A leading private sector economist in Washington, Morris Goldstein, is suggesting that developing countries move towards flexible market determined exchange rates as a means to avoid financial crises.
Mr. Goldstein was for 25 years a top researcher at the International Monetary Fund before moving to the Institute for International Economics.
His argument is that in most cases a fixed exchange rate doesn't work in developing countries. He concedes that are a few exceptions like Hong Kong which has succeeded in holding its dollar at a fixed rate to the U.S. dollar. But, said Mr. Goldstein, it was a fixed exchange rate that got Argentina into trouble this year and in the Asian financial crisis of 1997, 98, rigid exchange rates could not be defended when they came under speculative attack in financial markets.
Mr. Goldstein said in fixed currency systems interest rates are the main policy tool to hold the exchange rate steady. But changes in interest rates can have unintended consequences. "If you lower interest rates," he said, "maybe you get a free fall in the currency. Then you get these big balance sheet effects and you make a lot of banks and firms insolvent. On the other hand if you raise interest rates to support the exchange rate then you get highly leveraged companies increasing the interest rate burden and you make the economy more contractionary."
At a presentation Tuesday, Mr. Goldstein expressed doubt that developing countries in Asia can effectively use interest rates to defend even target zones for their exchange rates.
Mr. Goldstein said, "I don't think in the end you'll be able to defend those loose zones by interest rate policy. You have to defend them essentially through interest rate policy. The financial structures in these countries are improving but certainly in the next three to five years I wouldn't see these countries able to do high-interest rate policies to defend any kind of zone."
Since Asia's financial crisis most countries in the region have moved to floating exchange rate system, which so far have worked rather well.
Mr. Goldstein said among emerging economies financial systems are most developed in Hong Kong, Mexico, Poland, Singapore and South Africa. "There's a second tier - Brazil, South Korea, Taiwan, Hungary and [the] Czech Republic - where liquidity is not as good as in the first tier but," he said, "it is improving. And then you've got a lot of others."
In the latter category are countries like Argentina, Chile, Indonesia, Malaysia, Russia, Thailand, Turkey and Venezuela.