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RM Crisis
Section 4
A puzzle remains Recently, however, some interesting new evidence has emerged with respect to macroeconomic performance under both fixed and freely-floating exchange rate regimes. Recall that one of the implications of a fixed exchange rate regime is that where prices and wages cannot adjust instantaneously, or at least that they cannot adjust as quickly as financial markets can, that would have real effects upon output and employment. That is, by fixing exchange rates, we are simply shifting the volatility to another part of the economy, rather than getting rid of it.
The papers of Baxter and Stockman (1989) and Flood and Rose (1995) suggest that there is no clear difference in the behaviour of economic aggregates (GDP, unemployment, inflation, money supply etc.) under freely-floating and fixed exchange rates. Flood and Rose in particular conclude from their investigation that "...the most critical determinants of exchange rate volatility are not macroeconomic." (p.5)
If they are indeed right in saying that the most critical determinants of exchange rate volatility are not macroeconomic in nature, then whereas fixing exchange rates would remove a great proportion of uncertainty, it should not harm the real economy in any serious way. If so, why not fix exchange rates? Since these findings imply that price changes are not important in determining exchange rates, the conclusion would be puzzling from the aspects of all the presently-available theoretical models; and so the virtual quest continues.

The gist of this article argues that the cause of the ringgit crisis may be found in Bank Negara's decision to fix exchange rates vis--vis the US dollar. Section 1 gives an account of the events which led to the precipitation of the crisis. It was suggested that a fixed exchange rate prevented the ringgit from being allowed to depreciate when it needed to in order to preserve stability. That this was not coupled with credit contraction, the other alternative to preserving economic stability, by the end of 1996 a ringgit crisis was bound to happen. The implied loss of confidence in the Malaysian economy meant that currency dealers began off-loading their holdings of ringgit and that - even more so after Thailand - led to a self-fulfilling crisis.

Section 2 discusses the advantages and disadvantages of fixing the exchange rate. We found that whilst there are convincing reasons in favour of fixing the exchange rate, none of them are particularly relevant to Malaysia. We also argued that the main disadvantage of a fixed exchange rate regime is the implied loss of control over domestic monetary policy. That in turn means that output and employment is bound to be more volatile under a fixed-exchange rate regime.

Section 3 considers some lessons as well as non-lessons. In particular, we considered three policy-responses which have been put forth and found them to be either largely ineffective or inappropriate. We also examined the advantages of allowing a currency to float freely. Of particular relevance to Malaysia at the present moment was that huge current account deficits cannot persist for long under a freely-floating exchange rate and that as a result economically distortive measures such as capital controls and tariff increases will not have been necessary. Moreover, it was found that FDI will not be harmed by exchange rate volatility, contrary to what many have suggested, insofar as such volatility pertains only to the short-run. Since genuine FDI is likely to be resident in the country for a span of several years or more, empirical findings which suggest that exchange rates are predictable over several years confirms this claim.

Finally, Section 4 exposes a persisting conundrum: since fixed exchange rates tend to imply more volatile output and employment, we should find that there is a clear difference in the behaviour of these aggregates between countries with fixed exchange rates and those with freely-floating rates. That empirical evidence cannot confirm this, the puzzle remains as to what happens to the exchange rate volatility when the rate is fixed and why it is not reflected in more volatile output and employment, notwithstanding that all models of the exchange rates predict they would.

I end in the manner with which I began, with the same quote from the 1994 Annual Report of Bank Negara:

"The level of the exchange rate has some impact on the exports of manufactures but the volatility or variability of the exchange rate is not a significant factor affecting trade."

Since the main advantage of fixing one's currency is the reduction of exchange rate volatility, and not to maintain a particular rate of exchange, it would appear from the above that Bank Negara chose to target the ringgit for the wrong reasons.
That, perhaps, is the real culprit of the ringgit crisis.

Manzur, Meher and Mohamed Ariff (1995). Purchasing power parity: new methods and extensions. Applied Financial Economics. Volume 5, pp.19-26

Baxter, Marianne and Alan C Stockman (1989). Business Cycles and the Exchange Rate Regime: Some International Evidence. Journal of Monetary Economics. Volume 23 (May); pp. 377-400

Flood, Robert P and Andrew K Rose (1995). Fixing Exchange Rates: A Virtual Quest for Fundamentals. Journal of Monetary Economics. Volume 36, pp. 3-37


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