[VIEWPOINT]Currency mismatches can biteThe period since the Asian financial crisis of 1997-98 has seen a multilateral effort to strengthen the international financial architecture. The adoption of more flexible exchange rate arrangements by emerging economies, agreement on a set of international standards and codes of conduct (ranging from banking supervision to corporate governance) and an upgrading of transparency and disclosure are all areas of significant progress.
But there remains an important problem that deserves much greater attention than it has received so far. I speak here of currency mismatches in emerging economies. By a currency mismatch, I mean a situation where the currency composition of assets and liabilities differs ― so that an economy or sector’s net worth becomes sensitive to changes in the exchange rate. For example, if the corporate sector’s liabilities were primarily denominated in U.S. dollars while its assets were mainly denominated in local currency, then a large depreciation of the local currency could render that sector insolvent.
Currency mismatches are important on three counts. First, there is strong empirical evidence that currency mismatches not only increase the probability of getting into a financial crisis but also raise the cost of getting out of one. Almost all the recent financial crises in emerging economies (Mexico, the Asian financial crisis, Russia, Turkey, Brazil and Argentina) have been marked by large currency mismatches. In Korea, for example, the ratio of short-term external debt to international reserves rose from about 185 percent in 1995 to 330 percent in 1997, while borrowing by domestic banks from international banks (as a percent of domestic bank lending to the private sector) increased from 25 percent to 46 percent. No wonder that currency mismatch variables have proved to be one of the better leading indicators of currency and banking crises in emerging economies. Moreover, studies have reported that output contractions in the 1990s have been deeper in emerging economies with large currency mismatches and large exchange rate depreciations.
Second, sizeable currency mismatches undermine the effectiveness of monetary policy during a crisis. Sizeable mismatches make it harder to reduce interest rates after a deflationary shock because the authorities worry that an interest rate decline could set off a sharp fall in the currency that in turn could initiate a wave of bankruptcies. In contrast, when currency mismatches are small, interest rate cuts can be used to stimulate the economy.
A third concern is that large currency mismatches can severely handicap the operation of floating exchange rates in emerging economies. When currency mismatches are sizeable, the authorities are apt to engage in heavy exchange market intervention and in interest rate management to keep the exchange rate from depreciating sharply. But such a “fear of floating” sacrifices the benefits of monetary policy independence and of better cushioning against external shocks.
Currency mismatches in emerging economies are not inevitable. In a forthcoming book for the International Institute of Economics, I argue that the following policies would be most effective against currency mismatches:
Those emerging economies that are involved substantially with international capital markets should opt for a currency regime of managed floating. The de facto movement of the nominal exchange rate will produce an awareness of currency risk as well as an incentive to keep currency mismatches under control.
A monetary policy framework of inflation targeting should be employed to provide a good nominal anchor against inflation. Good inflation performance is crucial for developing a healthy local-currency-denominated domestic bond market.
Banks in emerging economies should apply tighter credit limits on foreign-currency loans to customers that do not generate sizeable foreign-currency revenues, and banking supervisors should strengthen regulations and capital requirements on banks' net open positions in foreign exchange.
To help harness market discipline, the International Monetary Fund should publish regularly data on currency mismatches at the economy-wide and sectoral levels and should comment on mismatches regarded as excessive; the IMF should also make reduction of currency mismatches a condition for IMF loans if mismatches are significant.
Emerging economies that have a high share of public debt denominated in, or indexed to, foreign currency should adopt a medium-run objective of reducing that share; for countries with a poor track record on inflation, inflation-indexed bonds can serve as a transition to fixed rate, domestic-currency-denominated debt.
Higher priority in emerging economies should be accorded to enlarging domestic bond markets, to the use of hedging instruments and to reducing barriers to entry for foreign-owned banks.
If these measures were implemented persistently, currency mismatches would be better controlled and emerging economies would have a better opportunity for sustained growth.
* The writer is a senior fellow at Institute for International Economics.
by Morris Goldstein