Does a country’s exchange rate regime affect moral hazard in capital markets or address the problem of international overborrowing? Is there merit in resurrecting the de facto “East Asian dollar standard” that operated for more than a decade before the crises of 1997–98? Ronald I. McKinnon of Stanford University addressed these issues at an IMF Institute seminar on August 14.
The financial crises suffered by emerging markets in the 1990s, beginning with Mexico in 1994, were of ten precipitated by large capital inflows to finance ambitious stabilization and reform programs. Financial liberalization, which was in many cases a part of these programs, had enabled domestic banks to borrow heavily in international capital markets and had resulted in massive, of ten excessive, inflows of foreign capital. This phenomenon, which McKinnon called “the overborrowing syndrome,” became a source of macroeconomic imbalances that ultimately proved unsustainable. In McKinnon’s view, overborrowing is a moral hazard issue rather than, for example, a matter of “getting the exchange rate right.”
Because of their systemic importance to the domestic economy, banks expect to be bailed out when they run into trouble. Near certainty of official bailout further increases the magnitude of overborrowing and leaves the economy more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack.
Modeling the overborrowing syndrome, McKinnon posited the hypothetical situation of a small open economy whose banks enjoy a government guarantee. The government embarks on a credible program of economic reform designed to eliminate distortions and make the economy more productive—for example, by lifting restrictions on foreign and domestic trade. To achieve this, a certain level of investment in the new technology is needed. However, the magnitude of the productivity rise depends on the overall macroeconomic success of the reform program.
In assessing investment risks in the reforming economy, banks may discount the risk of unfavorable outcomes and be more willing to borrow, secure in the knowledge that official bailout provisions will keep their depositors from deserting the ship. Because of the moral hazard in domestic lending, the quantity borrowed internationally is too high, which leads to an excessive expansion of credit. Only an unusually good macro outcome can then prevent a financial crisis.
Foreign exchange markets
Evidence from recent emerging market crises—especially in East Asia—suggests that banks also took excessive risks in the foreign exchange markets, McKinnon noted. Banks enjoying a government guarantee of their liabilities have an incentive to speculate on exchange rate developments, because, as with credit risks, they are protected from adverse outcomes.
Nominal developments in exchange rates are uncertain and introduce risk into foreign exchange transactions, McKinnon said. Investors in foreign currency assets base their demand for a particular asset on its riskiness, which is captured by the currency risk premium. Interest rates and price levels are typically more volatile in emerging markets than in industrial countries. Because wealth holders demand more compensation for holding emerging market assets, the interest rates on assets denominated in emerging market currencies have to be higher to maintain international portfolio balance.
To reduce the risk, investors engage in hedge transactions—that is, they take other positions that reduce risk, usually at the expense of maximum reward. Thus, unhedged transactions cost less than hedged ones, because the risk is higher.
In many, if not most, emerging market countries, the regulatory and supervisory institutions are too weak to impose and enforce 100 percent hedging requirements on domestic banks. Consequently, banks with moral hazard have an incentive to borrow unhedged in foreign exchange markets at a lower interest rate, transferring the resulting foreign exchange risk to the government through the implicit government guarantee.
McKinnon termed the difference between the cost of capital for hedged borrowers and unhedged borrowers the “margin of temptation.” This margin is reflected in the “super risk premium,” which has two components: the currency risk premium and the part of the interest differential between domestic and foreign currency arising from the small probability of a large, sudden devaluation whose timing is unpredictable.
When they borrow unhedged foreign currency, domestic banks with deposit insurance and other government guarantees ignore the downside bankruptcy risks implied by such large devaluations. They also ignore ongoing volatility in the exchange rate. A bank exploiting a government guarantee by borrowing unhedged in the international capital market will charge a lower lending rate than a domestic bank borrowing in foreign currency but fully hedging its foreign exchange exposure.
This highlights a regulatory dilemma, McKinnon said. If the super risk premium is high and the ability of the regulatory authorities to enforce hedging rules is imperfect, there will be large differences in the perceived cost of capital to different financial agents and firms in the domestic market. Those that the authorities succeed in policing will face a much higher cost of capital than those that gamble and borrow unhedged. A declining market share could undermine the resolve of well-behaved banks to hedge their foreign exchange positions and lead to a breakdown in the domestic regulatory system, McKinnon cautioned.
Good “fix” versus free float
The current consensus in the academic literature, which has been endorsed by the IMF and other international organizations, McKinnon said, is that more flexible exchange rate arrangements are needed. With flexible exchange rates, this argument contends, the risks of accepting short-term deposits are clear. However, as McKinnon noted, while floating may reduce the super risk premium, it does not necessarily reduce the currency risk premium. Therefore, a free floating regime may not reduce moral hazard or the margin of temptation for unhedged borrowing by banks.
Of course, it is necessary to distinguish between a “bad” fix—one that is obviously unsustainable because of, say, ongoing fiscal deficits and correspondingly high domestic interest rates that create a huge margin of temptation—and a credible, “good” fix. A good fix, McKinnon argued, may be preferable to floating, because it can reduce the likelihood of a sharp devaluation and may also better stabilize the domestic economy while limiting moral hazard in the banking system. However, no exchange rate regime, no matter how well chosen, can obviate the need for prudential regulation of domestic banks against undue risk taking, McKinnon asserted.
No exchange rate regime, no mater how well chosen, can obviate the need for prudential regulation of domestic banks against undue risk taking.
East Asia dollar standard
As an example of a good fix that, at least on the surface, appeared to have failed, McKinnon described the experience of the East Asian economies that for more than a decade before the crises of 1997–98 pegged to the U.S. dollar. The crisis economies of Indonesia, Korea, Malaysia, the Philippines, and Thailand, as well as the noncrisis economies of Hong Kong SAR, China, and Taiwan Province of China, organized their domestic monetary policies to keep their dollar exchange rates remarkably stable. Besides insulating each other from beggar-my-neighbor devaluations, these informal dollar pegs successfully anchored domestic price levels during their remarkably rapid economic growth from the 1980s through 1996.
With the benefit of hindsight, however, McKinnon said, we can see that this unofficial “East Asian dollar standard” was incomplete. First, the authorities failed to properly regulate the financial system—including the central bank in some cases—against undue risk taking, including short-term foreign exchange exposure. Overborrowing was thus primarily a regulatory problem compounded by unnatural interest disparities and was not due to exchange rate mismanagement per se. Whether the countries were on fixed or floating exchange rates, McKinnon said, the margin of temptation to overborrow by banks with moral hazard would still be there.
The absence of a formal exchange rate anchor as part of the monetary strategy of a country whose currency is under attack will leave international investors in the dark about where the exchange rate will end up in the aftermath of a crisis. Under the nineteenth-century gold standard, a country whose currency was attacked allowed its exchange rate to float until the dust settled, at which point it was expected that the parity with gold would be reestablished. This understanding lessened market uncertainty about the future behavior of an individual currency.
With the exception of Hong Kong SAR, none of the East Asian debtor countries had formally declared a dollar parity, McKinnon said. Because of the short-term structure of finance, each was vulnerable to speculative attack on its currency, but none had a long-run exchange rate strategy in place to mitigate the worst consequences of such an attack. Thus, with the forced suspension of these dollar pegs in the 1997–98 crisis, there was no traditional dollar parity to which the government was bound to return.
Formalizing the standard
The good record of fiscal balance in the East Asian economies suggests that a longer-term commitment to maintain their dollar exchange rates could be credible, McKinnon observed. Thus, to secure a common monetary anchor, the advantages of returning to virtually stable dollar exchange rates in Asia greatly outweigh the disadvantages; and, in effect, most of the East Asian five have quietly, if unofficially, returned to dollar pegging.
McKinnon concluded by suggesting some modifications to the existing informal system that would make this common monetary standard more robust and efficient.
Prohibit net foreign exchange exposure by banks or other financial institutions with short-term assets or liabilities.
Move from informal dollar pegging to official dollar parities and treat these parities as long-term obligations to which governments in the region are committed after any crisis.
Make other institutional changes to lengthen the term structure of domestic finance by encouraging the development of bond and mortgage markets.