With the growth of structured finance instruments, inflation and currency risks had not been a hindrance for "hot" capital, until July 1997. In theory, these conditions are retardants for foreign direct investment. And FDI grew at a much slower rate than opportunistic speculative investment in the equity markets in the past 2 decades.
The IMF, in order to attract global capital to return to Asia, had to eat its hat and revert to low interest rate policies, after the failure of initially high interest rate conditionalities of IMF rescue packages. In fact, it is now clear that initial IMF policies exacerbated the crises in Asia, Russia and Brazil.
In July 1997, when the Asian financial crises began in Thailand, the meltdowns had not been triggered by hyperinflation. They were triggered by a collapse of an over-valued Thai currency peg to the US dollar which drained foreign exchange reserves. Generally, in hindsight, it is indisputable that the conditions leading to the Asian financial crises were: unregulated global foreign exchange markets and the widespread international arbitrage on the principle of open interest parity (in banking parlance, this type of activity is known as "carry trade"); short term debts to finance long-term projects; hard currency loans for project with only local currency revenue; overvalued currencies unable to adjust to changing market values because of fixed pegs. Under these conditions, when there is a threat of currency devaluation caused by a dwindling of reserves, the whole financial house of cards collapsed in connected economies in a chain-reaction, called contagion. It then became a regional economic crises within weeks, that eventually hit Russia a year later and then Brazil in January 1999, despite efforts of the G7 to contain the contagion.
In Brazil, the government was forced to allow a short, 2-day period of 9% devaluation before it threw in the towel on January 15, 1999 and suspended foreign exchange control and abandon the peg to allow the Brazilian real to free float.
During the first 2 days, the government try to do a stock purchase, copying Hong Kong's example in August 1998. But it was a non-starter. Hong Kong had to use US$18 billion in 2 days to cushion the manipulation of its stock and futures markets in August 29, 1998. Brazil had only US$30 billion left by January 14, 1999 as compared to HK's US$100 billion in 1998. So, the Brazilian government decided that it was futile to even try, after some fake moves to try to spook the market. For many years, some economists have touted the myth of the indispensability of fixed exchange rates for small economies heavily dependent on external trade, like Hong Kong, or large free-trade economies facing high inflation, like Brazil. The inertia of the status quo and the lack of hard data on the uncertain effects of depegging have permitted this myth to assume the characteristics of indisputable truth.
Brazil pegged its currency to the dollar as a means of fighting chronic and severe inflation. When the Real Plan was introduced in 1994, inflation was 3,000%. Hong Kong pegged its currency to the dollar in 1983 to instill confidence in the uncertain political climate following the announcement in 1982 of its return to Chinese sovereignty in 1997.
As Hong Kong knows from first-hand experience, the penalties of an overvalued currency are injuriously high interest rates and runaway asset deflation, resulting in economic contraction that produces business failures and high unemployment, not to mention credit crunches and illiquidity that threaten potential systemic bank crises and recurring attacks on currency through manipulation of markets.
Brazil, burdened historically with costly social programs that have become politically untouchable, the overvalued currency peg inflicted much pain on the economy, particularly the export sector. Both industry and labor have wanted for a long time a lower real to relieve Brazil from high (70%) interest rate and to stimulate export, even if the current low inflation of 3% will rise as a result.
The recent crisis in Brazil was triggered by a moratorium on state debt payments imposed by the large and wealthy state of Minas Gerais on January 12, 1999. On January 13, Brazil devalued the real by 9%, having seen its foreign reserves dropped by more than half in the last 5 months to $31 billion. A drain of $1.8 billion from the Brazilian central bank was recorded the following day.
On the morning of January 15 1999, to stop the financial hemorrhage, Brazil lifted exchange rate control entirely and allowed the real to float freely in the foreign exchange markets. Within minutes, the real fell to 1.60 to the dollar from its previous 1.32, but by day's end, settled around 1.43. By the end of the trading day on January 15, Brazil had managed to halt the flight of the dollar, with the real down 10.4% for the day and 18% from the pegged rate, even though the market had estimated the real to be overvalued by 30%.
With a free floating currency, Brazil's short term interest rate fell from 71.65% to 36.11% and the stock market jumped 34% on January 15 from its previous low, with lifting effects worldwide on other markets. The DJIA rose 219.62 points, or 2.4% to 9,340.55. US Treasuries dropped sharply, reversing the flight to quality, pushing yield on 30-year bonds to 5.12% from 5.05%. By 7 pm on January 15, only $173 million had left Brazil's foreign reserves coffer.
For recovery, Brazil still has to put its economic fundamentals in order, to cut government deficits within its political realities and to reduce its $270 billion foreign debt. But its self imposed penalty of a overvalued peg has now been removed, gaining improved conditions for export and stimulative effects for domestic demand. With Brazil's currency free floating, it is highly unlikely that Argentina's currency board regime can hold. Argentina either has to free float its currency or to go the dollarization route.
According to Krugman: the Brazilian free float "started out with good news. When Brazil floated the real on a Friday, the initial drop in the currency was moderate, and the stock market soared on hopes that the grim austerity program would soon be loosened up. Then Brazilian officials went to Washington; and over the weekend they were persuaded - bullied, according to rumor - into announcing that interest rates would be raised, not lowered. The result was despondency, and a collapse in the currency."
Brazil's decision to abandon the peg is significant because it is the last large economy that follows free trade, market deregulation, fixed currency and privatization, the fundamental components of globalization promoted by neo-liberal economic theories. The decision represents a de facto declaration that market valuation of currencies is a more realistic option than placing faint hope of an international regulatory regime on capital movement or control down the road.
Hong Kong's situation is not congruent to Brazil's. Yet Hong Kong has incurred much unnecessary pain in holding onto the myth of an indispensable peg as Brazil did.
The reality in Brazil last week has punctured the myth of the magic of the currency peg. That lesson deserves to be taken seriously by Hong Kong in reviewing the role of its own monetary policy in its strategy for recovery.
In a few sentences, a currency board system is a linked exchange rate system which theoretically requires the monetary base to be backed by a foreign currency at a fixed exchange rate.
The monetary base is normally defined as the sum of the amount of bank notes issued and the balance of the banking system (the reserve balance or the clearing balance) held with the currency board for the purpose of effecting the clearing and settlement of transactions between the banks themselves and between the currency board and the banks.
The monetary base would increase when the foreign currency to which the domestic currency is linked, is sold to the currency board for the domestic currency (capital outflow). The expansion or contraction in the monetary base would lead to interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital inflow or outflow respectively, ensuring stability of the exchange rate throughout the process.
A currency board system effectively removes the power of the central bank to set monetary policies, such as interest rates, liquidity, money supply, etc. It assigns that power to the market and the monetary policy of the target currency.
When the local currency is pegged at below market value, local interest rates will fall, at time to negatives levels as in Hong Kong in the 80s. When the local currency is pegged at above market value, local interest rates will rise. When the underlying exchange rate set by a currency board is not supported by economic fundamental, speculative and manipulative attack on the local currency will occur, as it did repeatedly in Hong kong during the past 18 months. There are very few, if any, pure currency boards operating in today's unregulated global economy. This is because, in real life, the linkages between asset prices, interest rates, and liquidity are affected dynamically by interlinked financial derivatives.
The direct penalties of a fixed exchange rate pegged at an overvaluation level are: high interest rate and deflation of asset denominated in local currency, not to mention the need to tie up foreign reserves to support the overvalued currency, instead of using it for stimulative fiscal packages. When the peg is released after a long period, both interest rate and asset price will bound back from peg-induced lows and settled according to economic fundamentals. For Brazil this is the best option, if it does not set off a round of competitive devaluation from around the region and the globe. Free float, nevertheless, will reduce the impact of competitive devaluations, because each currency will have to seek its proper value in trade terms according to fundamentals. For almost two years now, I have been calling for HK to ditch its peg. A currency board or dollarization comes with a great deal of pain. Usually smaller economies are not in phase with the US economy, so when Greensapan lowers interest rates and easy monetary policy, it would exacerbate economic problem for the pegged currency economies. HK got itself into a bubble economy with its 7.8 to 1 linkage through a currency board adopted in 1983 when the dollar was undervalued during the 80s and HK experience negative interest rates. Now with the dollar overvalued, HK suffers from repeated attacks on its currency by hedge funds, causing recurring high interest rate (280% at its worst), deflated assets by 60%, contracting consumer demands and falling exports, and pending banking crisis, not to mention unemployment and corporate bankruptcies. As Paul Davidson has aptly suggested, a currency board is like a blood letting cure which cures the patient from the disease but kills him with the cure.
For Brazil, the real plunged when it was allowed to trade freely in January, and 4 month later, the real is recovering from its low (below US$0.50 to one real), stabilizing around US$0.60 to one real and rising. Export is up due to more competitive prices. The stock market is up, the Bovespa index rose from its low of below 5000 in January to over 11,000 now. Inflation in March was 3.9% from 205 in 1996. Interest rates drop: the interbank rate for loans longer than one day fell in 30% from 55% in January. On April 22, Brazil sold US$2 billion of 5-year notes at 11.88%, only 6.75 percentage points above 5-year US Treasuries. About two-thirds of the notes went to US investors and the rest to Europe. The second part of the Brazilian debt sale closed on April 23, involving a swap of previously issued Brazilian Brady bonds for the new 5-year notes. Aminio Farga, Brazilian central banker and former aid to Soros, announced that " we are putting a program together to better manage our yield curve", referring to efforts to sell debt with longer maturities. The strong demand caused George Soros to declare in an investors conference in NY that "the global financial crisis is now officially over.... So now we can look for the next one."
Rubin, Summers and Greenspan made policy statements in the last few days on the question of the future global financial architecture and dollarization. While these positions have been well known for some time, the fact that these issues are now being debated in the American public arena is significant.
For almost two year now, I have been vocal in my reservation about the efficacy of the currency board regime for Hong Kong. My view is that the HK dollar should either free float or HK should adopt dollarization. My preference leans towards free float to gain long term independent monetary prerogative for the SAR. As Greenspan told Congress, American monetary policy will continue to be made solely with US interest in mind. Reviving the discussion on the currency board for HK seems now to be appropriate.
The recent spectacular rise in the Asian equity markets may be mere speculative plays by global funds. The fundamentals for Asia, including China and HK, have yet to turn for the better. Even if China manages to gain WTO admission within this year, (which is by no means certain due to continuing US Congressional opposition), the immediate impacts for both China and HK remain decidedly not all positive. The currency board issue and the impact of China's admission to the WTO are two of the most important issues affecting HK's economic future.
Henry C.K. Liu ****************************************** April 21, 1999 RR-3093
TREASURY SECRETARY ROBERT E. RUBIN REMARKS ON REFORM OF THE INTERNATIONAL FINANCIAL ARCHITECTURE TO THE SCHOOL OF ADVANCE INTERNATIONAL STUDIES
Excerpts:
Exchange rate regimes
Second, choice of exchange rate regimes for emerging market economies. No exchange rate, fixed or floating, can remain stable unless it is backed by sound policies. Flexible rates generally allow more monetary policy independence and greater flexibility in response to shocks. But countries with a history of extreme volatility understandably may show a preference for greater exchange rate stability. Countries that choose fixed rates must recognize the costs and tradeoffs. They must be willing, as necessary, to subordinate other policy goals to that of fixing the rate. Recent history suggests that institutionalizing that subordination may be essential or close to essential for sustaining a credible commitment to fixed rates; and in some cases, where the conditions are right, currency boards appear to have been effective toward that end. But these institutional mechanisms will work only when backed by a real political commitment to reform and sound policy.
The right exchange rate regime is a choice for the individual country. Yet at the center of each recent crisis has been a rigid exchange rate regime that proved ultimately unsustainable. The costs of failed regimes can be significant, not only for the countries involved but also for other countries and for the system as a whole. We believe that, under the circumstances, the international community's judgments about how to respond to the recent crisis were right. Yet it is also important to shape expectations about the official response going forward, as this will have an important impact on policy choices and we want to strengthen incentives for the adoption and maintenance of sustainable exchange rate regimes. As a matter of policy, we believe that the international community should not provide exceptional large scale official finance to countries intervening heavily to defend an exchange rate peg, except where the peg is judged sustainable and certain exceptional conditions have been met, such as when the necessary disciplines have been institutionalized or when an immediate shift away from a fixed exchange rate is judged to pose systemic risks.
Some countries have recently considered making another country's currency their own: in particular, adopting the dollar. This is a highly
consequential step for any country, one that has to be considered very carefully and, in our view, should not be done without consultation with United States authorities. On one hand, dollarization offers the attractive promise of enhancing stability. On the other hand, the country also must be prepared to accept the potentially significant consequences of doing without the capacity independently to adjust the exchange rate or the direction of domestic interest rates. The implications for the United States are also consequential. We do not have an a priori view as to our reaction to the concept of dollarization. We would also observe that there are a variety of possible ways for a country to dollarize. But it would not, in our judgment, be appropriate for United States authorities to extend the net of bank supervision, to provide access to the Federal Reserve discount window, or to adjust bank supervisory responsibilities or the procedures or orientation of U.S. monetary policy in light of another country's decision to dollarize its monetary system.
Full speech: http://www.ustreas.gov/press/releases/pr3093.htm
April 22, 1999 RR-3098
DEPUTY TREASURY SECRETARY LAWRENCE H. SUMMERS SENATE BANKING COMMITTEE SUBCOMMITTEE ON ECONOMIC POLICY AND SUBCOMMITTEE ON INTERNATIONAL TRADE AND FINANCE
Excerpt:
This has been said to make the case for dollarization, in such circumstances, somewhat stronger. But even here countries will need to consider the benefits against the potential costs:
On the one hand, the presumed irrevocability of dollarization holds the promise of lower interest rates, greater stability and possibly deeper financial markets, by adding to the credibility and discipline of its own policies and advancing its integration with the world economy. It is striking that dollarized Panama is the only country in Latin America with an active 30-year fixed rate mortgage market.
On the other hand, the country must also be prepared to embrace an equally irrevocable subordination of domestic monetary policy to that discipline. In addition, a dollarizing government will have to accept losing the seigniorage revenue that domestic currency creation produces.
Full Statement: http://www.ustreas.gov/press/releases/pr3098.htm