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Exchange-Rate Regimes for Emerging Markets: Moral Hazard and International Overborrowing

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  • McKinnon, Ronald I
  • Pill, Huw
Abstract
This paper investigates the role of the exchange-rate regime in a simple Fisherian model of the overborrowing syndrome. Where domestic banks are subject to moral hazard, the choice of exchange-rate regime may have important implications for the macroeconomic stability of the economy. Banks that enjoy government guarantees have an incentive to increase foreign borrowing and incur foreign-exchange risks that are underwritten by the deposit insurance system. In the absence of capital controls, this increases the magnitude of overborrowing and leaves the economy both more vulnerable to speculative attack and more exposed to the real economic consequences of such an attack. While "bad" exchange-rate pegs will tend to exacerbate the problem of overborrowing in emerging markets, it is unclear that flexible exchange rate always dominates fixed exchange rates. A "good fix"--one that is credible and close to purchasing power parity--may reduce the "super risk premium" in domestic interest rates and thereby narrow the margin of temptation for banks to overborrow internationally. Contrary to the current consensus regarding the lessons that should be drawn from the Asian crisis, a good fix may better stabilize the domestic economy while limiting moral hazard in the banking system. Copyright 1999 by Oxford University Press.

Suggested Citation

  • McKinnon, Ronald I & Pill, Huw, 1999. "Exchange-Rate Regimes for Emerging Markets: Moral Hazard and International Overborrowing," Oxford Review of Economic Policy, Oxford University Press and Oxford Review of Economic Policy Limited, vol. 15(3), pages 19-38, Autumn.
    • Handle: RePEc:oup:oxford:v:15:y:1999:i:3:p:19-38
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    References listed on IDEAS

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    JEL classification:

    • O15 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Economic Development: Human Resources; Human Development; Income Distribution; Migration
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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