Mr. Grenville discusses exchange rates and crises against the background of
the financial turmoil in Asia* Talk by Mr. Stephen Grenville, a Deputy Governor of the
Reserve Bank of Australia, to the Third Biennial Pacific Rim Allied Economic Organizations
Conference in Bangkok on 16/1/98.
Economists have an unenviable reputation for being practitioners of the "dismal
science", but this is undeserved. The economist's characteristic response to a crisis is a positive
this is something that can be put
one: they identify a central crucial factor, and generally right.
Economists rarely throw up their hands and say that it is all too difficult. This capacity to
produce simple answers which purport to avoid further problems is, in one sense, admirable.
But it carries with it the danger that complex causality will be mis-diagnosed. It opens the
possibility, too, that pet panaceas, rules of thumb, and glib nostrums - often driven more by
doctrine than by careful analysis - will influence the response.
The 1994/95 Mexican crisis, which provides a foretaste of the current problems in
Asia, provides a classic example of this. After the crisis (which involved an almost 50 per cent
fall in the exchange rate), one might have gained the impression from contemporary analysis
that, if only Mexico had published accurate figures of its foreign exchange reserves in a timely
way during 1994, the crisis would have been averted or at least greatly lessened.
In the case of Thailand, there was a view - particularly in the early days of the
episode - that if only Thailand had floated its exchange rate sooner, everything would have been
all right. According to this view, there were a couple of relatively simple policy mistakes (fast
growth and a fixed exchange rate) and, when these were remedied, everything would quickly
return to normal. What I will be arguing here is that the problems are much more complex and
multi-faceted than this. To be sure, there have been very large falls in the exchange rate in a
number of Asian countries, and this has been an important part of the story. But when we look
back on the early analysis, which identified the basic problem as an exchange rate over-valuation
of 10-15 per cent which could be corrected by floating the exchange rate, events since then
should have demonstrated the inadequacy of this view.
I have argued elsewhere (Grenville 1997) that, if there is an identifiable principal
problem, it is more deep-seated and lies in the fragility of the financial sector. It has many of
the characteristics of an old-fashioned bank liquidity crisis, with failing confidence at the heart
of the problem. I am not going to go through this argument again today, because this session is
about exchange rates. And, in any case, the exchange rate clearly did play an important part in
the story. What I shall argue, however, is that it was not the central, over-riding, element of the
story.
The facts
First, the facts. Table 1 shows the exchange rate movements in a number of
East-Asian countries during 1997 and of course there have been some further large falls in the
early days of 1998. These have been very large movements and unusually rapid, but the
magnitudes, at least during 1997, are not unprecedented.
Not long after the exchange rate was floated in Australia in 1983, there was a
change of close to 40 per cent in the trade-weighted exchange rate (which would be of the same
order of magnitude that we saw in Asia in 1997). For Japan, in the two years beginning in
April 1995, the exchange rate depreciated by 34 per cent: over a longer period of time (e.g. ten
years), we can find much larger changes in the yen, from around 250 to the dollar at one
extreme, to 80 to the dollar at the other extreme. Even the exchange rate between the two "safe
havens" - the US dollar and the German mark - experienced changes (both up and down) of
around 50 per cent in the mid 1980s.1
Table 1: East Asian Exchange Rates
per cent change during 1997
vs US dollar trade-weighted*
Indonesia -56 -44
Malaysia -35 -24
Philippines -33 -26
South Korea -47 -43
Thailand -45 -38
* RBA calculation
Why do these big changes in exchange rates occur?
This is a central question, to which there is no clear answer yet. But I want to put
forward two issues which may be a large part of the story: the first has to do with large capital
flows; and the second has to do with what the technicians would call "model uncertainty": there
is no close, well-established relationship between the fundamentals of the economy and the
exchange rate. When these uncertainties are great, it is difficult for markets to assess what is the
"right" exchange rate.
First, capital flows. One of the outstanding (indeed amazing) characteristics of
the 1990s has been the extraordinary increase in international capital flows, particularly to the
emerging countries, and particularly to the countries of this region. Graph 1 shows a measure of
the increase in overall flows. The ten countries that were the main recipients, shown in Graph 2,
accounted for about three-quarters of the total, and half of them are in East Asia. Graph 3 is a
reminder that these flows were extraordinarily large relative to the size of these economies
routinely amounting to 6 per cent or more of GDP. The other characteristic of international
capital flows (shown in Graph 4) was the greatly increased importance of portfolio investment
first channelled through banks and, more recently, directly from funds management institutions.
One of the characteristics of these professional fund managers is that they have applied more
formal, structured principles to portfolio management, including the idea that diversification will
protect fund holders from some volatility. At the same time, few of these fund managers are
experts in the individual emerging markets - they tend to treat these markets as an investment
class, rather than develop country-specific detailed information. In this world, contagion is
- 3 -
common and changes of sentiment can be driven by herd behaviour. It is a bold fund manager
who stands his ground when the herd is stampeding.2
Graph 2: Concentration of Private Capital Flows
Graph 1: Developing Countries Net Capital Flows
1990-95
Billions of US$
US$B US$B
China
Mexico
180 180 180 180
Brazil
Private
Korea
120 120 120 120
Malaysia
Argentina
60 60 60 60
Thailand
Official
Indonesia
0 0 0 0
Russia
India
-60 -60 -60 -60
1972 1977 1982 1987 1992 1997 0 20 40 60 80 100 120 140 160 180
Graph 3: Private Gross Capital Flows
Graph 4: Developing Countries Net Private Capital Flows
12 largest recipients of private capital, % of GNP
Billions of US$
% % US$B US$B
Direct investment
6 6 6 6
80 80 80 80
5 5 5 5
Portfolio
investment
40 40 40 40
4 4 4 4
3 3 3 3
0 0 0 0
2 2 2 2
Other investment
-40 -40 -40 -40
1 1 1 1
0 0 0 0
-80 -80 -80 -80
1970 1975 1980 1985 1990 1995
1992
1972 1977 1982 1987 1997
At the same time as these large mutual funds were discovering the attractions of
diversification, the financial infrastructure to implement this was also being put in place, mainly
driven by international financial institutions searching out expansion opportunities. They were
encouraged in this by the general intellectual climate which promoted globalisation, and by the
official international financial institutions (IMF, World Bank, and so on) who saw freeing up of
financial capital as an important part of the development process.3,4 The recipient countries
were happy enough to see these flows, as they themselves embraced the increasing sophistication
of their financial infrastructure as a symbol of modernity and as a driving force for the growth.
Progressive dismantling of capital controls in the recipient countries was a factor, but in a
number of cases the capital accounts had already been substantially opened (in Indonesia, for
instance, capital flows were, to all intents and purposes, free from 1970 onwards).
2
One other point worth noting is the disparity between the size of these funds and the size of the
recipient countries. Even though these funds have not diversified all that much, their size is enormous.
Even if the US mutual funds bought every share listed on the ASEAN stock markets, this would still
represent less than a tenth of their assets.
3
Korea, for example, as a pre-condition for entry into the OECD "rich countries'" club, had further to
deregulate capital flows.
4
Coming out of this, we saw such developments as the Bangkok International Banking Facility,
which began as an offshore banking centre, but very quickly developed into the smooth facilitator of
massive flows of capital into Thailand (over $10 billion per year - more than 10 per cent of GDP - since
1993). At the same time, Thai finance companies hoped to improve their claims for banking licences by
facilitating inflows.
It was not so much change of regulation but change of attitude and perceptions
that was the driving force of the enormous increases in capital flows. By 1990, a number of
these countries had recorded two decades of high growth and had established an enviable track
record of political stability, balanced budgets and lowish inflation. If there was an "economic
miracle" occurring (cf. World Bank, 1993), it is not surprising that foreign investors wanted a
slice of the action.
Not least, domestic investors in these countries took the opportunity of what
looked like extremely low borrowing rates on these overseas funds to finance an investment
boom, including, inevitably, a good share of over-investment and misplaced investment.
These big flows (and the big current account deficits that went with them) were
not some kind of aberration, but reflected the normal working of market forces. For those who
find these deficits to be aberrant behaviour, could I remind you of the Feldstein and Horioka
(1980) analysis, which suggested that the true aberrant behaviour was the close correspondence
between saving and investment within most countries in the world. In other words, the amount
of capital flow between countries has been smaller than optimal behaviour would seem to
suggest. While a number of poor investment opportunities were certainly undertaken (most
notably, excessive real estate investment), at an aggregate level it is still correct to say that there
were many high profit opportunities available in these countries, as they moved from well inside
the technological frontier towards the frontier itself, driven by an eagerness to adopt all sorts of
productivity-enhancing techniques.
Graph 5: Singapore Current Account
Per cent of GDP
% %
10 10 10 10
0 0 0 0
-10 -10 -10 -10
-20 -20 -20 -20
-30 -30 -30 -30
-40 -40 -40 -40
1968 1972 1976 1980 1984 1988 1992 1996
Source: IMF International Financial Statistics .
If all this sounds a bit textbook-ish, consider the experience of Singapore. As
shown in Graph 5, they ran a current account deficit averaging more than 10 per cent of GDP for
two decades, in a period of policy-making which would universally be regarded, with hindsight,
as extremely successful. I should remind you also that all these countries ran, in the textbook
sense, "good" deficits - i.e. they were used to fund investment and not consumption, and were
certainly not funding budget deficits.
Some of these countries understood, perhaps intuitively more than by rigorous
logic, that big current account deficits made them vulnerable: Indonesia, for instance, was
uncomfortable if its current account deficit was above 3 per cent of GDP. Korea, too (in recent
years at least), ran quite modest current account deficits. But by and large, once these countries
accepted the idea of financial deregulation and open markets, they were going to be on the
receiving end of very substantial capital inflows.5
Table 2: Saving, Investment, Current Account and Budget Balances
1991-1995 average
Saving Investment CAB Budget Balance
(% of GNP) (% of GNP) (% of GDP) (% of GDP)
Indonesia 31.8 34.1 -2.5 0.8
Malaysia 34.2 40.5 -6.3 0.1
Philippines 18.7 21.7 -3.4 -0.6
South Korea 35.4 36.9 -1.3 -0.2
Thailand 34.9 41.8 -6.4 2.9
Memo: Mexico 17.6 19.4 -5.2 0.1
United States 15.5 16.0 -1.2 -3.6
Germany 21.8 22.2 -0.9 -2.0
Japan 34.8 30.4 2.6 -0.6
There is not a lot of point in trying to identify precisely whether the capital flows
were more supply-driven than demand-driven, because we have known since Marshall that the
outcome depends on the two blades of the demand and supply scissors. Nevertheless, it might
be worth noting that the financial flows were often significantly larger than the amount that
could be absorbed in terms of real flows of goods and services - i.e. the capital inflow was larger
than the current account deficit: Graph 6 illustrates this.
Graph6: Private Capital Inflows and the Current Account
As a percentage of GDP
%
Norway •
Colombia
Chile (89-94)
Indonesia
-2 •
• •
•
Sweden
Argentina (92-93)
•
•
Finland
Malaysia (89-94)
Philippines (89-94)
•
-4 •
Venezuela (92-93)
•
Thailand (88-94)
• •
Mexico (89-94) Malaysia (80-86)
-6
•
-8
-10
0 2 4 6 8 %
Private capital inflows
Source: World Bank (1997)
We will return, later, to the issue of whether the policy problems created by these
huge capital flows (and the resultant rapid growth of domestic credit) could have been avoided
by a different exchange rate regime. The basic point made here is that these countries embodied
significant profit opportunities (albeit with lots of opportunities to over-invest and invest in the
wrong industries), and that it was normal for large amounts of capital to flow from the "old
world" of savers towards the new opportunities available in these countries.
The second major issue behind exchange rate fluctuations revolves around
perceptions of how the economy works - "the model". What is the "mind-set" of participants in
the market - what do they think is the "proper" exchange rate? This is based not just on their
views about some "fundamentals", but also their guesses about other market participants' views,
so there is certainly plenty of opportunity for exchange rates to move very significantly, and stay
away from the underlying fundamentals for significant periods of time. We noted, earlier, that
this has happened in the case of countries such as the United States, Japan and Australia, where
there are well-developed views about how the economy works and detailed analytical and
econometric studies of what proper pricing relativities should be. The "models" or "mind-sets"
for the countries in question are much less fully developed and universally held, so there is far
more opportunity for prices to shift sharply, and stay at rates which, earlier, would have seemed
abnormal. On top of this, there are substantial information asymmetries, asymmetries which
made market participants very nervous about going against the run of the market or taking
significant contrarian positions.
This combination - very large, footloose capital flows and an exchange rate not
firmly anchored by "fundamentals" - goes a long way to explain the big exchange rate moves.
When sentiment and confidence changed and the original investors began to pull out their
capital, the exchange rate fall did nothing to induce new inflows. Where were the stabilising
speculators of textbook theory, who were supposed (in the textbook view) to respond to the fall
in the exchange rate by recognising that, once the exchange rate was below its fundamental
level, there was a profit opportunity for those who bought the currency? In the absence of a
firmly-defined "fundamental" equilibrium exchange rate, as the exchange rate fell, the market
changed its view on what was the "correct" equilibrium rate. Even when most market
participants agreed that exchange rates had gone too far, they recognised the possibility that they
could go further still. To stand against the run of the market in a contrarian position might be
ultimately vindicated, but in the short run required a degree of courage and confidence that no
fund manager (whose performance is evaluated more-or-less constantly) could afford to take. In
short, there were no equilibrating flows to anchor the exchange rates.
How should exchange rates behave?
Let's try to develop this a bit further to see whether there is any clear, fairly
universally-accepted idea of how exchange rates should move in the circumstances in which
these countries found themselves.
Perhaps the nearest guidance we can get from formal academic ideas is the old
discussion about the "transfer problem". The key point is that as financial flows shift from one
country to another, it is necessary to induce equivalent real flows of goods and services (which
would take the form of a current account deficit, corresponding to the financial flows in the
capital account). The old literature observed that there could be a wide range of outcomes for
the "transfer problem": where the financial flow took the form of direct foreign investment, the
same decision about the financial flow generally induced the real flow - as a company decided
to invest overseas, it shipped plant and machinery in roughly corresponding amount. But if the
flows took the form of portfolio investment, then the exchange rate had to appreciate to
encourage the real resource transfer.
The other longer-term structural influence on the exchange rate was the rapid
productivity increases in the tradeables sectors: in theory, these countries might have expected
to find, over time, their real exchange rates appreciating. In the Balassa/Samuelson (1964)
model, productivity rises fastest in the tradeables sector, and equilibrium requires a higher real
exchange rate.
Of course, there were other forces at work. In 1996, there was a very significant
fall in the terms of trade of these countries.6 And the story is further complicated by the specific
nature of the exchange rate regime - fixed more-or-less to the US dollar - so the effective
exchange rate swung with the US dollar. To further complicate the picture, capital flows
responded to the changing monetary stance in the big capital-exporting countries - low interest
rates in Japan in recent years encouraged the so-called "carry trade" - borrowing at low interest
rates in Japan and lending at high rates elsewhere in Asia.7
These factors were transient, and taking the dominant structural elements as being
the capital transfer issue and Balassa/Samuelson, it was not surprising to find upward pressure
on exchange rates during the 1990s and some modest appreciation of real exchange rates. The
exchange rate strength might have been expected to last for a considerable length of time, and
perhaps become permanent because of the structural improvement in productivity. The
relatively modest increases in the real exchange rate seen in countries like Thailand were thus
not, in themselves, a clear indicator of an over-valued exchange rate or impending depreciation.
Table 3: East Asian International Reserves
change from December 1991 to December 1996; US$bn
Indonesia 9
Malaysia 16
Philippines 7
South Korea 20
Thailand 20
Source: IMF, International Financial Statistics
In the face of this upward pressure on the exchange rate, the policy approach of
these countries over the decade (until 1997) had been to resist significant appreciation. This is
reflected in the increase in their foreign exchange reserves (Table 3). Why did they resist the
upward pressure? This was, in part, because the lower exchange rate was seen as offering a
beneficial general incentive for the most dynamic parts of the economy - the tradeables sector
and, in particular, the export sector. Partly, too, it reflected a perception that high exchange
rates left countries vulnerable to sudden changes in sentiment. Looking at the experience of
these countries, it is hard to disagree strongly with these sentiments. Dornbusch (1994, p. 280),
writing about Mexico, notes "... over-valuation is one of the gravest policy errors along the way.
Over-valuation stops growth and, more often than not, ends in a speculative siege on the
exchange rate and ultimately currency realignment".8
Lessons
I have tried to put the case that the capital inflows that occurred into these
countries in the first half of the 1990s were not some aberration of policy-making, but were
more-or-less to be expected. But we now know, with hindsight, that they were unsustainable.
Where did it go wrong? What should be done?
The first lesson is that whatever the "model" suggests is the norm for capital
flows, when these flows get large, economies are vulnerable to changes in sentiment. The model
does not say much about how policies should handle changes of sentiment which bring very
large variance to capital flows and GDP. Wherever there are large foreign capital flows, there is
a high probability of rapid changes of mood, because - whoever bears the exchange rate risk
(whether borrower or lender) - one of the parties to the transaction is holding an exchange rate
position which is not "natural". This makes that party flighty and quick to re-assess their
position. In many cases, the response was that the party with the most information bore the
exchange rate risk - i.e. the domestic borrower borrowed in foreign currency. It was not
irrational to expect exchange rates to remain reasonably stable, not only because policy in these
countries had succeeded in keeping a high degree of stability over a reasonably long period of
time, but also because (based on our earlier argument) they might have expected, if anything, the
exchange rate to appreciate over time, which would have reduced the cost of their overseas
borrowing.9 But in the end it was the old issue of variance or the variability over time that
brought the best-laid plans of borrowers to such an unhappy end. We noted earlier that the
textbook equilibrating forces were largely absent - as foreign exchange became dearer, people
wanted to buy more, not less. This was reinforced by lenders' behaviour. As the exchange rates
fell, foreign lenders, although protected from exchange rate risk, began to realise that they were
exposed to increasing credit risk, and became extremely reluctant to roll over their lending. The
credit-rating agencies added their own special twist-of-the-knife, down-grading these countries
six months after the problems began, so that portfolio managers were forced to sell into the
collapsed markets.
Now we have looked at some of the forces operating on the exchange rate, we can
ask: "Would an earlier float of the exchange rate have avoided these problems?" With
hindsight, it is hard to argue against this view - the actual path proved unsustainable, so any
alternative looks attractive. But this does not tell us whether the alternative would, in fact, have
handled the situation more satisfactorily: for this, we would need to sketch out what the
exchange rate path over time would have been under this alternative scenario. Given the
capital-transfer process underway, how much would the exchange rate be expected to
appreciate? This is hard to think through, but the key idea here is that an interest rate
differential should be balanced by an expectation of exchange rate depreciation if portfolios are
to be held in balance. Portfolio equilibrium could not be achieved by lowering domestic (local
currency) interest rates, because these were set - in effect - by the high domestic marginal
efficiency of capital: high interest rates were needed to rein in the intrinsic dynamism of the
domestic economy. If the interest differential was expected to be maintained for a significant
period of time (say, a decade or more), then there would need to be a very large appreciation of
the exchange rate to balance the likelihood that interest differentials would be maintained over
this period of time. How far would it have had to appreciate before foreign investors would
have stopped extrapolating the appreciation and begun to expect depreciation? Would this
process have been smooth, without the over-shooting we have seen? What sort of knife-edge
equilibrium would this have been, in which portfolio managers' calculations teeter between the
recent history of appreciation, but incorporate a steady, gentle, expected depreciation from here
on? Would the even-higher current account deficits that would have occurred during the
9
Were they foolish not to hedge their borrowing? This is a common ex post criticism, but it seems
to ignore the obvious financial-market identity that if they had hedged their borrowing, then they would have
eliminated the interest rate advantage of borrowing in foreign currency. This does not say that it would
have been unwise to hedge - merely that it is understandable that they did not.
appreciation phase have spooked the market? There are no answers to these "what if" questions,
but it seems naive to argue that markets would have maintained a smoothly-evolving equilibrium
exchange rate through the extraordinary changes of the 1990s. Greater exchange rate flexibility
may well have provided a better outcome (or, more likely, brought on the crisis earlier), but it
needed to occur within a financial infrastructure which had the capacity to withstand the
exigencies of real-world flexible markets.
I now turn to more immediate issues, particularly the events of 1997. Once
exchange rates were floated, why didn't higher interest rates work more effectively to stabilise
the exchange rates of these countries? There are new lessons and old lessons to be re-learned:
• if the market does not believe that high interest rates will be sustained,
then there is no encouragement to capital inflows (and, in fact, the market may think that the
exchange rate will fall further when the unsustainable interest rates are lowered);
• high interest rates are supposed to work by encouraging domestic
borrowers to roll over their foreign exchange debt and borrow more overseas, and by
encouraging foreigners to lend more, denominated in domestic currency. But foreigners are
now worried about credit risk: higher local-currency interest rates do not encourage them to
roll over their foreign exchange loans (in fact, will cause them to worry more about the
financial health of their debtors), and it seems unlikely that many foreigners will be tempted
to lend in local currency (the Stiglitz and Weiss (1981) "adverse selection" argument is
relevant here: only the most daring (and therefore risky) borrowers will be willing to pay
higher interest rates).
None of this, of course, argues for low interest rates - but it is a reminder that
simple manipulation of interest rates will not always protect an exchange rate.
What other lessons should be drawn, specifically on the appropriate exchange rate
regime for the future? Policy-makers of these countries always accepted, in principle, that as
their countries became more integrated with the outside world, they would not be able to control
both interest rates and the exchange rate. They understood this, but were perhaps hoping to put
off the day for somewhat longer. It seems unlikely, now, that these countries can go back to
anything like the fixed exchange rates that they had before: nor would this be desirable. But we
could also understand if the policy-makers of the region find both the extent of the movement
and the actual levels which the market has now produced to be aberrant, and hardly a
recommendation for "leaving it up to the market". Those of us who have experienced floating
exchange rates for some time now might offer a couple of points:
• like them, Australia did not float because we had decided that it was a
good idea, but because we were forced by circumstances to do so;
like them, Australia found the initial stages of the float to be extremely
•
uncomfortable, and even over the longer term, there seem to have been moments when the
exchange rate was not closely anchored by the fundamentals;
• nevertheless, most of us have come to the view that floating exchange
rates work well for us (although there will be times when we believe we can do beneficial
intervention in the market). Our systems have built up some resilience as people become
more accustomed to exchange rate swings, and build these variations into their decisions.10
It is also clear that the proper answer is not to restrict capital flows, although these
countries may be, in future, less enthusiastic about encouraging some of the more footloose and
volatile forms of capital inflow. These countries should move forward with financial
deregulation, although the central lesson from this experience is that the prudential framework
should advance in step with the opening up of the financial sector.11 The sine qua non of
smooth adaptation to large capital flows must be a resilient and robust formal financial sector,
with risk-averse conservative banks forming a large stable core. Such risk-averse institutions
would have been reluctant to expose themselves to the sort of exchange rate shocks that have
occurred, and so a well-functioning formal financial sector would have borrowed less in foreign
currency and would have been more conscious of the credit risk of lending to those who had
borrowed extensively overseas. To the extent that this left private non-bank borrowers still
borrowing excessively in foreign currency, then we might hope that the "consenting adults"
view would prevail, leaving the borrower and lender to sort out repayments on a one-on-one
basis without putting the entire economy at risk. But those who are confident that this private
non-bank borrowing will be a smooth, well-informed process might contemplate just how
quickly private investors changed from wide-eyed enthusiasm to gloomy disillusionment, and
how slow the international credit agencies were to see the impending problems. The alarm-bells
went off when the building was well-and-truly ablaze. The problems of lack of a
clearly-understood model and asymmetrical information may be addressed by greater
transparency and provision of data, but it hardly seems likely that they can be overcome. The
lesson we should draw from all this is that inconvenient fluctuations in exchange rates are
inevitable, and we have to design systems which can cope with them.
To put this point in different words, we need to enlarge our view of "the
fundamentals". To the conventional list of "fundamentals", we need to add another vital one
some assessment of the health and resilience of the financial system. Whether these countries
can afford to return to their old pace of growth depends very largely on their ability to cope with
variance - particularly variance of capital flows and exchange rates. So the constraint on growth
will not be the conventional one of available resources, but whether the financial sector has
proven itself to be able to withstand vigorous "stress-testing" - can it withstand big exchange
rate changes? Can it cope with asset booms and busts? It also needs to be able to handle big
swings in perceived company profitability, because we know that a project which is performing
well in an environment of 8 per cent growth can turn into a loser when growth slows.
10
This is not to argue that the sort of exchange rate changes which have occurred in Asia are helping
to bring about a new and beneficial equilibrium. They are, in fact, very damaging, not just because of the
inappropriate price signals they embody, but because of the high interest rates used to contain the
exchange rate movements, and the damage to firms which have borrowed in dollars. Much more modest
changes would have achieved an improved competitiveness, and as far as capital flows are concerned, big
movements in exchange rates seem to be inhibiting rather than encouraging capital flows, by worsening the
basic situation in these countries, reducing profitability, limiting GDP growth and creating substantial
policymaking uncertainty. It might be worth noting, too, that in the Mexican case, the large nominal exchange
rate fall which was initially seen (in 1994/95) as being an important part of the corrective process has been
more-or-less offset by subsequent inflation, so that the improvement in the real exchange rate and
competitiveness has been largely lost.
11
When people used to argue about the correct sequencing for the deregulatory process, they
recognised that financial deregulation should come last, because if there remained any opportunities for
disequilibrium profits in the meantime, a very open financial sector would allow these to be exploited.
I have already noted how important it is to improve prudential supervision in
these countries. This is not controversial, although putting it into practice will be difficult and
time consuming. One more-controv