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Following the 1997–1998 financial turmoil, crisis countries in Asia moved away from exchange rate arrangements featuring “soft” exchange rate pegs with open capital accounts. While this development is superficially consistent with the bipolar view of exchange rate regimes and the “hollow middle” hypothesis, some observers have claimed that, despite the changes in their de jure exchange rate regimes, the crisis countries' exchange rate policies have in fact been very similar in the post- and pre-crisis periods. This paper analyzes the evidence and concludes that, except for Malaysia, which adopted an official peg buttressed by capital controls, the other crisis countries have actually moved to intermediate regimes in which they are floating more than before, though less than “real” floaters do. The intermediate exchange rate policies pursued by most of the crisis countries during the post-crisis can be justified on second-best arguments.

The severe financial crises experienced over the past decade by many emerging market economies have been attributed to a variety of causes, of which an important common one is the attempts by the crisis countries to maintain exchange rate regimes (“soft” pegs) that were no longer viable in light of their greatly enhanced integration with international capital markets. In the context of such enhanced integration, it has been argued, only the polar extremes of floating exchange rates or fixed exchange rates supported by very strong commitment mechanisms (“hard” pegs), can be sustained for extended periods. In other words, the recurrent crises of recent years reflect the inevitable breakdown of intermediate regimes in a financially integrated world. Among the crises of the 1990s, the Asian financial crisis of 1997–1998 has certainly played a key role in generating the perception of a vanishing middle ground for exchange rate regimes in developing countries, a doctrine that has come to be known as the “hollow middle.” The macroeconomic performance of the Asian economies that later succumbed to currency and banking crises (Indonesia, Korea, Malaysia, the Philippines, and Thailand) had previously been hailed as an economic miracle, and active management of the exchange rate in pursuit of the competitiveness objective had often been credited with making an important contribution to their “miraculous” macroeconomic performance. The crisis forced all of these countries to abandon their de facto exchange rate pegs, and the subsequent floats of their currencies were associated with very sharp fluctuations in their values. Thus, if even these economies with such exceptional macroeconomic fundamentals proved unable to sustain a policy of active exchange rate management in a more financially integrated world during the 1990s, prospects would appear to be bleak for other developing countries to do so. More recently, doubts have arisen about post-crisis exchange rate policies in the Asian crisis countries themselves. Several observers have noted that in the wake of their crises, several of these countries may be reverting to exchange rate practices similar to those of the pre-crisis period, in the sense that their authorities have sought to stabilize the values of their currencies against the US dollar without adopting any of the strong commitment mechanisms that would be called for under the doctrine of the “hollow middle.” The worry among such observers is that, in view of the vanishing scope for ‘soft’ peg arrangements under current international financial conditions, resuming such practices in the former crisis countries may make them vulnerable to a repetition of the events of 1997–1998.1 The implied policy advice is that these countries themselves should opt for one of the extreme currency arrangements that their own past experience (and that of others) suggests as the only viable options as long as they remain highly integrated with world capital markets. This paper addresses two issues raised by this recent experience. Its narrower objective is to identify and evaluate post-crisis exchange rate policy in five of the countries that suffered most severely from the Asian financial crisis. For this purpose, we seek to determine the extent to which these countries have indeed reverted to their pre-crisis exchange rate practices, to characterize the exchange rate policies they are currently pursuing, and to evaluate the appropriateness of such policies in light of both contemporary international financial conditions as well as of the post-crisis circumstances of those economies. The broader objective is to draw lessons from that experience for the doctrine of the “hollow middle” for exchange rate policies. The paper is organized as follows. In 2 and 3, we attempt to identify the exchange rate regimes that have prevailed in five former crisis countries—Indonesia, Korea, Malaysia, the Philippines, and Thailand—during the post-crisis period. To eliminate the period of most severe instability associated with the crisis, we define the post-crisis period as 1999–2001.2 Having characterized the exchange rate regimes, we turn in Section 4 to a consideration of the possible objectives that may have been driving the formulation of post-crisis exchange rate policies in the former crisis countries. Our next task, undertaken in Section 5, is to evaluate the objectives and conduct of exchange rate policy in light of the post-crisis circumstances faced by these five economies. Section 6 takes up some considerations that can be expected to influence longer-term exchange rate policies in these economies. In our concluding section we summarize our findings and attempt to draw lessons from the post-crisis experience of the Asian crisis countries for exchange rate management in other developing countries.

The basic questions we have addressed in this paper are: what exchange rate policies have the Asian crisis countries pursued in the post-crisis period, why have they done so, and how do we evaluate these policies? Moreover, we would like to use the post-crisis experience of these countries do draw lessons about exchange rate policies under conditions of high financial integration in other countries. In summarizing our results, it is useful to begin with a rather obvious observation: the simple classification of exchange rate regimes into “hard pegs,” “soft pegs,” and “floating” is a fiction. In practice, exchange rate regimes operate along a continuum. The crisis simply caused the Asian crisis countries to move along this continuum. But this move has not been uniform within the region: (a) Malaysia moved in the direction of much greater fixity and less integration with world capital markets. (b) Korea and Thailand appear to have entered a post-crisis (i.e., tranquil) period in 1999–2001. During this period, they have maintained or increased their degree of integration with world capital markets and moved in the direction of greater flexibility, but not to the extreme pole of clean floating (especially Thailand). (c) Because of domestic political uncertainties, it is not so clear that the Philippines and Indonesia truly moved into a post-crisis period during 1999–2001. Relative to the pre-crisis period, both countries have altered their exchange rate regimes in the direction of greater flexibility, however. While all of these countries have moved along the exchange rate regime continuum, none of them have opted to jump to either of its extreme poles. If we define the intermediate range of exchange rate regimes as consisting of those in which exchange rates continue to be actively managed, with or without explicit numerical exchange rate targets, these countries are squarely within that range. In that sense, their post-crisis experience suggests that the “middle” has not become as hollow as is sometimes claimed. How well have these modifications in their exchange rate regimes served the Asian crisis countries? The most plausible interpretation of the objectives of exchange rate policy in these countries is that they were designed to achieve three objectives: to stabilize high-frequency exchange rate movements, to slow the pace of real appreciation after the overshooting associated with the crisis, and to accumulate a “war chest” of liquid foreign exchange reserves. We have argued that all of these were reasonable objectives of policy in the post-crisis context. Moreover, these post-crisis regimes have been successful both from the narrow perspective that they have apparently been judged sustainable by the markets (i.e., they have not been subjected to extreme episodes of “exchange market pressure”) and from the broader perspective that, especially in countries that have avoided political instability, they have been associated with very successful macroeconomic performance, both in terms of real activity as well as of the economies' external accounts. Growth has picked up rapidly, inflation has remained low, and current accounts have adjusted rapidly. Is there a link between the exchange rate practices adopted and these measures of performance? On this we have offered little evidence. We can speculate that the removal of the “one-way bet” in the foreign exchange market, together with the crisis-induced real exchange rate overshooting, may have made a difference in preventing the emergence of exchange market pressures, and that the depreciated real exchange rate together with the accumulation of large stocks of reserves, may have respectively supported aggregate demand and enhanced confidence. But there is also a darker side to exchange rate policies in these countries. In particular, reserve accumulation may have been a substitute for other measures that need to be undertaken in these economies, such as the complete elimination of implicit guarantees and expected government bailouts, or moral hazard behavior resulting from the existence of undercapitalized banks, etc. To the extent that these measures have been absent and/or remain incomplete, reserve accumulation is best interpreted as a second-best transition strategy, and the authorities may actually have had little discretion over its adoption. Given the incompleteness of such measures, however, the chosen exchange rate policy is an appropriate one. Nonetheless, from this perspective, the chosen exchange rate policy represents a symptom of something that is wrong or unfinished, rather than a component of an optimal policy package. Once these other components of reform have been completed in the crisis countries, continuation of the chosen exchange rate policy may prove to be sub-optimal, since a policy of floating with a large reserve “war chest” would be a wasteful use of scarce national resources. Finally, what lessons can be drawn for other countries? One tentative lesson is that, along the continuum of exchange rate regimes, the portion of the “middle” that is actually “hollow” is probably small. What enhanced financial integration has undoubtedly done is to have made it far more difficult for financially integrated countries to sustain “soft” pegs, simply because capital markets will not allow domestic policy mistakes to go unpunished. But whether there is literally no scope for such regimes depends on whether the domestic authorities can avoid vulnerability through their policy choices. In other words, the part of the “middle” that may be “hollow” is the maintenance of explicit or implicit “soft” pegs with unfettered capital movements and potentially skeptical capital markets. That is the lesson of pre-crisis Asia, where policy mistakes were not avoided and “soft” pegs fell apart through the reactions of unfettered capital markets. It may also be the lesson of post-crisis Malaysia, where the adoption of an exchange rate peg, together with policies viewed by markets in an unfavorable light, were perceived to require the imposition of barriers to capital movements. The lesson that emerges from the experiences of the other post-crisis Asian countries seems to be that there remain other choices away from the extremes of the exchange rate regime spectrum, and that active management of the exchange rate not only remains feasible under current international conditions, but may actually be desirable depending on country circumstances. Specifically, under post-crisis conditions, if the fragility of domestic balance sheets rules out “hard” pegs as an option (because of the strains imposed by periods of high interest rates that may be needed to defend the peg), a “dirty” float designed to resist real appreciation and accumulate reserves has much to recommend it over the polar extreme of “clean” floating