Globalization, Macroeconomic
Performance, and the Exchange
Rates of Emerging Economies
Keynote Speech by Maurice Obstfeld

Among the developing countries of the world, those emerging markets
that have sought some degree of integration into the global financial
system are characterized by higher per capita incomes, higher long-run
growth rates, and lower output and consumption volatility. These
characteristics are more likely to be causes than effects of financial
integration. The measurable gains from financial integration appear to belower for emerging markets than for higher-income countries, and appear
to have been limited by recent crises. One factor limiting the gains fromfinancial integration is the difficulty emerging economies face in resolving
the open-economy trilemma. Given their structural and institutionalfeatures, many emerging economies cannot live comfortably either with
fixed or with freely floating exchange rates. Most recently, the exchange
rates of several emerging countries display attempts at stabilization
punctuated by high volatility in periods of market stress.
Keywords: Developing countries; Emerging markets; Convergence;
Macroeconomic volatility; Exchange rate regimes; Institutions;
Dollarization; Original sin
JEL Classification: F34, F36, F43, O11, O16

University of California, Berkeley (E-mail: obstfeld@econ.berkeley.edu)
Miguel Fuentes and Gabriel Chodorow-Reich provided superb research assistance. I thank Alan
M. Taylor for permission to draw on our joint research. Any remaining errors are mine.
MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004
DO NOT REPRINT OR REPRODUCE WITHOUT PERMISSION.

29

I. Introduction
How do economists now view the effects of economic globalization? The mostproblematic obstacles to realizing conventional gains from trade arise for the poorer,industrializing economies, and they are especially severe in the arena of international
currency relations and finance. A decade of experience and research since Mexico’s
1994–95 crisis has led to a modal outlook which, if not decidedly more pessimistic,is certainly more nuanced than the one that prevailed during the heady early 1990s.
In the early 1970s, industrial countries moved to a regime of floating U.S. dollar
exchange rates, within which they were able progressively to liberalize international
financial flows while maintaining substantial national sovereignty over monetary
policy decisions. The resulting “nonsystem,” as it was often labeled, has now endured
longer than its Bretton Woods predecessor, and its stability has on the whole beenenhanced by monetary innovations such as explicit and transparent inflation targeting. Industrializing countries, by contrast, have found it much harder to settle into
a comfortable resolution of the open-economy monetary policy trilemma. In thosecountries, institutional distortions and market failures complicate credible inflation
targeting, render large exchange rate movements more dangerous, make fixedexchange rates acutely crisis-prone, and apparently reduce the beneficial effects offinancial liberalization.
While events of the 1990s have underscored these difficulties, none of them is anentirely new phenomenon. Many received extensive discussion in past academic
research, for example, in the literature on the contractionary effects of devaluationand in that on the optimal sequencing of economic opening.1 What is new is thatan important subset of the industrializing world has now established sufficiently
extensive financial linkages with the rich countries, and achieved a sufficient degreeof economic size, that its fortunes have first-order repercussions on the rest of theworld. In other words, the relative success of some middle-income countries ingrowing and opening their economies also gives them a position in which theirvicissitudes raise global concerns. No longer are the structural features of developing
countries viewed as exotic special cases; indeed, newer institutional and geographic
theories of the wellsprings of prosperity are sufficiently broad to encompass thepoorest as well as the richest economies. It is hoped that this line of research
can point the way toward fundamental reforms that will ease the difficulties of the
globalization process.
This paper is a selective overview of industrializing countries’ macroeconomic
performance and external financial linkages. In Section II, I review some salient
differences in economic growth and volatility among three country groups, thehigh-income industrial countries, the generally middle-income countries with somedegree of global financial integration, and the generally poor countries that remainclosed to private international financial flows. In particular, I show that acrossthese country groupings, both macroeconomic volatility and the ratio of per capita
consumption volatility to output volatility are inversely related to per capita income.
1. Earlier contributions include Díaz Alejandro (1975), Black (1976), and McKinnon (1982).

30 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

Section III looks at the postwar history of financial liberalization, the economic gains
it has yielded, and their dependence on national institutions and per capita income.
Although middle-income emerging markets may benefit less from financial opening
than do richer countries with higher institutional quality, some do appear to gain
(at least those with sufficiently high income and/or institutional quality), whichhelps explain their determination to participate in financial globalization. Given
financial openness, emerging markets may have difficulty in finding a feasible
exchange rate regime, a factor that heightens economic volatility and reduces theirbenefits from globalization.2
In Section IV, I focus upon one classic reason for the difficulties emerging market
countries face in operating their exchange rate regimes, their inability to borrow intheir domestic currencies. I show how this institutional feature of markets makes
floating more difficult by inducing additional exchange volatility and by complicating the process of current account adjustment. I go on to argue that reliance on
foreign-currency borrowing can undermine fixed exchange rates by generating
financial fragility. Section IV also examines more closely emerging countries’ experiences with flexible exchange rates. While the Calvo and Reinhart (2002) “fear of
floating” phenomenon is confirmed at one level for a number of nonindustrial
countries, it is also true that some have benefited from exchange flexibility throughthe accommodation of competitiveness trends and through the use of the exchange
rate as a safety valve during intervals of turbulence. In general, the record reflects thedifficulties emerging countries have had in exchange rate management, given theirstructural problems and their more open capital markets. Section V offers someconcluding thoughts.

II. Economic Performance within Three Country Groups
The reality of the economic growth experience is messy. Track records differ greatly
across national, regional, and stage-of-development units, defying simple generalizations. Accordingly, explanations of growth experience focus increasingly on geographyor the diverse institutions governing nations’ political, economic, and legal systems.
Recent attempts at generalized theories emphasize “deep” factors, such as those thatmight explain the origins of institutions.
Figure 1 portrays a basic fact, emphasized by Romer (1987), that there is no systematic tendency for national levels of GDP per capita to converge (unconditionally) overtime. The figure plots GDP per capita in 1960 (horizontal axis) against the averageannual growth rate of per capita GDP over the following four decades (vertical axis).
In a simple world of structurally identical Solow economies, capital-scarce poor
countries would show faster growth, fueling a tendency toward convergence overtime. Yet the slope of the regression line shown in Figure 1 is significantly positive
rather than negative. Some countries that were poor in 1960 indeed have displayed
2. Calvo and Mishkin (2003) argue that the choice of an appropriate exchange rate regime is secondary to a soundinstitutional infrastructure for the economy, which is an ultimate determinant of economic success.

31

Figure 1 Average Annual per Capita Growth Rate, 1960–2000
Average annual growth rate of per capita GDP from 1960 to 2000, percent
8
7
6
5
4
3
2
1
0
–1
–2
High income–3

Emerging

Insular

–4
0

5,000

10,00015,000GDP per capita in 1960, 1996 U.S. dollars

Source: Penn World Table 6.1.

rapid subsequent growth, and some that were relatively well off then have donecomparatively poorly since (for example, Argentina and Venezuela). Nonetheless,the average tendency is toward divergence in national per capita incomes.
Figure 1 distinguishes among countries based on a tripartite classification thatwill be useful below. Following Husain, Mody, and Rogoff (2004), I classify countries
as “high income,” “emerging,” or “insular” (based on recent data). For those authors,
the emerging market countries are those included in the Morgan Stanley CapitalInternational (MSCI) index. I depart from them in transferring from their insular
to the emerging category countries that, while not in the MSCI index, are classified
by the International Monetary Fund (IMF) as having open financial accounts (forexample, Uruguay). Thus, my insular group is composed mainly of financially closed
economies. While many in the emerging markets group are currently financiallyopen, a number of the countries included in the MSCI index—China is a notable
example—still maintain some restrictions on international financial transactions.
Furthermore, the insular group is on average the poorest group, while emerging
market countries generally are in the middle-income category. The Appendix
lists the country groups. Husain, Mody, and Rogoff (2004) refer to countries in
my “insular” group as “developing,” but I will reserve that term (as well as theterm “nonindustrial,” to be used synonymously) for the union of the emerging andinsular sets.3
3. I borrow the term “insular” economy from McKinnon (1981), who applied it in a somewhat different sense.

32 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

The finding of overall unconditional divergence is, in a mechanical sense, due tothe insular group, which consists largely of African countries. These countries, whichwere among the poorest in 1960, have tended to become relatively poorer over time.
But the convergence one would then find in a sample consisting of emerging plus
high-income economies would be illusory, that is, it is not the result of factors
stressed in a simple, uniform, Solovian account of the world. Within the emerging
markets group, the East Asian economies have indeed displayed upward convergence,with some, like Singapore, growing so fast as to reach high-income status. But theLatin American countries, also mainly within the emerging markets group, show
downward convergence. That is, some of the countries that were relatively rich in1960 (much richer than the East Asian countries were then) have grown most slowly,
but not as a result of relative capital abundance! Among the countries that are mostprosperous today, there are a number of notable success stories, but as De Long
(1988) has stressed, it is misleading to judge convergence on the basis of a sample ofcountries that, ex post, have become rich.
A more illuminating way to track the world income distribution is to compare
countries’ output positions relative to the United States as they evolve over time.4
Figure 2 presents some relevant data, plotting the log of per capita GDP relative to
Figure 2 GDP per Capita Relative to the United States (log)
2000
1

0

–1

–2

–3

–4

–5
–5

–4

–3

East Asia
Latin America
Other

–2

–1

0

1
1960

High income
Sub-Saharan Africa

Source: Penn World Table 6.1.

4. For a complementary discussion, see William R. Easterly’s contribution to this conference (Easterly [2004]).

33

the United States in 1960 (horizontal axis) against its value in 2000 (horizontal axis).
The country sample is subdivided by region. Countries lying above the 45-degreeline through the origin converged closer to U.S. output levels over the last four
decades of the 20th century, whereas those below only fell further behind. Many
countries classified as high-income today were substantially further behind theUnited States in 1960, but of course, the standouts in improving per capita income
are the East Asian countries. (Singapore is in the high-income group in Figure 2,
though it was middle-income in 1960.) Some other countries, such as India andPakistan, have to some degree improved their relative position. The performances ofthese countries and much more so, that of China, underlie Fischer’s (2003) observationthat global unconditional output convergence appears more pervasive when the unitof observation is the individual rather than the nation.
Divergence in per capita output over the second half of the 20th century isconcentrated mostly in Latin America and Sub-Saharan Africa. Those few Latin
American countries that lie above the diagonal in Figure 2 (one is Brazil) are close toit. In Sub-Saharan Africa, poverty is much greater and growth has been lower. These
countries, with only a few exceptions, appear mired in low-output poverty traps,
made worse by increasing political disintegration and the prevalence of Acquired
Immune Deficiency Syndrome (AIDS).
For the most part, Latin America and East Asia make up the middle-income
emerging markets group. The financial criterion on which this classification isbased—a sufficient degree of openness to private capital movements, or inclusion in
the MSCI index—is, again, an ex post criterion. All of these countries were relatively
closed financially for much of the 1960–2000 period. But the regions’ divergent
experiences suggest that, for emerging economies, it will be hard to establish any
simple unidirectional causal link running from financial opening to economic growth
performance (as the next section discusses more fully).
The volatility of economic growth, not just its mean level, affects economic
welfare. Figure 3 therefore plots the standard deviations of annual per capita GDP
growth (horizontal axis) and annual per capita private consumption growth (verticalaxis). Countries are distinguished by membership in the high-income, emerging, or
insular groups, and two comparative facts stand out. First, growth volatility, whetherof consumption or of output, is highest (on average) in the insular group and lowest,
by far, in the high-income group, with emerging markets generally occupying anintermediate position. Poorer economies tend to produce a greater proportion ofprimary products subject to highly variable supply and demand conditions, and theirgovernments’ policies often are erratic, so the comparatively high volatility of GDP isto be expected. Consumption volatilities would, however, be comparable acrossincome groups were all idiosyncratic risks internationally diversifiable.
The second fact apparent in Figure 3 concerns the relative volatilities of consumption and output growth. The simplest consumption theories suggest that individuals
will smooth consumption relative to income through domestic and foreign
investment. In this context, it is worth underscoring that the GDP data, strictly
speaking, measure output rather than income, so that conclusions should be drawn
with caution. I will return to this problem in a moment. Nonetheless, for many

34 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

Figure 3 Standard Deviations of Consumption and GDP Growth Rates, 1975–2002

Standard deviation of annual growth in per capita
private consumption
0.15

0.10

0.05

0.00

High income
Emerging
Insular
0.00
0.05
0.10
0.15
Standard deviation of annual per capita GDP growth
Source: World Bank, World Development Indicators.

countries income and output are sufficiently highly correlated that we would still
expect consumption to be less volatile than output. For the high-income countries,
this prediction is largely borne out. In only four within my high-income sample isthe volatility of per capita consumption growth higher than that of per capita output
growth, and in three of those four cases they are approximately equal (the exceptionis Iceland). In the high-income group, the average ratio of the standard deviation of
consumption growth to that of output growth is 0.82.
The emerging markets group displays wide discrepancies in the relative volatilities of per capita consumption and output growth. The range is from 1.8 (Chile)
to 0.5 (the Philippines). On average, the ratio of standard deviations is 1.05, amean relationship of approximate equality.
For a large majority of the insular economies, consumption volatility exceeds
output volatility, often substantially. In this group of countries, the average ratio ofconsumption to output growth volatility is 1.5. This is especially painful because,
as pointed out above, economic volatility in general is so much higher in poorer
countries. The average standard deviation of annual per capita consumption growthis 7.4 percent in my insular-country sample, 4.1 percent in my emerging markets
sample, and only 2.3 percent in my high-income sample. That is why estimates ofthe potential benefits from eliminating national consumption variability tend to be
so much higher for poorer countries (Obstfeld [1995] and Pallage and Robe [2003]).
What explains these differing patterns of per capita consumption and output
growth volatility across country groups? One possibility, mentioned above, is thediscrepancy between GDP and national income. This difference could be important35

in some cases, for example, nonindustrial countries for which highly variable remittances from workers abroad form a substantial share of national income. Of course,
another main factor separating GDP from national income is the net flow of interestand dividends on foreign investments, although for many countries this flow is notvery large compared to output. Data quality, especially of consumption data, mightalso be an issue.
There are also some theoretical hypotheses. Neumeyer and Perri (2004) and
Uribe and Yue (2003) suggest that changing perceptions of country risk on the partof foreign investors, which affect country borrowing spreads, can induce additional
volatility in emerging market consumption and business cycles. As Figure 3 shows,
however, the problem is even worse for insular countries, which are largely closed to
private capital movements and carry out even sovereign borrowing on a more limited
scale. This fact alone indicates that openness to international financial flows, while
possibly aggravating volatility in some cases, is far from being the only culprit.5
The heterogeneity of country experience, and of experience across income groupings,
suggests that a variety of factors may be at work in generating the high volatility
and countercyclical relationship between output and saving that characterize many
developing economies. In light of the important positive and normative implications,this pattern should be a focus for future research.
Figure 4 investigates the output-income distinction further by plotting consumption volatility against GNP rather than GDP volatility. (Again the data are in per
Figure 4 Standard Deviations of Consumption and GNP Growth Rates, 1975–2002

Standard deviation of annual growth in per capita
private consumption
0.15

0.10

0.05

0.00

High income
Emerging
Insular
0.00
0.05
0.10
0.15
Standard deviation of annual per capita GNP growth
Source: World Bank, World Development Indicators.

5. This is also suggested by the decadal evidence on consumption growth volatility reviewed by Prasad et al. (2003).

36 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

capita terms.) The change slightly lowers the mean slope of the observations,while maintaining the general volatility orderings found earlier: on average, per capita
income volatility is highest in the insular group and lowest in the high-income group,and the same is true of the ratio of consumption volatility to income volatility (with afew outliers for the insular group). Of course, the reason the points in Figure 4 tend
to be lower than in Figure 3 relative to the 45-degree line is that GNP volatility
typically is not lower than GDP volatility, and for many developing countries, GNP
volatility tends markedly to exceed GDP volatility. Figure 5 illustrates these facts.
For high-income countries, the average relation between GDP and GNP volatility is
consistent with Lane’s (2001) findings. In basic models of portfolio diversification,international trade in idiosyncratic risks should reduce income volatility comparedwith output volatility, so Figure 5 poses a further puzzle deserving future research.
As just noted, the differing positions of these three country groups vis-à-vis theworld capital market make it unlikely that a single explanation will apply in all cases.
Later I will consider some potential problems raised for the emerging economies byfeatures of the international capital market.
Figure 5 Standard Deviations of GNP and GDP Growth Rates, 1975–2002
Standard deviation of GNP growth
0.15

0.10

0.05
High income
Emerging
Insular

0.00
0.00

0.05
0.10
0.15
Standard deviation of GDP growth

Source: World Bank, World Development Indicators.

37

III. Financial Integration, Performance, and Institutions6
The period following World War II is characterized by an overall trend of international financial liberalization that has culminated in virtually free cross-border asset
trade for many countries. Nonetheless, financial opening has proceeded at different
paces in different regions, remains unrealized in a fair number of countries, andsometimes has been subject to reversals.
Industrial countries followed a steady return to financial freedom after 1950, withhigh points including the return to current account convertibility in Europe at theend of the 1950s, the widespread liberalization following the move to floating U.S.
dollar exchange rates in the early 1970s, and the abolition of European capital controls
in preparation for the launch of economic and monetary union in 1999. Figure 6,
which displays the index of capital account openness developed by Quinn (1997)
and by Quinn and Toyoda (n.d.) for a number of regions, illustrates this evolution.
In our recent book (Obstfeld and Taylor [2004]), Alan Taylor and I argue that thepattern of industrial-country liberalization reflects different approaches to the openeconomy trilemma. The Bretton Woods arrangements governing the immediate
postwar decades called for fixed exchange rates relative to the U.S. dollar. But Bretton
Woods also permitted a regime of international capital control consistent withand supported by the extensive domestic financial restrictions inherited from theGreat Depression and the world war. As a result, countries retained considerable
independence in setting interest rates (see Obstfeld, Shambaugh, and Taylor [2004]),
as well as the option of occasional discrete exchange parity changes.
Figure 6 Quinn’s (1997) Measure of Capital Account Openness, by Region

100

Capital account openness

90
80
70
60
50
40
30
20

OECD
South America
Middle East/North Africa

10
0
1950

55

60

65

70

75

80

East Asia
Sub-Saharan Africa

85

6. This section draws extensively on Obstfeld and Taylor (2004).

38 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

90

95

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

The return to current account convertibility and the rapid growth of world trade,however, made international financial flows ever more difficult to contain. Just as
China recently has struggled to shut out speculative capital inflows, European countries under Bretton Woods found themselves under speculative pressures which, by thelate 1960s, had become seriously destabilizing despite tighter capital controls. While
the move to floating U.S. dollar exchange rates early in 1973 was initially viewed as atemporary tactical retreat, the system proved durable. It gave countries monetary independence in the face of severe macroeconomic shocks, and allowed a gradual loweringof capital controls by some of the major industrial countries. Greater freedom ofinternational transactions, in turn, served the interests of a resurgent financial services
industry, which found new profit opportunities in the recycling of Organization ofPetroleum Exporting Countries (OPEC) surpluses and in expanding foreign exchange
trading. The resulting resolution of the trilemma has proved quite durable with regard
to dollar exchange rates, although euro zone members have taken a quite different, andlargely politically motivated, approach, sacrificing national monetary autonomy infavor of absolute intra-zone exchange stability and capital mobility.
Figure 6’s depiction of the Organisation for Economic Co-operation andDevelopment (OECD) capital account openness is consistent with this narrative.
The figure also shows the evolution of openness in nonindustrial country groups.
Like the OECD, East Asia has trended upward, but without yet reaching an equal
degree of openness, as some important regional actors, including China, retain
controls. Africa and the Middle East have made less progress, although the trend is
still toward greater financial openness.
The Latin American case is instructive. By 1960, Latin America had reached ahigh degree of financial openness. Indeed, aside from Canada and the United States,
all the countries that declared early current account currency convertibility under
Article VIII of the IMF’s Articles of Agreement were located in Central America or
the Caribbean. Given Europe’s need to reconstruct and their favorable Western
Hemisphere location, these countries enjoyed strong terms of trade in the early 1950s.
Although this happy conjuncture could not persist indefinitely, capital account liberalization moved forward in the region. For example, on December 29, 1958, just as
major European countries were making their transitions to Article VIII convertibility,
President Arturo Frondizi of Argentina announced a stabilization plan that included
removal of quantitative trade controls and unification of the foreign exchange
market under a floating exchange rate. The reasons were not unlike those that
promoted regional liberalization moves some three decades later—a desire to establish
credibility with foreign investors through thoroughgoing reforms, as well as the hopeof emulating the more prominent growth success stories of the day. In Argentina’s case,stated goals included the attraction of foreign capital and the emulation of West
Germany’s Wirtschaftswunder under free-market policies (Díaz Alejandro [1965]).
Capital controls returned to the region in the mid-1960s as the volume of globally
mobile capital expanded and as other balance of payments pressures built up.
The shocks of the early 1970s greatly reinforced this reversal. Díaz Alejandro (1975,
p. 12) has described how the trilemma progressively restricted the room for maneuverof the developing countries:

39

During the 1950s and early 1960s, even small countries with fixed exchange
rates maintained a modest degree of autonomy over monetary policy, thanks
to imperfections in international capital mobility. As such mobility improved
dramatically during the late 1960s and early 1970s, small developing countries(and not-so-small ones, like Mexico) were faced with choices new to them but
familiar to small industrialized economies: letting their remaining monetary
autonomy evaporate, imposing or tightening exchange controls, or abandoning
fixed rates.
Even though most industrial countries adopted floating U.S. dollar exchange
rates, developing countries were reluctant to do so, and for the same reasons (some ofwhich are discussed in the next section) that make floating problematic for them
today. Fixed exchange rates, absent capital controls, would have opened the door tofinancial crises. So fixed rates plus an intensification of capital controls represented
the preferred resolution of the trilemma. As Figure 6 shows, the retreat from financial
openness in the nonindustrial world, while more pronounced in Latin America, also
occurred in East Asia. Among the causal factors was the system of floating dollar
exchange rates itself, insofar as movements in third-country dollar exchange rates
altered the competitive positions of countries pegging to the dollar. The sovereign
debt crisis of the 1980s served as a further brake on the progress of international
capital mobility, which resumed only at the end of the 1980s.
There is now a substantial theoretical and econometric literature on the gains
from financial liberalization. Space prevents a complete review, and instead I referreaders to Prasad et al. (2003), Obstfeld and Taylor (2004), and the references
therein. The financial crises that many developing countries have suffered since 1990
raise the question of the realized gross gains from financial liberalization being worth
the costs. For some observers, the answer is a clear no; and even previous advocates ofcapital account opening now usually urge greater caution in doing so, and point tostricter preconditions for successful relaxation of controls.
My reading of the empirical literature is consistent with the view that, so far,financial opening generally has yielded smaller net gains for nonindustrial than forindustrial countries. Consider, for example, the study by Bekaert, Harvey, andLundblad (2002) on consumption- and output-growth volatility following equity
market opening. Using pooled time-series and cross-section data, the authors estimate
much smaller volatility declines as a result of equity market liberalization in theiremerging markets sample than for mixed samples that include industrial countries.
For the latter samples, in contrast, they find that equity market liberalization
significantly reduces the volatility in consumption and output growth, even when the
Asian crisis years are included and even after controlling for certain macroeconomic
reforms and the level of financial development.7 Apparently, the risk-sharing benefits
that emerging countries have derived from liberalization are smaller than for industrial
economies (though such gains as can be reaped may be quite valuable, in welfare
terms, at the margin).
7. These authors find much weaker results using the IMF’s zero-one index of overall capital account openness, which
is a notoriously coarse measure compared to others such as that of Quinn (1997).

40 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

Indeed, for emerging market countries, Bekaert, Harvey, and Lundblad (2002)
find significant volatility declines following liberalization only over the 1980–97
period. Once the sample is extended through 2000 to include the Asian crisis years,
equity market liberalization is estimated to have an insignificantly negative (andsmall) or even positive impact on the volatility of consumption and real GDP growth
rates. The positive mean growth rate effects found by Bekaert and his coauthors arealso lower in a longer sample period that includes the Asian crisis. And the greatest
decline in the estimated growth effect can be seen in the emerging market subsample
of countries. Because most of the high-income countries in the authors’ sample
liberalized their equity markets before the start of the sample period in 1980, a major
concern is that apparent declines in volatility “following” liberalization mostly
reflect the cross-sectional fact, documented above, that perhaps for other reasons,high-income economies are less volatile.
Another important objection to econometric studies of the effects of financial
opening is that any steps taken toward liberalization are endogenous and really reflect
deeper parameters, that is, “institutions” however defined (Rodrik [1998]). Countries
with strong institutions will both liberalize and deploy complementary policy
reforms, creating positive statistical correlations between financial integration and avariety of beneficial economic outcomes. That correlation need not imply, however,that countries can gain by liberalizing à la carte, without making the necessary
complementary policy changes. For example, without effective prudential supervisionof financial institutions, economic growth is likely to falter and capital inflows will
likely aggravate the problems. A good institutional infrastructure, one in which therule of law protects investor property rights, generates both good overall economic
performance and an ability to reap net benefits from opening up to foreign capital.
This linkage could help explain why poorer countries, which typically have weakerinstitutions, seem to gain less when they do open themselves to financial flows.
Better governments both liberalize external payments and create environments
favorable to economic growth, but any independent effect of liberalization on growth
remains unidentified in much of the linear cross-sectional analysis of growth effects.
There could, however, be an important nonlinear interaction between quality of
governance (which improves the prospects for productivity growth, raises returns toinvestment, and hence the demand for capital) and the benefits of financial opening(which speeds convergence to the steady state by augmenting the supply of lower-cost
capital). In a recent study that examines the interaction between governmental
quality, financial liberalization, and growth, Klein (2004) finds that indeed thebiggest gains in economic performance—and, hence, implicitly in welfare—accrue
to nonindustrial countries that have reached some minimum level of institutional
capability. Such countries are likely to prefer open capital markets, but in that casemay face a delicate task in trading off domestic monetary policy goals against
exchange stability.

41

IV. Market Failure and the Exchange Rates of Emerging Markets
I alluded earlier to the structural features that have made it difficult for emerging
markets to embrace floating U.S. dollar exchange rates as a resolution of the trilemma,
but which simultaneously make fixed-rate schemes prone to crises when capital isinternationally mobile. Most of these features have been discussed in earlier academic
literature, and they continue to influence exchange rate policies in the nonindustrial
world today. They include the tendency to avoid the domestic currency as a contractual unit of account and a lack of deep and resilient financial markets. Because
these structural obstacles to fixing or floating stem from persistent institutional
shortcomings, their recurrence in analyses of exchange rate policies is not hard tounderstand. These problems certainly help explain the limitations to date on emerging
markets’ realized gains from asset trade.
A. The Sinful Circle
Discussing Argentina’s recent experience from the perspective of the early 1960s,
Díaz Alejandro (1965, p. 31) identified clearly how a prevalence of foreign-currency
external debts could lead to contractionary currency depreciations:
Devaluation may produce another type of wealth effect when some groups ofthe country have debts to foreigners expressed in terms of foreign currencies.
A devaluation will then increase the value of the debt expressed in domestic
currencies and will exert a depressing influence on the expenditures of thesegroups, especially when the domestic prices they receive for the sale of theirproducts or services do not increase proportionally with the devaluation.
When a country has a net foreign debt, this effect will make more likely an
improvement in the trade balance and a drop in output following devaluation,
especially when the debt is held by the private sector and is concentrated in
short-term maturities.
Eichengreen and Hausmann (1999) coined the colorful term “original sin” todescribe the impossibility of borrowing externally in terms of the domestic currency.
More broadly, Guillermo Calvo speaks of “liability dollarization” to describe the extent
to which domestic as well as external liabilities tend, in fact, to be denominated indollars (for example, Calvo, Izquierdo, and Talvi [2003]). Greater liability dollarization
may be associated with a more extensive gross dollar liability position for the economy
as a whole, spreading the negative impact of a currency depreciation. Even when dollar
liabilities are nominally matched by dollar assets, there may be currency mismatches insome states of nature, for example, when important corporate debtors of domestic
banks are unable to meet their dollar obligations in full. Brazil is subject to original sin,but its domestic liability dollarization was relatively limited in January 1999, whichenabled it to devalue the real then without the calamitous balance-sheet effects seen
in some other emerging markets. Other countries have proven more vulnerable to“sudden stops” in foreign lending, which force large exchange rate adjustments and, inthe presence of liability dollarization, sharp deterioration in balance sheets.

42 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

Economists do not have a full understanding of the factors that have allowed
industrial countries to escape from original sin and to avoid extensive denominationof domestic liabilities in foreign currencies. It seems more than likely, however, that
histories of fiscal excess and inflation lower the perceived quality of domestic currency
and make people reluctant to hold substantial creditor positions denominated in thatcurrency’s terms. In a deep sense, then, the problem stems from the weak government
institutions that generate high and variable inflation. Even after the quality of
institutions has begun to improve, liability dollarization can persist for some time, given
the investments already made in avoiding the local currency. The phenomenon can bea circular one, because an inability to denominate debts in domestic currency leads toa harsher macroeconomic adjustment process, slower growth, and additional inflationary expropriations. Extensive foreign-currency liabilities make a floating exchange
rate harder to live with, heightening the need for limiting exchange rate movements
relative to that for interest rate independence under capital mobility. On the other
hand, tighter limits on exchange rate fluctuations raise the likelihood of some sortof speculative attack on the currency. As Eichengreen and Hausmann (1999) suggest,
for some economies complete dollarization (of assets as well as liabilities, throughabandonment of the national currency) may be the best solution of the trilemma.
B. Original Sin, Volatility, and External Adjustment
Discussion of original sin has stressed its implications for a given exchange rate
movement, but it is less appreciated that original sin will also affect the nature offoreign exchange equilibrium, generally complicating current account adjustment
and exacerbating exchange rate volatility. This observation follows from the classic
portfolio-balance model of exchange rate determination (for example, Kouri [1983]).
In the most standard, industrial-country version of that model, domestic residents
hold a fraction of their wealth in foreign-currency bonds whereas foreign residents
hold a fraction of their wealth in domestic-currency bonds—there is no original sin.
Domestic residents do, however, have a home-currency habitat preference compared
to foreign investors.
To guide the discussion, I write the condition of equilibrium in the market fordomestic-currency bonds as
B =  (i * +  , i )W +  (i *, i −  )EW *,(1)

where B > 0 is the outside supply of domestic-currency bonds, W is home wealth indomestic-currency terms, W * is foreign wealth in foreign-currency terms, E is theexchange rate (domestic-currency price of foreign currency), i * is the interest rate on
foreign-currency loans, i that on domestic-currency loans, and  is the expected rateof depreciation of the domestic currency (so that  1,  1 < 0 and  2,  2 > 0). Interest
rates are held constant by the monetary authorities over the adjustment period that
I will contemplate below.
In this setting, consider the mechanisms of portfolio adjustment following a
shock that opens up a home current account deficit. Because the foreigners whose
wealth is growing are less keen on domestic assets than the domestic residents whose43

wealth is correspondingly shrinking, a wealth transfer to foreigners causes a fall in
the relative demand for domestic-currency assets. The domestic currency therefore
depreciates, restoring general portfolio equilibrium in three distinct ways, the firsttwo of which depend on valuation effects:(1) Foreign investors suffer a capital loss, in foreign-currency terms, on theirdomestic asset holdings. As a result, their domestic asset holdings, measured interms of foreign currency, shrink relative to their total wealth W *. To maintaina given desired portfolio share of domestic assets, they must add to theirdomestic-currency asset holdings.
(2) Domestic investors enjoy a capital gain on their foreign assets and allocate partof the resulting increase in wealth W to domestic assets.
(3) The last equilibration mechanism is the most subtle and the most dependent on
investors’ having an accurate long-run view of the exchange rate’s trajectory. As
the wealth transfer to foreigners continues, the exchange rate depreciates further.
But if the current account adjustment process is stable, by which I mean that theworld economy is converging toward a new steady-state wealth distribution, therate of domestic-currency depreciation will decline over time. This trend of
decline in expected depreciation,  , raises the desired portfolio shares  ( ) and ( ) over time, helping to stabilize the foreign exchange market.
In this transition process to a stable foreign asset position, capital gains and losses
on asset positions partially offset the effect on domestic net foreign debt of the wealthtransfer through the current account, an aspect of international adjustment recently
emphasized by Gourinchas and Rey (2004), Lane and Milesi-Ferretti (2004), andTille (2003). This pattern of asset-valuation effects eases the adjustment to a newlong-run wealth distribution.
Next, consider how the process works in a setting of original sin, with a debt
(rather than assets) denominated in foreign currency. Because foreigners will not holddomestic-currency assets at all,  ≡ 0 and home investors’ wealth equals W = B + EF,
where F, assumed to be negative in the steady-state or long-run equilibrium, is thestock of foreign-currency assets that domestic residents hold in their portfolios.8
To render the model more applicable in the emerging markets context, I assume
that foreigners’ demand for the home country’s foreign-currency liabilities is anincreasing function of the country spread i C* − i *; that is, to compensate foreign
investors for perceived country risk, the home country must pay a foreign-currency
borrowing cost i C* in excess of the foreign risk-free rate i *, with the spread anincreasing function of the external debt. If foreign demand for home debt is given by−F = (i C* − i *)W *, ′(i C* − i *) > 0,then one can write the required country borrowing spread as an increasing functionof the share of foreign wealth invested in domestic liabilities,

8. I am abstracting from the possibility that the developing country has gross foreign-currency assets as well as
gross liabilities.

44 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

i C* − i * =  (F/W *),  ′(F/W *) < 0.
Equation (1) therefore becomes
B =  [ (F /W *) + i * +  , i ](B + EF ),or.,) B ≡  ( , F )B.
1 −  (, —EF = ————
 (, .,)(2)––
The condition for steady-state F < 0 is that  > 1. Observe that 1 = − 1/ 2 > 0:higher expected depreciation raises the expected domestic-currency cost of foreigncurrency debt, thereby inducing lower desired foreign-currency indebtedness. Also,2 < 0; a lower foreign-currency debt (a higher F ) is associated with a lower
borrowing spread and, thus, with a higher desired ratio of foreign borrowing EF 
to domestic assets. Notice for future reference that along the locus of portfolio
equilibrium points such that  = 0,dE 2B − E—— = ———— > 0.
dF
F(3)

What is the equilibration process now after the emergence of a domestic current
account deficit? Notice that the valuation effects 1 and 2 discussed earlier are in thepresent case inoperative and perverse, respectively. Regarding effect 1, foreign
demand simply does not enter equation (2). Regarding effect 2, currency depreciation (a rise in E ) raises the domestic-currency value of the foreign debt—reinforcing,rather than offsetting, the effect on domestic wealth of the initial wealth transfer toforeigners through the current account. In particular, this means that, as the local
currency depreciates in the face of a current account deficit, the external debt burden,
measured in home currency (and in real terms if the real exchange rate is moving
in the same direction) is increasing more rapidly than the pace of capital inflow
alone would indicate. These considerations raise the possibility that current accountadjustment actually is unstable.
That is not the case if expectations are rational, however, due to effect 3, thetendency for expected depreciation to subside as a deficit is eliminated over time.9 To
see this, augment the equilibrium condition of equation (2) with a simple current
account equation of the form.
F =  (E, F ),effect) and  2 < 0 (a wealth effect). By imposing
where 1 > 0 (a competitiveness.
perfect foresight,  = E /E, in equation (2), one obtains a two-dimensional dynamical
9. Discussions of the stability question in this type of model include Henderson and Rogoff (1982), Kouri (1983),
and Masson (1981).

45

system in E and F, .as depicted in Figure 7 for the case of a net foreign-currency
external debt. The E = 0 schedule is positively sloped, as indicated by equation (3),but it differs from the customary rectangular hyperbola because of the country-risk
effect of external debt.
There is a unique, stable adjustment path leading to a steady state in the system’s
two variables. Observe that even though the value of the foreign debt, EF, rises morethan proportionally to F during the stable adjustment process, portfolio equilibrium ismaintained at each point in time by a sharply changing value of expected depreciation,
 . The model has two immediate implications.
First, the stable, saddle path of convergence is steep relative to the case in which
foreigners hold domestic-currency assets and the home country is a creditor inforeign currency. That difference gives rise to relatively high exchange rate volatility
in response even to minor shocks. The basic intuition is that of Dornbusch’s overshooting paradigm: in the absence of stabilizing wealth effects, very big exchange rate
movements away from long-run equilibrium are needed to generate the expectedexchange rate reversals that, alone, can equilibrate the asset markets.
Second, under expectational assumptions less optimistic than long-run rational
expectations, market instability is a possibility, perhaps accentuating volatility. It is aninteresting question to integrate realistic learning processes into models of this type.
One way to illustrate the response to shocks is to investigate an unexpected but
permanent foreign portfolio shift away from domestic assets—formally, a rise in theshare −F/W *.
required country spread i C* − i * for any level of the foreign portfolio.
In Figure 8, this change is shown as a rightward shift of the E = 0 schedule: given
the deterioration in external credit terms, the emerging country’s desired foreign
Figure 7 Current Account Adjustment with External Debt and Original Sin
E
•

E=0

•

F=0

F

46 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

Figure 8 Effects of an Adverse Foreign Portfolio Shift
E
•

E=0

E0

•

F=0
F

borrowing −F is now lower at any value of E. The exchange rate overshoots indepreciating up to the new stable saddle path (point E 0). On impact, the stock offoreign liabilities measured in home-currency terms, EF, actually rises and domestic
wealth therefore falls. Sharp initial overshooting, however, creates an expected appreciation rate of domestic currency sufficient to maintain balance in the domestic
bond market. Currency depreciation also creates a current account surplus. In theadjustment to a new steady state, E falls and F rises, with the resulting fall in the ratioof foreign borrowing to domestic wealth accommodated by a steadily declining rate of
expected currency appreciation.
An alternative shock is a. fall in foreign demand for domestic exports, represented
by an upward shift of the F = 0 locus. The impact effects are much the same as forthe last shock analyzed, which was basically a fall in foreign demand for the country’s
assets rather than its goods. The sharp fall in home wealth caused by the currency
depreciation helps to explain the initial current account surplus, which is consistent
with the country’s reduced capacity to service foreign debts.
To summarize, we have another adverse implication of original sin. Left to its own
devices, the foreign exchange market is likely to perform less smoothly than that of acurrency which foreign investors are willing to hold. In essence, the greater incompleteness of the foreign exchange market removes a potential source of stabilizing demandfor home-currency assets.
C. Dollarization and Financial Fragility
If liability dollarization causes problems under floating, it simultaneously makes fixedexchange rates harder to maintain. The financial fragility arising from unhedged

47foreign debts exposes fixed exchange rate regimes to speculative attack through anumber of channels. One of these is the resulting vulnerability of the banking system
to depositor panic, a possibility that, as is well known, can be avoided by sophisticatedasset-market structures less likely to be utilized in nonindustrial economies (Freixas
and Rochet [1997]).
A simplified paradigm, based loosely on the model of Chang and Velasco (2001),
shows how foreign investor panic can destabilize local banks, leading to huge crisisinduced depreciations such as those seen in East Asia (1997–98) and more recently inArgentina (2002).
Initially the exchange rate is fixed at E 0 through central bank intervention. One
can write the balance sheet of the domestic private banking sector as
E 0 M * + M + C = I + H.
Here, M * denotes foreign-currency deposits (for simplicity, all held by foreigners);
M denotes domestic residents’ local-currency deposits; C denotes bank capital;
I denotes illiquid banking system assets, unavailable at short notice; and H stands forthe banking system’s high-powered deposits at the central bank.
In turn, the central bank’s balance sheet is
H = E 0R + D,
where R denotes foreign reserves and D domestic credit. The major assumption
is one of currency mismatch, so that for the banking system as a whole, short-term
foreign-currency obligations exceed liquid foreign assets:
M* > R.

(4)

This mismatch opens the door to a foreign investor panic, in which foreign
lenders demand immediate repayment of the foreign deposit liability M *. For
convenience (albeit quite artificially), I assume tentatively that domestic investors do
not simultaneously panic. I also assume that, at least initially, there is no maturity
mismatch issue in paying off the foreign creditors: H > E 0 M *.
If foreign lenders panic, the banking system, under a “sequential service” arrangement, uses some of its high-powered money holdings to purchase the central bank’s
reserves R. The central bank is assumed to sell all of these and then to withdraw from
pegging the exchange rate once R = 0. The banking system pays these reserves out toforeign creditors and then, by equation (4), owes the balance of M * − R .
Because there is a panic, the banking system is unable to borrow more foreignexchange from foreign sources. The only way it can obtain the resources needed
to pay off the remaining foreign deposits is to sell high-powered money on theforeign exchange market to domestic private holders of foreign currency. As a result,domestic-currency deposits rise by M. For simplicity, assume that local money
demand is interest- and income-inelastic and that purchasing power parity holds.
Then the increase in domestic deposits, M, and the new equilibrium exchange rate,

48 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

E1, satisfy the equations
M+ —M = —,M———
E1
E0
M = E1(M * − R ).
The solution for currency depreciation isM
E1 = ————————.
E0 M − E0(M * − R )Notice that for a big currency mismatch and a substantial extent of liability
dollarization, the currency depreciation can be huge. It is in this sense that thefinancial fragility model can explain some of the huge currency depreciations seen in
emerging market crises.
Note also that bank capital falls by (E1 − E0)(M * − R ), the capital loss on the
portion of foreign bank liabilities not covered by central bank support. Obviously thesolvency of the banks will become questionable, probably leading to the domestic
panic that I have so far assumed away. That panic, plus the negative effects on output
and interest rates, will only worsen the ensuing economic chaos.
D. How Emerging Markets Have Floated
Data on emerging market exchange rates are suggestive of some of the difficulties
these countries have encountered in living with open financial markets, yet also revealthat some countries have been relatively successful in pursuing greater exchange
flexibility. Husain, Mody, and Rogoff (2004) show that compared to emerging
markets with somewhat open financial accounts, many more insular countries
operate currency pegs. They also show that insular-country pegs are more durable
than emerging market pegs, and that in general, emerging markets experience moreexchange regime transitions than do insular countries. The relative financial isolationof the insular countries makes exchange rate choices under the trilemma less stark
for them.
Most emerging markets now live with a “limited flexibility” or “managed floating”
arrangement. A look at how individual countries actually have managed rates often
shows a marked reluctance to tolerate large currency fluctuations on a regular basis,though some countries have been transitioning toward higher levels of de facto
exchange rate flexibility. Figure 9 shows the monthly log U.S. dollar exchange rates
for seven emerging markets since July 1994, comparing their behavior with that ofthe dollar exchange rate of the yen. Of these countries, Chile exhibits the exchange
rate behavior that appears most similar to Japan’s. Rather than the recurrent cyclingthat has characterized the yen/dollar rate, however, the Chilean peso has experienced
a more definitive trend depreciation against the dollar—one manner in which emerging markets can utilize their exchange rate flexibility over time, even if they do notwish to allow large short-term movements. Significantly, Chile has less liability

49

Figure 9 Log Exchange Rate versus U.S. Dollar[1] Brazil[2] Republic of Korea

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03[3] Chile[4] Mexico

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03[5] Indonesia[6] Peru

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03[7] Thailand[8] Japan

2.0

2.0

1.5

1.5

1.0

1.0

0.5

0.5

0.0

0.0

–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03–0.5
July July July July July July July July July July
1994 95 96 97 98 99 2000 01 02 03

Source: Global Financial Data. Graphs show U.S. dollar’s price in local currency.

50 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

dollarization than many other emerging economies, and, according to Lane andMilesi-Ferretti (2004), engages in a relatively high degree of two-way asset trade,presumably leading to greater risk diversification.10 Mexico’s peso, like Chile’s, has
followed a distinct depreciating trend against the dollar since late 1995, but with apath that follows more muted short-term oscillations than in the Chilean case, except
around the time of the Asian crisis.
The “fear of floating” type behavior posited by Calvo and Reinhart (2002)
appears quite clearly for Peru after the Asian crisis period. As for the emerging Asian
countries themselves (Indonesia, Republic of Korea, Thailand), there is a diversityof experiences. Since the turbulence of the late 1990s, the Republic of Korea andespecially Thailand have maintained relatively smooth exchange rate paths, withlittle trend. Indonesia’s political and economic crisis has been more protracted, and it
also has experienced terrorist attacks. Nonetheless, the rupiah has been fairly stableagainst the dollar since early 2002. Indonesia’s experience shows how an emerging
market government, despite a preference for exchange stability, may resort to greater
flexibility in turbulent periods.
Brazil also illustrates the use of exchange flexibility. After the January 1999
devaluation, the real followed a weakening trend against the dollar (a trend ended
by a sharp appreciation as the Argentine collapse approached). The prospect ofPresident Lula da Silva’s election in October 2002, which emerged as a strong
possibility in the spring of that year, widened Brazil’s borrowing spread sharply andsent the real spinning downward. Rather than battling the markets, the Brazilian
authorities accepted wider exchange rate fluctuations during the stressful period ofpolitical transition. Since the financial markets’ apparent acceptance of the Lularegime in the spring of 2003, however, there has been remarkably little change in thereal’s dollar exchange rate.
In summary, a few emerging markets (such as Chile) seem to be transitioning
to fairly mature floating exchange rate arrangements. Others practice extensivesmoothing, but may allow longer-term trends to accommodate gradual shifts incompetitiveness. The financial vulnerabilities of these countries make large shortterm exchange rate movements perilous, but also make it unwise to set up a narrowly
pegged rate as a target for speculation. Finally, even countries with a preference
for stability will temporarily let the exchange rate loose under duress, as a kind ofpressure-release valve. While the resulting volatility may have costs, it is preferable
to drawing a line in the sand and daring speculators to cross it. A more stableexchange rate can be reestablished once the turbulence has passed. These “regimechanges” in exchange volatility, if present for industrial-country exchange rates, aremuch less pronounced.

10. An interesting recent discussion of Chile’s experience, with comparisons to Australia’s, is in Caballero, Cowan,
and Kearns (2004).

51

V. Conclusion
As Fischer (2003) points out, it is remarkable how persistent emerging markets
have been in retaining or returning to open capital accounts. This revealed preferenceindicates that emerging market governments perceive economic gains to financial
globalization. There is little doubt, however, that for emerging markets, those gains arelimited by institutional deficiencies, such as those that generate liability dollarization
and restrict many countries to borrowing in foreign currency. In particular, those
deficiencies are obstacles to a comfortable solution of the trilemma. Fixed exchange
rates have led to costly crises—a main negative of open financial markets—whereas
more flexible regimes raise their own problems. While some emerging economies havebeen able to use floating successfully to relieve market pressures, others exhibit “fear of
floating,” trading off the risks of currency crisis against those of excessive volatility.
Those countries I have labeled “insular” have on the whole performed worse thanthe emerging markets in terms of both average long-term growth and volatility. They
have largely chosen to maintain closed capital accounts. But it would be wrong
to ascribe the superior performance of the emerging markets to financial openness.
It is much more plausible that both relative economic success and the desire for
integration into world capital markets stem from a superior institutional infrastructureof the economy. Improvement of that infrastructure is critical both in moving thepoorest developing countries toward improved living standards and in ameliorating thedifficulties emerging markets have encountered during financial globalization.

52 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies

APPENDIX: COUNTRY GROUPSCountries used in Figure 1 convergence regression
Insular

Emerging

Also included in the figures

High income

Insular

Emerging

High income

Algeria

Argentina

Australia

AngolaHungary

Antigua

Bangladesh

Bolivia

Austria

BelizePolandCyprusBenin

BrazilBarbados

Botswana

TaiwanGermany

Burkina Faso

Chile

Belgium

Central African Rep.

Puerto Rico

BurundiChina

CanadaCongo, Dem. Rep. ofSingapore

Cameroon

Colombia

Denmark

Dominica

Cape Verde

EcuadorFinland

Fiji

Chad

Egypt

FranceGrenadaComoros

GuatemalaGreeceGuyanaCongo, Rep. of

India

Hong Kong

Haiti

Costa Rica

Indonesia

Iceland

Mauritania

Côte d’Ivoire

IsraelIreland

Namibia

Dominican Rep.

JordanItaly

Papua New Guinea

El Salvador

Korea, Rep. ofJapan

Equatorial Guinea

Malaysia

LuxembourgSão Tomé and
Príncipe

Ethiopia

MexicoNetherlands

Sierra Leone

Gabon

MoroccoNew Zealand

St. Kitts and Nevis

Gambia, The

Pakistan

NorwaySt. Lucia

Ghana

PanamaPortugal

Guinea

Peru

Spain

St. Vincent and the
Grenadines

Guinea-Bissau

Philippines

SwedenHonduras

Seychelles

Switzerland

IranSouth Africa

United Kingdom

JamaicaThailand

United States

Kenya

TurkeyLesotho

Uruguay

Madagascar

Venezuela

Tunisia

MalawiMali
Mauritius
Mozambique
Nepal
Nicaragua
Niger
NigeriaParaguay
Romania
RwandaSenegalSri Lanka
Syria
Tanzania
Togo
Trinidad andTobagoUgandaZambiaZimbabwe53

References

Bekaert, Geert, Campbell R. Harvey, and Christian Lundblad, “Growth Volatility and Equity Market
Liberalization,” mimeo, Columbia University, Duke University, and Indiana University, 2002.
Black, Stanley W., “Exchange Policies for Less Developed Countries in a World of Floating Rates,”
Princeton Essays in International Finance, 119, 1976.
Caballero, Ricardo J., Kevin Cowan, and Jonathan Kearns, “Fear of Sudden Stops: Lessons from
Australia and Chile,” NBER Working Paper No. 10519, National Bureau of Economic
Research, 2004.
Calvo, Guillermo A., and Frederic S. Mishkin, “The Mirage of Exchange Rate Regimes for Emerging
Market Countries,” Journal of Economic Perspectives, 17, 2003, pp. 99–118.
———, and Carmen M. Reinhart, “Fear of Floating,” Quarterly Journal of Economics, 117, 2002,
pp. 379–408.
———, Alejandro Izquierdo, and Ernesto Talvi, “Sudden Stops, the Real Exchange Rate, and Fiscal
Sustainability: Argentina’s Lessons,” NBER Working Paper No. 9829, National Bureau of
Economic Research, 2003.
Chang, Roberto, and Andrés Velasco, “A Model of Financial Crises in Emerging Markets,” Quarterly
Journal of Economics, 116, 2001, pp. 489–517.
De Long, J. Bradford, “Productivity Growth, Convergence, and Welfare: Comment,” American
Economic Review, 78, 1988, pp. 1138–1154.
Díaz Alejandro, Carlos F., Exchange-Rate Devaluation in a Semi-Industrialized Country: The Experienceof Argentina, 1955–1961, Cambridge, Massachusetts: MIT Press, 1965.
———, “Less Developed Countries and the Post-1971 International Financial System,” Princeton
Essays in International Finance, 108, 1975.
Easterly, William R., “Globalization, Inequality, and Development: The Big Picture,” Monetary andEconomic Studies, 22 (S-1), Institute for Monetary and Economic Studies, Bank of Japan,
2004, pp. 57–87 (this issue).
Eichengreen, Barry, and Ricardo Hausmann, “Exchange Rates and Financial Fragility,” in New
Challenges for Monetary Policy, Kansas City: Federal Reserve Bank of Kansas City, 1999,
pp. 329–368.
Fischer, Stanley, “Globalization and Its Challenges,” American Economic Review, 93, 2003, pp. 1–30.
Freixas, Xavier, and Jean-Charles Rochet, Microeconomics of Banking, Cambridge, Massachusetts: MIT
Press, 1997.
Gourinchas, Pierre-Olivier, and Hélène Rey, “International Financial Adjustment,” mimeo, Universityof California, Berkeley, and Princeton University, 2004.
Henderson, Dale W., and Kenneth Rogoff, “Negative Net Foreign Asset Positions and Stability in a
World Portfolio Balance Model,” Journal of International Economics, 13, 1982, pp. 85–104.
Husain, Aasim, Ashok Mody, and Kenneth Rogoff, “Exchange Rate Regime Durability and
Performance in Developing Countries versus Advanced Economies,” Journal of Monetary
Economics, 2004 (forthcoming).
Klein, Michael W., “Capital Account Liberalization, Institutional Quality, and Economic Growth:
Theory and Evidence,” mimeo, Fletcher School, Tufts University, 2004.
Kouri, Pentti J. K., “Balance of Payments and the Foreign Exchange Market: A Dynamic Partial
Equilibrium Model,” in Jagdeep Bhandari and Bluford Putnam, eds. Economic Interdependence
and Flexible Exchange Rates, Cambridge, Massachusetts: MIT Press, 1983, pp. 116–156.
Lane, Philip R., “Do International Investment Income Flows Smooth Income?” Weltwirtschaftliches
Archiv, 137, 2001, pp. 714–736.
———, and Gian Maria Milesi-Ferretti, “Financial Globalization and Exchange Rates,” mimeo, Trinity
College Dublin and the International Monetary Fund, 2004.
Masson, Paul R., “Dynamic Stability of Portfolio Balance Models of the Exchange Rate,” Journal ofInternational Economics, 11, 1981, pp. 467–477.
McKinnon, Ronald I., “The Exchange Rate and Macroeconomic Policy: Changing Postwar
Perceptions,” Journal of Economic Literature, 19, 1981, pp. 531–557.

54 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004

Globalization, Macroeconomic Performance, and the Exchange Rates of Emerging Economies———, “The Order of Economic Liberalization: Lessons from Argentina and Chile,” CarnegieRochester Conference Series on Public Policy, 17, 1982, pp. 159–186.
Neumeyer, Pablo A., and Fabrizio Perri, “Business Cycles in Emerging Economies: The Role of Interest
Rates,” Staff Report No. 135, Research Department, Federal Reserve Bank of Minneapolis, 2004.
Obstfeld, Maurice, “International Capital Mobility in the 1990s,” in Peter B. Kenen, ed. Understanding
Interdependence: The Macroeconomics of the Open Economy, Princeton: Princeton University
Press, 1995.
———, and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth, Cambridge,
England: Cambridge University Press, 2004.
———, Jay C. Shambaugh, and Alan M. Taylor, “The Trilemma in History: Tradeoffs among
Exchange Rates, Monetary Policy and Capital Controls,” CEPR Discussion Paper No. 4352,
Centre for Economic Policy Research, 2004.
Pallage, Stéphane, and Michael A. Robe, “On the Welfare Cost of Economic Fluctuations in
Developing Countries,” International Economic Review, 44, 2003, pp. 677–698.
Prasad, Eswar, Kenneth Rogoff, Shang-Jin Wei, and M. Ayhan Kose, “Effects of Financial Globalization
on Developing Countries: Some Empirical Evidence,” IMF Occasional Paper No. 220,International Monetary Fund, 2003.
Quinn, Dennis P., “The Correlates of Change in International Financial Regulation,” American
Political Science Review, 91, 1997, pp. 531–551.
———, and A. Maria Toyoda, Global Finance and Democracies, manuscript, n.d.
Rodrik, Dani, “Who Needs Capital-Account Convertibility?” in Stanley Fischer et al., Should the IMF
Pursue Capital-Account Convertibility? Princeton Essays in International Finance, 207, 1998.
Romer, Paul M., “Crazy Explanations for the Productivity Slowdown,” in Stanley Fischer, ed. NBER
Macroeconomics Annual 1987, Cambridge, Massachusetts: MIT Press for the National Bureau
of Economic Research, 1987, pp. 163–202.
Tille, Cédric, “The Impact of Exchange Rate Movements on U.S. Foreign Debt,” Federal Reserve Bankof New York, Current Issues in Economics and Finance, 9, 2003, pp. 1–7.
Uribe, Martín, and Vivian Z. Yue, “Country Spreads and Emerging Countries: Who Drives Whom?”
NBER Working Paper No. 10018, National Bureau of Economic Research, 2003.

55

56 MONETARY AND ECONOMIC STUDIES (SPECIAL EDITION)/DECEMBER 2004