World economy in transition

• Author: Imf staff
• Pages: 46-48

To counter the speculative attacks on their currencies in late 1997 and early 1998, a number of Asian countries have tightened monetary policy. Although this approach has been questioned by some, experience shows that a period of tight money may be needed to restore exchange rate stability if policymakers fail to act early and forcefully.

Page 46

DURING the second half of 1997 and in early 1998, a series of speculative attacks caused several Asian currencies-notably, the Thai baht, Malaysian ringgit, Indonesian rupiah, and Korean won-to depreciate sharply. Although these currencies may have been overvalued before the attacks, their depreciation was far greater than any "correction" that might have been necessary to restore the export competitiveness of the countries in question. What explains the acuteness and persistence of the crisis?

One key explanation is that policymakers failed to address problems in advance of the crisis and did not act forcefully enough when the crisis erupted. Their reluctance either to tighten monetary policy to bolster exchange rates or to keep it sufficiently tight more than temporarily was a particularly important factor contributing to the erosion of investor confidence in the region. The crisis became self-perpetuating.

It is true that, in the short term, tightening monetary policy may exacerbate the difficulties of economies with weak financial systems. But experience has shown that, during a crisis of confidence, the alternative is likely to be worse. An easy monetary policy, by allowing the domestic currency to continue depreciating, undermines confidence and threatens rapid inflation. For countries with substantial debts in foreign currencies, like some of the Asian economies, a steep currency depreciation may undermine the solvency of domestic firms and financial institutions as much as-or even more than-temporary increases in interest rates. And if confidence in a currency continues to erode, a larger and more prolonged increase in interest rates may be required to stabilize the situation than would normally be necessary in the early stages of a crisis.

As the Mexican crisis of 1994-95 and recent experiences in Brazil, the Czech Republic, Hong Kong Special Administrative Region, and Russia have shown, once confidence in a currency has been compromised, a period of sufficiently tight money is necessary, whether to defend a currency peg or to stabilize a flexible exchange rate. How tight varies from...