Capitalizing on Globalization

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ECONOMICS AND RESEARCH DEPARTMENTERD WORKING PAPER SERIES NO. 1

Barry Eichengreen

January 2002

Asian Development Bank

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ERD Working Paper No. 1C APITALIZING ON GLOBALIZATION

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Foreword

The ERD Working Paper Series is a forum for ongoing and recentlycompleted research and policy studies undertaken in the Asian DevelopmentBank or on its behalf. The Series is a quick-disseminating, informal publicationmean t t o stimulat e discussion a nd elicit feedba ck. P a pers published under th isSeries could subsequent ly be revised for publication a s a rticles in professiona ljournals or chapters in books.


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Contents

Page

I . Int roduct ion 1

I I . P olicies a nd Inst it ut ions for Asia n G row t h 3A. C ontours of Asia n G row th 4B. Int erna t iona l a nd In ter t empora l C ompa risons 5C. The Asia n Model 7

I I I . Ma na ging Innova t ion 8A. C ha nnels 9B . P olicies 11C. Ada pt ing t o G loba liza t ion 14

IV. Ma na ging P overty 16A. S ocia l Insura nce 18B. S t ructura l Remedies 20

V. Ma na ging Vola t ility 22A. E ffect s of Vola t ilit y 22

1. E ffect s on G row t h 242. E ffect s on Other S ocia l Indica tors 24B. Limit ing Vola t ility 27

VI. Ma na ging E xcha nge Ra t es 38A. The Va nishing Middle G round 38B. Choosing betw een the Rema ining Opt ions 41

VII . Ca t a lyzing Inst it ut iona l C ha nge 42A. The Const ruct ive Role of C rises 43B. G loba l Init ia t ives 45C. Na t iona l In it ia t ives 47

D. The Regiona l Opt ion 48

VII I . Conclusion 50

References 52


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instit utions to a ccommodate these new impera tives, and how to do so in a ma nner consistentwith the opportunities and constraints of globalization.

Section II sets t he sta ge by pla cing Asia n growt h in compa ra tive perspective. It r eview sevidence suggesting that (i) the continents growth has depended disproportionately on factora ccumula tion ra ther t ha n increases in th e efficiency of resource utiliza tion, (ii) tha t t his pat ternis not unusual for countries at a relatively early stage of industrial development, and (iii) thatAsian institut ions ha ve been designed t o encoura ge factor a ccumula tion a nd imports of technicalknow-how. I t argues that sus ta in ing g rowth in the 21 s t cen tu ry wi l l requ ire adap t ing theseinstitutions in wa ys tha t place a great er premium on innovat ion a nd technica l cha nge. In part icular,this will entail modifying institutions for managing innovation (Section III), poverty (Section IV),vola tility (Section V), a nd excha nge ra tes (Section VI), in each case in a ma nner consistent w iththe imperatives of globalization.

But answering these questions only poses another: how to develop the capacity to adaptexisting institutions. Section VII asks whether this capacity is best developed at the national,

regional, or global level and whether initiatives to address the challenge at these three levelsa re properly regarded a s substit utes or complements. I t exam ines the role of crisis in cat a lyzingthe tra nsforma tion of the insti tu t ions providing the fram ework for growth, sta bili ty a nd equityin a world of globalized ma rkets, both in Asia a nd in h igh-income countries like the US tha t h a vealready undergone this transition. Section VIII concludes.

II. Policies and Institutions for Asian Growth

Consensus on th e rela tive importa nce of factor a ccumula tion and increa ses in TFP in thegrowt h of the Ea st Asia n economies remain s elusive. The dat a a re imperfect: na tiona l account sprovide data on investment, not capital stocks, for example, and strong assumptions must bea pplied before they ca n be used to construct estima tes of the lat ter. Tra nsla ting t he number ofw orkers w ith different demographic an d economic cha ra cteristics int o an effective stock of laborinputs requires other, equally restrictive assumptions. That the dual and the primal lead to differentconclusions is less than reassuring (Hsieh 1998). And any attempt to distinguish the rate anddirection of productivity growth from t he elast ici ty of substi tu tion between capital a nd la borrequires the imposition of strong assumptions regarding the form and stability of the aggregateproduction function. 3

3 A classic art icle by Dia mond, McFad den, an d Rodriguez (1978) shows t ha t it is not in genera l possible to identifysepara te ly a t ime-varying e last ic ity of substi tut ion and the bias of technical chan ge.

Section IIPolicies and Institutions for Asian Growth


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A. Contours of Asian Growth

Th e s e v er i t y o f t h e s e pr o bl e m s m a k e s t h e a c t u a l b r e a d t h o f a g r e e m e n t o n w h a tdist inguishes Ea st Asian growt h from tha t in other regions par t icula rly str ik ing. Over t he last40 years, most investigators agree, growth in East Asia has relied disproportionately on inputsof capital and labor and to a strikingly slight extent on increases in the efficiency with whichthose inputs a re used. One need not a dopt the extreme position of Young (1992) and Krugm a n(1994) that there was essentially no TFP growth in East Asia from the late 1960s to the early1990s in order to reach this conclusion. Thus, Kim and Lau (1994) estimate translog productionfunctions for H ong Kong, Ch ina ; Republic of Korea (henceforth K orea ); S inga pore; a nd Ta ipei,China ,wh ich a llow the da ta ra ther th a n th e investigat ors priors to determine the elasticity of substitution.

Table 1. Growth Rates of Labor Productivity and TFP in Newly Industrialized Economies

and Developed Industrial E conomies

Averag e G rowt h R at e per Year (%)

Out put Ca pit a l- P ercen t a geE la st icit y La bor La bor Cont r ibut ion

of Ca pit a l P roduct ivit y Ra t io TFP of TFP G (Y/L) G (K /L) G (A) (G (A)/G (Y/L))

Newly I ndustr ia l ized E conomiesK orea 1960-90 0.45 5.1 8.9 1.1 21Ta ipei,C hina 1953-90 0.49 6.2 9.6 1.5 24Hong Kong,

China 1966-90 0.40 5.2 6.1 2.8 54S in ga pore 1964-90 0.44 4.5 6.6 1.6 36Avera ge 0.45 5.3 7.8 1.8 34

Developed EconomiesFra nce 1957-90 0.28 3.8 4.7 2.5 66FederalRepublicof G erma ny 1960-90 0.25 3.6 4.9 2.4 67U K 1957-90 0.27 2.3 3.0 1.5 65U S 1948-90 0.23 1.5 1.6 1.2 80J a pa n 1957-90 0.30 6.0 9.7 3.1 52Avera ge 0.27 3.4 4.8 2.1 66

Notes: : Average estimates using the translog production function.Y: Real GDP per work hour.K: Reproducible capital (excluding residential buildings) adjusted for ut il ization ra tes.L: Work hour s.

Source: Kim an d La u (1994, Tables 3-1, 6-3, 7-1).


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Kim a nd La u find tha t TFP a ccounted for only a th ird of the growt h of real G DP. This contra stsw ith t he US , where TFP a ccounted for fully 80 percent of the growth of real G DP between 1948a nd 1990 (see Ta ble 1). Apparent ly, Ea st Asia initia ted it s high-growt h mira cle by boostinginvestment rates (capital being the factor input whose rate of accumulation is easiest to varyin the short run ) a nd susta ined its growth by ma inta ining those high ra tes of investment. In crea sesin t he efficiency w ith wh ich ca pita l a nd other fa ctors of production w ere used, while not negligible,made a relatively small contribution, arithmetically, to overall output growth.

There is less agreement on the meaning of this pattern. Is it evidence of East Asias singularsuccess at promoting savings and investment, which are two of the keys to modern economicgrowt h? Or does it r eflect some peculiar failure t o boost productivity? Is t he pat tern n ormal foreconomies at East Asias stage of economic development, or does it reflect a distinctive Asiangrowth model and the regions pursuit of a unique development strategy?

B. International and Intertemporal Comparisons

Answ ers ca n only be obta ined by placing Ea st Asia in a n interna tional context (here thediscussion dra w s on the insight s of Ha ya mi 1998). Ta ble 1 shows t ha t t he relat ive contributionof increases in TFP growth to GDP growth is higher, while the relative contribution of factoraccumulation is lower, in all of the now advanced industrial countries. The closer an economyis to th e technologica l frontier (mea sured for present purposes by rela tive per capita output inthe nonprimary sector, and epitomized for purposes of 20 t h centu ry compa risons by the US ), thelar ger a ppea rs t o be the rela tive contr ibution of productivity growt h. Thus, for t he post-WorldWa r II period a s a wh ole, Fra nce, Germ a ny, a nd U nited Kingdom (U K) were closer to the UStha n J apan , a nd J apan wa s closer to France, Germany, and U K tha n the newly indust r ia l izedeconomies (NIEs). When we restrict the comparison to the second half of the period, by whichtime Eu rope and J a pan h a d closed much of the ga p vis-a -vis the U S, th e rela tive contributionof TFP growt h is grea ter. The proximat e sources of growt h in E urope a nd J a pan resemble evenmore closely its proximate sources in the US.

Th e o b v io u s i n t e r p r e t a t i on i s t h a t g r o w t h d e p en d s d i s p r op or t i o n a t e l y o n f a c t oraccumulation, capital accumulation in particular, in its initial stages (as emphasized in the 19 t h

century context by Gerschenkron 1962). When the late-developing economy develops the abilityto utilize modern indust ria l technologies, the equilibrium capit a l/labor ra tio shifts u p. Duringthis t ra nsition, the economy exhibits a relat ively high level of investment a nd a correspondinglyhigh r a te of growt h, subject to th e a va ilability of savings. The foreign t echnologies developed byprevious indust ria lizers a re embodied in this capita l equipment. This is evident in t he fact t ha t

the elasticity of output with respect to capital is relatively high in economies as they begin todevelop (ty pica lly, a t hird higher t ha n in ma tur e economies). Eith er beca use the capa city t o innovat eis particularly late to develop or because the processes of importing technology and of innovatingat home compete for the same limited domestic resources, absolute as well as relative rates ofTFP growth are relatively low at this early stage of economic development.

Section IIPolicies and Institutions for Asian Growth


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foreign technologies. Thus, oth er count ries emula ted t he 1950s J a pa nese MITI-model of indust rycrea tion, predica ted on th e a ssumption t ha t the a ppropriat e technology a lready existsthereis no need to create it from scratchand can be acquired by one means or another. 8

B ut t he longer Asian r a tes of grow th outstripped compar a ble ra tes in Europe, J a pan, a ndUS, the closer Asia drew to the technological frontier. This had important implications since, closerto the frontier, the rate of return to innovation is greater, while the rate of return to emulationis less (Krugm a n 1985). P ut a nother w a y, a s convergence proceeds, growth responds less t o ca pita lforma tion, an d more to R&D a nd other sources of productivity a dva nce. 9 There is overw helmingevidence tha t t he production of new t echnologies ta kes place close to a firms home ba se (Freema n1995, P a tel 1995) a nd tha t technological spillovers w eaken w ith dista nce (Keller 2000) even inour technologically globalized w orld. This points t o the need t o rema ke the Asia n m odel t o encourageinnovation rather than emulation.

As Ma th ews a nd C ho (2000) document, t here ha s been considera ble evolution of the Asia nmodel in this direction. At the same time, the fear remains that because institutions inevitably

exhibit inertia , Asian innovat ion syst ems designed for importing a nd a da pting known t echnologiesremain less well suited to nurturing the radical innovations needed if countries are to remainnear the frontier in our technologically dynamic, globalized world.

A. Channels

Channels for the acquisition of technology from abroad include licensing, capital goodsimports, t urnkey plan ts, foreign direct investment (FDI), joint ventures, stra tegic alliances, andoutsourcing. Of these, capita l goods imports, licensing, a nd joint vent ures ha ve long been the sta plesof th e Asia n model; they ha ve been the mechan isms most compa tible wit h th e lat e developmentof Asian economies and with the desire of Asian governments to promote the acquisi t ion oftechnology a nd encoura ge productivity spillovers.

Capital goods imports have long been a key element of the Asian innovation system.Reflecting this fa ct, Ea st Asia n count ries have a h igher propensity to import ca pita l goods tha nthe typical developing country. New technologies are typically embodied in new capital goods,and importing and utilizing such equipment opens up opportunities for learning by using andreverse engineering. Ta ble 3 shows m a chinery imports a s a percenta ge of domest ic expendit ureson machinery for six economies at different stages of development, including two Asian economies.

8 Mathews and Cho (2000, 76). The elements of the model were well known. As these authors describe them,MITI first selected a field with innovation and spin-off potential. After extensive study, it took a decision ofwh ether or not to ta rget t he industr y. Tar geting enta iled pump-priming subsidies designed to get some generictechnology developed and to encourage firms to follow up on the commercial possibilities. Where needed,government leverage wa s used to a cquire foreign technology on fa vorable terms. The recipient firms w ere thenencouraged, thr ough ad ministra t ive coordination a nd other mechanisms, t o avoid destructive competi t ion ,coordinate t he a dapta tion and commercia l iza tion of the new technology, an d collaborate in R&D.

9 See G itt lema n a nd Wolff (1995) an d P ian ta (1995). This is evident in t he tend ency, described in Section II a bove,for the elasticity of output with respect to capital to decline as an economy matures.

Section IIIManaging Innovation


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firms to bundle imports of heavy electronic machinery with licences to produce copies of theequipment, and supported entry by domestic producers into the production of this equipment(Ozawa 1985). Korea both protected domestic producers and placed pressure on foreign jointventure part ners in the 1970s to wit hdra w a nd leave the field to indigenous firms (Mat hews a ndCh o 2000, 19). The Korea n La w for P romotion of En gineering S ervices, adopted in 1973, stipula tedth a t a ll government -fina nced projects sh ould enga ge local engineering firms a s th e prime contra ctor.A 1976 revision extended favorable tax treatment to local engineering firms involved in suchprojects (Kim and Ma 1997).

Macroeconomic, trade, and financial policies can also be regarded as part of the Asiansyst em of innova tion. St a ble moneta ry a nd fisca l policies, supplemented by favora ble demographics,suppor ted h igh and r i s ing levels o f sav ing . 14 Mu ch o f th i s sa v in g w a s ch an n e led th ro u ghgovernment-controlled banking (and postal savings) systems that provided concessionary creditsto firms and conglomerates in technologically progressive sectors. More controversially, controlson capital exports were used to ensure that domestic saving, once mobilized, was used to support

capita l forma tion at h ome. J a pan; Korea; a nd Ta ipei,China a ll employed such restrictions in theearly sta ges of their industrial growth, a nd th e PRC continues to do so. 15 Barriers to entry bymultinational corporations and by domestic start-ups as well gave incumbents Schumpeterianbreath ing space to learn by do ing . Where economies o f scale were impor tan t , and wheremultidivisiona l st ructure w a s seen a s necessar y to captur e technologica l spillovers, governmentsof countries like Korea provided preferential credit for the growth of integrated industrial groups(chaebol ). Since leading-edge technologies (for integrated steel making in the 1970s and 1980s,or semiconductors in t he 1990s) were cha ra cterized by subst a nt ial m inimum efficient scale a nddyna mic increa sing ret urns, policies of export promotion w ere used to overcome th e const ra intsposed by limit ed domestic mar kets, w hile the impera tive of exportin g exposed producers to th ediscipline of foreign competition.

Asia is not alone in pursuing policies designed to encourage the transfer of advancedtechnologies from a broad an d t o facil i tat e their d isseminat ion, though i t ar guably ha s ha d moresuccess th a n m ost other lat e-developing r egions. Auth ors like Nelson (1992) a nd Ma thew s a ndCho (2000) a tt ribute t he superior performa nce of t he Asian model to three fa ctors. F irst, Asia neconomies possess the engineers and scientists needed to recover the principles underlying foreigntechnologies, which in tu rn fa cilita tes th e disseminat ion of techniq ues from foreign firms to domesticproducers a nd a llows substitut es for foreign capita l goods to be produced a t h ome at a relat ivelyear ly date . 16 Hong Kong, China ; Singa pore; an d Ta ipei ,China ha ve long been ah ead of otherdeveloping countries in the share of their populations enrolled in postsecondary education in

14 P olicies encouraging saving and investment a re trea ted separa te ly in S ection IV below.15 At th e same t ime, Hong Kong, China and Singa pore promoted savings, investment, a nd technology tran sfer

while permittingindeed, encouragingthe free international flow of portfolio capital.16 Thus, Ur at a and Ka wa i (2000) measure t echnology t ran sfer by comparing the level of TFP between parent firms

and overseas a ff i li t ia t es, and f ind t hat tra nsfer is highest for Asian countr ies wit h re la t ively a mple suppliesof scientists and engineers.


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scientific a nd engineering fields an d ha ve encouraged th e best students in th ese fields to a cquirea dvanced tra ining abroad. One of Singa pores f irst in i t ia t ives when the decision w a s ta ken t oattract foreign high-tech producers was to train a cadre of knowledge workers (Mathews andCho 2000, 18). Korea a nd Ta ipei ,China ha ve esta blished publicly fun ded a dva nced r esea rchinstitutes staffed by these scientists and engineers trained at foreign universities, and encouragedthem to establish links with commercial firms. That such initiatives have enhanced domesticabsorptive capacity is clear.

More controversial is a second assertion: tha t the Asian system of innovation w as successfulbecause domestic firms were subjected to relatively intense competition, applying pressure toemulate best practice, specifically the best-practice techniques of foreign-owned and operatedfirms. The intensity of the competi t ion to which producers in Asias rapidly industrial izingeconomies ha ve in fa ct been exposed is a cont ested issue. 17 Inst a nces can be cited w here incumbentfirms enjoyed protection from both foreign competitors and potential domestic entrants and devotedtheir energies to lobbying the government a ga inst gra nting licences to new entr a nts ra ther th a n

to raising productivity. 18Third , this Asia n sys tem of innova tion w a s successful, it is a ssert ed (viz. World B a nk 1993),

beca use restra ints on entr y a nd other policy int erventions w ere guided by well-defined rules a ndbeca use technocra ts enjoyed the burea ucrat ic a utonomy necessar y to a void captur e by domesticindustr y. Bur eaucra ts a re protected by civil service systems tha t ensure adequ a te compensa tionand merit- (exam-) based recruitment and promotion, and disciplined by strictly enforced dismissalpolicies. J a pan, Korea, an d Singa pore are the para digmat ic cases. Ea rly land r eform a nd supportfor sm a ll-scale an d m edium-sca le industry wa s similar ly important for preventing t he emergenceof concentra ted int erests positioned t o ca pture t he policy ma king process.

This a rgument ha s been rendered contr oversia l by t he Asian crisis; w here commenta torsonce wrote approvingly of bureaucratic autonomy, they now decry crony capitalism. The captureof indust ria l policy, in th is view, is as m uch a problem in Asia a s in other par ts of the w orld. Perha psthe tra dit iona l in terpreta tion w a s never r ight, or ma ybe the new emphasis on crony capita l ismis overdraw n.

Or possibly problems of ca ptur e ha ve intensified w ith t ime. The longer indu str ia l policiesare pursued, the more intimate grow the connections between the regulators and the regulated.The longer t he period for w hich preferences a re extended to certa in firms a nd sectors, an d t hegreater the governments emphasis on solving coordination problems, the larger grow the leadingfirms and conglomerates, and the more able they are to influence policy. Further, as the economygrows m ore technically sophisticat ed, monitoring the performa nce of th e enterprises receivingpreferential treatment grows more difficult for the bureaucrats.

17 In a ddit ion, this argument is controversia l because of Schumpeter s famous thesis that a degree of restra intof competi t ion ma y a ctually encourage t echnical progress by giving f irms th e breathing space they need toexper iment w ith unproven t echniques.

18 Kim a nd Ma (1997) cite the Ind ian petrochemical in dustr y in t his connection. To the extent t ha t competitivepressure has been felt, this would appear to have been experienced mainly by export-oriented firms.

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IV. Managing Poverty

G loba lizat ion w ill meet the w a rmest r eception if its benefits a re widely sha red. The factthat economies that are more deeply integrated into global markets tend to have larger publicsectors can be understood as providing social protection for those who cannot protect themselvesfrom th e volatility a nd pressures of globa lizat ion (Rodrik 1998a). Such protection h elps to supportthe broad-based political coalition needed to sustain a commitment to openness. In addition itfa cilita tes th e quick policy adjustm ents needed to absorb globa lizat ion-rela ted shocks, since th erewill be the perception tha t t he immediat e costs of a djustment, like the benefits, ar e being equita blyshared . 23

There ar e tw o cha ra cteriza tions of the links between globa lization a nd poverty. One currentin the a dvanced industrial economies is tha t g loba lizat ion a ggrava tes inequali ty by increasingskill premiums a nd reducing the dema nd for unskilled la bor. 24 There a ppear s t o be evidence forindividual countries, such a s the P RC a nd Tha iland, tha t opening and globalizat ion a ggrava te

inequa lity a nd lead t o an increasing concentr a tion of poverty in pa rticular r egions a nd occupa tions(Ahuja, B ida ni, Ferr eira , a nd Wa lton 1997) (see Ta ble 5 for t rends in povert y in Asia .) H owever,systematic cross-country empirical studies of developing countries provide little support for thiscla im. Dollar a nd K ra a y (2000) find no evidence tha t openness to foreign t ra de benefits t he poorless than the whole economy. They find no evidence that the presence or absence of capital accountrestrictions ha s a different ial impact on the rela tive sta tus of the poor. There is no evidence, inother words, that globalization causes redistribution away from the poor.

The other view is t ha t globalizat ion increa ses risk rat her tha n redistributing income, andthat the poor are least able to cope with the consequences. The poor have the least savings. Theyha ve the fewest a ssets a nd least valua ble collateral . They a re the least a ble to afford insurance.Hence, they suffer disproportionately from the insecurity created by globalization. 25

For count ries seeking t o ca pita lize on globaliza tion, this points to th e need for t w o policies:for the short term, insurance against shocks; and for the long term, measures to foster theaccumulation of forms of human capital that are useful in an economically globalized world ,specifically among socioeconomic groups that have not traditionally possessed them.

23 The adva nta ges of sha red growt h a re a t heme of much of the recent litera ture on the Asian Model: see for exam pleWorld B a nk (1993) a nd C a mpos an d Root (1996). Rodrik (1997) links t he concept t o ease of adjust ment to extern a lshocks.

24 In relat ively poor developing count ries, however, the opposite is plausibly t rue: openness a nd globaliza tion shouldlead to increasing specialization in the production and export of labor-intensive goods, not skill-intensive goods.

25 Agenor a nd Aizenman (1998) show tha t globaliza tion th at ra ises growth but a lso ra ises vola t i l i ty can reducewelfare when costly state verification makes insurance difficult to obtain. While the authors do not explicitlydist inguish the poor, i t is to them tha t t he ra t ioning of insuran ce most plausibly a pplies.


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Ta ble 5. Poverty in E ast Asia, 1975-1995

Number of P eople in P over t y H ea dcount Index P over t y G a p(millions) (%) (%)

E conom y 1975 1985 1993 1995 1975 1985 1993 1995 1975 1985 1993 1995

Ea st Asia a 716.8 524.2 443.4 345.7 57.6 37.3 27.9 21.2 n .a . 10.9 8.4 6.4

Ea st Asiaexclud ing P RC 147.9 125.9 91.8 76.4 51.4 35.6 22.7 18.2 n .a . 11.1 6.0 4.6

Ma la ysia 2.1 1.7


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2. T h e sa f e t y n e t sh o u l d p r o v i d e t a r g et e d t r a n sf er s f o r t h o se u n a b l e t o w o r k .Workfa re should be supplemented w ith ca sh tr a nsfers ta rgeted a t subgroups such as t he elderlya nd pregnant women. Effective ta rgeting ma ximizes t he budgeta ry ba ng for buck. On the otherha nd, ta rgeting run s the risk of crea ting socia l stigma for the recipients, especially in t he Asia ncontext (B irdsall a nd H a ggard 2000). And a n emphasis on t a rgeting can crea te a clash betweenpoverty a llevia tion, strictly defined, an d other social progra ms, such a s th e provision of educat ion,wh ich a re universa l a nd investment-based.

In any case, making targeting effective is a perennial problem in such programs, sincepoli t ically powerful groups seem to be able to insist on a share of the spoils. Indias PublicDist ribution Syst em ha s long been criticized for fa iling to ta rget its benefits. 29 Bangladeshs publicfood distribution scheme is said t o cost six times the va lue of the t ra nsfers a ctua lly received byta rgeted households. The P hilippiness generalized food subsidy progra m costs t he governm entthree pesos for every peso transferred to households, and the households in question are notgenerally the poorest. 30

3. T h e sa f e t y n e t sh o u l d p r o vi d e m i c r o cr ed i t f o r t h o se a f f ec t ed b y t h e f a l l o u t f r o m f i n a n c i a l c r i s es. Cr isis condit ions can force poor households int o distress s a les of productiveassets that depress their postcrisis income and productivity. Disruptions to financial marketscan int errupt a ccess to the tr a de and producer credit needed to obta in essentia l inputs. Limitedamounts of microcredit extended in response to these disruptions should therefore minimize thea dverse consequ ences for poor h ouseholds. H ere, too, Asia ha s considerable experience wit h suchprogra ms, providing a foundat ion on w hich t o build. India s Int egrated Rura l Development P rogra mprovides credit to mea ns-tested h ouseholds for purcha ses of nonla nd a ssets. While it h a s beencriticized for not rea ching th e poorest households or only doing so a t considerable budget a ry cost,the a pproach taken by B a ngladeshs G ra meen B an k is seen as a solution to th is problem. Loansa re extended t o groups of 5 to 8 self-selected persons w ho ag ree to form a group in order to monit orone another. Rates of repayment and economic impacts have been impressive. Credit has beeneffectively cha nneled to the ultra poor, including women. S tudies suggest tha t part icipant s incomesrose by more than 50 percent relative to those of the relevant control groups (Khandker, Khalily,and Khan 1994).

4. I n t h e ev en t o f a c r i si s , p o v er t y a l l ev i a t i o n sh o u l d b u i l d o n t h e ex i s t i n g sa f e t y n et . As noted above, scaling up exist ing workfare, microcredit , and targeted transferprograms in response to a crisis is easier than creating new programs from scratch. Additional

29 An exception is the state of Kerala, where the poorest 60 percent of the population has historically received80 to 90 percent of the benefits. Other Indian states are now using various forms of means testing to moreeffectively ta rget th e systems benefits. Sri La nkas food sta mp program a lso appears t o be relatively w ell-ta rgeted.

30 Thus, in the first half of the 1990s, the National Capital Region and Cagayan Valley, which account for lessthan 3 percent of the poor (measured in terms of nutritional standard) received 35 percent of the subsidizedr ice (Subbara o, B raith wa ite , and J a la n 1995).

Section IVManaging Poverty


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B eca use globaliza tion exposes na tional economies to externa l shocks, it requires w orkersas well as firms to be quick on their feet. The implication is that educational spending shouldimpart genera l knowledge rat her t ha n t echnical t ra ining a nd sector-specific skills. The literat ureon this su bject (e.g., Heckma n 2000) shows t ha t s uch general kn owledge is impar ted most efficientlya t early st a ges in the educa tion process. This suggests ta rgeting educat iona l subsidies a t primaryeduca tion a nd ensur ing th a t t he poorest (an d both genders) a re included. The first point feedsinto an obvious Asian strength: the high-performing Asian economies have long allocated adisproportionat e sha re of educa tional spending t o basic a s opposed t o higher educa tion. 32 I ncontrast , the second observation points to the need to reorient the Asian model, which hastradit ionally focused heavily on vocational training of sorts that are l ikely to be less easilytra nsferred in a ra pidly chan ging high-tech w orld .

Recent cont ribut ions to th e development litera tu re (e.g., Lopez, Thoma s, a nd Wa ng 1998)suggest that a more equal distribution of education has a positive impact on average per capitaincome. The obstacle to a more equal d is t r ibu t ion o f educat ion , accord ing to much o f the

development litera tur e, is th e povert y tr a pth e fact th a t t he extra income from child labor, w hichis indispensable to poor families, comes at the expense of the childrens longer-term prospectsof esca ping poverty thr ough educa tion. 33 And insofar as openness leads poor countries to specializein th e production a nd export of la bor-intensive goods, there is the da nger th a t globaliza tion w illdra w poor children out of school. Ta rgeted s ubsidies for school a tt enda nce ar e the obvious policyresponse. Bangladeshs Food-for-Education Program, which offers a stipend to selected participants(somewha t more tha n t he equivalent of 13 percent of month ly ear nings for boys a nd 20 percentfor girls) has demonstrated an ability to ensure nearly full school attendance by those to whomit is extended. 34 Ea rly evidence similarly suggests tha t Indonesias St a y in School progra m, w hichprovides gra nts t o th e poorest schools an d tra nsfers to the poorest st udents, ha s been simila rlyeffective (B irdsall a nd H agga rd 2000, 31). Such program s ha ve the addit ional a dvant age th atlocal schools a re import a nt s ta keholders, leading t hem to become actively involving in monitoringand administering their operation.

Another potential effect of globalization is on the safety net available to the poor. Theda nger is tha t th e commercializa tion att endant on globaliza tion will undermine informal insura ncemechanisms; as labor becomes more mobile, for example, traditional village-level mutual insurance

32 World Bank (1993) takes the contrast between Venezuela and Korea as illustrative: whereas Venezuela allocated43 percent of its educa tion budget t o higher educat ion in 1985, in th e sam e year K orea a lloca ted only 10 percentto higher educat ion. While governm ent fina nce in Korea account s for nearly 100 percent of the direct costs ofprimary schooling, it provides less than 50 percent of such costs for tertiary education.

33 The a ncillary assumption is tha t parents ca nnot borrow to f inance schooling.34 Ravillion and Wodon (1999) find, however, that reductions in the incidence of child labor account for only a

proportion of the increase in school enrollment. Ta ken litera lly, their result s suggest t ha t ma ny householdsare substituting childrens leisure for their schooling. But it is also not possible to reject the hypothesis thatinformal, nonreported work is the actual substitute for schooling. Similar results obtain for the Bol sa Escola program in B ra zil, both it s effectiveness in increasing school enrolment an d its uncerta in effects on child labor(Sedlacek, Ilahi, and Gustafsson-Wright 2000).

Section IVManaging Poverty


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35 If, on the other hand, commercialization allows village residents to supplement their other activities with off-far m employment , poorer households ma y experience less income a nd consumption va ria bility. There is evidencetha t t his has been th e dominant effect in rura l PR C in r ecent yea rs (Giles 1999).

36 While the view that openness is a source of volatility is commonplace (and will strike many readers as intuitive),the evidence is mixed. Kraay (1998) analyzes the connections between financial openness and the volatilityof capital flows and fails to detect a consistent effect.

37 A compendium of research on this topic is Interamerican Development Bank (1995).38 Obvious issues arise a bout t he direction of causa lity und erlying a ll of these correlat ions, which should be borne

in mind wh en interpre ting the results .

ma y no longer be incentive compa tible for th e part icipan ts. 35 This points to the need to substit utepublic programs for what the local community can no longer provide. Moreover, insofar as theexistence of a safety net encourages the poor to participate in relatively risky but productivemarket-based activity, safety nets can be good for growth. They should thus be seen as a formof productive investment for a world of globalization.

V. Managing Volatility

Globalization, recent experience has made clear, can be a source of volatility. As theyintegrate into the global economy, emerging markets are increasingly exposed to disturbancesema na ting from outside their borders. For example, the slump in globa l semiconductor prices,a n insta nce of a n a dverse terms-of-tra de shock, is blam ed for undermining t he health of the K orea neconomy in the run-up to its 1997-1998 crisis (Goldstein 1998). And as they become integrated

into global markets, economies become increasingly susceptible to contagion-related spilloversfrom national, regional, and global financial crises. The fact that the PRC did not succumb tothe Asian crisis has been ascribed to the fact that it retained capital controls and consequentlyw a s not deeply integra ted into globa l finan cia l ma rkets. More genera lly, Eichengreen, Rose a ndWyplosz (1995) ha ve shown t ha t countries a re more likely t o be a ble to conta in speculat ive pressurewhen t hey a re not yet in tegrated in to global f ina ncial m ar kets. This is not to suggest t ha t t hecosts o f g lobal iza t ion swamp the benef i t s , bu t to emphasize the impor tance o f develop inginstitutions and pursuing policies aimed at limiting volatility and minimizing its adverse socialconsequences. 36

A. Effects of Volatility

There is now ample evidence of the costs of macroeconomic volatility. 37 Ramey and Ramey(1995) estimate that a unit increase in the standard deviation of the innovation in GDP reducesthe ra te of growt h of GDP per capita by one-fifth of one percent per a nnum. Ea sterly and Kra ay(1999) a lso find tha t a n increa se in the sta nda rd deviation of growt h reduces the a verage a nnua lra te of per capita growt h by roughly the same order of magnitude as Ra mey and Ram ey. 38 Uponcontrolling for other determinants of the secula r ra te of growt h t ha t a re sta nda rd in t he empirica l


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growt h l i terat ure, the Int eramerica n D evelopment B an k (IDB 1995) finds tha t growt h dependsnegatively on the volati l i ty of the terms of trade, the volati l i ty of the real exchange rate, thevola tility of moneta ry policy, a nd t he volatility of fisca l policy. 39 Using da ta ending in 1992, IDBestimat es that r eal GDP (measured in growt h ra tes) wa s half a gain a s volati le in Ea st a nd SouthAsia as in the a dvanced industrial countries. 40 De Ferranti et al. (2000), upon updating thesecalculat ions t hrough t he end of th e 1990s (thereby including the Asia n crisis), predicta bly finda larger differential : real G DP volati l i ty ha s been fully tw ice as volat i le in Ea st Asia a s in theindustria l countr ies. 41 South Asia, for i ts part , l ies midway betw een E ast Asia an d the industrialcountries according to these calculations. 42

Does this volatility reflect external disturbances or domestic policies? For the period ending1992, the a nsw er is policies if the compa rison is with the indust ria l count ries. On avera ge, theexternal shocks experienced by East and South Asian countries have not been dramaticallydifferent in ma gnitude as those hitting t he adva nced industria l countries. The sta nda rd deviationof the change in the terms of tra de wa s roughly th e same. 43 Nor w as t he standa rd devia tion of

internationa l capital f lows as a percenta ge of GD P drama tically different t ha n in Europe, J apa n,a n d U S .44 B ut budget def ic it s w ere rela t ively vo la t i le ou ts ide the four Ea st Asian miracleeconomies (in which the volatility of fiscal policy is indistinguishable from the advanced-industrialcountries). 45 And monetary policy was relatively volatile throughout the region. The IDBs estimatesimply that this volatility reduced growth in East Asia over the period 1960-1985 by about a tenthof a percent a year. 46

39 The largest effects a re associat ed with t he volat ility of the term s of tra de and t he real excha nge rat e. A var ietyof other st udies (e.g. , Mendoza 1994; Guillaum ont, J eann eney, and B run 1999; East erly an d Kra ay 1999) ha vealso documented this association between terms-of-trade volatility and growth.

40 In a n a ccounting sense, much of this differentia l is a t tr ibuta ble to investment (again m easured in terms ofits ra te of growth), which wa s tw ice as volat ile in the Ea st Asian Mira cle economies as t he industria l countriesover the sample period.

41 Their estim at es (Figure 2.1) include a lso seven Pa cific count ries.42 Thus, real G DP growth volat ility a s calculated by de F errant i et a l. (2000) has risen from 3 percent in t he 1960s

thr ough 1980s to 4.5 percent in the 1990s for Ea st Asia, but fallen from m ore tha n 2.5 percent to a bit morethan 1.5 percent in South Asia over the same period.

43 Terms-of-tra de shocks can obviously be calculat ed in different w ay s, an d decisions of how to do so ma y be importa ntfor such comparisons. Thus, de Ferra nti et a l. (2000) compar e the volatility of the change in t he terms of tra deacross regions an d decades, but also intera ct this measu re with t he openness of the economy (to derive a mea surethey la bel terms of tra de shocks). While terms-of-tra de distur ban ces to South Asia in the 1990s were nea rlyfour t imes a s large a s to Ea st Asia a ccording to the f irst measure , they w ere of identica l ma gnitude accordingto the second.

44 This pat tern obviously cha nged a s Asian economies opened their m ar kets to interna tiona l capita l flows in t he1990s, as the 1997 crisis revealed and the updated estimates to be discussed momentarily indicate clearly.

45 The public consumption component of the budget, however, has consistently been more volatile in East Asiathan the industrial countries (de Ferrenti et al. 2000).

46 And by about half tha t amount in South Asia .

Section VManaging Volatility


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1. Effects on Growth

The negative association of volatility with growth reflects adverse impacts on productivityand investment. Productivity will suffer if unpredictable changes in relative prices render onetechnology appropriate but lead firm s to chose an other. In the fa ce of relat ive price uncerta inty,companies may hedge their bets by investing in several alternative technologies, all but one ofwhich will less efficient and productive than the optimal technology in any state of nature.Countries where volati l i ty is h igh also display relat ively low investment rates, reflecting thereluctance of entrepreneurs to commit to projects when prices and macroeconomic conditionschange unpredicta bly. While Ea st Asian investment ra tes a re high by internat iona l sta nda rds,recent empirica l work suggests t ha t they w ould ha ve been higher st i l l (by a n a ddit iona l tw o tothree percentage points of GD P ) if vola ti l i ty had been as low a s in the Europe, J apa n, and U S(see IDB 1995, Goldberg 1993, and Kenen and Rodrik 1986).

It can be ar gued tha t t his emphasis overlooks a ma jor source of volat ility a nd a key cha nnel

through which volatility exercises its adverse effect on growth, namely, financial crises. Crisesare incompatible with growth: they lead to stop-go policies, interfere with the operation of thedomestic fina ncial syst em, ca use distress in th e corpora te sector, a nd force governm ents t o curt a ilpublic invest ment . According t o Bord o an d E ichengreen (2000), t he t ypica l post-1972 crisis costthe countr y in w hich it occurred a cumulative 9 percent of G DP tha t is, one to two years of growthfor an Asia n count ry. Different t ypes of crises have different output effects: the estima tes of theseauthors suggest output costs ranging from 3 percent for banking crises, to 7 percent for currencycrises, to 15 percent for tw in crises (w hich ha ve both ban king a nd currency components; see Ta ble 6).

Crises ha ve multiple causes, but one unquestiona bly importa nt cause is financial fragility,wh ich becomes increa singly importa nt a s t he a ction shifts from t he current to the capita l a ccounta nd thus from nonfinancia l to f ina ncia l tra nsa ctions. B ecause creditors w ill rat ionally hesitateto tie up th eir funds in a vola tile ma croeconomic environment , volatility encourages relian ce onshort-term debt, w hich heightens the fra gility of financial syst ems. Creditors w ill similarly hesitat eto invest in a ssets denomina ted in domestic currency w hen excha nge ra tes a re vola tile. This doublemismatch problem, which the balance sheets of domestic financial and nonfinancial firms displayeither as a maturity mismatch (a combination of long-term assets and short-term liabilities) ora currency misma tch (a combina tion of domestic-currency-denomina ted a ssets a nd foreign-currencydenominat ed liabilities), lea ves domestic mar kets vulnera ble to desta bilization by sudden cha ngesin financial conditions.

2. Effects on Other Social Indicators

There i s now ample ev idence that vo la t i l i ty has undesi rab le consequences fo r thedistribution of income, poverty, and educational attainment. The poor, unskilled, and uneducateda re least a ble to protect themselves by h edging their incomes a nd diversifying their investments;it stands to reason that they should suffer disproportionately from volatility. Gavin and Hausmann


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Ta ble 6. Costs of Crises in Lost Output Relative to 5-year Trend, 1973-1998

(53 countries)

Avera ge Loss of C rises w it h Loss of Out putNumber of Recovery Out put per Out put per Cr isis w it h

C rises Time Cr isis Losses Out put Loss(%) (%) (%)

Currency CrisesAll Count r ies 117 1.7 4.3 63 6.8

(1.1) (6.3) (6.8)

Indust r ia l Count r ies 37 1.4 1.9 62 3.1(0.6) (2.8) (3.0)

E merging Ma rket 80 1.8 5.4 64 8.4(1.2) (7.2) (7.4)

Ba nking Cr isesAll Count r ies 24 2.7 7.6 71 10.7

(1.8) (9.4) (9.6)

Indust r ia l Count r ies 6 3.2 6.9 50 13.9(2.4) (8.3) (5.2)

E merging Ma rket 18 2.6 7.8 78 10.0(1.6) (10.0) (10.3)

Twin CrisesAll Count r ies 30 3.4 15.6 93 16.7

(3.1) (14.9) (14.8)

Indust r ia l 5 5.4 17.7 100 17.7

(3.5) (14.3) (14.3)E merging Ma rket 25 3.0 15.2 90 16.5

(2.9) (15.3) (15.2)

All CrisesAll Count r ies 168 1.8 5.2 68 7.6

(1.3) (7.1) (7.4)

Indust r ia l 48 1.9 3.4 65 5.3(1.4) (4.9) (5.2)

E merging Ma rket 120 1.7 5.9 70 8.5(1.3) (7.7) (8.0)

Notes: Cumulat ive loss o f GDP growth wa s calcu lated re la t ive to the 5 -year p recr is is t rend . S tanda rd erro rs are g ivenin parentheses.

Source: Bordo an d Eichengreen (2000).



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(1995) find, in a study of a cross section of count ries, tha t t he volat ility of real G DP ha s a strongnegative effect on the equality of income distribution. Other studies (e.g., Guitan 1995) havesimilarly found that countries with more volatile rates of inflation display higher levels of incomeinequality. Moreover, there is evidence that crises and the policy adjustments they entail arepar t icu lar ly bad fo r income d is t r ibu t ion and that thei r unequal iz ing effects are especia l lypronounced in middle-income count ries (th e cat egory int o wh ich ma ny Asian economies fa ll) (seeB ourguignon, de Melo, a nd S uw a 1991).

Sim ilar results obta in for poverty r a tes. The poor an d nea r poor t end to be employed insectors and activities that suffer from volatility, and cuts in social spending in times of crisisfall disproportionately on their shoulders (Morley 1994). As noted above, households near thepoverty line have the least savings, the worst collateral, and the most tenuous access to creditand insurance. Moreover, volatility aggravates poverty through its negative impact on growth.Ravallion (1997) estimates that the elasticity of poverty, as measured by the proportion of thepopulation falling below the poverty line, with respect to the growth of per capita income lies

betw een -1.5 a nd -3.5. Dollar (2000) obta ins simila r r esults for a lar ger sa mple of countr ies. Crisesa re a n extreme case in point, in tha t t he ela sticity of poverty w ith respect t o income rises shar plyin crisis periods. In Ind onesia in 1997-1998, th e ra te of increa se of poverty is estima ted t o havebeen t en t imes t he ra te of decline in income a nd consumption. In K orea, t he poverty ra te a sconventiona lly mea sured more tha n doubled betw een 1997 an d 1998. Pr evious stu dies relat ingpoverty rates to per capita incomes in Korea would have led to forecasts of barely a fifth thisamount (see the discussion in World Bank 2000b).

Cut ler et a l. (2000), in a stud y of several s uccessive Mexica n crises, find t ha t crisis-relat edvola tility w orsens healt h outcomes. In the Tequila crisis of 1995-1996, morta lity r a tes w ere 5to 7 percent higher tha n in the immedia te pre-crisis yea rs. The great est percenta ge increase w a sa mong the elderly. This effect seems t o operat e ma inly by r educing incomes a nd pla cing a h eavierburden on the medical sector, rat her th a n by forcing less hea lthy members of the populat ion int othe la bor force or by compelling prima ry caregivers to go to w ork.

Fina lly, volat ility is a ssociat ed with low levels of educational a tt ainm ent. It affects educationpar tly t hrough its impa ct on inequa lity: Williamson (1993) finds th a t m ore egalita ria n societies(a s mea sured by t he ra tio of th e sha re of tota l income of the bott om 40 percent t o the sha re ofth e top 20 percent) have higher seconda ry school enrollment r a tes. In economies tha t a re vola tile,the poor, who ar e alrea dy on the ma rgin of subsistence, may be forced periodically to wit hdra w thei r ch i ld ren f rom school so tha t t he la t ter ca n con tr ibu te to househo ld income, a nd t h isinterruption of a t tenda nce will h inder educat iona l a t t ainment. G overnments, forced by crisesto cut social services, may be una ble to susta in a dequa te levels of spending on schooling a nd t o

reta in capa ble instr uctors. Where volat ility hinders t he development of financial m a rkets, fa miliesw ill find it pa rticular ly difficult t o insure a ga inst t hese risks, forcing them to rely on th eir childrenfor relatively inefficient insurance. These effects are likely to be most pronounced in poorer countriessuffering larger shocks: thus, it is revealing that school enrollment rates fell in Indonesia butnot in Korea or Thailand in 1998 (Frankenberg, Thomas, and Beegle 1999).


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har d budget constra ints on financial inst i tu tions. If ba nk capital ization is ina dequate, ma na gerswill be inclined to excessive risk taking, and the offshore funding available through the capitala ccount will permit them t o lever up their bets. If ba nk liabilities are gua ra nteed on th e groundstha t w idesprea d bank fa ilures would be devast at ing to a f inancial system domina ted by banks,foreign investors w ill not hesita te t o provide the r equisite funding. A simple expla na tion for wh ythe resolution costs of banking crises have been larger in the 1980s and 1990s than in earlierdecades and larger in emerging than advanced economies is the coincidence of these domesticfinancial w eaknesses w ith prema ture capita l a ccount opening.

Capital account liberalization thus should follow rather than precede recapitalization ofthe ba nking sector, the reinforcement of prudential supervision a nd regula tion, an d th e removalof blanket guarantees. A possible exception is the removal of interest rate controls: Hellman,Murdock, a nd S tiglitz (2000) ha ve questioned wh ether deposit r a te decontr ol is desira ble on t hegrounds th a t forcing ba nks to compete for deposits erodes franchise value a nd t hereby encouragesexcessive risk taking in t he presence of a financial sa fety net. H owever, mainta ining deposit ra te

controls once the capital account is opened runs the risk of inducing and disintermediation. Thispoint is fa milia r from th e early 1980s (w hen deposit r a te cont rols were prevalent ): see McKinnona nd Ma thieson (1981) a nd E dw a rds (1984). The implica tion is th a t once the capit a l a ccount isopened, the retention of deposit rate controls will no longer be feasible, rendering it essentialto intensify prudential supervision and eliminate implicit guarantees in order to prevent financialinstitutions protected by the official safety net from taking on excessive risk.

The corollary is tha t capita l account r estrictions should rema in in place unt il prudentia lsupervision is strengthened a nd implici t gua ra ntees are removed. Unfortunat ely, ma inta iningbarr iers to cap i ta l f lows and fo re ign f inancia l compet i t ion may d imin ish the p ressure fo rrestructuring; developing countries may never achieve the nirvana where their domestic financialsyst ems ha ve been strengt hened sufficiently t o allow the capita l a ccounts to be libera lized. Thissuggests using capital account liberalization to force the issue. But recent experience in Asiaa nd elsewhere casts doubt on the notion t ha t externa l l ibera liza tion t ha t increases the urgencyof complement a ry fina ncial reforms w ill necessa rily deliver the needed reforms before crisis st rikes.While crisis itself can breed reform, it does so at a price. 48

2. L i b e r a l i z e F D I a s q u i c k l y a s p o ssi b l e . Foreign direct invest ment is the formof foreign investment tha t most p lausibly comes packaged w ith m an a gerial an d t echnologica lexpertise. It is the form least likely to aggravate weaknesses in the domestic banking systema nd t o be a ssocia ted w ith capita l flight a nd creditor pa nic. This suggests libera lizing inw a rd foreigninvestment a s the first sta ge of f inancial side opening, and l iberalizing inwa rd FD I a s quickly

a s possible. This a dvice w ould seem obvious but for the la rge number of governm ents t ha t h a vefa iled t o heed it . As of 1996, 144 of 184 countries surveyed by the I nt erna tional Moneta ry Fund(IMF ) still ma inta ined controls on FD I. One element of the Korea n crisis wa s th e governments

48 This is a theme elaborated further in Section VII below.


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There is an enormous debate over the effectiveness of these measures (a comprehensivereview of the issues and literatur e is Ula n 2000). Some wa rn t ha t a voidance is a problem. Otherspoint to th e lack of evidence tha t C hiles ta xes limited t he overa ll level of foreign borrow ing. Andstill others observe tha t t he Chileans ha ve themselves abolished the measure, w hich should raisequestions about its efficacy.

The third objection is misplaced in the sense tha t t he Chilean ta x rema ins on the books;all that has been done is to set the tax rate to zero for the time being. The rationale for doingso was tha t capita l inflows were in part icularly short supply following t he Asian a nd Russiancrises; a prudential measure that might have been desirable under other circumstances thenbeca me t oo expensive to operat e in t his period of capita l scar city.

More fundamentally, Chilean-style holding periods taxes can be justified as a form ofprudentia l supervision, where short-term inflow s, beca use they a re vola tile, pose risks to finan cia lstabil i ty.54 Attempting to limit bank borrowing offshore will be futile if domestic nonfinancialcorporat ions a re free to borrow a nd t o pa ss on the proceeds t o the ban ks. Hence the case for a n

across-the-board holding period tax on inflows on prudential grounds. 55 This sh ould be regar dedas a transitional policy to be pursued until more conventional forms of prudential supervisionand regulation have been upgraded, at which point exceptional measures directed toward thecapita l a ccount can come off. Chile itself can be thought of a s ha ving completed this process ofupgrading in the 1980s and 1990s.

The second objectionth a t t here is no evidence of the mea sure redu cing th e level of ca pita linflowsoverlooks the fact that the goal was never to limit the level of borrowing. Rather, thegoal was al ter i ts maturi ty : to l imit short-term inflows as a share of to tal debt and a share ofinternational reserves. And on the maturi ty front the evidence is compell ing (see Gallego,Hern a ndez an d Schmidt -Hebbel 1999; 56 see als o Ta ble 7.) As for t he first objection, it is im porta ntto recall that such a measure, to effectively lengthen the maturity structure of the debt, neednot be evasion-free.

The sa me pointthe desira bility of tra nsparent , comprehensive, mar ket-based t a xes ra thertha n controlsa pplies equa lly to the outflow side. One man ifesta tion of this fa ct is how Ma laysiahas moved from comprehensive outflow controls to an exit tax on foreign capital satisfying aminimum-sta y requirement. 57 But not too much should be expected of outflow controls in timesof crisis, given the strong incentives that then exist for avoidance.

54 This analogy is not without limitations; see Laurens and Cardoso (1998) for the relevant objections.55 Valdes-Prieto and Soto (1998) argue that this invocation of prudential supervision does not justify controls

on nonbanks. But this view overlooks the scope for arbitrage between the bank and nonbank sectors.56 Tha t st udies of other countries t ha t ha ve employed simila r policies reach a na logous conclusions is rea ssuring.

See for example Ca rdena s and B ar rera (1995) on Colombia. More genera lly, Calvo and Reinh ar t (1999) findin a 15 country pan el , including Chile , tha t t he presence of capita l controls is a ssocia ted w ith a lower shareof portfolio plus short-term capital flows as a percentage of total flows. That they do not find the same whenthey look at portfolio flows alone suggests that the impact on short-term flows is doing most of the work.

57 In September of 1998, nonresidents were prohibited f rom repatr ia t ing investments in domestic-currency-denominat ed f inancia l a sse ts for a 12 month per iod. These quant i ta t ive controls w ere replaced by gra duat edexit levies in February 1999.



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Table 7. Capital Flows and Reserves before and after Implementationof Capital Controls

Period a

t - 1 year t t + 1 y ea r t + 2 y e a r

Ca pita l Account B ala nce (percent of GD P )B ra zil (August 1994) 1.7 1.5 4.2 4.3Chile (J une 1991) 9.4 2.8 7.5 6.7Colom bia (S ept ember 1993) 0.4 5.3 4.3 5.1Czech Republic (August 1995) 11.0 15.8 7.3 2.1Ma la ysia (J a nua ry 1994) 16.8 1.8 8.7 9.4

Ma la ysia (S ept em ber 1998) 2.2 -3.5 -3.6b

Short-term F lows (percent of G DP )B ra zil (August 1994) 1.1 -0.8 1.0 1.4Chile (J une 1991) 0.0 -2.6 4.2 0.6Colom bia (S ept ember 1993) 2.1 0.9 2.0 0.8Czech Republic (August 1995) 4.2 1.6 1.2Ma la ysia (J a nua ry 1994) 5.2 -1.1 1.5 3.3Ma la ysia (S ept em ber 1998) 3.4 -7.4 -1.8 b

Change in Reserves (billions of US dollars)B ra zil (August 1994) 8.1 6.5 12.7 8.6Chile (J une 1991) 2.5 1.0 2.1 0.5Colom bia (S ept ember 1993) 1.3 0.2 0.2 0.4Czech Republic (August 1995) 2.4 7.7 -1.5 -2.7Ma la ysia (J a nua ry 1994) 10.0 -1.8 -1.6 3.2Ma la ysia (S ept ember 1998) -6.2 4.8 4.2 c

Ratio of Reserves to Short-term DebtB ra zil (August 1994) 1.0 1.5 1.6 1.4Chile (J une 1991) 1.5 2.2 1.9 1.9Colom bia (S ept ember 1993) 2.4 2.2 1.5 1.4Czech Republic (August 1995) 3.8 3.6 2.6 1.8Ma la ysia (J a nua ry 1994) 3.7 3.9 3.0 2.4Ma la ysia (S ept em ber 1998) 1.4 2.8 3.8 b

a Period t refers to the year in which controls were imposed.b World Bank staff estimate.c As of November 1999.

Sour ce: World B a nk (2000b).


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In pra ctice, the informa tiona l an d contr a ctua l prerequisit es for th e development of deepa nd a ctive stock ma rkets are substa ntia leven more substa ntia l tha n th e prerequisites for t hedevelopment of deep and active bond markets. In the absence of disclosure by firms followingrecognized aud iting a nd a ccounting pra ctices, outsiders w ill be reluctan t t o purcha se their securit iesfor fear of market ma nipulation by insiders; hence, stock ma rket capita lization a nd t urnover w illbe low. In the absence of adequate contract enforcement and equitable bankruptcy procedures,investors will be relucta nt t o invest for fear tha t issuers will wa lk aw a y from their obligat ions.And in the absence of adequate mechanisms for corporate control, investors will be reluctantto purchase minority stakes in publicly traded enterprises for fear of being expropriated by majoritysta keholders. This is wh y significant stock ma rket capita lizat ion a nd tu rnover tend to be observedrelatively late in the process of financial development; it is why historically this was the caseeven in countries l ike the UK a nd U S t ha t now h a ve some of the most a dvanced market-basedfinan cia l systems in th e world. It is wh y ma ny countr ies, a nd developing countries in pa rticular,rely on ba nks for in t ermediat ion services, banks ha ving a compara tive adva nta ge through long-

term relationships with their clients in assembling information and enforcing contracts.Creat ing act ive s tock and bond markets thus requ ires pu t t ing in p lace a regu la to ry

framework mandating the disclosure of accurate and up-to-date financial information, the useof recogn ized aud i t ing and accoun t ing s tandards , penal t ies fo r ins ider t rad ing and marketma nipulat ion, a nd sta tutes protecting th e rights of minority shar eholders. In the U S, putt ingin pla ce these prerequisites for deep and liquid ma rkets t ook several d eca des (B ordo, E ichengreen,a nd Irw in 1999). La te-developing economies in Asia a nd elsew here can telescope th is processby im portin g proven regulat ory t echnologies. 59 St ill, developing deep and a ctive stock a nd bondmarkets is a hard slog. Success will not be achieved overnight.

6. A c c u m u l a t e r e ser v es . The response of ma ny Asian count ries to t he volat ility of1997-1998 ha s been to a ccumula te a cushion of int erna tiona l reserves. The stra tegy ha s met w ithsupport from a cademics an d officials. Feldstein (1999) has encouraged emerging m a rkets t oa ccumula te reserves a s insura nce a gainst the disruptive domestic fina ncial effects of abrupt ca pitaloutflows . G uidotti (1999) a nd G reenspan (1999) ha ve similar ly suggest ed tha t countries hold foreignexcha nge reserves equa l to all t he short-term debt scheduled to fall due over t he next 12 month s.They point t o th e success of count ries w ith s ubst a nt ia l reserves (Ta ipei,Chin a for exa mple) inwit hsta nding t he Asian crisis. A recent I MF st udy (Bussiere and Mulder 1999) suggests tha tcountries may want to hold even larger reserves, perhaps as much as twice those suggested bythe G uidott i-G reenspa n rule, and tha t countr ies tha t run chronic current a ccount deficits shouldhold still larger r eserves, as should countries seeking to limit excha nge ra te va ria bility (on this,

see Section VI below).

59 They can also follow the exa mple of US compa nies prior to t he emergence of deep and liquid domestic securit iesma rkets (US ra ilwa ys, the lar ge corpora tions of their t ime, issued bonds a nd debentures in London a s a w ay ofcircumventing the underdevelopment of American financial markets). But this will not solve the currency-of-denominat ion issue; i t will not creat e an investor ba se with an appetite for domestic-currency-denominat ed issues.


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There ar e reasons to quest ion t his a dvice. First , even la rge reserves a la Ta ipei,Chinaare small relative to the liquidity of the markets. A confidence crisis can cause investors to tryto tra nsfer a broad not only short-term foreign liabilities but the w hole of M2. Converting t heseclaims in to foreign currency is likely to be impossibly expensive for a government or centra l ba nkseeking t o support a currency peg.

Moreover, lar ge reserves ca n provide dangerous encoura gement t o the carr y t ra de (Dooley1998). Normally, interest rates are lower in the major money centers than in an emerging markettha t ha s recently sta bilized and opened its ca pita l account , encouraging foreign investors to funnelmoney into th e country. The la rger t he reserves, the more confident will investors be th a t t heyw ill be able to get out w ithout suffering losses when sentiment t urns sour an d the ba nking syst emcomes under pressure. H ence, the grea ter w ill be bank-to-ban k lending, a nd t he higher w ill bethe costs of a banking crisis.

Moreover, holding r eserves a ga inst short-term external liabilities is expensive, since U Strea sury bonds bear low er interest ra tes th a n K orean or Tha i ba nk deposits. As G renville (1999,

6) ha s put it, G reenspans a dvice ra ises the issue of w hy t his short-term debt w a s useful in thefirst place, if the proceeds of the short-term borrowing have to be stacked away in reserves (ata lower ra te of return tha n th e cost of borrowing). The implicat ion is stra ightforw a rd: If short-term foreign borrowing comes wit h risks th a t a re expensive to insure aga inst, w ouldnt it be bett erto avoid it in the first place?

Clea rly, count ries seeking protection from volat ility should a ccumula te a cushion of reserves.But more is not always better. Even sound advice can be taken too far.

7. A r r a n g e c om m er c i a l c r e d i t s . The other approach to ensuring the availabilityof adequate liquidity in an emergency is to negotiate commercial credit lines in advance. Fromthe st a ndpoint of the borrowing count ries, these lines would provide add itional r esources to insurea ga inst sh ocks to investor confidence. If foreign investors refuse to renew their ma tur ing loans,the authorit ies can draw on their credit l ines to f inance the lender-of-last-resort operationsappropriate for dealing with a liquidity crisis.

Argentina, Indonesia, a nd Mexico negotiat ed facil i t ies with in ternat iona l banks t ha t , inreturn for a commitm ent fee, allowed th em to dra w ha rd-currency credits. These facilities ty pica llyomit the no-adverse-material-change clause that permits banks to back out of an agreement inthe event of a crisis. Argentinas agreement with 13 commercial banks, finalized in December1996, provided for a $6.1 billion contingent credit line to be accessed through a repurchase facility(dra w ings on which a re collat eralized by t he deposit of an equiva lent a mount of peso-denominat edgovernm ent bonds). It ha s been rolled over once, with a n increase in the commit ment fee from

approximately 30 to 60 basis points. The $2.5 billion Mexican facility, in contrast, was a purecredit line. Mexico drew its lines in S eptember 1998 despite compla ints by t he ba nkers, w ho objectedtha t t here wa s no emergency justifying the action at the t ime; part ly a s a consequence of th isdispute, the Mexican facil i ty was not renewed. Indonesia made two drawings on i ts stand-byfacilities, totaling $1.5 billion, most recently in April 1998.



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Tha t t hese credits a re a form of insura nce aga in ra ises the issue of how a dverse selectionis overcome. Argentina , In donesia , a nd Mexicos success in purchasing this insura nce suggeststhat the problem of asymmetric information that might o therwise cause the market to breakdown can be overcome at least partially by the posting of collateral (as in the Argentine case,wh ere the value of tha t collat eral is enha nced by t he countrys currency-board la w ) a nd by otherpolicies tha t help to signa l credit w orthiness. Tha t t hese countries succeeded in negotia ting t hesea rra ngements suggests tha t a t least some other countries show ing evidence of institut iona l reformand a record of strong policies could do likewise. But given that other countries lacking thesea dvant ages w ill not be able to signa l their credit q uality so easily, this option ma y not be a vailableto al l .

Insurance unavoidably creates the danger of moral hazard, so those who advocate theuse of such lines need to w orry a bout the incentive effects. These ar ra ngements a re essentia llyunconditional; in contr a st t o IMF loans, a ccess is not contingent on the countr y a greeing t o specifica djustment m easur es. Consequently, access to a dditiona l funds ma y encoura ge some governments

to engage in addit ional r isk-ta king and put off a djustment. The penalty ra te they pay to draw these lines may be some deterrent, but t here remains t he question of wh ether it is enough. Thestrong steps Argentina and now Mexico are taking to strengthen their institutions and policiesprovide some reassurance that they will not succumb to these temptations. But it is not clearthat the same will necessarily be true of other countries.

A further w eakness of these arra ngements is t ha t t he banks w ill be able to hedge theirexposures. At the sa me t ime th ey provide addit ional credits, t hey can dra w down t heir otherexposure to the country or sell short government bills and bonds. The sell-off in the Mexicanbond m ar ket tha t occurred w hen tha t country s government drew it s l ines in the fa l l of 1998ma y ha ve been a n insta nce of th is effect. Ta ken to an extreme, this dy na mic-hedging argum entsuggests the countr y w ill have no ad ditional fina ncial resources for propping up its ban king systemand coping with the other consequences of a crisis. The less extreme version is that countriesrelying on this technique may have less insurance than meets the eye.

Thus, while commercial credits lines are not a bad idea, they are likely to be availableonly to countries with relatively strong policies, and the amount of money they actually makeavailable may be less than i t appears.

8. S t r en g t h en m o n et a r y a n d f i sc a l i n st i t u t i o n s . Limiting volat ility in a financiallyglobalized world req uires building credible policy-ma king inst itut ions. The grea ter t he credibilityof the individua ls an d instit utions responsible for moneta ry policy, the lesser the da nger tha t ashock will incite an investor panic and a self-fulfilling crisis. On the contrary, if policymakers

ha ve accumulat ed sufficient credibility, the ma rkets w ill do much of th e sta bilizing w ork for th em.If inflation accelerates, for example, pushing up interest rates and depressing the prices of short-term interest-bearing assets, investors anticipating that the acceleration of inflat ion is onlytemporary will buy into temporarily depressed fixed-income markets, stabilizing asset prices andinterest r a tes. If t he currency depreciat es, investors w ill similarly purchase domestic-currency-


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denominated assets at their temporarily depressed prices, providing capital inflows that workto strengthen the excha nge rat e.

Sim ilar ly, th e more credible is fisca l policy, th e great er w ill be the capa city to pursue count er-cyclica lly sta bilizing budgeta ry policies. If the fiscal a uth orities are commit ted to running bud getsthat are balanced over the cycle, they will be able borrow and run deficits in recessions. If, onthe other h a nd, policyma kers intentions a re suspect, t hey w ill ha ve to cut spending a nd/or ra isetaxes in recessions, rendering fiscal policy procyclical and aggravating rather than limiting volatility.

One solution is to delegate responsibility for policy to an individual or individuals witha reputa tion for va luing the a ppropriat e objectives. The utility of this a pproa ch is questionable,however, so long a s the policyma kers in question ca n be ar bitra rily dismissed (Dra zen and Mas son1994). The a lterna tive is t o design policy-ma king instit utions so tha t the individua ls in q uestionha ve an incentive to pursue part icular objectives and the capa city to do so. Har d a nd fa st rulesa currency board arrangement for monetary policy (as described in Section VI) and a balancedbudget rule for fiscal policyare the obvious way of doing so, but these lack the flexibility desirable

for coping w ith a vola tile environment. A more flexible approa ch is t o give the policy a uth oritiesa ma nda te a nd th e independence to pursue it. For moneta ry policy this is the w ell-known formulaof independence for the central bank and a mandate to pursue price stability. For fiscal policythere is an a na logous a rgument for crea ting a n independent fiscal a uthority responsible for settinga ceiling for the budget deficit and a set of rules for cutting expenditure in the event that thefiscal authorities overrun it (Eichengreen, Hausmann, and von Hagen 1999).

This is only one of a variety of possible formulas for enhancing the credibility of policy-ma king insti t u tions. There ar e a number of o ther a pproa ches t o developing moneta ry policycredibil i ty. Inflat ion t ar geting, a regime in which the centra l bank is g iven a ma nda te to pursuean explicit target for inflation, is an increasingly popular approach in many parts of the world.With inflation targeting, the central bank shares with the public its forecasts and its model ofthe l inks from monetar y policy t o inflat ion, a nd is held a ccounta ble for missing th a t t ar getThe adva nta ges of infla t ion ta rgeting are greater f lexibil i ty tha n a r ig id monetary rule but w iththe sa me sta bilizing impact on ma rket expecta tions. I ts principal l imita t ion is th at i t can crea tepolicy credibility only when the central bank has the independence required to pursue it. Notonly must the central bank enjoy statutory independence, but there must be political supportfor its in dependent st a tus, in order to limit t he prospect t ha t it s a utonomy w ill be compromisedif it pursues policies tha t a re not congenial t o the government. Moreover, its ma nda te to pursuelow inflation must be supported by a broadly compatible economic policy stance by the government.In particular if the fiscal authorities are prone to chronic deficits, monetary policy may have toused to fill th e fisca l ga p (th e fisca l domina nce problem), in w hich case t he sta ted objective of

pursuing policies of low inflation will lack credibility.In the case of fiscal policy, alternatives to rigid rules include delegating more agenda-

setting and veto power to a single agent (typically, the finance minister or the prime minister)w ho possesses more of an incentive to interna lize the externa lities ass ociat ed wit h excessive deficits,a nd a dopting more centra lized and hierarchical budgeta ry procedures (von H a gen and Ha rden1994, Alesina and Perotti 1994).



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St ill oth er mean s of building credibility a re conceiva ble. But , wh a tever th e solution, policycredibility is essential in a world of globalized markets.

VI. Managing Exchange Rates

One of the most d ifficult challenges posed by globa lizat ion, r ecent experience suggests,i s how to ma nage th e nat iona l cu rrency in a f inancia l ly in ternat ional ized w orld . Because i tencapsulates many of the most difficult issues posed by financial globalization, this case studyis worth considering separ at ely a nd in deta il . 60

A. The Vanishing Middle Ground

If there is anything approaching a consensus, it is that intermediate arrangementssoft

pegs, pegged-but-a djusta ble rat es, cra wling ban ds, a nd t he likea re problemat ic in a globa lizedworld.61 The presence of large and liquid international capital markets makes it more difficultfor th e aut horities to support a sha ky currency peg, since the resources of the ma rkets fa r outstr ipthe reserves of even the best armed central banks and governments. Effective defense of theexchange ra te requires raising interest ra tes an d restricting domestic credit, something tha t w illhave significant costs unless the economy is strong. 62 If t hey detect a chink in t he country s a rmorbe it high unemployment, a heavy loa d of short-term debt, or a wea k ba nking systemtha t couldrender the a uth orities relucta nt t o ra ise interest ra tes in order to defend the currency, then themarkets will pounce, exposing the authorities weakness.

Thus, a funda menta l implication of democra tiza tion is tha t few governments can crediblya tt a ch priority to defending a curr ency peg a bove a ll oth er goals of policy. Consider a governm entjust willing to bear the pain of high interest rates and other policies of austerity in return forenha ncing its reputa tion for follow ing policies of excha nge ra te a nd price sta bility, wh ose benefitsaccrue later. If the markets attack the currency, forcing the government to raise interest ratesto defend it, the game may no longer be worth the candle. With the costs of austerity nowinthe form of higher unemployment , more fina ncial a nd commercial fa ilures, and a wea ker economy

60 The focus of this section is on country policies chosen unilat erally at the n at ional level. Collective options ra ngingfrom common basket pegs to monetary union are considered separately in the next section.

61 This point w a s first a rgued in Eichengr een (1994). The syn thesis h ere dra ws on Eichengr een (2000b).62 In technical terms, the ava ilabil ity of reserves a l lows th e aut hor i t ies to enga ge in ster i l ized intervention, in

wh ich they a ttempt t o support th e exchange rat e by selling foreign exchange wit hout at t he same time alt eringthe domestic money supply. But wh en speculat ive sales of the currency are lar ge relative to reserves, this str at egywill not rema in feasible. A credible defense will th en require th e aut horities to buy the domestic currency th atma rket part icipants sell, reducing the supply of domestic credit, raising interest ra tes, and tightening th e screwson weak banks a nd corpora te s . Dominguez and Fra nke l (1993) make the s ta nda rd a na lys is o f s te r i l izedintervention, which suggests that i t can be effective in the shor t run as a way of s ignaling the author i t iesintent ions, but only if it is backed up subsequent ly by unst erilized intervention (changes in t he money supply)tha t indicate their w il l ingness to put t heir money w here their mouths are .


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generallyhaving risen relative to the benefits accruing down the road, authorities may now op t t o let the currency peg col lapse . And t he ma rkets , knowing tha t the a u thor i t ies a t ta chimporta nce to other a spects of economic performa nce in ad dition to exchange ra te st a bility, ha vea n incentive t o force the issue. 63

P rior to democra tiza tion, governm ents enjoyed insula tion from pressure to use their policyinstrum ents t o minimize unemployment a nd foster economic grow th. They could credibly a tt a chpriority to the ma intena nce of excha nge ra te sta bility over an d a bove all other economic policygoals. In our modern world this is no longer the case. In t his sense, the cha nges crea ting grea terexcha nge ra te flexibility a re not just fina ncial a nd t echnological but a lso political. They rendercurrency pegs increasingly fragile, since they rob governments of the capacity to defend them,and at the same t ime give the markets more ammunition with which to at tack them.

Maintaining an exchange rate peg or band in the face of open capital markets can beespecially difficult for emerging ma rket economies. Many emerging ma rkets depend on exportsof a few prima ry commodities, rendering th em vulnera ble to terms-of-tra de shocks. Their fina ncial

systems are small relat ive to world markets and even the assets of a handful of hedge fundsand investment banks. Their fragile banking systems are incapable of withstanding sharp hikesin interest rates. Their political systems are incapable of delivering a broad-based, stable consensusin favor of exchange rate stabilization over and above all other economic and social goals.

Moreover, w hile the devalua tion of a previously pegged currency can enha nce internat iona lcompetitiveness and even stimulate growth (or so the cases of the UK and Italy in 1992-1993suggest; see Gordon 1999), the Mexica n a nd Asia n crises suggest t ha t currency deva lua tions indeveloping count ries can be st rongly cont ra ctionar y. B eca use developing count ries borrow in foreigncurrency, depreciat ion increa ses the bur den of debt service a nd w orsens t he fina ncial conditionof domestic ba nks a nd firms. B eca use those banks a nd firms d o not hedge th eir foreign exposures,they get smashed when the currency band collapses.

This a na lysis begs tw o questions: Why dont ba nks a nd firms hedge if doing so is in theirinterest, a nd w hy dont the a uthorities a ba ndon the peg before being forced to do so in a crisis?Ta king th e second question first, th ere is alw a ys a n incentive to lea ve the exit problem for a notherda y. I f the government ha s bu i lt i t s en t i re moneta ry pol icy opera t ing s t ra tegy ar ound thema intena nce of the ba nd, a ba ndoning it ca n be a sha rp shock to confidence. To keep the excha ngera te within i ts band, th e authorit ies ha ve to reiterat e that th is is their in tention. Exit ing meansgoing back on that promise. If monetary credibility is anchored by the peg, then credibility islost w hen the peg is aba ndoned. It is not possible (in th e presence of open capita l ma rkets, a nyw a y)to pre-a nnounce tha t t he peg will be aba ndoned tomorrow, or currency tra ders will sta rt bett ingagainst i t today.

63 This is a simple illustra tion of how problems of multiple equilibria ca n a rise in foreign exchange ma rkets. Notetha t if the ma rkets a tt ack, the currency peg collapses, but if they d o not it can persist indefinitely. Thus, thereare two equilibria, one in which the peg collapses and one in which it does not.

Section VIManaging Exchange Rates


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This is why few banks and firms hedge their exposures when the authorities operate aband or peg. For that arrangement to be credible, the authorities have to commit to preventingthe exchange rate from moving beyond certain limits. If they do not assert their willingness todo so, the excha nge ra te w ill not behave a s desired. To defend the peg, the governm ent is inevita blyforced to insist tha t t here is a bsolutely no prospect t ha t it w ill cha nge. How ma ny chief financialofficers will then be rewa rded for purchasin g costly exchange ra te insura nce before the fa ct? Apegged ra te t hus provides a n irr esistible incentive for t he privat e sector to a ccumula te unh edgedforeign debts. And un hedged foreign debts imply a crisis if the ba nd or peg collapses.

Indonesia illustrates the consequences. 64 For some time prior to the outbrea k of th e Asia ncrisis, the countr y ha d been opera ting a craw ling band a llowing for fluctua tions of plus or minus4 percent against a basket of currencies. As is typical of many emerging economies, it had relativelyhigh interest ra tes, which ma de it at tra ctive for interna tional investors to place their money there.These la rge ca pital inflows worked to push t he rupiah t owar d t he strong end of its ba nd. B eca usethe a uthorities were commit ted to limiting exchange ra te fluctua tions (a nd beca use the strength

of the currency lent credibility t o tha t commitm ent), domestic ba nks a nd (especia lly) corporat ionsa ccumula ted u nhedged foreign exposures.

When Tha ilan d devalued t he bah t, capita l flows reversed direction. On August 13th t herupiah went from the strong edge of the band (which had been widened to six percent) to thew eak edge in one da y. This 12 percent deprecia tion w a s a sha rp shock to Indonesian corporat ionswit h un hedged exposures, whose solvency w a s cast into doubt. Now openly questioning the st abilityof the economy, investors scram bled out of th e curr ency. Fur th er interest ra te increa ses to defendit w ere out of the question, given th e financial dist ress in the corpora te sector a nd ba nking syst em.Instea d, the a uthorit ies a bandoned the band, a l lowing t he excha nge rat e to drop further. G iventh e dam a ge alrea dy done to the economy, it dropped like a st one, fa lling by a s much a s 10 percenta da y. This is a st ylized version of Indonesian h istory, but it m a kes an essentia l point a bout t hefragility of currency bands and the high costs of their collapse.

At the theoretical level, the question is why the prerequisites for the smooth operationof f loat ing ra tes and r ig id pegs are no t a lso the p rerequ is i tes fo r the smooth operat ion o fintermedia te regimes. For a float ing excha nge ra te to be well-behaved, i.e., for it to display limit edvolat i l i ty a nd to provide a fra mew ork conducive to economic grow th , f iscal policy must bestrengthened, debt m an agement a nd prudential regulation must be upgra ded, and a coherentand credible monetary policy operating rule must be installed. In the absence of these prerequisites,the floating r a te is likely to fluctua te erra tically. Simila rly, for a currency board or dolla riza tionto be conducive to stability a nd growt h, fiscal policy mu st be str engthened, financial policy mustbe upgraded, and a coherent and credible monetary policy rule must be adopted (this time by

pegging to or a dopting t he currency of a count ry t ha t itself follow s a sound a nd sta ble moneta rypolicy). Otherwise the rigid peg will only bequeath unemployment and inflation, undermining

64 This exam ple is apposite because Williamson (1996) cites it a s a n exam ple of the benefits of ha ving a craw lingband. F

Capitalizing on Globalization

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