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

July 1999 Forthcoming: Oxford Review of Economic Policy 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 dominate 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 stabilise the domestic economy while limiting moral hazard in the banking system. JEL Classification: O15, F31, F33. Keywords: Exchange rate regime, emerging markets, capital flows, overborrowing.