The Sunday Review

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End of Singapore $?

Now that Brazil has abandoned its pegged exchange rate, a US dollar-zone may come to be an attractive idea for both emerging economies and the US alike, says STEPHEN FIDLER.

WHEN a gale hits a windmill, there are two ways to save it. You can either make the sails absolutely rigid and trust that the edifice is strong enough to withstand the storm. Or you can disengage the sails from the grinding machinery and let them spin freely in the wind.

What you cannot do is leave the machinery engaged and try to ensure the sails turn only slowly, resisting the wind's force. If you do, the storm wrecks the machinery and mill.

Currencies are a bit like windmills. Absolutely fixed exchange rates -- such as Hongkong's or Argentina's currency boards -- have so far survived speculative gales. The second alternative -- freely floating rates -- have at least avoided full-blown currency crises. Everything in between -- managed floats, exchange-rate targets, etc -- has been wrecked.

Having seen its pegged exchange rate destroyed last week, Brazil yesterday announced it would choose the second alternative: a float. But the question raised by its devaluation -- and by the experience of Latin America since Mexico's devaluation in 1994 -- is whether any independent currency regime is sustainable in the region in a world of free capital mobility.

Professor Guillermo Calvo from the University of Maryland's department of economics fears Latin America's independent currency regimes will not survive if volatile capital flows continue to exact such heavy costs.

"If we don't take care of these global fluctuations, what is going to happen is that individual countries will start imposing controls on capital mobility," he says.

But controls are not a solution for emerging economies, which by definition are net importers of capital. "They would isolate a country from investment," he explains.

Moreover, adopted in country after country, capital controls would threaten a 1930s-style disintegration of the global economy.

There is a second alternative to deal with exchange rate crises: the creation of a global international lender of last resort with sufficient resources to rescue governments which fell prey to abrupt shifts in capital flows.

Some proponents, such as International Monetary Fund deputy managing director Stanley Fischer, believe the IMF should play this role. But in the world of Realpolitik, powerful national governments could be expected to resist ceding power and financial resources to a relatively unaccountable supranational agency.

It is also hard to guess at the amount of capital that would have to be mobilised to make the IMF an effective lender of last resort.

A third and more radical alternative, which is receiving serious consideration in Washington, is to do away with many currencies altogether, thereby removing the targets for speculative attack.

This suggests a world in which two or perhaps three currency zones begin to appear. In Latin America, the obvious candidate as a currency would be the US dollar. Perhaps in Europe, the euro could be extended to its eastern flank. And as Japanese officials have suggested, the yen could dominate Asia.

To understand why economists are coming to this conclusion, some history is needed. Latin America's long-standing love affair with the sort of pegged exchange rate abandoned last week by Brazil was irresistible for two reasons.

An exchange rate anchor offers a guide for the conduct of monetary policy, and it helps control inflation by allowing governments to influence the setting of wages and prices.

Given Latin America's history of economic mismanagement and high inflation, exchange rate anchors gave governments a credible instrument with which to convince the public that inflation could be managed.

Yet, these anchors came under extreme duress in the economic environment of the 1990s. Governments, starved of investment for years, had dismantled exchange controls to encourage foreign capital.

But they were confronted by huge volatility in capital movements that tested to the limits their abilities for economic management, and that blew up one exchange rate anchor after another, starting with Mexico in December 1994.

As exchange rate pegs across Asia collapsed one after the other in 1997, followed by Russia's last year and Brazil's this year, the first broad conclusion drawn by many economists was that pegged exchange rate regimes are untenable in the conditions of high capital mobility in the 1990s.

Thus, governments would be driven to one of two solutions. Either, they would adopt controls on capital -- as did Malaysia -- in a bid to stop the flows of global capital from engulfing them. Or they would move to more robust exchange rate regimes.

Governments should either allow their currencies to float, as did Mexico in 1994 ( it had no reserves to defend any peg), or they should follow the Argentine and Hongkong examples -- anchoring their currencies much more rigidly to a credible currency, in their case the US dollar, through a currency board.

Yet Mexico's experience of floating rates since 1994 has not been encouraging. The country has experienced wild swings in capital flows since then, exacting a heavy cost. This has increased volatility and led to sharp exchange rate fluctuations that bear no relation to the situation in the real economy.

Moreover, inflation has been stubborn, leaving the country with one of the highest inflation rates on the continent.

The costs of flexibility have been high elsewhere too, for example, in Chile.

Meanwhile, in Argentina and Hongkong, credible currency board regimes have clearly stood up relatively well. But, they have suffered high costs too.

Since there is still a prospect that a speculative attack may force a devaluation, that risk is reflected in higher interest rates.

In Argentina last week, they rose by about 3 percentage points, following Brazil's devaluation. Overnight rates stand at 11 to 12 per cent, some 7 percentage points higher than in the US. It is the cost to the country of preserving a separate currency.

Argentina also incurs further costs because of the way it protects its financial system through the high liquidity requirements it places on its banks. The currency board means the country's central bank is limited in its ability to defend its banks against runs -- to act as a lender of last resort. It cannot print money to bail out the banking system without having the dollars in its reserves. Therefore, banks are forced to keep their own liquidity high by holding reserves in the central bank.

So, when Argentinian President Carlos Menem says he will dollar-ise rather than abandon the exchange rate peg, what would be the cost to his country of so doing? The answer is, actually, not all that high.

The first and most obvious loss is so-called "seignorage". In a currency board system, this is interest the central bank earns on those dollar reserves used to back the currency.

In Argentina, currency circulating is worth about US$13 billion (S$22 billion). Because of the currency board, the central bank has to hold that amount in dollars. Assuming an interest rate of 5 per cent, the central bank will earn US$650 million a year.

The second loss is some flexibility in the lender-of-last-resort function. The central bank has some limited devices in its currency board that gives it greater leeway than it would have if its economy was dollar-ised. The third loss is the ability to switch to another currency peg, such as the euro, if the conduct of US economic policy should become irresponsible. Argentina could, in theory, decide to dollar-ise and assume all the costs itself.

Prof Calvo advises against this, arguing that it would be far better to negotiate in advance with the US Federal Reserve, so that the latter would in effect be prepared to stand ready as a back-up lender of last resort. He says he has advised other states in the region, like Peru, on the advantages of dollar-isation.

Nonetheless, it is clear that for other countries, dollar-isation would entail heavier costs than for Argentina, which in a sense is already half way there. Seignorage foregone would be higher, and adapting the banking systems and other institutions to a hard currency regime would be more difficult.

And even if it were feasible economically in some countries, the political obstacles to such an obvious and symbolic loss of national sovereignty might make it impossible.

Dollar-isation would not need the US' imprimatur -- it is happening in Russia without it. But Washington's help would increase the possibility that a US dollar bloc could emerge in the western hemisphere and further afield.

The implication of this for the US could be huge, and its Treasury has already begun to study the ramifications. A dollar-zone is a long way from policy, some officials say, but the possibility that the US could help some economies dollar-ise is not dismissed out of hand. Unconfirmed reports suggest Hongkong has explored the issue with the Fed.

Medley Global Advisers, a consultancy in New York which often reflects official thinking in Washington accurately, has cited sources saying the US administration "has been pushing for dollar-isation as an antidote to the currency problems of the region".

The idea of the US helping others to dollar-ise may be a difficult sell now to inward-looking politicians in Washington. But it may gain ground if the euro starts to threaten the hegemony of the greenback.

It may also look better to policymakers if more governments threaten the alternative of a disintegrating world economy by creating Malaysian-style obstacles to capital flows. -- Financial Times

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