and “bipolar view” or “two corner solutions” have been put forward as the only viable options for these countries. Eichengreen (1994) is one of the first proponents of the so-called “Hollowing of the Middle” theory or “bipolar view” according to which only the two-corner solution “hard pegs” and “full floats” are feasible in a world of high capital mobility. This view is further supported by Fisher (2001) who argues that high capital mobility makes intermediate regime less viable in financially open economies.
Since monetary policy under this circumstance cannot simultaneously achieve a stable exchange rate and smooth cyclical output fluctuations, these countries should pursue the corner solution strategy and adopt either a hard peg or a pure float. In addition, the effectiveness of controls for capital inflows and outflows is deemed to be very limited, at least on a sustained basis (Ariyoshi et al., 2000). Considering the rapid process of financial deepening and innovation also may reduce the effectiveness of capital control, the traditional trinity dilemma is usually reduced to the two options or a monetary policy-exchange rate stability trade-off.
2.2.3 Currency Crises Theory
The theoretical and political arguments regarding the exchange rate regimes have been intensified following the currency crises as well as the collapse of several traditional fixed or crawling peg arrangements in the 1990s. The merits and drawbacks of both fixed and floating exchange rate regimes have been compared and debated. More and more attention has been given to the ability of a given exchange rate regime to face periodic and potentially contagious financial crises. Thus, the vulnerability of countries to currency crises under different exchange rate regimes has been highlighted by extensive literature in evaluating the exchange rate regime.
In the literature on exchange rate instability, one approach that often referred to as first-generation models2 views a currency crisis as the unavoidable outcome of unsustainable policy stances or structural imbalances (Krugman, 1979). This view
2 The approach was pioneered by Krugman (1979) who adapted a model by Salant and Henderson (1978) to the analysis of currency crises. It was further refined by Flood and Garber (1984).
stresses that the exchange rate regime is a component of border policy package, and the regime can be sustained only if it does not conflict with other monetary and fiscal objectives. It is further implies that the expansionary monetary policy combined with a fixed exchange rate leads to external imbalances (Krugman, 1979). This is because under a fixed exchange rate regime, domestic credit expansion in excess of money demand growth would lead to a gradual but persistent loss of international reserves.
This would eventually lead to a speculative attack on the currency. Extending this logic, many others thereafter investigated the implications of market speculation against an exchange rate regime, including the precise time of collapse of a regime (see Flood and Garber, 1984; Connolly and Taylor, 1984, and others). Fischer (1999) and Krueger (1999), among others, point out that fixed exchange rate regimes often lack credibility and invite speculation against the pegged rate, in particular when unfavorable conditions arise. Rana (1998) also argues that the return to an announced peg is an open invitation for future speculative attacks in the context of the ongoing crisis that severe banking sector and low levels of reserves are evident. These scholars also claim that the costs associated with increases in exchange rate variability are lower when compared with the costs incurred when speculators attack a pegged exchange rate system. Thus, adherents of this view suggest the merit of floating exchange as a mechanism to prevent the crisis.
On the other hand, some studies point out that a floating system would bring about considerable volatility in the exchange rates. This is particularly for the affected countries where financial markets are not well developed and foreign exchange rate markets are weak (see, for example, Rana, 1998). Several researchers argue that floating exchange rates indeed exhibit great volatility and such excess volatility has in some cases restrained the international trade (Flood and Rose, 1995; Rose, 2000; Klein and Shambaugh, 2004). The flexible exchange rate regime is also argued to increase risk premiums through increased volatility in the exchange rate, giving rise to moral hazard problems for poorly regulated banking system, and thereby increase nation’s vulnerability to currency crises (McKinnon, 2000). Fixed exchange rates, according to this alternative view, will result in lower risk premiums and bankers will face less
temptation to increase their dollar liabilities. The intermediate regime of managed floating become worth considering in light of these problems regarding both peg and floating regimes. For example, Ohno (1999) point out moving to a crawling peg system may be advisable in this context as it combines the advantages of both fixed and flexible exchange rates. Not only impose disciplines on exchange rate polices, it also provides flexibility if the country is affected by capital flights. Nevertheless, the intermediate regime is not a panacea and soft pegs (or crawling pegs) are viewed to be more crisis-prone than the regimes at either end of the continuum of exchange rate system (Fischer, 2001). Soft pegs are argued to be unsustainable and hard pegs and free floating extremes have been gaining ground among practitioners in favor of this argument. Haile and Pozo (2006), in particular, argue that pegs that are not truly pegs appear to invite speculation against the currency, increasing the odds of currency crisis.
Nevertheless, some researchers recently argue that nations can choose, in principle, to pursue a fixed, floating, or intermediate exchange rate regime without being concerned that one or another is apt to increase the odds of currency crises. For example, Stiglitz (2002) suggests that neither fixed nor flexible rate can properly be blamed as the crisis trigger. Instead, liberalisation of capital market together with macroeconomic and
“bail-out” policies makes countries more vulnerable to shocks and thereby is responsible for currency crises. In recent years, as Kaminsky and Reinhart (1999) argue, currencies crises have been increasingly associated with financial fragilities and several researchers have tested for external common shocks or market contagion3. Haile and Pozo (2006) find no role played by the actual or de facto exchange rate regime in determining currency crisis periods. It is not distinguishable for different exchange rate regimes in terms of raising susceptibility to currency crises. They further point out currency crises can be propagated by economic polices and certain unsustainable exchange rate policies rather than alternative exchange rate regimes. Overall, the question that which kind of exchange rate regime contributes to the incidence of currency crisis still remains debatable and controversial.
3 Other papers that discuss financial contagion include, for example, Eichengreen et al. (1996), Glick and Rose (1999), Sachs et al. (1996) and Tornell (1999).