Discuss importance of exchange rate (regime) in East Asian crisis. Summarize previous discussion into 3 main arguments about relation between financial fragility and exchange rate:

1. Moral Hazard Hypothesis: Pegged exchange rates are a form of implicit guarantee and, hence, a source of moral hazard. They promote unhedged foreign-currency borrowing and, because they are least credible at long horizons, skew financial flows toward the short end. These unhedged, short-term, foreign-currency-denominated liabilities are a time bomb waiting to explode. By implication, more flexible exchange rates are desirable to limit short-term capital inflows and buttress the stability of the financial system.
2. Original Sin Hypothesis: The original sin hypothesis. The second view emphasizes an incompleteness in financial markets we call 'original sin'. This is a situation in which the domestic currency cannot be used to borrow abroad or to borrow long term, even domestically. In the presence of this incompleteness, financial fragility is unavoidable because all domestic investments will have either a currency mismatch (projects that generate pesos will be financed with dollars) or a maturity mismatch (long-term projects will be financed with short-term loans).
   ...
   The incompleteness of financial markets is, thus, at the root of financial fragility.
   ....
   The solution, rather than a more flexible exchange rate, is no exchange rate - dollarization or its euro equivalent.
3. Commitment Problem Hypothesis: A third view sees financial crises as resulting from neither moral hazard nor original sin but from the weakness of the institutions that address commitment problems. In contrast to a textbook spot market, where the parties meet once to complete their transaction, financial contracts are discharged over time. Creditors lend their money today but have to wait until tomorrow to be repaid. Financial transactions, in other words, are intertemporal trades carried out over time. Inevitably, therefore, problems of commitment and enforcement arise.
   ... The implications for exchange rate policy are less clear. On the one hand, there is an argument for greater flexibility to free the authorities to backstop the market, which in conditions of institutional underdevelopment is likely to be particularly fragile and in need of official support. If they are committed to a fixed rate, the central bank and government may be prevented from providing lender-of-last-resort services. They will be prevented from engineering a surprise inflation to bring down the real value of otherwise unsustainable debts and save the banking system. At the same time, however, lenders will understand the authorities' incentive to resort to this tax of last resort and demand higher interest rates in compensation. And higher interest rates will make the financial system more fragile to the extent that debts grow faster than the capacity to service them.

Outline of the paper: Are these three views incompatible, and, if so, which one is correct? What are the implications for the exchange rate regime and monetary policy?

Moral Hazard

Original Sin:

Our second view seeks to explain why financial markets in developing countries are fragile and crisis prone in terms of three national characteristics: good economic prospects, openness to international capital flows, and a national currency that cannot be used by local firms or the government to borrow abroad and cannot be used, even at home, for long-term borrowing. (emphasis added)

This is a fact about world but what explains this situation (esp. point 3 - emphasized above)? What is solution?

• Solution: Dollarization or equivalent.
• Explaining the situation:
  1. Pegged exchange rates are problematic: The currency and maturity mismatches caused by original sin create a dilemma for exchange-rate policy. If the government seeks to defend the currency by hiking interest rates and draining liquidity from the financial system, banks faced with the increased cost of funding will be forced to contract their portfolios by calling their loans. If borrowers are unable to repay immediately due to maturity mismatches, a banking crisis can result. Under these circumstances, the financial system may be subject to self-fulfilling runs. If people think that other people are about take their money out because they fear that the interest- rate defense will bring down the banking system, they will want to be first through the door, requiring the authorities to raise rates to defend the currency and producing the very result investors most feared.11 This is the basis for the now-prevalent view that pegged exchange rates and open international capital markets are an accident waiting to happen in all but the most financially robust emerging markets. exchange rates and open international capital markets are an accident waiting to happen in all but the most financially robust emerging markets.
  2. But floating has major problems too. Since central bank can still not let XR fluctuate too much (as this would lead to bankruptcies) thus they still protect. To do this they manipulate interest rate -} high interest rate volatility (higher than in pegged situations - why??) -} people won't want to hold domestic currency securities -} can't borrow in domestic currency long term

Which explanation works?

The evidence:

1. Capital flows to emerging and developing countries are small
2. Composition of capital flows: Table 4 presents data on the structure of lending by BIS reporting banks. It shows that developing countries, in fact, have proportionally less debt flowing through banks than developed countries (32 versus 40 percent) and more debt flowing through non-banks (53 versus 50 percent), while the proportion going to governments is roughly the same (15 versus 14 percent).
3. Developing/Emerging economies have nearly all long term debt in foreign currency whether they have fixed or floating regime (chile, mexico, peru). Almost all developed countries have debt denominated in domestic currency.
4. Case studies and historical evidence: a. Gold standard 1880 - 1914. Argentina and British colonies (Canada, NZ, Austrailia, India). b. In this period (late 19th c.) association between savings and investment was weaker than now

Implications for hypotheses:

1. Small capital flows weight against moral hazard but are compatible with original sin and commitment problems. That [capital] flows are small poses the greatest difficulty for the moral-hazard view, which predicts that flows should be large. That investors face artificially low risks implies that they should be willing to invest more than is socially optimal. So, the moral hazard hypothesis would predict too much, not too little capital flowing across borders. This does not mean that moral hazard is absent. It does imply, however, that moral hazard is not the only policy-relevant distortion and, arguably, not the most important.
2. Composition of flows also weighs against moral hazard as we would expect flows to be skewed towards those borrowers most likely to be bailed out (banks and the government). But as per fact 2 above this is not the case.
3. Fact 3 weighs strongly towards original sin and against commitment and moral hazard as we would expect different behaviour for developing countries depending on whether fixed or floating.
4. Case Studies (fact 4). Although colonies did well is this the gold standard or that they imported good set of institutions and good legal framework from UK? Fact that Argentina had big crisis 1890 onwards is indicative that this is so. That gold standard was only small part of the story. An interpretation is that internationalization of the currency under the gold standard was no panacea, and that happy results hinged on putting in place other supportive policies, such as fiscal discipline, a strong banking system, arms-length lending, and adequate disclosure and transparency. This reading of history suggests that dollarization is bound to produce happy results only if it is adopted in the context of a sound policy framework.

Conclusions

1. Major issue is not floating vs pegged. Without being able to borrow in domestic currency you are always exposed. Just a question of who carries the risk (coporations, banks, government ...). In a world of high capital mobility, the textbooks teach, countries seeking economic and financial stability cannot peg. But neither, recent experience as interpreted by Cooper and the apostles of original sin suggests, can they safely float.
2. Solution is to get rid of original sin and the associated maturity and currency mismatches on debt.
3. How to do this? a. Dollarization b. Need to develop deep, liquid, transparent capital markets in long-term domestic denominated securities.

Further Research

1. gathering survey (and other) data on hedged and unhedged exposures and analyzing their determinants should be a high priority for academics and the multilaterals.