REAL EXCHANGE RATE, EXCHANGE RATE REGIMES AND MACRO-ECONOMIC PERFORMANCE IN EAST ASIA

Abstract

The East Asian countries at the center of the recent crisis were for years admired as some of the most successful emerging market economies, owing to their rapid growth and the striking gains in their populations' living standards. With their generally prudent fiscal policies and high rates of private saving, they were widely seen as models for many other countries. No one could have foreseen that these countries could suddenly become embroiled in one of the worst financial crises of the postwar period. What went wrong? Were these countries the victims of their own success? This certainly seems to have been part of the answer. Their very success led foreign investors to underestimate their underlying economic weaknesses. Partly because of the large-scale financial inflows that their economic success encouraged, there were also increased demands on policies and institutions, especially those safeguarding the financial sector; and policies and institutions failed to keep pace with these demands (see Chapter 2). Only as the crisis deepened were the fundamental policy shortcomings and their ramifications fully revealed. Also, past successes may have led policymakers to deny the need for action when problems first appeared. Much has already been written about the East Asian economies dramatic depreciations since June 1997. However, nominal depreciations cannot be taken at face value. This paper has developed a trade-weighted real exchange rate index to track the respective currency's performance against a number of foreign currencies. Analysing the trend of this index over a period of 17 years (Jan 1980 - Dec 1997), the following conclusions can be drawn: ? The prolonged maintenance of pegged exchange rates, in some cases at unsustainable levels, which complicated the response of monetary policies to overheating pressures and which came to be seen as implicit guarantees of exchange value, encouraging external borrowing and leading to excessive exposure to foreign exchange risk in both the financial and corporate sectors; ? problems of governance and political uncertainties, which worsened the crisis of confidence, fueled the reluctance of foreign creditors to roll over short-term loans, and led to downward pressures on currencies and stock markets. External factors also played a role, and many foreign investors suffered substantial losses:

? international investors had underestimated the risks as they searched for higher yields at a time when investment opportunities appeared less profitable in Europe and Japan, owing to their sluggish economic growth and low interest rates; ? since several exchange rates in East Asia were pegged to the U.S. dollar, wide swings in the dollar/yen exchange rate contributed to the buildup in the crisis through shifts in international competitiveness that proved to be unsustainable (in particular, the appreciation of the U.S. dollar from mid-1995, especially against the yen, and the associated losses of competitiveness in countries with dollar-pegged currencies, contributed to their export slowdowns in 1996-97 and wider external imbalances).