erkki liikanen : external financing condition, the exchange rate and policy tradeoffs for central banks speaking notes by mr erkki liikanen, governor of the bank of finland, for the second high - level seminar of the eurosystem and latin american central banks, rio de janeiro, 26 november 2004. * * * let me start by saying that the debate on appropriate exchange rate regimes has been surprisingly lively over the last few years. my impression is that this debate is partly boosted by the fact that economic theory has proved to be rather lame in guiding policymakers on exchange rate regime choice and many countries have experienced severe foreign exchange crises in recent years. in this connection, the role of free capital movements in determining the performance of exchange rate regimes appear to have been at the core of recent policy discussions. in the 1990s, too many economies, i believe, were victims of economic crises. the fall of tightly managed exchange rate regimes in east asia, russia, brazil, turkey and argentina resulted in a massive decline in living standards in these countries. these crises also brought the issue of optimal exchange rate regimes to the core of the international policy agenda. while there are no simple recipe for the optimal choice of a currency regime in any country, one can safely emphasise the importance of consistency within the exchange regime and its underlying macroeconomic policies and economic fundamentals. it is easy to agree with those who have pointed out that no regime can ultimately substitute for sound macroeconomic policies. in this short talk i will try to argue that, in the current environment of high capital mobility, sound fiscal policy and the choice of exchange rate regime are even more important. i will illustrate my point by highlighting the general developments in emerging markets and by two examples from finland ’ s neighbouring countries. i believe that free capital mobility is the key factor underlying not only the appropriate choice of exchange rate regime, but also understanding the recent crises in emerging markets. there is a broad consensus today that the sudden reversal of capital flows played a central role in triggering recent crises. compared to more advanced economies emerging markets seem to be more prone to institutional and financial sector weaknesses. consequently, they are less capable to manage these large capital flows. capital flows often depend not only on domestic fundamentals and policy management, but also on external variables. higher interest rates in the us or crises in other countries can bring about abrubt changes in financial conditions and trigger crises in emerging markets. but domestic policy management is very important as well. recent studies,

the countries develop economically and institutionally, a more flexible exchange rate and proper inflation target may well represent a less costly regime choice. to conclude, it is difficult nowadays to isolate oneself totally from external shocks and sudden capital movements. but the authorities in emerging markets can render their economies less vulnerable by running sustainable fiscal policies and choosing a suitable exchange rate regime. to build a sounder banking sector might be more challenging. again it is very difficult to isolate the banking sector from capital movements, but the authorities can demand large capital requirements. authorities could also supervise the currency mismatches in the banking sector properly. more capital and less foreign currency liabilities might render the economies less vulnerable to sudden capital movements and crises.