The recent financial crises in Asia, Brazil, Russia, and Mexico, and the success of regimes of financial control in China, India, Chile, Colombia, and earlier in most OECD countries, have motivated me to think about ways that emerging economies can capture the benefits and contain the costs of financial integration. I have noticed that orthodox and heterodox accounts of these crises have failed to identify the various distinct types of risks facing emerging economies. This omission is problematic as it impairs the project of designing policies to prevent and ameliorate future crises. In what follows, I will identify five distinct (though interrelated) types of risks--currency, flight, fragility, contagion, and sovereignty. I will explain what I mean by each type of risk and then propose measures that might be employed to manage each one.
Targeting Policies to Risks in Emerging Economies
Currency risk refers to the risk that a country's currency may significantly decline in value following investors' decisions to sell their holdings. This risk is an attribute of any type of exchange rate regime, be it floating, fixed, or a pegged regime, provided that the government maintains full currency convertibility. Thus, it is currency convertibility, rather than the choice of exchange rate regime itself, that introduces the possibility of currency risk.
That floating exchange rates introduce currency risk is rather obvious. However, as Milton Friedman made clear in his 1953 work, and as events us Asia have underscored, pegging a currency does not eliminate currency risk. If the currency's fixity is not economically sustainable, then investors will "play chicken" with the government, and the government ultimately loses. Thus, pegging the exchange rate will not insulate a country from the risk of currency collapse (even if it delays the collapse).
There are some key differences between emerging and wealthier economies as far as the severity of the currency risk they confront, holding constant for the exchange rate regime. Emerging economies confront much more severe currency risk than do wealthier economies for several reasons. First, governments in emerging economies are unlikely to hold a portfolio of currency reserves that is large enough to protect the value of their currency should there be a generalized investor exit. Because investors know this, an initial exit from the currency is likely to trigger a panic, thereby validating investors' concerns about reserve adequacy. An exception would be the case where an emerging economy has a currency board in place, such as m Hong Kong and Argentina, or where the government has extremely large reserve holdings, such as Singapore, China, and Taiwan. A second reason why currency risk is more severe in emerging economies is that their governments are not able to orchestrate multilateral currency rescues or pooling of reserves as are G7 countries. Thus, emerging economies can do little of a multilateral nature to protect their currencies once a wave of selling commences.
What kinds of policy would mitigate currency risk in emerging economies? Emerging economies can mitigate currency risk by declaring their currency inconvertible. For example, under China's regime, foreigners' access to the currency is tightly controlled through licensing and permit requirements. Non-convertible currencies cannot be placed under pressure to depreciate because there are substantial obstacles to investors' acquiring the currency in the first place. An alternative to declaring currency inconvertibility is presented by the type of exchange rate management that has been successful in Chile since 1991. The Chilean central bank has managed its currency via a crawling peg (adjusted modestly and with some frequency) while also sterilizing private capital inflows. These measures, in the broader context of the country's successful program of "capital inflows management" and the credibility afforded by a neoliberal regime, have helped to maintain the viability of the Chilean currency through the Asian an d Mexican crises. …