FRBSF Economic Letter
1999-37 | December 17, 1999
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.
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.
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.
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.
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.
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,
Glick, Reuven, and Andrew Rose. 1998. “How Do Currency Crises Spread?” FRBSF Economic Letter 98-25 (August 28).
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