Stop Devaluation
"... If you try to cure a hunchback with a hammer, you cure the hunchback but kill the man."- Korean proverb
The Asian currency crisis has entered its seventh month amid new speculations that the currency meltdown will worsen in the coming weeks. The United States and its economic allies as well as the donor agencies, specially IMF, have come up with standard bailout packages calling for expelling crony capitalism, rescheduling loans, reducing trade barriers, and privatising state companies. IMF's prescription for the troubled economies in the region also include banking reforms, increased transparency in government policy-making and implementation, and market liberalisation.
The crisis in individual countries and IMF's response has now become routine. As an economy starts to plunge, IMF introduces as bailout package. But the local currency - whether it is baht, won, or rupiah - continues its free fall triggering further IMF bailouts. The declining currency reduces wages and global buying power of the country's citizens, lowers the income of the exporting industries facing inelastic demand while raising the liability to foreign banks.
Some of the IMF policy prescriptions are, of course, necessary. However, the immediate concern should be to stabilise the exchange rate. The financial crisis has devalued many of the region's currencies by more than fifty per cent although the price level in these countries haven't yet increased by that proportion. For instance, the price of the US dollar in Indonesia is up by more than 200 per cent. The monthly inflation rate in only December measured 3 per cent triggering a buying spree among consumers. If the Indonesian rupiah stays at current levels, the economy will register a 200 per cent inflation rate over the next two years.
Given the potential catastrophe awaiting these countries, they should use whatever resources are available to stop devaluation of individual currencies, such as, baht, rupiah, or won. This can be achieved by restricting the supply of money in response to currency weakness. In other words, reduce the supply of money to match its shrinking demand. IMF's bailout package has avoided this simple route and instead prescribed sterilised currency inflows and outflows.
The case of Indonesia stands out in this regard. In September, as Indonesia switched from its fixed to the flexible exchange rate system, the demand for rupiah declined overnight by about 50 per cent. Yet IMF guidelines called for a gradual increase in money supply which led to additional capital flight out of the rupiah, and thus further devaluation.
Two recent examples can be given in support of my argument that devaluation is harmful for the Asian countries. During the 1994 Latin American currency crisis, Mexico and Argentina went the two different directions. Maxico devalued its currency by more than 50 per cent and received a financial bailout from the international community. Argentina, on the other hand, withstood the attack on its currency using international aid to stop runs on its banks.
Events since the crisis show the varying effects of their policies. Argentina's GDP has grown by about 15 per cent since 1994; while Mexico's 1997 GDP is still below its 1994 level in real terms. The Mexican peso has devalued by more than 120 per cent against the US dollar since 1994 while its price index over the same period rose by 122 per cent. The increase in price level in Argentina, on the other hand, has been much more modest.
The success of the Argentina-approach can be attributed to its decision, in 1991, to set up a currency board, to end years of spiral inflation. The currency board gives its monetary authority a tool not enjoyed by any other central bank - an automatic and theoretically unassailable mechanism for keeping exchange rate stability - no matter how high interest rates must go. Instead of playing with the exchange rate, the government pegs its money to some other currency, e.g., US dollar. The local currency is fully convertible and its supply is backed by dollar reserve. Under this system, attempt to redeem local currency for dollar leads to an automatic decline in the supply of local currency thus providing a clear signal to the market.
The second example brings us close to home. The recent performance of Hong Kong compared to the other affected countries in the region - Indonesia, Korea, and Thailand. Despite the wave of currency devaluation that has swept through these three countries, only the Hong Kong dollar has clung on to its peg to the US dollar. This may be attributed to the presence of a currency board in Hong Kong, while the other three countries decided to float their currency. The currency board helped Hong Kong defend its currency while most around it fell.
For the other Asian countries nervously sitting on the sidelines, the Argentina and Hong Kong-approach will provide a superior tool in facing any speculative currency attack. These countries should either set up a currency board or simply let their central bank select an exchange rate and defend it. This would be a simple policy of changing domestic money supply in order to match the demand for money and to keep constant the country's foreign exchange rate.
This method will, of course, lead to some short-term costs - higher internal interest rate, slower economic growth, and higher bank failures. But these costs are in all likelihood lower than if a devaluation inflation takes hold.
The IMF insists that its bailout package are well-designed and constructive. However, they violate one of the fundamental economic principles by ignoring the direct causal connection between devaluation and inflation.
The author is a Professor of Economics at Marquette University, Wisconsin, USA.
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