To understand the causes of hot money flows, we must examine the basic types of exchange‐rate regimes. Let’s take a look (see accompanying chart).
Although floating and fixed rates appear dissimilar, they are members of the same free‐market family. Both operate without exchange controls and are free‐market mechanisms for balance‐of‐payments adjustments. With a floating rate, a central bank sets a monetary policy but has no exchange rate policy — the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a central bank. With a fixed rate there are two possibilities: either a currency board sets the exchange rate, but has no monetary policy — the money supply is on autopilot — or a country is “dollarized” and uses a foreign currency as its own.
Under a fixed‐rate regime, a country’s monetary base is determined by the balance of payments, moving in a one‐to‐one correspondence with changes in its foreign reserves. With both of these free‐market exchange rate mechanisms, there cannot be conflicts between monetary and exchange rate policies, and balance‐of‐payments crises (and hot‐money flows) cannot rear their ugly heads. Floating‐ and fixed‐rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance‐of‐payments crises and hot money flows.
Pegged Rates Invite Trouble
Most economists use “fixed” and “pegged” as interchangeable or nearly interchangeable terms for exchange rates. While these two types are superficially similar, they are fundamentally very different types of exchange‐rate arrangements. Pegged‐rate systems are those where the monetary authority is aiming for more than one target at a time. Indeed, pegged rates require a central bank to manage both the exchange rate and monetary policy.
With a pegged rate, the monetary base contains both domestic and foreign components. Pegged systems — which include pegged, but adjustable rates, crawling pegs, and managed floating rates — go hand‐in‐glove with hot money flows. These systems often employ exchange controls and are not free‐market mechanisms for international balance‐of‐payments adjustments. Pegged exchange rates are inherently disequilibrium systems, lacking an automatic mechanism to produce balance‐of‐payments adjustments.
Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And when outflows become “excessive,” a central bank attempts to offset the decrease in the foreign component of the base by buying bonds, increasing the domestic component of the monetary base.
Balance‐of‐payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange rate and monetary policies (as they did in the Asian financial crisis of 1997—98) and force a devaluation, the imposition of exchange controls, or both.
Hot Money and Exchange Controls
Hot money flows are principally associated with pegged exchange rates. Many analysts have misdiagnosed the so‐called hot money problem because they have failed to appreciate this all‐important linkage. In consequence, they have prescribed exchange controls as a cure‐all to cool off the hot money. That prescription treats the symptoms. It fails to treat the disease: pegged exchange rates. Until pegged rates are abandoned, there will be volatile hot money flows and calls to cool the hot money with exchange controls.
Currency convertibility is a simple concept. It means residents and nonresidents are free to exchange domestic currency for foreign currency. However, there are many degrees of convertibility, with each denoting the extent to which governments impose controls on the exchange and use of currency.
The pedigree of exchange controls can be traced back to Plato, the father of statism. Inspired by Lycurgus of Sparta, Plato embraced the idea of an inconvertible currency as a means to preserve the autonomy of the state from outside interference. It is no wonder that the leadership in Beijing finds the idea of an inconvertible yuan so attractive.
The temptation to turn to exchange controls in the face of disruptions caused by hot money flows is hardly new. Tsar Nicholas II first pioneered limitations on convertibility in modern times, ordering the State Bank of Russia to introduce, in 1905—06, a limited form of exchange control to discourage speculative purchases of foreign exchange. The bank did so by refusing to sell foreign exchange, except where it could be shown that it was required to buy imported goods. Otherwise, foreign exchange was limited to 50,000 German marks per person. The Tsar’s rationale for exchange controls was that of limiting hot money flows, so that foreign reserves and the exchange rate could be maintained. The more things change, the more they remain the same.
Before more politicians come under the spell of exchange controls, they should reflect on the following passage from Nobel laureate Friedrich Hayek’s 1944 classic, The Road to Serfdom: