Economists have long debated the issue of whether the international monetary system would be more or less stable under a system of flexible or fixed exchange rates. Ever since the breakdown of the Bretton Woods system in 1971, individual countries have weighed the pros and cons of these systems, or hybrids of them, to determine which best suits their own particular circumstances. In this paper we direct our attention to the rapidly-growing emerging nations in Southeast Asia, namely, Thailand, Singapore, Indonesia, Malaysia, and Hong Kong, and describe their recent experiences with different exchange rate regimes. The development of the "southeast Asia currency crisis", which began in June 1997 and which involved all of these countries, provides a convenient backdrop to examine the economic outcomes resulting from the adoption of different exchange rate policies.(The paper focuses mainly on the experience in Thailand, but the economic conditions contributing to the crisis were very similar in the other countries).

One of the traits shared by many emerging economies is the co-existence of trade deficits and investment capital inflows. These trade deficits and capital inflows are beneficial to developing economies because they supplement their own scarce capital by providing capital good inputs and financial investment, including infrastructure investment. In order to encourage these vital trade and capital flows, a fixed exchange rate regime would appear to be preferable to a floating rate regime since the former removes the "currency risk" as a factor which might inhibit these flows.

In the last decade, capital flows from the developed, industrialized world have increasingly been re-directed to emerging economies, especially those in Southeast Asia. With the growing globalization of financial markets, international investors and financial institutions have taken their business to countries with less stringent financial supervision and regulation. Singapore and Hong Kong, for example, have become the world's fourth and fifth largest foreign exchange trading centers (IMF Research Department Staff, December 1996, p. 26). These redirected capital flows have changed the nature of the international financial system and have raised a host of questions about the nature of speculative currency attacks, appropriate defensive policies against those attacks, and the degree of exchange rate flexibility that is appropriate in the evolving international financial environment (IMF Research Department Staff, December 1977, p. 8).

A strategy followed by the Southeast Asian countries to attract international capital has been the adoption of a fixed exchange rate regime that would reduce the "currency risk" factor for international investors. A problem not anticipated by these countries, however, was the emergence of "speculative" capital flows, the intent of which was to launch an attack on the currency with the purpose of causing its devaluation. Such destabilizing capital flows test the commitment and the ability of a country to maintain its fixed exchange rate. Whereas 15 or 20 years ago international capital flows mainly financed private and public investment which contributed to the real growth rates and the transfer of technology to emerging economies (foreign direct investment), increasingly capital inflows to emerging economies have been of the short term "speculative" variety (portfolio investment) (See Bergsman and Shen, December 1995, p. 7, to contrast the phenomenal growth of portfolio investment with that of foreign direct investment). According to The Economist (September 27, 1997, p.87), the IMF estimates that private hedge funds can mobilize between $600 billion and $1 trillion to use in betting against currencies and other assets. Since under a fixed exchange rate system the central banks of these emerging economies are required to defend their currencies by drawing down their international reserves, two questions arise for policy-makers when confronted by a speculative "run" on the currency: 1) Are the central bank's reserves adequate to meet the speculative demand for reserves? 2) is the government willing to withstand the political and social pressure of a prolonged contraction with the accompanying bankruptcies, unemployment, high interest rates, etc.?

This paper takes the case of Thailand (as a representative country of the Southeast Asian emerging nations) and shows how its adherence to a fixed rate regime in the 1990's attracted foreign capital and resulted in rapid rates of economic growth and improved living standards. These "good times", however, caused fundamental imbalances in the economy to develop which in turn led to speculative attacks on the currency and the abandonment of the fixed rate policy. These large capital inflows were accompanied by substantial increases in the domestic money supply (required under the fixed exchange rate policy) and helped to inflate stock market and real property values to unsustainable high levels, while at the same time financing an economic growth rate which could not be maintained for long (See Krugman, September, 1997, p. 12). In all cases but one, Hong Kong, the Southeast Asian countries chose to devalue their currencies rather than face the tough medicine of contraction required under a system of fixed exchange rates ( See The Economist, October 18, 1997 for the impact of the currency crisis on the GDP of these countries).

In the next section of the paper we will describe briefly the pros and cons of fixed versus flexible exchange rate policies and follow this with the introduction of a simple economic model which we use to analyze the currency crisis in Thailand. We have used this model at both the undergraduate and graduate levels to describe the economic events in both the Southeast Asian currency crisis of 1997 and the Mexican currency crisis of 1994. In the last section of the paper we draw some conclusions about the viability of different exchange rate mechanisms for emerging economies in today's world of massive capital flows.

Under a system of fluctuating or flexible exchange rates any changes in either the demand or supply of a currency will cause a change in its value. A change in the value of a currency causes a country's exports and imports to become more or less expensive bringing about changes in exports and imports, resulting in changes in the size of the current-account and capital-account deficit or surplus. One major advantage of freely fluctuating exchange rates is that, except for temporary deficits or surpluses in response to changes in demand and supply, there will always be an overall balance of payments. The government is free to use stabilization policy to meet the country's domestic economic goals without worrying about the impact of these policies on the exchange rate and the trade balance.

The major disadvantage of fluctuating exchange rates lies in the uncertainty that they interject into international trade and finance. Suppose an importer contracts with a dealer in a foreign country for the delivery of a product at some future date. If between the date of contract and the date of delivery and payment the exchange rate fluctuates, then that importer might find herself paying a much higher price than she anticipated. What she thought was a profitable deal might result in losses instead. Consequently, fluctuating exchange rates add an element of risk to international trade and, therefore, might result in diminished trade. Similarly, if one invests in a foreign country, she does it with the expectation of a profit on her investment, albeit not a certain one. If after one makes an investment in a foreign country, the exchange rate fluctuates, then what might have otherwise been a profitable investment might turn into an unprofitable one. Fluctuating exchange rates add an additional element of risk to international investment and, therefore, can lead to diminished investment.

These negative effects on international trade and investment can tempt nations desiring increased foreign investment and rapid growth to opt for a fixed exchange rate regime. This is often especially true of small countries. Large countries are more independent and do not feel the need to subject their economies to the domestic constraints necessary to maintain fixed exchange rates. Further, the more open an economy happens to be (that is, the larger the degree to which a country depends on

foreign trade), the more likely it is to select a fixed exchange rate system (see Melvin, 1997, pp. 56-59). This is because the more open an economy is, the greater the proportion of its domestic spending that will be on imported goods. The greater a country's spending on imported goods, the greater will be the effect of an exchange rate fluctuation on the domestic price level. One would expect, then, to find relatively small, open economies (like many of the Southeast Asian economies) to be prime candidates for fixed exchange rates.

While the great virtue of fixed exchange rate systems is that they reduce exchange rate risk, as mentioned above, and therefore promote international trade and investment, they are not without problems (Obstfeld and Rogoff, Fall 1995, pp. 77-81). The major disadvantage of fixed exchange rate systems is that domestic monetary policy is held hostage to international events. If changing market conditions threaten to drive the value of a currency up, then the central bank must prevent the rise in value through actions that increase the domestic money supply. This, of course, has a stimulating effect on the economy putting upward pressure on GDP, employment and prices. This might not be what the economy's current condition calls for and might be counterproductive. Similarly, if market conditions threaten to drive the currency below the pegged value, then the central bank must prevent the decrease by taking actions that cause the money supply to decrease, putting downward pressure on GDP, employment and prices. Again, the economy's current condition might not warrant such action and the results could be damaging

Strict adherence to a fixed exchange rate regime, where a country gives up domestic autonomy over its money supply, constitutes a currency board (See The Economist, November 1, 1997, for a description of the role of currency boards). It was this type of system that the Southeast Asian nations adopted and were subsequently forced to abandon. To maintain the integrity of the currency board system, the country's central bank must be willing to impose severe economic hardship on its citizens when its currency comes under speculative attack (See The Economist, November 15, 1997 for an analysis of the role of the banking system in the Southeast Asian debacle). In the next section we introduce the economic model which we have used to show the relationship between trade deficits and capital flows and their impacts on exchange rates under flexible and fixed exchange rate regimes

In order to facilitate a discussion of the Thai currency crisis, it is useful to develop a simple model of exchange rate determination. Suppose for now that there are just two motives for desiring the currency of another country. That is, one might want to obtain the currency of another country for purposes of buying goods and services from that country (currency flows deriving from this motive are part of the current account) or one might desire foreign currency for purposes of making direct or financial investments in foreign countries (currency flows resulting from this motive are part of the capital account). We ignore for now the motives of currency speculators seeking profits on exchange rate fluctuations and those of government officials seeking to stabilize their currencies.

In Figure 1 ( see following graph ) let D_T be the demand for the Thai baht by those residing in other countries that desire to buy goods and services produced in Thailand and let S_T be the supply of baht to the currency markets by Thai residents desiring to buy goods and services produced in other countries. Thai citizens supply these baht in order to purchase foreign currencies in order to buy foreign products. If trade were the only motive for desiring currency from another country then the value of the baht would be P₁ and the quantity of baht demanded and supplied would be Q₁.

Foreigners would be buying Q₁ baht worth of Thai products, say, each week (Thai exports) and Thai residents would be buying Q₁ baht worth of foreign products each week (Thai imports) and there would be an exact balance in the current account.

When the baht desired by foreigners for purposes of investment are added to the baht they desire for trade, then the total demand for baht (ignoring speculative and government motives) is D_T+C. If the supply of baht by Thai residents for purposes of obtaining foreign currencies for foreign investment is added to the supply of baht for trade, then the total supply of baht is S_T+C. The value of the baht will now be P₂ and the total quantity demand and supplied will be Q₂. There is an overall balance of payments. However, there is no longer a current-account balance since exports, shown on D_T, are now Q₃ and imports, shown on S_T, are now Q₄ so that there is a current-account deficit of Q4 - Q₃. Since there is an overall balance of payments, there is a surplus in the Thai capital account of an equal amount, Q₄ - Q_3.

Suppose in Figure 2 ( see following graph ) that the demand and supply of baht are again D_T+C and S_T+C, respectively, and that equilibrium is at P₁ and Q₁. Exports are Q₂ and imports are Q₃. Suppose that P₁ is the exact value at which the Thai government has pegged the baht. During the prosperous years the attractiveness of investment in Thailand caused massive inflows of capital, which are reflected as a shift to the right in the demand for baht to D_T+C1. At the same time, rapid growth caused rapid increases in Thai income, which caused an increase in the demand for foreign products. This is reflected as a shift to the right of the Thai import curve from S_T to S_T1 and an accompanying shift from S_T+C to S_T+C1. This caused an increase in the current-account deficit from Q₃ - Q₂ to Q₄ - Q₂. In order to maintain its peg at P₁, the Thai central bank

had to sell Q₅ - Q₆ baht per week adding P₁ (Q₅ - Q₆) dollars per week to its international reserves.

As noted above, however, the good times were not sustainable. The combination of overvalued assets, a growth rate that was too rapid, a poorly supervised banking system, and large trade deficits created great strains. The realization that stocks and real property were overvalued led to a sell off by investors. Speculators began to sell baht in anticipation of its demise. Investment in Thailand suddenly became unattractive. In Figure 3 ( see following graph ), let P₁ again represent the pegged value of the baht. As investors sell off their assets, they sell the baht that they receive for dollars on the currency markets. These sales are added to the currency sales of speculators, resulting in large increases in the supply of baht to the currency markets, shown by a shift from S_T+C to S_T+C1. At the same time the newfound unattractiveness of investment in Thailand causes a decrease in the demand for baht by international investors to, say, D_T+C1. In order to prevent a drop in its value, the Thai central bank must buy Q₅ - Q₄ baht per week resulting in a loss of P₁ (Q₅ - Q₄) dollars per week in reserves. The Thai central bank was unwilling to subject the economy to the economic "crunch" (a sharp drop in the money supply accompanied by a large increase in interest rates) required to sustain the baht's value. It ceased its support, capitulating to the international currency speculators, and the baht's devaluation ensued.

Although fixed exchange rates are preferable to flexible rates for a developing country heavily dependent on foreign trade and capital flows, a so-called open economy, giving up domestic autonomy over macroeconomic policy in order to adhere to a fixed exchange rate anchor can subject the economy to periodic crises brought on by currency speculation. Capital inflows which are attracted to a country for productive investment and which enhance the productivity and growth rates of the country will be welcomed by developing economies (See Haque, Mathieson & Sharma, March 1997, pp. 3-6 for a discussion of the causes of these capital inflows). The resulting easy monetary policy which stimulates growth further and leads to attractive profit opportunities is a boon to the securities and real estate markets, which in turn attracts more foreign capital and contributes to the overall euphoria in the country. The problem with this scenario is that it is not sustainable since asset prices become overvalued, inflationary excesses become increasingly more evident, and trade deficits become increasingly larger. The emergence of these excesses triggers the speculative attack and the capital outflows. Now the fixed exchange rate policy requires a contraction in the economy with all the unpleasant social and economic upheavals that go with it (See Calvo, Leiderman & Reinhart, Spring 1996, pp. 123-139 for a description of this process). Once these excesses have been purged from the economy, new investment capital is again attracted and the cycle repeats itself.

Of course, the precursor to the "bust" is always the temptation on the part of policy-makers to continue supporting and influencing the conditions which are contributing to the extraordinary growth rates and asset values. Under a fixed exchange rate system, policy-makers are pleased to undertake the easy monetary policies which are called for during a period of rapid capital inflows. The political party in power has an incentive to perpetuate the economic "boom" since it benefits many segments of society while masking the problems of income inequality which typify these economies. The shortcomings of this "live for the present" approach become evident when the "bust" occurs and the adjustments that eliminate the excesses begin to work their way through the economy.

In a world where large capital movements into and out of countries can occur rapidly and with very little warning, it appears that the fixed exchange rate policy will forever doom a country to periodic boom and bust cycles. For this reason, we feel that the best policy for these emerging economies is to keep control of their macroeconomic policy and let the exchange rate fluctuate (although periodic exchange rate interventions would not be precluded). As long as the policy-makers implement prudent macroeconomic policies leading to sustainable non-inflationary growth rates, the underlying economic fundamentals of the country will attract foreign investors and the exchange rate will reflect the economic strength of the country. This will require policy-makers to take a long term rather than a short term perspective in the formulation of policy. Reliance on the integrity of the central bank not to over-inflate even under intense political pressure is the key to sound policy making. If the central bank is subjected to these political pressures, the case for reverting to automatic monetary policy under a fixed exchange rate regime is more compelling.

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