A new conventional wisdom about the choice of exchange rates has emerged in the international forums. For truly open markets, like Hong Kong, the credible choice is either an impregnable linked exchange rate or a genuine free float.
Globalisation, as manifested in financial markets, has involved an unprecedented explosion in international financial flows. The phenomenon has profound implications on the choice of exchange rate regimes, particularly for jurisdictions with open and liquid financial markets, which are big enough to attract the ever-increasing number of market participants capable of mobilising substantial international capital and looking for short-term profit opportunities. Where such opportunities present themselves, whether as a result of improved economic prospects or perceived policy weaknesses, or through economic shock, very large sums relative to the size of the markets can, within a short period of time, flow into and out of those markets. This often leads to considerable volatility and market dislocation, causing the prices of whatever is traded in those markets to overshoot, to the extent of creating systemic problems that could be quite damaging and difficult to handle. The foreign exchange market is a conduit for international capital, and therefore these destabilising phenomena often appear first in that market. Where specifically there is an exchange rate target against which bets can be laid, on the exchange rate itself and on interest rates for the currency concerned, the pressures that build up can be quite formidable. Even when the exchange rate is freely floating, and therefore theoretically with no precise target to aim at, when sentiment is one-sided, which often is the case in financial markets, exchange rate overshooting is quite common.
The financial crises of the 1990s are full of incidents of this kind. As a result, the choice of exchange rate regime has been a prominent, if not central, issue for discussion at international financial forums. Having taken part in many of these discussions, I sense the emergence of a new conventional wisdom that could, at the risk of over-simplification, be described as follows:
-
the credibility of any exchange rate regime is built upon sensible economic policies, strong institutions and robust market infrastructures;
- for markets that are truly open, the choice is between what is now referred to as the two corner solutions, that is either an exchange rate target that is perceived to be impregnable, as in the case of a currency board system, or a regime that does not involve any exchange rate target, as in a free float;
- while the two corner solutions seem to be viable, they are not crisis immune, particularly for open and liquid markets of considerable size;
- the important factors that have to be taken into account when choosing between the two include the degree of external orientation of the economy and the responsiveness of the economy to exchange rate changes; and
- while regimes in between the two corner solutions are inappropriate for truly open markets, those with controls in either the foreign exchange market or the domestic money market, or both, which effectively discourage fund flows or activities that risk market dislocation can afford to experiment with them.
But clearly no exchange rate regime can be perfect and there is no one regime that suits all. Our currency board system has served us well and the case for it has never been clearer. The floating exchange regime seems at present to be quite popular elsewhere. But it seems to work well only for selected economies, notably the large ones where the foreign exchange markets are big enough to absorb the voluminous capital flows. The US is an obvious example, although with the US dollar serving as the "numeraire" in the expression of exchange rates for all other currencies, there is no one exchange rate on which to focus as a policy instrument. Furthermore, the US economy is not particularly externally oriented. The level of the exchange rate, however measured, is of much less significance to economic policy in the US than in other jurisdictions. But there is, nevertheless, a strong dollar policy, whatever that means, and this incidentally seems contradictory to the long established advocacy for a freely floating exchange rate regime. For the other major currencies that are currently freely floating under open market conditions, it is very difficult to tell whether such a regime is working well. But then there are no politically viable alternatives. Concerted intervention is difficult enough to achieve, not to mention exchange rate co-ordination or the establishment of a global currency, as advocated recently by a few academics. And so, with the exception of the US, they continue to face the possibility of exchange rate overshooting ? witness the current weakness of the euro. Let's hope that this will turn out to be a short-term phenomenon so that the extent of the overshooting will not in the mean time lead to systemic problems or generate inflation that undermines long-term economic growth.
Joseph Yam
14 December 2000
More information on Hong Kong's Linked Exchange Rate System can be found here.
Related publications:
Click here for previous articles in this column.
Document in Word format
