The currency crises of the 1990s have led economists to rethink their views on exchange rate policies in emerging countries. Specifically, these crises have led many economists to question the merits of pegged-but-adjustable exchange rates, both in the sII.1 Nominal Anchors and Exchange RatesIn the late 1980s and early 1990s, and after a period of relative disfavor, rigid nominal exchange rates made a comeback in policy and academic circles. Based on time-consistency and political economy arguments, a number of authors argued that fixed, orHowever, a recurrent problem with exchange rate-based stabilization programs – and one that was not fully anticipated by its supporters —was that inflation tended to have a considerable degree of inertia. That is, in most episodes domestic prices and waIf inflation is indeed characterized by a high degree of inertia, a fixed – or predetermined -- nominal exchange rate will result in a real exchange rate appreciation, and consequently in a decline in exports’ competitiveness. Dornbusch (1997, p. 131) fCapital Flow Reversals, Capital Controls and Exchange Rate RegimesIV.1 Super-Fixed Exchange Rate Regimes: Myths and RealitiesIV.1.1 Argentina’s Currency BoardIV.1.2 Panama and DollarizationIV.2 On the Feasibility of Floating Exchange Rates in Emerging Economies: Lessons from MexicoTable 1ArgentinaSource: Constructed from data obtained from DatastreamTable 5: Comparative Exchange Rate VolatilitySource: Constructed from data obtained from DatastreamNovember 1997 - May 1998June 1998 – April 1999January 1996 – October 1999List of FiguresEXCHANGE RATE REGIMES, CAPITAL FLOWSANDCRISIS PREVENTIONBySebastian EdwardsUniversity of California, Los AngelesAndNational Bureau of Economic ResearchOctober, 2000Revised: September 2001* This is a revised version of a paper prepared for the National Bureau of EconomicResearch Conference on “Economic and Financial Crises in Emerging MarketEconomies,” held in Woodstock, October 19-21, 2000. I have benefited fromconversations with Ed Leamer. I thank Marty Feldstein for comments.1I. IntroductionThe emerging markets financial crises of the 1990s had remarkable similarities.1Attracted by high domestic interest rates, a sense of stability stemming from rigidexchange rates, and what at the time appeared to be rosy prospects, large volumes offoreign portfolio funds moved into Latin America, East Asia and Russia. This helpedpropell stock market booms and helped finance large current account deficits. At somepoint, and for a number of reasons, these funds slowed down and/or were reversed. Thischange in conditions required significant corrections in macroeconomics policies.Invariably, however, adjustment was delayed or was insufficient, increasing the level ofuncertainty and the degree of country risk. As a result, massive volumes of capital leftthe country in question, international reserves dropped to dangerously low levels and realexchange rates became acutely overvalued. Eventually the pegged nominal exchange ratehad to be abandoned, and the country was forced to float its currency. In some cases --Brazil and Russia are the clearest examples --, a severe fiscal imbalance made thesituation even worse.Recent currency crises have tended to be deeper than in the past, resulting in steepcosts to the population of the counties involved. In a world with high capital mobility,even small adjustments in international portfolio allocations to the emerging economiesresult in very large swings in capital flows. Sudden reductions in these flows, in turn,amplify exchange rate and/or interest rate adjustments and generate overshooting, furtherbruising credibility and unleashing a vicious circle. Two main policy issues have beenemphasized in recent discussions on crises prevention: First, an increasing number ofauthors have argued that in order to prevent crises, there is a need to introduce majorchanges to exchange rate practices in emerging economies. According to this view,emerging economies should adopt “credible” exchange rate regimes. A “credible”regime would reduce the probability of rumors-based reversals in capital flows, includingwhat some authors have called have called “sudden stops.” These authors have pointedout that the emerging economies should follow a “two-corners” approach to exchangerate policy: they should either adopt a freely floating regime, or a super-fixed exchange 1 I am referring to the crises in Mexico (1997), East Asia (1997), Russia (1998) and Brazil (1999).2rate system.2 Second, a number of analysts have argued that the imposition of capitalcontrols – and in particular controls on capital inflows -- provides an effective way forreducing the probability of a currency crisis.The purpose of this paper is to analyze, within the context of the implementationof a new “financial architecture,” the relationship between exchange rate regimes, capitalflows and currency crises in emerging economies. The paper draws on lessons learnedduring the 1990s, and deals with some of the most important policy controversies thatemerged after the Mexican, East Asian, Russian and Brazilian crises. I also evaluate somerecent proposals for reforming the international financial architecture that haveemphasized exchange rate regimes and capital mobility. The rest of the paper isorganized as follows: In section II I review the way in which economists’ thinking aboutexchange rates in emerging markets has changed in the last decade and a half. Morespecifically, in this section I deal with four interrelated issues: (1) The role of nominalexchange rates as nominal anchors. (2) The costs of real exchange rate overvaluation. (3)Strategies for exiting a pegged exchange rate. And (4), the “death” of middle-of the-roadexchange rate regimes as policy options. In Section III I deal with capital controls as acrisis-prevention device. In this section Chile’s experience with market-based controlson capital inflows is discussed in some detail. Section IV focuses on the currentlyfashionable view that suggests that emerging countries should freely float or adopt asuper-fixed exchange rate regime (i.e. currency board or dollarization). In doing this Ianalyze whether emerging markets can adopt a truly freely floating exchange rate system,or whether, as argued by some analysts, a true floating system in not feasible in lessadvanced nations. The experiences of Panama and Argentina