Conclusion

The main argument of this paper is that it is more important to avoid an inconsistent monetary policy framework than it is to avoid capital account liberalization. While Asia has avoided de jure capital account liberalization, integration into the world economy has continued de facto.

Asia-11 economies have moved forward with domestic financial sector liberalization. The average value of the Dorrucci, Meyer-Cirkel and Santabarbara (2009) measure of domestic financial system capability went up from a low of 0.45 in 2000 to 0.51 in 2006. The effectiveness of capital controls is diminished when the financial system is sophisticated, and growing current account integration gives economic agents the opportunity to engage in illegal transfers of capital. With the exception of Indonesia, Philippines, and Malaysia, the Asia-11 economies increased de facto capital account openness from 2000–2008.

Increasing de facto integration poses questions about the possible evolution of the exchange rate regime. On average, Asian exchange rate regimes have moved towards greater flexibility when compared with the ‘fear of floating' which immediately succeeded the Asian Financial Crisis. At the same time, de facto arrangements show considerable exchange rate pegging. None of the Asia-11 economies have a floating exchange rate—not even Korea, which has the most flexible exchange rate in Asia. From 2000 to 2008, Malaysia and India moved towards greater flexibility; PRC has likewise moved slightly towards more flexibility. Apart from this, Asia-11 largely appears to be on a trajectory of increasing de facto openness, coupled with a lack of reform in the monetary policy regime.

Increasing de facto capital account openness while maintaining exchange rate rigidity has two consequences:

• Central banks seeking exchange rate rigidity may have to distort the policy rate in order to achieve exchange rate targets. To the extent that capital flows are procyclical, exchange rate pegging would generate procyclical monetary policy. Of particular interest would be the extent of procyclicality in PRC and India, which have weaker financial systems and lower de facto openness than most of Asia. If these economies, despite their enviable position, are unable to avoid procyclical monetary policy in the presence of exchange rate inflexibility, then other Asian economies are likely to experience procyclicality to a far greater extent.
• Systemic crises could also arise. Asian economies continue to experience clashes between speculators and central banks, problems with unhedged foreign currency borrowing by corporations, and other consequences of an inconsistent monetary policy regime. Bigger problems in the future cannot be ruled out, particularly in Malaysia and Taipei,China, where there is an awkward combination of (i) considerable de facto openness, (ii) sophisticated domestic financial systems and iii) exchange rate inflexibility comparable to PRC.

From the viewpoint of systemic crises, the key source of problems lies in households, banks, and corporations which count on exchange rate rigidity. When it is felt that exchange rate fluctuations will not take place, substantial exchange rate exposures build up. This leads to difficulties when large exchange rate movements do take place. Hence, the first stages of reform should emphasize exchange rate flexibility and the development of currency derivatives markets. Exchange rate flexibility would give economic agents the incentive to undertake risk management, while currency derivatives markets would give them the ability to execute desired trades. Asia is, by and large, disregarding this advice on sequencing, by moving forward with de facto capital account openness before bringing in the currency flexibility.

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