Ronald I. McKinnon

International Overborrowing: A Decomposition of Credit and Currency Risks

February 1998 The severity of the financial crises enveloping the ‘tiger’ economies of South East Asia in 1997 came as a surprise to many observers. This paper uses a simple Fisherian model of the ‘overborrowing syndrome’ to compare the Asian crises of 1997 with earlier overborrowing episodes in Mexico and Chile. While important similarities exist, the crises in South East Asia have been exacerbated by the unhedged foreign exchange positions of Asian banks. These open currency positions not only imposed significant additional losses on the banks following devaluation, they also magnified the scale of overborrowing during the cycle’s initial boom phase. Failure to limit the exposure of banks to foreign exchange risk therefore increased the magnitude of the boom - bust overborrowing cycle both ex ante and ex post. The paper highlights the importance of effective regulation and supervision of capital markets, with a focus on limiting the speculative currency positions of banks, especially those that form the core of the domestic payments system and therefore enjoy a (possibly implicit) public guarantee. Improving the institutional infrastructure of financial supervision is the only effective way of mitigating the macroeconomic costs of overborrowing. JEL Classification: O16, F32, F34, E44. Keywords: Overborrowing, capital flows, financial crises, sectoral credit.

Synchronized Business Cycles in East Asia and Fluctuations in the Yen/Dollar Exchange Rate

Because many authors have proposed stimulating the ailing Japanese economy by monetary expansion and yen depreciation, we explore the repercussions of depreciating the yen against the dollar on the other East Asian economiesiXwhich largely peg to the dollar. Since 1980, economic integration among Japani¦s neighborsiXChina, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, and ThailandiXhas intensified and (except for China) their business cycles have been highly synchronized. These cycles have been closely linked to fluctuations in the yen/dollar exchange rateiXthrough changes in their export competitiveness and inflows of foreign direct investment. We show that a major yen devaluation would have a negative impact on incomes in other East Asian economies and that it is not a sensible policy option for Japan.

How to Manage a Repressed Economy

Chile from 1974 to the present is one of the few recent examples of a sustained economic liberalisation; fiscal, exchange-rate and monetary policies were manipulated more or less correctly (with the possible exception of wage indexing) to secure free trade, an unrestricted domestic capital market, rapid real growth and a stable currency.

Japan's Negative Risk Premium in Interest Rates: The Liquidity Trap and the Fall in Bank Lending

May 2002 Japans interest rates have been compressed toward zero because of pressure coming through the foreign exchanges. Twenty years of current account surpluses have led to a huge build up of claims – mainly dollars – on foreigners. Because of ongoing fluctuations in the yen/dollar exchange rate, Japanese financial institutions will only willingly hold these dollar claims if the nominal yield on them is substantially higher than on yen assets. In the 1990s to 2002 as U.S. interest rates have come down, portfolio equilibrium has been sustained only when nominal interest rates on yen assets have been forced toward zero. One consequence is the now infamous liquidity trap for Japanese monetary policy. A second consequence is the erosion of the normal profit margins of Japans commercial bank leading to a slump in new bank credit and an inability to grow out of the overhang of old bad loans. Working Papers Index

China's Exchange Rate Trap: Japan Redux?

Today’s American mercantile pressure on China to appreciate the renminbi against the dollar is eerily similar to the American pressure on Japan to appreciate the yen that began over 30 years ago. Indeed, the yen went all the way from 360 to the dollar in August 1971, at the end of the Bretton Woods period of fixed exchange rate parities, to touch 80 to the dollar in April 1995. Then the American government relented and announced a strong dollar policy that signaled the end of “Japan bashing”. But the overvalued yen, and the expectation of appreciation, destabilized the Japanese financial system; the bubble economy of the late 1980s was followed by a deflationary slump and a zero-interest liquidity trap in the 1990s [McKinnon and Ohno 1997]. At least some of today’s critics of East Asian countries’ pegging to the dollar would agree that international saving imbalances rather than misaligned exchange rates are the root cause of the U.S. current-account deficit. One can argue whether it is mainly a saving deficiency in the United States or a saving glut in the rest of the world [Bernanke 2005]. Either way, the central position of the United States under the world dollar standard gives it alone an unlimited international line of credit in its own currency. However, suppose that the U.S. trade deficit is misdiagnosed to result from a misaligned exchange rate, so that a surplus country on the dollar’s periphery is forced to appreciate against the world’s dominant money. It will suffer a slowdown in economic

Optimum Currency Areas and the European Experience

Across nations or regions, the debate on optimum exchange rate cum monetary policies is not yet resolved on three levels. First is the optimum domain of fixed exchange rates versus keeping them flexible. Second is the subordinate debate on whether one needs full monetary union (as in continental Europe) to secure an optimum currency areas internal domain; or, whether virtually fixed exchange rates - where national currencies remain in circulation - can be sufficient. Third is whether a regional grouping of economies with close trade ties (as in East Asia) gain by collectively pegging to an outside currency such as the US dollar. Using an axiomatic approach, which limits the set of cross-country financial claims to what is feasible, I analyse how best to both share and reduce macroeconomic risks on these three levels.

China and its Dollar Exchange Rate: A Worldwide Stabilizing Influence?

We argue that criticism concerning the Chinese dollar peg is misplaced as no predictable link exists between the exchange rate and the trade balance of an international creditor economy. The stable nominal yuan/dollar rate is argued to have stabilized Chinese, East Asian and global growth. However, linked to US low interest rates, Chinese sterilization policies and potentially subsidized capital allocation in China the real yuan/dollar rate is undervalued. This has caused—both in China and the United States— structural distortions and threatens to undermine global growth and stability. We propose Sino-American policy coordination to escape from the policy dilemma, which continues to drive global imbalances.

Intermediate Products and Differential Tariffs: A Generalization of Lerner's Symmetry Theorem

I. Introduction and summary of main conclusions, 684. — II. A model with three tradable goods usable in production or consumption, 588. — III. Intermediate products, production technology, and the gains from trade, 601. — IV. The structure of production in protected industries, 610.

Taxation, Money, and Credit, in a Liberalizing Socialist Economy

AbstractUnderstanding the system of financial control in the pre-existing régime of ‘classical’ socialism is a key to understanding what might go wrong in the transition. Accordingly, this paper proceeds in four steps by examining:(1)how domestic fiscal and monetary processes complement central planning in the classical socialist economy;(2)why this mechanism for securing domestic financial control under classical socialism tends to break down naturally into inflation when decentralization begins and central planning though direct materials balancing is weakened;(3)how, in a more deliberate transition, domestic tax and monetary arrangements might be better managed to keep the price level stable as prices of individual goods and services are freed; and(4)how, in moving toward free foreign trade, explicit policies governing tariffs and foreign exchange convertibility could best parallel and complement the evolving restraints on money and credit in domestic commerce. In effect, moves to dismantle the apparatus of central planning, decontrol prices, privatize property, and so on need to be supported by a proper sequence of fiscal, monetary and foreign exchange measures-as analyzed more fully in the authors new bookThe Order of Economic Liberalization. In this short essay, a summary outline of such a financial order is provided.

Exchange rate co‐ordination for surmounting the East Asian currency crises

Keynote Speech, 6th Convention of the East Asian Economic Association 4-5 September 1998, Kitakyushu, Japan(This abstract was borrowed from another version of this item.)