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A key reason for the move by emerging markets from pegged exchange rates to floating exchange rates has been the rise in the importance of global capital flows and the extent to which emerging markets have participated in and been integrated within those capital flows. As stated, the rise in the importance of capital flows since the early 1980s reflects the wave of capital account liberalization and capital market integration that has taken place since that time. As a proportion of GDP, capital inflows to the emerging markets rose six-fold in the 1990s relative to the 1970s and 1980s, only to fall back in 1998 in the wake of the Asian and Russian crises. A similar trend has been seen in bank lending, which also fell back in the wake of these crises. The vulnerability of emerging markets to capital outflow and reversal has been a key focus for the emerging markets, and is likely to remain the case for some time to come. A key differentiation between the emerging markets and the industrial countries is the depth of their asset markets and their ability to absorb capital inflows and outflows without significant policy and economic distortion.
1995– This last period has been characterized above all by volatility, on the one hand by huge capital inflows and on the other hand by frequent currency devaluations. One by one, peggedexchange rate regimes tried to defend themselves, tried to delay the inevitable. However, capital mobility, coupled with pegged exchange rate regimes and in some cases a degree of monetary independence were a poor policy mix, forgetting the principles of Mundell–Fleming, and one by one they were forced off their pegs, to “float” (devalue) their currencies. Among those emerging market currencies forced to devalue during this time were:
1994/95 — Mexico
1996 — Czech Republic
1997/98 — Asian region (Thailand, Indonesia, Korea, Philippines)
1998 — Russia
1999 — Brazil
1999 — Ecuador
2000 — Colombia
2001 — Turkey
The year 2002 has brought with it so far the devaluation of the Argentine peso, the first “currency board” in history to be defeated, and also that of the Venezuelan bolivar. There have also been cases where emerging market countries have either had some success in fighting back or alternatively have de-pegged voluntarily during periods of exchange rate stability, rightly anticipating that a freely-floating exchange rate would provide a far more effective buffer for the economy during subsequent periods of market turbulence than the alternative, which would require defending an overvalued exchange rate. In the first camp, we have had countries such as Malaysia and also Hong Kong, which have tried various strategies to fight the market. Malaysia, for its part, in September 1998 banned offshore trading of the Malaysian ringgit and pegged it to the US dollar at 3.8 — where it has stayed ever since. Hong Kong, long the self-proclaimed bastion of the free market, intervened in the stock market, ostensibly to rid it of “manipulative, speculative elements”. In the second camp, countries like Chile, Poland and Hungary have de-pegged their exchange rates voluntarily, under calm and stable market conditions. As a result, when market conditions became more volatile, the freely floating exchange rate was able to buffer or insulate the real economy from damaging imbalances or instability.
As the emerging markets became integrated into the global economy and particularly within the global financial system rather than just commercial trade, so the pressure became irresistible for them to move from a fixed or pegged exchange rate system to more flexible exchange rate arrangements, such as the free float — the reed that bends in the wind, rather than the pane of glass that shatters. Two major trends in terms of the liberalization of capital markets have played a major part in the development and history of exchange rate systems within the emerging markets — the rise of capital flows and the opening of the emerging markets to international trade.
The history of emerging market currencies and exchange rate systems can most usefully be divided into four main periods — 1973–1981, 1982–1990, 1991–1994 and 1995–2001.
1973–1981 For the most part, this period saw relative exchange rate stability, not least because most emerg- ing market currencies were not freely convertible either on the current or capital accounts. There was a steady if modest capital outflow from the industrial countries to the emerging markets, which were mostly at that time dependent on commodities rather than the manufacturing bases they would become.
1982–1990
If the previous period was characterized by stability, that of 1982–1990 was one of anarchy followed by a gradual attempt at restructuring. Massive tightening of monetary policy in the US and a consequent dramatic rise in the US dollar, plunging commodity prices and a reversal in capital flows out of the emerging markets combined to trigger first emerging market currency devaluations and then defaults, most notably in Mexico and also elsewhere in Latin America. Given ensuing capital flight, many emerging market countries sought to impose capital controls, driving interest rates artificially low in response. The gradual debt restructuring process during 1985–1990 helped restore some stability to emerging markets, helped in part by lower interest rates in the US and a sharp fall in the value of the US dollar. The currency devaluations and then low nominal interest rates — and negative real rates — as capital controls were imposed, resulting in very poor returns for passive currency investors.
1991–1994
This was the heyday for the emerging markets. As the Berlin Wall was torn down, so the East was opened up to investment. Latin America had a slightly better time of it as economies gradually recovered in the wake of the Brady bond restructuring programme. Capital controls were lifted, largely as demanded by the IMF, and domestic interest rates, which had been kept artificially low, were set free to the whim of market forces. “Privatization” of state assets was greatly accelerated, supporting budget balances and helping to attract capital inflows. Rising interest and exchange rates greatly boosted total returns for currency investors during this period. In light of this, the Mexican peso devaluation of December 1994 came as rather a rude awakening.