McKinnon e Schnabl - The Return to Soft Dollar Pegging

McKinnon e Schnabl - Forthcoming in International Finance The Return to Soft Dollar Pegging in East Asia Mitigating Conflicted Virtue Ronald

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Unformatted text preview: Forthcoming in International Finance The Return to Soft Dollar Pegging in East Asia Mitigating Conflicted Virtue Ronald McKinnon Gunther Schnabl 1 Stanford University Tübingen University. July 2004 Abstract Before the 1997-98 crisis, the East Asian economies—except for Japan—informally pegged their currencies to the dollar. These soft pegs made them vulnerable to a depreciating yen thereby aggravating the crisis. To limit future misalignments, the IMF wants East Asian cur- rencies to float freely. Alternatively, authors have proposed increasing the weight of the yen in East Asian currency baskets. However, dollar pegs are entirely rational from the perspec- tive of each Asian country—both to facilitate hedging by merchants and banks against ex- change risk, and to help central banks anchor their domestic price levels. Post-crisis, as the East Asian economies transform themselves from being dollar debtors into dollar creditors, they face “conflicted virtue”: pressure to appreciate their currencies that could lead to a defla- tionary spiral. Rather than undervaluing their currencies to promote exports as is commonly alleged, East Asian governments are trapped into returning to—and then maintaining—soft dollar pegs. Keywords: Exchange Rates, Business Cycles, East Asian Dollar Standard JEL: F3, F31, F32, F33 1 E-mail: [email protected], [email protected] URL: http://www.stanford.edu/~mckinnon/, http://www.uni-tuebingen.de/uni/wwa/homegs.htm. 1 I. Introduction The 1997-98 crisis triggered an extensive debate about what proper exchange rate policy should be in East Asia. Before 1997, all the East Asian countries—with the important excep- tion of Japan—informally pegged to the dollar at both high and low frequencies of observa- tion. See Figure 1. But then opinions diverge as to whether this soft dollar pegging aggravated the crisis, and whether or not it should be abandoned in the future. The IMF’s position is that these soft dollar pegs accentuated moral hazard in poorly regu- lated domestic banks. In the absence of immediate foreign exchange risk, they over-borrowed by accepting foreign currency deposits at lower interest rates in order to make higher-yield loans in their domestic currencies. Post-crisis the IMF has warned of “an important danger […] in slipping back into de facto pegging of exchange rates against the US dollar ” (Mussa et al. 2000: p. 33). For emerging markets open to international capital flows, Fischer (2001, pp. 5-10) has argued that soft pegs are not sustainable. Fischer sees movement towards a bipolar world where a few emerging markets such as Hong Kong adopt hard pegs, while all the others move toward greater exchange rate flexibility. However, for curbing moral hazard in banks, floating the exchange rate may not be the correct policy response. McKinnon and Pill (1999) suggest that the differential between domestic and foreign interest rates might actually widen under a volatile float—thus aggravating the temptation to overborrow. under a volatile float—thus aggravating the temptation to overborrow....
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This note was uploaded on 09/25/2010 for the course ECO IntEco taught by Professor Andre during the Spring '06 term at UFRGS.

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McKinnon e Schnabl - Forthcoming in International Finance The Return to Soft Dollar Pegging in East Asia Mitigating Conflicted Virtue Ronald

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