Limiting Moral Hazard and Reducing Risk in International Capital Flows: The Choice of an Exchange Rate Regime

Abstract

Monetary and financial management is much more difficult in emerging markets on the periphery of the industrial world than at the center. On the periphery, the domestic term structure of finance is short, and all foreign borrowing is denominated in foreign currency--usually dollars. An acute policy issue is whether the exchange rate should be fixed or more flexible in inhibiting banks and other financial institutions from cycles of overborrowing and undue foreign exchange exposure. This article shows that a "good" fix is better than floating, which in turn is better than a "bad" fix. But even a good fix must be complemented by strict domestic regulations forcing banks to preserve their capital and hedge their net foreign exchange exposure to stay good.