McKinnon says long-term peg could help reduce incidence of crises for emerging markets

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McKinnon: Banks may discount the risk of unfavorable outcomes and be more willing to borrow, secure in the knowledge that official bailout provisions will keep their depositors from deserting the ship.

Does a country’s exchange rate regime affect moral hazard in capital markets or address the problem of international overborrowing? Is there merit in resurrecting the de facto “East Asian dollar standard” that operated for more than a decade before the crises of 1997–98? Ronald I. McKinnon of Stanford University addressed these issues at an IMF Institute seminar on August 14.

Overborrowing syndrome

The financial crises suffered by emerging markets in the 1990s, beginning with Mexico in 1994, were often precipitated by large capital inflows to finance ambitious stabilization and reform programs. Financial liberalization, which was in many cases a part of these programs, had enabled domestic banks to borrow heavily in international capital markets and had resulted in massive, often excessive, inflows of foreign capital. This phenomenon, which McKinnon called “the overborrowing syndrome,” became a source of macroeconomic imbalances that ultimately proved unsustainable. In McKinnon’s view, overborrowing is a moral hazard issue rather than, for example, a matter of “getting the exchange rate right.”

Because of their systemic importance to the domestic economy, banks expect to be bailed out when they run into trouble. Near certainty of official bailout further increases the magnitude of overborrowing and leaves the economy more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack.

Modeling the overborrowing syndrome, McKinnon posited the hypothetical situation of a small open economy whose banks enjoy a government guarantee. The government embarks on a credible program of economic reform designed to eliminate distortions and make the economy more productive—for example, by lifting restrictions on foreign and domestic trade. To achieve this, a certain level of investment in the new technology is needed. However, the magnitude of the productivity rise depends on the overall macroeconomic success of the reform program.

In assessing investment risks in the reforming economy, banks may discount the risk of unfavorable outcomes and be more willing to borrow, secure in the knowledge that official bailout provisions will keep their depositors from deserting the ship. Because of the...