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China Rebalancing, Not Overheating Global Living with the Trilemma View GEF Archive

		The Global Economics Team

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Industrial production - steady rather than overheating, characterizing growth rebalancing... Industrial value-added grew 18.5%Y (+0.3%M SA by our estimate) in December, surprisingly slower than the 19.2% gain in November, and weaker than our (+20%) and market (+19.6%) forecasts, especially given the sharp rebound in exports in the month (delivery for exports +12.4%Y in December versus +5.3% in November). We believe that this illustrates the growth rebalancing we have been advocating: as external demand recovers, industrial activity derives much less growth momentum from policy-driven domestic investment. For the full year, the export slump slashed overall industrial output growth to 11%, the weakest since the tech burst-plagued 2001.

...though rebalancing will take time: Needless to say, even though production for exports has reclaimed positive year-on-year gains, the manufacturing sector remains dependent on domestic demand for growth. We admit that external demand will take time to recuperate, as evidenced in the continued outperformance of local enterprises (shareholding companies +20.5%Y in December, SOEs +21.7%) over foreign-invested producers (+15.7%), but we are confident that this gap will narrow in 2010.

Trade - much-stronger-than-expected rebound in December: After disappointing for several months, Chinese exports finally staged a stronger-than-expected rebound in the last month of 2009. Exports jumped 17.7%Y (+5%M seasonally adjusted) to US$130.7 billion in the month. The surge in imports also surprised on the upside, up 55.9%Y (+8.7%M SA). The strong gains in December served to compensate for the disappointing data in the preceding months, bringing the full-year results close to our earlier forecasts; exports dipped 16% to US$1.2 trillion in 2009, in line with our forecast, while imports slipped 11.2% to US$1 trillion, slightly lower than our expectation (-13%). The trade surplus totaled US$196.1 billion, the smallest in three years, and was a tad lower than our forecast (US$216 billion).

Trade - import surge driven mostly by manufactures: The breakdown of imports between the broad categories of primary versus manufactured products is not yet available. Nevertheless, from detailed data on individual import commodities, it was revealed that the 113%Y surge (in value, contributed by 48% increase in volume and 44% increase in price) in crude oil imports lifted the overall import growth rate by 6.1pp, while the intake of iron ore (+74%) contributed an increase of 2.7pp, and other primary products made a relatively small impact on the overall import growth rate. We can hence deduce that most of the pick-up in imports came through the manufactured segment.

Retail sales - strong growth at year-end: Retail sales growth picked up significantly in December, to 17.5%Y (+1.4%M SA), beating our above-consensus forecast (we forecast +17%, consensus +16.3%), making up for the disappointing result in November (+15.8%Y, +0.2%M SA). Needless to say, the acceleration was partly driven by the pick-up in inflation. Nevertheless, we estimate that sales growth in real terms picked up to above 16%Y in the month. The most noticeable pick-up in sales growth was seen in jewelry (+25.4% in December versus +11.6% in November), medicine (+27.6% versus +22.6%), communications equipment (+11.5% versus +6.9%) and oil (+27.9% versus +16.4%), although autos (+57.7%), furniture (+37.6%) and construction and decoration materials (+53.9%) remain the leaders in terms of growth in sales. For the full year, retail sales growth in nominal terms weakened to 15.5%, from 21.6% in 2008, but actually picked up in real terms, to 16.9%, from 14.8% in 2008.

Fixed asset investment (FAI) - moderating momentum as growth rebalances... Nationwide FAI grew 30.1%Y in 2009, while urban FAI gained 30.5%. They both fell slightly below our forecast (+33% and +31.5%, respectively), and implied noticeably slower growth towards year-end. Nationwide FAI saw growth slip to 24.5%Y in 4Q09 (+33.2% in 3Q), while urban FAI growth slipped to 24.1% in December (+24.3% in November) and 26.2% in 4Q (+32.9% in 3Q). It appears that as external demand shows signs of recovery, policy-driven domestic investment is easing off promptly enough to help prevent a full-blown overheating in the overall economy. 

...with capex in manufacturing recovering: Policy-driven investment projects in primary (+49.9% in the full year versus +51.5% in January-November) and tertiary (includes infrastructure) (+33% versus +36.6%) had been the main growth driver in 2009, but they are giving way to the recovery in capex in the secondary/manufacturing sector (+26.8% versus +26.1%) as the prospects for exports improve.

Monetary data - normalization continued in December: The gradual retreat in monetary growth continued in December, in line with expectations. New loan creation rebounded somewhat to Rmb380 billion, from Rmb295 billion in November. Though beating our forecast of Rmb310 billion, it does not buck the trend of enlarging year-on-year declines, which came to 51% versus 38% in November. For 2009, new loans totaled Rmb9.59 trillion (+95%Y), while outstanding loan growth retreated to 31.7% (+33.8% in November). In line with the normalization trend, bills financing loans decreased for the sixth straight month, by Rmb112 billion in December, while short-term loans (to non-financial institutions) also slipped for the third month, by Rmb29 billion, suggesting that medium- and long-term loans continue to be the main driver of the ongoing credit expansion, consistent with growth-supporting policy initiatives, and this signals enhanced sustainability. Meanwhile, M2 growth also softened in line, to 27.7% (+29.7% in November).

Monetary data - foreign reserves data support our contention that ‘hot money' inflows picked up further in 4Q09: Foreign reserves reached US$2.4 trillion at the end of December. Although the US$127 billion increase in 4Q was smaller than the US$141 billion gain in 3Q, it was partly hurt by valuation losses as the USD strengthened considerably (4.4% against the euro and 7.5% against the yen) in December. Our proxy for ‘hot money' inflows, which is the incremental change in reserves, net of the trade surplus and FDI and adjusted for exchange rate movements and interest income, showed sustained positive inflows above US$10 billion in all three months in 4Q09, totaling US$38.1 billion and beating 3Q's US$25.3 billion.

Inflation - pick-up in upstream inflation broadly in line with expectations... Producer and raw materials purchasing price indices both reclaimed positive year-on-year gains in December, broadly in line with our expectations. PPI rose 1.7% (-2.1% in November), while RMPPI gained 3% (-3.6% in November). On a month-on-month seasonally adjusted basis, both indices sustained sequential gains, by 1.8% (+0.9% in November) and 2.1% (+1% in November), respectively. The uptick was driven primarily by the jump in energy prices due to the low base effect. The faster-than-expected turnaround in upstream prices and the rapid monetary expansion last year are fuelling concerns of high inflation this year. Given the approximately six-month lag effect of accommodative monetary conditions in 2009, the key swing factor in determining inflation is how fast the output gap will close, which is a function of export growth rate (see China Economics: Worried About Inflation? Get Money Right First, October 20, 2009).

...while higher-than-expected consumer inflation is attributable entirely to food: CPI inflation picked up to 1.9%Y in December, beating our and market forecasts (+1.4%).  Nevertheless, the upside surprise stemmed entirely from the food component (+5.3%Y versus our forecast of +3.7%), while non-food inflation still fell below expectations (+0.2% versus our forecast of +0.6%). On a seasonally adjusted basis, consumer prices rose 0.7%M (+0.4% in November), the biggest climb since November 2007. The uptick in the final month of the year narrowed full-year CPI deflation to 0.7%, marginally milder than our forecast (0.8%). 

Concluding the December/4Q09 Dataset - Impact on Our Views

Aggressive policy stimulus has successfully decoupled China from the deep recession in the developed markets in the aftermath of the late 2008 financial turmoil. The strong economic rebound, which commenced and was primarily policy-driven in 2Q09, has sustained into 4Q09, and has become more balanced between domestic versus external drivers, and between private versus public sector initiatives. 

Entering the New Year, there have been two important surprises. First the PBoC raised the ratio for required reserves (RRR) last week, the timing of which was earlier than expected by the market (see China Economics: RRR Hike Cycle Kicks Off Earlier than Expected, January 12, 2010). Second, China's export growth in December 2009 was very strong (+17%Y), much higher than our and consensus forecasts. These two surprises, together with the latest 4Q09 datapack that indicates strong sequential growth momentum, beg the question whether the two key assumptions underlying our base case still hold.  Specifically, a) have we been too conservative in forecasting the strength of external demand?; and b) does the RRR hike represent the beginning of an aggressive monetary tightening? We take this opportunity to elaborate our views.

A) A Revisit to Our Four-Season Framework

Regular readers of our research may recall that in discussing the outlook for 2010, we envisaged two types of uncertainty facing the Chinese economy in 2010: a) G3 economic outlook: is it a tepid recovery, which is our base case, or could it be a vigorous recovery? And b) domestic policy stance: is there going to be normalization, as we are expecting? Might the Chinese authorities tighten aggressively?

Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 in a four-season framework (see China Economics: A Goldilocks Scenario in '10, November 23, 2009). Specifically, ‘autumn' features a combination of a tepid G3 recovery and normalizing policy stance in China that would deliver a ‘Goldilocks Scenario'. We assign a 70% subjective probability to this scenario.

‘Summer' features a combination of vigorous G3 recovery and normalizing policy stance in China that would result in ‘Overheating'. If G3 economic recovery in 2010 were to be much stronger than expected, China's export growth and thus industrial capacity utilization, as well as global commodity prices, could both surprise to the upside, likely resulting in higher GDP growth and stronger inflationary pressure if the policy stance were to remain unchanged. We think that this is the most likely alternative scenario and assign it a 15% subjective probability.

‘Spring' features a combination of a vigorous G3 recovery and aggressive tightening that would help achieve a ‘Policy-Induced Soft Landing'. To realize this scenario, the timing and modality of policy tightening would be absolutely key. Given the Chinese policymakers' track record, this tends to be difficult to achieve. We therefore assign only a 5% probability to this scenario.

‘Winter' features a combination of a tepid G3 recovery and aggressive tightening in China that would lead to a ‘policy-induced double-dip'. The key headline macroeconomic indicators (e.g., year-on-year GDP and export growth) may improve rapidly because of the low base effect in the coming quarters. Subsequently, policymakers may turn complacent and launch a round of aggressive tightening for fear of economic overheating despite only a tepid G3 recovery. This would likely derail a recovery, causing a double-dip in economic growth. We assign a 10% probability to this scenario.

While a consensus has been formed around a ‘Goldilocks Scenario' (‘autumn'), the primary concern among market participants in the latter part of 2009 about the downside risks to the Chinese economy seem to have been a fear of the ‘winter' scenario, or a policy-induced double-dip due to premature tightening. However, developments in the last couple of months, domestic or external, have helped lower the probability of this scenario. First, the key message from China's Central Economic Work Conference, held in early December 2009, reassured the market of policy stability and continuity in 2010, thereby reducing policy uncertainty in the near term (see China Economics: Policy Priority Shifts Toward Boosting Private Demand, December 8, 2009). Second, there have been more convincing signs of a sustainable recovery in major industrialized economies (see US Economics: Outlook 2010: Higher Rates, Fed Exit and Sustainable Growth, January 4, 2010, and European Economics: Transition Towards a Tepid Recovery, January 4, 2010).

B) Is Tepid External Demand Intact?

The stronger-than-expected export growth points to upside risk to our baseline forecasts for both growth and inflation. The strong recovery in December 2009 has taken shipments back to a level only about 10% below the pre-crisis peak reached in September 2008. And the recovery has been broad-based across markets. Since exports to the US and Europe have not recovered to the same level as aggregate exports have, it suggests that the surprisingly rapid export growth in December must have been due to strong growth in shipments to emerging economies (i.e., AXJ, Latam, Africa), although the latest data points for these regions are not yet available.

Under our baseline scenario, we forecast 9% export growth in 2010, a significant bounce-back from the 16% decline in 2009. If, however, we were proved to be too conservative, especially vis-à-vis the potential strength of emerging market demand, China will face significant upside risk to inflation and growth, in our view.

Export growth is an important gauge for inflationary pressures, as it is a useful proxy for output gap, especially in the industrial sectors, in China. Weak exports are disinflationary. As we have pointed out, given the approximate six-month lag effect of accommodative monetary conditions in 2009, the key swing factor in determining inflation is how fast the output gap will close, which is a function of export growth rate (see China Economics: Worried About Inflation? Get Money Right First, October 20, 2009). Therefore, if export growth were sustained at a 15-20% range in 2010, instead of our current forecast of 9%, our forecasts of inflation and GDP growth would need to be lifted.

C) Is Policy Normalization Intact?

While the exact timing of the RRR hike was a surprise, our call has been that the RRR hike would be the first and primary monetary policy tool that the Chinese authorities use in 2010. This first RRR hike should not be interpreted as the beginning of outright tightening, in our view, and our call for a policy normalization while maintaining support for growth remains unchanged. Here's why:

First, the RRR hike is typically considered a strong and blunt policy instrument employed by central banks to tighten monetary policy. This is, however, not the case in China. The RRR more than doubled from 8% in mid-July 2006 to 17.5% in August 2008 through very frequent hikes during this period of time. This coincided with the rapid increase in FX reserves in China. RRR hikes should be considered a conventional policy tool for the central bank to sterilize excess liquidity in the system stemming from rapid reserves accumulation. Given the infeasibility of allowing a large-enough renminbi revaluation to help eliminate balance of payment surpluses, RRR hikes become the most-favored among a handful of policy instruments to help mop up liquidity. Given the current exchange rate regime, as long as sizeable balance of payments surpluses persist, the PBoC will need to keep mopping up liquidity through RRR hikes (again see China Economics: RRR Hike Cycle Kicks off Earlier than Expected).

Second, RRR hikes help mop up excess liquidity but do not necessarily reduce the existing liquidity in the system, and therefore do not impose a binding constraint on banks' capacity - even at the margin - to make loans. We had expected the first RRR hike in early 2Q. We believe that the earlier timing has to do with a jump in the excess reserve ratio (ERR) to over 3% at the end of December from 2% in September, reflecting the earlier-than-expected return of external surpluses and the massive drawdown of treasury deposits from the central bank by fiscal budget units in a year-end rush to spend. Therefore, we believe that the RRR hike was in response to this jump in ERR. This again suggests that the RRR hike does not affect banks' ability to make loans.

Third, the availability of credit is always the most important gauge of monetary policy stance in China. We forecast Rmb7.5 trillion of new loans in 2010 (with upside risk), implying 18-19%Y loan growth, which is still quite accommodative. We also estimate that about Rmb1.5 trillion out of Rmb9.5 trillion loans made in 2009 have not actually been utilized, but remain available for 2010. So, the effective amount of new bank lending in 2010 could be Rmb9 trillion, versus Rmb8 trillion in 2009. In other words, we see monetary and credit conditions remaining supportive of the real economy this year, and we believe that credit costs are unlikely to increase substantially.

D) Implications

The recent developments on both the economic and policy fronts carry two important implications: a) growth momentum in China is strong, with potentially stronger-than-expected external demand likely providing an additional boost. This suggests that demand from China for key commodities will be robust and sustainable, thus benefiting countries/companies with large exposure to China's domestic market. b) Concerns about imminent aggressive policy tightening that could derail the current trends are unwarranted, although stronger-than-expected economic activity could bring forward policy changes that are part of policy normalization (e.g., RRR hikes, interest rate hikes), in our view.

The primary risk to our calls is that full-blown overheating - as envisaged under the ‘summer' scenario (featuring 12% GDP growth and 5% CPI inflation) - could materialize in the latter part of the year and thus trigger campaign-style tightening, which would result in a boom-bust cycle in the Chinese economy. This scenario, while not impossible, is not probable, in our view.

E) What's Next?

We will likely revisit our forecasts and policy calls soon, after taking a comprehensive review of the entire dataset in 4Q09, together with the revised historical GDP data for 2008 and earlier years.

Global
Living with the Trilemma
January 22, 2010

By Manoj Pradhan | London

Living with the Trilemma: Recent data from emerging and developed markets underscore the diverging outlook for these two economic hemispheres. While Emerging Markets (EM) have continued to show robust growth, data in many Developed Markets (DM) have disappointed, especially in Europe and Japan. Unsurprisingly, recent communication from the major central banks has been dovish, suggesting that an AAA (ample, abundant, augmenting) liquidity regime will remain in place for a considerable period of time. The Asia ex-Japan (AXJ) region, with its economic outperformance and ‘soft-pegs' for some currencies, is the natural recipient of global capital flows that result from rising risk appetite and easy monetary conditions. As a response to the Great Recession, central banks the world over acted as one in slashing interest rates. Further down the road, however, the risk is that AXJ central banks might need to raise policy rates faster than others, which could attract even more capital and put upward pressure on their currencies - the Trilemma of a Sudden(ish) Start!

The Trilemma is the moniker associated with the balancing act of maintaining a currency peg, an independent monetary policy and free flows of international capital (see What Is the Trilemma? below). A pertinent example of the logic of the Trilemma is when a central bank (typically one in EM, with a preference for avoiding ‘excessive' appreciation of its currency) wants to raise policy rates to fight domestic inflation. Rising interest rates could then attract more capital flows, which would put upward pressure on the currency. Exactly this issue was echoed in the Reserve Bank of India's policy meeting in October 2009, when it expressed concern at the possibility of "perverse" capital inflows as a consequence of its efforts to ward off inflation by raising its policy rate. This is particularly interesting since India's currency enjoys considerably more flexibility than that of many of its regional neighbours whose currency values are pegged officially or unofficially to the US dollar.

A tale of two worlds...and central banks: Our base case is that AXJ economies will outperform the G10 region by a wide margin. The BBB (bumpy, below-par and boring) recovery in the major economies will assert itself by prompting central banks there to keep liquidity abundant. Our economists expect the first hikes from the Fed and the ECB to appear in 3Q10. The PBoC is expected to raise policy rates around the same time, but the RBI and the BoK are expected to start hiking rates already in the current quarter.

Risks to the outlook have diverged as well: In addition, the risks for the economic outlook are skewed to the upside for AXJ economies, while they are more balanced or even to the downside for developed economies. Asset prices are high in both theatres, but the run-up in house prices in Asia has surprised many and is clearly on the radar for central banks in the region. In all, AXJ central banks face the prospect of having to tighten earlier than expected, while the risk in the major economies is that central banks leave their policy rates lower for longer than markets expect. Therein lies the risk that the Trilemma will reassert itself.

Diverging monetary policy paths are key: Such a divergence in the policy stance is then likely to trigger further capital flows into the AXJ region, putting upward pressure on currencies there. Strong domestic growth in the AXJ economies would raise the risk of inflation (already apparent in India and Indonesia) and some monetary authorities would need to respond with tighter policy. But rising rates could result in even greater capital flows and more appreciation pressure for the currencies - the Trilemma in action.

Divergence and the Trilemma may show up as early as 2H10: The Trilemma is not a concern at the moment. Why? For one thing, capital flows are still not as strong as they were before the Great Recession, when the Trilemma was becoming a concern (see Impossible Trinity Challenge Emerges Again, Chetan Ahya, October 7, 2007). Second, AXJ countries are running smaller current account surpluses now than they were in 2007 on the back of weaker exports and stronger domestic demand. Core inflation is still at benign levels everywhere in the region. But, most importantly, in our opinion, there is not currently a great amount of divergence in the base case for the expected monetary policy paths of the G10 and AXJ regions.

The response to the Great Recession and to the ongoing recovery has meant that central banks all over the world have acted in a synchronised fashion. If they continue to withdraw stimulus in a synchronised manner, then AXJ central banks will be tightening policy in tandem with the major central banks. In this case, they would not need to assert monetary independence. If the Fed and the ECB start by 3Q10 as we expect, AXJ economies will inherit this tightening (see "The Peloton Holds Firm", The Global Monetary Analyst, November 4, 2009). But if the major central banks take on extra growth insurance by postponing rate hikes, then AXJ central banks may find themselves leading the pack and setting the stage for the Trilemma to reappear. AXJ central banks would then have to rely on the tools they have in place to ward off the trade-offs of the Trilemma...or relent.

Different tools for a common concern: The different approaches to dealing with the Trilemma are exemplified by the paths taken by the Chinese and Indian central banks. China, with its ‘soft-peg' to the US dollar has in place capital and credit controls that neutralise the role that capital flows play in the Trilemma. This allows the PBoC to maintain the exchange rate and retain monetary independence if it needs to raise interest rates to fight inflation. The Indian rupee, on the other hand, has considerably more flexibility, but it is difficult to believe that the RBI would be tolerant of excessive appreciation. The flexibility on the exchange rate front provides the RBI some monetary independence, and it now appears that this independence may be called into action soon to fight inflation. Indeed, our India economics team expects a kick-off to the policy rate hiking cycle at the January 29 meeting in the face of inflationary pressures. Most other countries are somewhere in between, allowing some currency appreciation already, possibly to prevent bigger issues later.

The Trilemma really kicks in only when either capital flows become excessive, or monetary policy needs to diverge meaningfully from that of the major central banks in order to fight domestic inflation. So far, capital flows into the AXJ region mean that foreign exchange reserves at central banks are rising again, but these flows have not reached levels that make them difficult to deal with. Inflation too is low almost everywhere in the AXJ region, but strong growth carries with it an inflation warning and central banks are paying attention, particularly in India and Indonesia where inflation is already a concern.

Ironically, rising inflation would help to alleviate the Trilemma somewhat. If nominal exchange rates are held steady, then a rise in inflation in AXJ economies would lead to real exchange rate adjustments which would release some pressure from the Trilemma. How? Allowing inflation to rise clearly requires less action from monetary authorities and hence reduces the need for monetary independence. But a real appreciation of the currency also reduces export competitiveness, thereby reducing the current account surplus. However, rising inflation is clearly not a preference for central banks anywhere in the world, so this manner of adjustment is unlikely to occur. Finally, a large chunk of the foreign exchange reserves that have been built up with Asian and other central banks have found their way back into developed markets, particularly the US (and to a lesser extent, the euro area) fixed income markets. As long as this recycling stays in place, it will continue to alleviate some of the pressure on EM currencies. There too, risks abound, particularly given our US team's forecast for 10-year Treasury yields rising to 5.5% by the end of 2010, creating a sell-off as yields rise from their current level of 3.7% (see US Economics: The Case for Higher Real Rates, Richard Berner/David Greenlaw, December 15, 2009).

What if countries do relent? "And if the cloud bursts, thunder in your ear" wrote Pink Floyd many years ago. Giving in to the demands of the Trilemma may not be quite as universally noticeable, but would certainly have quite an impact on markets. Relenting may take the form of allowing AXJ currencies to appreciate meaningfully, or for central banks there to check the rate at which they tighten policy to bring interest rates more in line with those of the major central banks, though the latter would mean less control over inflation. But investor interest is naturally particularly focused on the outlook for China. Our China economics team believes that capital controls in place in China are sufficient to allow the PBoC considerable monetary independence, and that any currency appreciation will likely only take place after interest rates have been raised (see China Economics: RRR Hike Cycle Kicks Off Earlier than Expected, Qing Wang, January 12, 2010). Markets also place a very low probability on a move in the renminbi. It would certainly be thunder in our ears if the Trilemma pushed monetary authorities there to allow currency appreciation sooner than expected.

What Is the Trilemma?

The Trilemma is the moniker associated with the balancing act of maintaining a currency peg, an independent monetary policy and free flows of international capital.

In a textbook world of perfect capital flows and a fixed exchange rate, a central bank can only choose two of the three. Why? This is easiest to explain with examples. Let's label the emerging market economy as the ‘domestic' economy and the country to which its currency is linked as the ‘base'.

Now suppose there are strong capital inflows into the domestic economy in response to strong economic growth. The first impact is to create greater demand for the EM currency. With no capital or credit controls, these funds would flow into the banking system and then into the broader economy, augmenting growth and raising the risk of inflation. The central bank of the domestic economy, forever distasteful of inflation, would then try to raise its policy rates. In doing so, domestic interest rates would rise relative to those of the base country, triggering even more capital flows into the domestic economy. Clearly, the central bank has to either (i) directly curb capital flows through capital and/or credit controls, (ii) allow the currency to appreciate, which would reduce capital flows by reducing the expected return on these flows, or (iii) give up monetary independence and allow domestic interest rates to be completely determined by interest rates of the base country.

Evidence from the real world: In the real world, the broad story still holds, but capital flows are restricted to some extent, currencies pegs are generally ‘soft' (i.e., unofficial pegs that are allowed to show some appreciation/depreciation) and central banks don't strive for complete independence from the base country as part of their monetary policy strategy. There has been some debate about whether the Trilemma is actually a valid concern in the modern era, but recent research by Shambaugh (2004) and Obstfeld, Shambaugh & Taylor (2008) suggests that the Trilemma is alive and well.

Does having a hard peg, a soft peg or a free float matter? Yes, but not as much as one might think: One would imagine that the Trilemma holds to a much greater degree for countries with a hard peg (i.e., currencies that are officially pegged), to a lesser extent for countries with soft pegs, and not at all for currencies that float freely. Obstfeld et al provide evidence that countries that peg their currencies face more constraints from the Trilemma than non-peggers do. However, the difference between hard pegs and soft pegs and between peggers and non-peggers is not as wide as it first seems in the real world. First, hard pegs are not necessarily perfectly credible, and probably never have been according to research by Mitchener & Weidenmier (2009). This brings them much closer in spirit to soft pegs, which often survive for long periods because the flexibility they provide may be seen to increase the credibility of such a regime. Finally, examples of freely floating currencies are seen mostly for advanced economies or some small EM economies.

In the aftermath of the Asian Financial Crisis of the late 1990s, EM and particularly AXJ currencies were advised to stay away from flexible exchange rates. But the evidence shows that many countries have continued to keep the currency peg with the US dollar quite stable. Calvo and Reinhart (2002) call this development the ‘Fear of Floating', as a reference to the uncertainty that a freely floating currency brings to export-oriented economies that depend on international debt markets for funding.

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