Kenneth R. Szulczyk
permanently outside the band, subsequently, we call it a devaluation. A country experiences a
continuous outflow of capital, and the central bank does not have the reserves to buy its
currency from the currency exchange markets. Thus, this country could devalue its currency to
reduce its balance-of-payments deficit.
Devaluation can trigger capital flight and a severe financial crisis. Moreover, devaluation
lessens the investors’ faith in a government's leaders. For example, international investment
fund managers invested approximately $45 billion in Mexico to earn the higher interest rate
before 1994. Influx of foreign capital appreciated the Mexican peso, which reduced exports and
boosted imports. Furthermore, Mexicans reduced their savings and increased their consumption.
Unfortunately, the Mexican government could not finance the large trade deficits as it depleted
its reserve funds. Then Mexico devalued the peso on December 20, 1994, triggering capital
flight. International investors cashed in their Mexican stocks and bonds and began massive
capital withdrawals from Mexico. Peso depreciated at least 40% by January 1995.
Unfortunately, capital flight can lead to a contagion, when investors question their investments
in other countries, spreading the crisis. The Bank of International Settlements and International
Monetary Fund (IMF) bailed out Mexico with a $53 billion package, which stabilized the
world's financial markets.
For another example, the investors were attracted to the Asian countries because their
economies grew rapidly, and they could earn high investment returns. The Thai government
pegged the baht to the U.S. dollar. Then the Thai government devalued the baht on July 2, 1997.
Next, the investors panicked and suddenly withdrew their investments from Thailand.
Subsequently, the crisis became a contagion, spreading to Indonesia, Malaysia, the Philippines,
and South Korea as investors questioned their investment in those countries. Crisis continued to
spread until it reached Russia and Brazil. Unfortunately, all the countries experienced large
devaluations of their currencies. Companies and corporations that accepted loans denominated
in foreign currencies quickly defaulted. Once their home currency began depreciating, they
could not afford to repay their foreign debt.
The IMF bailed out Indonesia, South Korea, and Thailand. As part of loan conditions, the
countries imposed austerity. Austerity is the government must reduce government spending
and/or raise taxes. The IMF also wanted the countries to raise the interest rates to stop capital
flight. International investors are attracted to high interest rates. Unfortunately, Thailand and
Indonesia experienced declines of 20% or more of their industrial production. Austerity in this
case worsens their economies. According to Keynesian economics, during a downturn in an
economy, a government must increase spending and/or reduce taxes to boost the economy.
Unfortunately, austerity does the opposite, which slows down the economy. Furthermore, for a
country to boost its interest rates, a central bank must reduce the money supply, which again,
slows down the economy, increasing the severity of the crisis.
The Rule of Incompatible Trinity states a central bank can only control two out of the three
variables: Fixed exchange rate, free international flow of capital, and independent monetary
policy. For example, Hong Kong allows the free flow of capital and pegs the exchange rate to
the U.S. dollar. Thus, it cannot support an independent monetary policy because the central bank
must maintain the fixed exchange rate. On the other hand, China and India impose capital