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Exchange-Rate Regimes for Emerging Markets: Moral Hazard and International Overborrowing

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  • McKinnon, Ronald I
  • Pill, Huw
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Abstract

This paper investigates the role of the exchange-rate regime in a simple Fisherian model of the overborrowing syndrome. Where domestic banks are subject to moral hazard, the choice of exchange-rate regime may have important implications for the macroeconomic stability of the economy. Banks that enjoy government guarantees have an incentive to increase foreign borrowing and incur foreign-exchange risks that are underwritten by the deposit insurance system. In the absence of capital controls, this increases the magnitude of overborrowing and leaves the economy both more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack. While "bad" exchange-rate pegs will tend to exacerbate the problem of overborrowing in emerging markets, it is unclear that flexible exchange rate always dominates fixed exchange rates. A "good fix"--one that is credible and close to purchasing power parity--may reduce the "super risk premium" in domestic interest rates and thereby narrow the margin of temptation for banks to overborrow internationally. Contrary to the current consensus regarding the lessons that should be drawn from the Asian crisis, a good fix may better stabilize the domestic economy while limiting moral hazard in the banking system. Copyright 1999 by Oxford University Press.

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Bibliographic Info

Article provided by Oxford University Press in its journal Oxford Review of Economic Policy.

Volume (Year): 15 (1999)
Issue (Month): 3 (Autumn)
Pages: 19-38

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Handle: RePEc:oup:oxford:v:15:y:1999:i:3:p:19-38

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  1. Ronald I. McKinnon & Huw Pill, 1996. "Credible Liberalizations and International Capital Flows: The “Overborrowing Syndrome”," NBER Chapters, in: Financial Deregulation and Integration in East Asia, NBER-EASE Volume 5, pages 7-50 National Bureau of Economic Research, Inc.
  2. McKinnon, Ronald I. & Pill, Huw, 1998. "International Overborrowing: A Decomposition of Credit and Currency Risks," World Development, Elsevier, vol. 26(7), pages 1267-1282, July.
  3. Ronald I. McKinnon & Huw Pill, 1996. "The overborrowing syndrome: are East Asian economies different?," Proceedings, Federal Reserve Bank of San Francisco, pages 322-355.
  4. McKinnon, Ronald I, 1993. "The Rules of the Game: International Money in Historical Perspective," Journal of Economic Literature, American Economic Association, vol. 31(1), pages 1-44, March.
  5. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  6. McKinnon, Ronald I & Pill, Huw, 1997. "Credible Economic Liberalizations and Overborrowing," American Economic Review, American Economic Association, vol. 87(2), pages 189-93, May.
  7. Maurice Obstfeld., 1998. "The Global Capital Market: Benefactor or Menace?," Center for International and Development Economics Research (CIDER) Working Papers C98-098, University of California at Berkeley.
  8. Garber, Peter & Taylor, Mark P, 1995. "Sand in the Wheels of Foreign Exchange Markets: A Sceptical Note," Economic Journal, Royal Economic Society, vol. 105(428), pages 173-80, January.
  9. Dooley, Michael P & Isard, Peter, 1980. "Capital Controls, Political Risk, and Deviations from Interest-Rate Parity," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 370-84, April.
  10. Frankel, Jeffrey A, 1992. "Measuring International Capital Mobility: A Review," American Economic Review, American Economic Association, vol. 82(2), pages 197-202, May.
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