Choice of regime

There are many reasons for choosing a tight peg over a more flexible exchange rate regime. For instance, the central bank may want to prevent depreciation in the context of high exchange rate pass-through, to keep inflation under control. Alternatively, if a large number of firms have large dollar borrowings (the problem of the 'original sin'), the central bank may want to prevent large depreciations to protect the balance sheet of these companies. Under such conditions, the central bank may lean against the wind when there is downward pressure on the exchange rate, and prevent depreciation by selling foreign exchange reserves.

Conversely, central banks may want to prevent currency appreciation. Capital inflows to emerging economies since the early 2000s have put pressure on their exchange rates to appreciate. During this period, many emerging economies, including some in Asia, have been pursuing policies of export led growth (Rodrik 2007). Allowing the exchange rate to appreciate can put export-led growth at risk; not surprisingly, the exchange rate regimes of most emerging markets in this period have been de jure managed floats, with central banks intervening in foreign exchange markets to prevent currency appreciation. Ramachandran and Srinivasan (2007) and Pontines and Rajan (2008) find evidence to support the hypothesis that Asian economies have intervened in the foreign exchange market to prevent currency appreciation. The rationale for doing so may lie in the large share of exports to GDP in many of these economies.

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