Currency Mismatches And Exchange Rate Regime Choice

The risk of currency mismatch, as a type of economic and financial feature universallyexisting in emerging market economies, is typically intermingled with the adjustment andvariation of the exchange rate, which is usually closely associated with the exchange rate regime.For this reason, in the circumstance of financial globalization and mass cross-border flows ofcapital, the currency mismatch makes the emerging market economies met with more difficult andcomplicated problems concerning the choice of the exchange rate regimes.On the one hand, since1990s, the emerging market economies have been undergoingintricate and complex evolution and changes of the currency mismatch, with intertwinedcoexistence and mutual conversion of two types—liability-based currency mismatch andasset-based currency mismatch. On the other hand, since1990s, with the evolving conditions ofcurrency mismatch, notwithstanding the remarkable improvement of the elasticity of the exchangerate regimes in most emerging market economies, their exchange rate regimes remain featured byintervention to a larger extent, taking on obvious fear of floating. And there exists thenon-monotonic relationship between the currency mismatch and the exchange rate regimeflexibility in emerging market economies, which shows a trend of inverted U-shape changes.This paper will focus on the discussion about the exchange-rate regime choice of theemerging market economies from the perspective of the currency mismatch mainly via themainstream macro-economics analysis methods as well as the exploration of the relationshipbetween liability-based currency mismatch, asset-based currency mismatch and the exchange-rateregime choice of the emerging market economies. The core questions to be answered in this textare: First, why can the conditions emerge as the significant restraint of the exchange-rate regimechoice of the emerging market economies? Second, how will these emerging market economiesmake choices of the exchange-rate regime in the context of the currency mismatch?In this paper, a simple model of small open economy is used for the analysis of the reasonwhy the currency mismatch will form the significant restraint on the exchange-rate regime choiceof the emerging market economies. It is discovered that, the output will not be sensitive to theexchange rate variations when the economy is at a moderate currency mismatch level, and theexchange rate variations will cause slight and substantial changes in the output on the occasions of modest and great deviation of the currency mismatch conditions from this moderate mismatchlevel respectively. This means that the sensitivity of the output to the exchange rate variationdepends on the conditions of the currency mismatch in the economy. It follows that the conditionsof the currency mismatch—either liability-based currency mismatch or asset-based currencymismatch, constitutes the significant restraint on the choices of the exchange rate regimes of theemerging market economies.On this basis, this paper also presents a further discussion about the relationship between thecurrency mismatch and the optimum choices of the exchange rate regimes of the emerging marketeconomies by virtue of a model of small open economy with micro basis to the effect what choicesof the exchange rate regimes are made in the context of diverse currency mismatch conditions.And it is indicated in this analysis that, on the prerequisite of rational expectations, the choice ofthe exchange rate regimes of the emerging market economies depends on the choice of originalexchange rate regime and the degree of the currency mismatch in the economy.If the floating exchange rate regime is being implemented in the economy and is featured byits suitable mismatch level, then such exchange rate regime is a balanced one. Such being the case,the choice of the floating exchange rate has the path dependence and the decision makers willcontinue to implement such exchange rate.On the other hand, if the fixed exchange rate regime is being implemented in the economyand is featured by a type of mismatch to a larger extent, then such exchange rate regime, be itliability-based currency mismatch or asset-based currency mismatch, is a balanced one. In thiscase, the choice of the fixed exchange rate has the path dependence and the decision makers willcontinue to implement this exchange rate. On the contrary, if the fixed exchange rate regime isbeing implemented in the economy and is featured by a type of mismatch to a lower degree, thensuch exchange rate regime remains not a balanced one, in which case the decision makers willshift from the fixed exchange rate regime to the floating exchange rate regime.Meanwhile, it is also indicated in this analysis that if the floating exchange rate regime andthe fixed exchange regime are balanced ones, the former can bring higher expected welfare.Therefore, in the context of the original fixed exchange rate regime and serious currency mismatch,if the decision makers conduct direct regulations on the asset portfolio through some policies andmeasures in order to guide the agent-held asset portfolio compatible with the floating exchangerate and lower the degree of the currency mismatch with a view to making the flexible exchange rate regime the optimum policy and regime, the decision makers will shift from the fixedexchange rate regime to the floating exchange rate regime to improve the welfare level of theeconomy.Based on the above analysis, we has further discussed the new features taking on in thecurrency mismatch and the choice of the exchange rate regimes of the emerging market economiesin East Asia since the new millennium. And since the21stcentury, the conversion from theliability-based currency mismatch to the asset-based currency mismatch has been seen in most ofthe emerging market economies in East Asia; simultaneously, the features such as "fear of floatingin reverse" or "fear of appreciation" have also taken on in the exchange rate regimes of theemerging market economies in East Asia. This feature shown in the exchange rate regimearrangements of the emerging market economies in East Asia, as a matter of fact, is an endogenousreflection of the asset-based currency mismatch under the circumstance of conflicted venture. Andsuch an exchange rate regime choice is still carrying potential great risks.Concerning the emerging market economies in East Asia, in the long run, the implementationof the flexible exchange rate regime cannot only facilitate the reduction of the risks from thecurrency mismatch but also bring higher welfare. To this end, it is required that the emergingmarket economies in East Asia give priority to the measures taken to lower the degree of thecurrency mismatch and create the prerequisites for the transformation of the pegged exchange rateregime into the flexible one.