NATO) security arrangements. Similarly, there are both global and
regional development banks (e.g., the World Bank and the Asian Development
Bank). It is hard to see what is different about the monetary sphere.
Can an Asian Monetary Fund coexist with
the IMF?
Would the existence of an AMF constitute a real threat to the IMF? In
essence the IMF achieves its objectives through two means: (1) surveillance
of the international community and (2) lending with conditionality. Surveillance
is the less important role of the IMF. Other institutions, both private
(like credit rating agencies) and public (such as the OECD) already engage
in surveillance. An AMF may do a better job of surveillance than the IMF
because of a focused mandate and greater regional expertise, or it may
help simply by adding some healthy competition.
The real power of the IMF stems from its second role, which amounts to
a monopoly on conditional lending. An IMF-endorsed program opens the way
for private lending. Clearly, an AMF would have to follow the IMF practice
of lending with conditionality. If it consistently gave inappropriately
weak conditionality, it would raise the problem of "moral hazard"--countries
might be more tempted to engage in dangerous practices in the expectation
of larger bailouts with looser conditions.
The risk of increased moral hazard is a danger. But it is an argument
for a good AMF, not an argument for no AMF. And while
the ability of the AMF to lend with conditionality could compromise the
IMF's authority, one should be wary of overstating the probable degree
of conflict between the two institutions. Regional banks operate smoothly
with the World Bank, and the IMF has not had fundamental problems with
either the American-led Latin America rescue packages or European monetary
integration. One would expect that an AMF would usually act simply to
replace the ad hoc groupings of countries that currently support IMF packages
with bilateral aid. It is also possible to overstate the importance of
moral hazard. No country chooses to embarrass itself and suffer the indignity
and pain of an IMF program voluntarily.
Conclusion
Currency crises tend to be regional. They tend to spread along the lines
of trade linkages and to disrupt regional trade flows. This is the essence
of the case for a regional monetary fund. Since currency crises create
regional costs, the region has an incentive to create institutions to
mitigate these costs by providing a financial safety net. Towards precisely
this end, Europe is currently engaged in a historic experiment of monetary
integration. The United States has provided strong leadership for the
Americas. Only in Asia is there a vacuum.
Andrew K. Rose
Visiting Scholar, FRBSF, and
Professor, Haas School of Business,
UC Berkeley
Reference
Glick, Reuven, and Andrew Rose. 1998. "How Do Currency Crises Spread?"
FRBSF Economic Letter
98-25 (August 28).
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