Exchange rate policy and the Asian crisis: Thailand, Indonesia and Korea

1 Peter Warr 8.1 INTRODUCTION Since the early 1960s, it has been well understood that a pegged exchange rate cannot be maintained simultaneously with both open capital accounts and domestic monetary independence (Mundell, 1962). This combination of policies is now known as the ‘impossible trinity’. However, during the decade leading up to the Asian crisis of 1997, this basic point was disregarded. In the presence of greatly increased international mobility of financial capital, controls on capital movements were steadily dismantled in those countries where they had previously existed, but exchange rates continued to be pegged to the US dollar. At the same time, central banks attempted to use monetary policy to ‘sterilize’ the domestic effects of capital inflows. The result was the steady development of vulnerability to a currency crisis. This chapter demonstrates the process through which this occurred. The chapter focuses on the three most prominent crisis countries: Thailand, Indonesia and Korea. Each of these countries was an outstanding economic performer prior to the financial crisis of 1997, measured in terms of sustained economic growth, moderate inflation and stable policy. Each was maintaining a pegged exchange rate, using the US dollar as its reference currency, and regarded this exchange rate policy as the cornerstone of its macroeconomic stability. By 1998, each was in deep recession, having abandoned its fixed exchange rate policy prior to the crisis in favor of a floating exchange rate, but with a very much depreciated currency thereafter, compared to the pre-crisis situation. Moreover, having previously….