Challenges for Exchange Rate Policy in the Emerging Markets in Asia
Remarks by Dr Khor Hoe Ee, Assistant Managing Director (Economics), at the South-East Asia Conference organised by South-East Asian Bank Representatives in London & The Bank of England's Centre for Central Banking Studies, London
Date: 12 Jun 2001
1 The framework and conduct of exchange rate policy has become increasingly complex for emerging market economies as they integrated with the world economy and the global financial markets. The events of 1997/98 have once again emphasised the key role that the exchange rate system plays in economic crisis. It is often pointed out that each of the major international capital market-related crises since 1994 had involved in some way, countries with loosely pegged exchange rate systems.
2 The challenge for emerging market economies is that exchange rate policy management has moved beyond the confines of the traditional parameters that we are used to - namely instruments, targets, transmission mechanism and inflation-output trade-off issues. Policymakers nowadays are confronted with a more complex and discerning financial market environment; one in which the integrity and efficiency of exchange rate policy framework derive not only from the credibility and soundness of decision making at the central bank but also from a range of other supporting policies and institutional factors within the economy.
3 In my intervention today, I would like to touch on some of these challenges for emerging market economies and identify the various supporting policies and infrastructure that are essential in buttressing the central bank's effectiveness in exchange rate policy management.
Challenges of Exchange Rate Policy
4 What are the challenges that are faced by emerging market economies? Let me identify three major ones. First, economies have to cope with increased volatility in international financial and currency markets. Of particular concern is the tendency for G3 exchange rates to undergo prolonged periods of misalignment, followed by sudden corrections. Such behaviour of the exchange rates can cause major shocks, both positive and negative to the emerging market economies.
5 Prior to the Asian financial crisis, the currencies of most emerging market countries in Asia were pegged to the US dollar, to varying degrees. The weakening of the US dollar after the Plaza Accord in 1985 resulted in conditions which were conducive for export-led growth of emerging market economies in Asia. Until about mid-1995, the close link between some of the Asian currencies and the US dollar served the economies well, as their exchange rates weakened along with the US dollar in 1985. At the same time, the appreciation of the Yen represented a positive shock for the Asian economies. Japanese foreign direct investments to the region surged as Japanese corporations relocated their production abroad in search of lower costs, further fuelling strong export growth and contributing to the investment boom in the emerging market economies of Asia.
6 From mid-1995, however, the US dollar strengthened sharply against the Yen. This in turn resulted in the appreciation of many Asian currencies, especially the Baht. The export competitiveness of the Asian countries began to erode at a time when markets in the West were weakening. This contributed to a worsening of their current account positions, which rendered these economies vulnerable to a reversal in investor sentiment. Not surprisingly, the currencies of these countries came under speculative attacks leading to the Asian financial crisis.
7 More recently, concerns have again arisen that sharp movements in the Yen might adversely affect financial stability and the regional economies. While the Asian economies are in a much stronger position now - including the adoption of more flexible exchange rate systems - this is an additional risk factor, at a time when countries are having to adjust to a sharp downturn in external demand.
8 The second factor that has complicated the conduct of exchange rate policy is the emergence of an increasingly borderless, integrated global financial market. Rapid advances in telecommunications and information technology have dramatically lowered transaction costs in financial markets, as well as drastically reduced the reaction time of market participants.
9 The increase in the speed and efficiency of international finance has, together with other factors, in turn induced dramatic increases in the volume and mobility of capital flows. In particular, the reduced costs of transactions facilitated by advances in telecommunication and IT have enabled investors in industrial countries to extend their search for higher yields beyond national borders. Efforts by institutional managers to achieve greater diversification of portfolios by increasing their exposure to emerging markets also provided an important stimulus for flows into emerging markets. At the same time, drawn by large potential gains, many of the emerging markets in Asia liberalised their capital accounts, to facilitate the inflows of private capital.
10 The gains from being integrated into the world capital market, however, do not come without costs. In particular, increased capital mobility and larger volume of capital flows, particularly private flows, have also created the potential for large and sudden reversals in such flows. The tendency for capital to rush in and out is attributable in part to the role of expectations which can lead to the irrational herding instincts of investors. For example, during a crisis, investors might shift their focus from evaluating the situation in the country to evaluating the behaviour of other investors, leading to a panic withdrawal of funds. An equally important cause of this behaviour is the tendency for investors to adopt common benchmark and trading rules. This has amplified the balance sheet vulnerability of emerging economies and increased their vulnerability to financial crises.
11 Third, the emergence of new financial institutions and products has further complicated the conduct of exchange rate policy. These include the emergence of huge institutional investors and hedge funds, particularly macro hedge funds, which are ever ready to arbitrage away any perceived inefficiencies in the markets arising from differences in regulatory regimes or policy errors. Innovative financial engineering has spawned a vast array of complex hybrid financial products. While these products may provide the opportunity for corporates and financial institutions to reduce risk, they also provide the instruments for speculators to punt against national currencies. Market participants and regulatory authorities would need to understand their risk characteristics, particularly during instances of extreme market distress.
12 In addition to the challenges above, the conduct of exchange rate policy in Asian emerging economies has also been made more difficult by the vulnerabilities presented by the lack of an efficient financial infrastructure. Domestic financial systems in Asian emerging markets tend to be dominated by banks while capital markets are generally underdeveloped. This has led to an excessive reliance by domestic corporates on bank borrowings in the past, which rendered them vulnerable to a liquidity or credit crunch.
13 Some emerging market countries are also constrained by the "original sin" problem. This is a situation where countries find it difficult to borrow abroad or to borrow long term in their own currencies. Consequently, financial fragility arises because domestic investments will have either a currency or a maturity mismatch. A large foreign currency denominated debt would place severe limitations on exchange rate policy. In particular, the central bank's flexibility to adjust an over-valued currency would be limited by the impact that such a devaluation would have on the value of external debt and the debt servicing capability of domestic corporates.
No Single Currency Regime is Right for All Countries or at All Times
14 What is the best exchange rate regime to meet these challenges faced by emerging market economies? There was a period just after the crisis when some very strong views were expressed that for small open economies, the only viable exchange rate regime was one of the corner solutions. That is, open economies should either fix their currencies to a hard currency via a currency board arrangement or go to the other side of the continuum and allow market forces to freely determine the value of their currencies. However, neither is a panacea for the problems faced by emerging markets in Asia. Rather, I tend to agree with Jeffrey Frankel that "no single currency regime is right for all countries or at all times".
15 The main disadvantage of a free float is a tendency towards volatility that is not always due to macroeconomic fundamentals. This is especially so in emerging markets where the foreign exchange markets could be relatively thin and dominated by a small number of players. In addition, financial markets may not be deep or broad enough to allow hedging at a reasonable cost. Furthermore, given that there is a tendency for exchange rates to over-shoot, a free float could be costly for a small open economy, with its attendant effects on competitiveness and foreign debt position.
16 How about a hard peg? In a world of global capital mobility, fixed exchange rates are difficult to sustain. Furthermore, they tend to be viable only when supported by flexibility in product and factor markets, large foreign reserves, and strong institutional arrangements. Moreover, sufficient political support is needed for the monetary discipline required. Under fixed rates, there is no room for adjustments in the real exchange rate through changes in the nominal exchange rate. Thus, the brunt of the adjustment must fall on other means, such as the levels of domestic prices and costs and changes in the level of economic activity and employment. At the same time, the central bank must also forfeit its ability to act as a lender of last resort and allow for interest rates to be freely determined by market forces.
17 In the case of Hong Kong, large foreign exchange reserves, internal flexibility and a well-developed financial infrastructure made its currency board both workable and credible. In other countries, a fixed exchange rate may be not be workable as the population may not be willing to tolerate the large swings in output and employment that may sometimes be necessary and the economy may not be able to withstand the volatility in interest rates, particularly if the domestic corporates are highly leveraged.
18 A number of emerging market countries in Asia, including those that were most affected by the crisis, have recently adopted the inflation-targeting framework. In my view, the benefits of such a system are the clarity of its policy objective and the elegant conceptual and institutional framework that underlies the conduct of monetary policy.
19 However, for the system to work, the central bank needs strong political support, particularly when there is a conflict between price stability and financial or exchange rate stability. We see this tension recently in Indonesia, Korea and Thailand. In addition, the central bank must build up the analytical capabilities required to support the formulation of monetary policy. In particular, it needs to address difficulties in forecasting inflation and uncertainty over the monetary policy transmission mechanism, especially for small open economies, which are constantly subject to external or exogenous shocks.
What Should be Done?
20 I have identified a number of challenges and vulnerabilities faced by emerging market economies in the conduct of exchange rate policy, and briefly considered the various alternatives in exchange rate systems. However, I would like to argue that the key issue facing policymakers in responding to the challenges lies not in the particular choice of the exchange rate system per se, but in the institutions and other policies underpinning it. In a sense, we could view the exchange rate system as a 'monetary overlay' on the real economy foundations. The challenges posed by the vagaries and dynamics of the global financial markets cannot be met by the judicious choice of exchange rate regime alone. Countries must also pursue a wide range of structural measures in order to strengthen the institutional foundations of the economy if they wish to take advantage of the benefits of the global financial markets without succumbing to the downside risks.
21 Let me identify five broad areas in which emerging economies need to do more.
22 First, it is essential for countries to pursue sound and credible macroeconomic policies to avoid the build-up of major macro imbalances in the economy. This will reduce their vulnerability to speculative attacks and swings in capital flows by preventing misalignments in the value of their currency. Here it is also worth highlighting the importance of coordinating macroeconomic policies across the relevant agencies, so as to achieve consistency in promoting conditions conducive for sustained growth of the economy.
23 Second, it is essential for emerging market economies to improve the flexibility of their product and factor markets in order to cope and adjust to shocks arising from the volatility of currency markets and swings in the terms of trade in world product markets. This is particularly true for small open economies, which are dependent on exports of goods and services.
24 Third, it is crucial for emerging market economies to develop and strengthen their financial systems in order to enhance their robustness to shocks. Well managed financial institutions which adhere to sound credit practices and have built up strong capital postiions are better able to withstand business cycle shocks. In addition, a sound and efficient banking system together with deep and liquid capital markets contribute to the efficient intermediation of financial flows. This will help prevent the emergence of vulnerabilities in the financial system by minimising unsound lending practices that could lead to the build-up of excessive leveraging in the corporate sector and exposure to foreign borrowings. Deep and liquid markets also help absorb the effects of external shocks and prevent their spillover to the rest of the economy.
25 Fourth, countries will need to build up their regulatory and supervisory capabilities to keep pace with financial innovations and the growing complexity of financial institutions' activities, and new products and services. Regulators need to ensure that financial institutions have proper credit and risk management systems in place and that they provide adequately for market and operational risks. This also implies that financial reforms need to be managed in a controlled and orderly manner. Countries which have not fully liberalised their capital accounts should do so at a pace that is commensurate with the strength and efficiency of their financial systems. Concomitantly, regulators need to build up their capabilities to cope with an enlarged supervisory role.
26 Fifth, policy makers should promote greater disclosure and transparency. This will help to foster market discipline, as well as reduce the likelihood of markets over-reacting due to lack of information or information asymmetries. Increased transparency can be brought about on several fronts. These include raising bank disclosure standards, improving corporate governance, providing more information on how government policies are conducted, and releasing economic and financial data in a timely and regular fashion.
The Singapore Experience
27 Allow me say a few words on how Singapore has responded to the challenges of exchange rate policy. Our monetary policy regime is based on the management of the exchange rate, reflecting the high degree of openness of our economy. We set a path for the trade-weighted exchange rate based on our expectations of the medium-term outlook for output and inflation. We set a band around the central policy line. The width of the band is determined by our assessment of underlying volatility in the currency market.
28 We have adopted this managed float exchange rate regime with relative success since the mid-1980's, including during the crisis period. Over the last two decades, we managed to achieve strong growth with low inflation. The inflation rate for Singapore was about 2 - percent per annum, compared with the OECD average of 7 percent. The trade-weighted Singapore dollar has also been fairly stable along an appreciating path.
29 This exchange rate regime has benefited Singapore in three ways. First, the use of a trade-weighted basket has allowed us to mitigate the effects of large misalignments among the G3 currencies. Second, the undisclosed band accorded us with a greater degree of flexibility in managing the exchange rate. In particular, during the recent period of stress, we were able to widen our policy bands as volatility in foreign exchange markets increased. Third, periodic review of the central parity has enabled us to avoid major misalignment of the currency in response to changing economic fundamentals.
30 Singapore's experience illustrates my key message today, which is that exchange rate policy does not operate in a vacuum. It needs to operate within a framework of consistent macroeconomic and microeconomic policies, and be supported by strong economic institutions. In Singapore, prudent fiscal policy has absolved the MAS of the need to finance the Government, and allowed it to concentrate on its primary responsibility of maintaining price stability. At the same time, MAS has established considerable credibility with the market, earned through its track record of running a monetary policy that has yielded low inflation and sustained economic growth over a long period. Our large foreign reserves and macro-prudential policy limiting the extension of credits to non-residents also discourage speculative attacks on the Singapore dollar. The public sector in Singapore has no foreign debt, while banks and corporations have generally not borrowed from abroad in foreign currencies given low domestic interest rates.
31 Nevertheless, to keep pace with the rapid changes in the global financial markets, we undertook a strategic review of our financial sector policies in 1997. This resulted in measures to develop the bond market, asset management industry, and insurance industry. It has also led to a major review of the regulatory framework for the whole financial sector, including a fundamental review of our supervisory and regulatory policies for banks. Measures have been implemented to liberalise the banking sector, strengthen corporate governance and raise disclosure standards of local banks, and shift our supervisory regime from a one-size-fits-all regulation to risk-based supervision. To promote the development of the capital market, we have taken steps to develop the SGS bond market in order to establish a benchmark yield curve. We have also liberalised our policy on the restriction of credits to non-residents in order to allow foreign investors to issue Singapore dollar bonds and finance their Singapore dollar investment with domestic funds. Through these measures, we hope to foster the development of a more diversified and robust financial system.
32 Finally, we have made a major effort in the last two years to improve the transparency of our monetary policy framework. In particular, we have provided more data and substantially increased the flow of information to the market and public through our publications and internet web site with regard to our analyses and views on developments and outlook of the economy and financial markets. The latest initiative is the recent decision to publish a Monetary Policy Statement soon after we complete our semi-annual review of exchange rate policy.
33 Exchange rate policy and management has increased in complexity in this increasingly borderless, integrated world. The challenge lies with all arms of policy, not just the central bank, to build policy credibility and strong institutional structures in all areas of the economy. This, coupled with the careful liberalisation of the capital account, would enable emerging market countries to reap the benefits of integrating with the world economy.