Executive Summary

1    The paper investigates the impact of the switch in the exchange rate regimes after the East Asian financial crisis on the conduct of monetary policy in Korea, Indonesia, Malaysia, and Thailand. Korea, Indonesia, and Thailand, which came under the IMF-supported programmes during the crisis, have adopted a more flexible post-crisis exchange rate regime and a monetary policy framework that explicitly targets inflation. Malaysia, on the other hand, has adopted a fixed exchange rate peg coupled with a system of exchange controls that aims at reducing currency volatility while allowing the authorities to secure greater autonomy in the conduct of monetary policy.

2     The study commences with an evaluation of the role of the pre-crisis quasi-US Dollar peg system, in which these countries were on, as a nominal anchor of domestic price level. The analysis suggests that the relatively low and stable inflation rates experienced in these countries during the early 1990s cannot be attributed to the monetary discipline imposed on the authorities by the quasi-fixed exchange rate system. The ability of the authorities to pursue tight monetary policy was often frustrated by the large capital inflows. The exchange rate system's contribution to price stability came from allowing the arbitrage of tradable goods to take place under stable exchange rates while the relatively open current account channelled the excess domestic demand to imports from abroad.

3     After stability in the financial markets was restored, Korea, Indonesia, and Thailand have redesigned the monetary policy framework to one of targeting inflation in order to provide a new nominal anchor under a more flexible exchange rate regime. Under the new framework the authorities have adopted interest rate as the key operating instrument. The analysis focuses on (i) how far the new exchange rate regimes have enabled the domestic money market interest rates to diverge independently from the US interest rate, and (ii) the degree to which the authorities have secured more effective control over the money market rates through their money market intervention activities. Estimates from a model of short-term interest rate dynamics indicate that the spread between the domestic and the US interest rates exhibited slower mean-reversion and the volatility of the interest rate differential has diminished during the post-crisis period.

4     The paper analyses the provisions of the revised Bank of Korea Act and the Bank of Indonesia Act together with the policy pronouncements of Bank of Thailand to assess the degree of legal independence that these central banks can enjoy in pursuit of the inflation targeting objective. The ultimate degree of credibility that the authorities will gain, however, will depend on the actual conduct of the monetary policy. Estimates from a forward-looking interest rate reaction function suggest that the authorities have placed greater weight on inflation objective following the outbreak of the currency crisis and are more willing to raise the nominal interest rates in face of expectation of high inflation. The post-crisis policy credibility is evident from the quick decline in the persistence of domestic inflation rates.