There has been a lot of talk about sovereign debt risk since the Dubai World panic over Thanksgiving. You have seen pressure not only on government obligations in Dubai, but also in Greece, Spain and Ireland and a spillover into other unrelated markets. At issue is how best to weather a crisis given the Impossible Trinity of free movements in capital, independent monetary policy and fixed exchange rates. A country can pick two, but no one can have all three.
The hallmark of a crisis is the wholesale and indiscriminate move to safe havens by investors. The likelihood of market contagion is huge as was well demonstrated during the Asian Crisis and Russian devaluation in 1997-98 and the collapse of LTCM. The events in Dubai certainly show this as well.
How do you protect your domestic financial markets from this kind of thing? Different foreign exchange regimes can be useful in preventing worst case scenarios. But, every solution has its problems; there is no magic bullet for countries looking to escape the volatility of financial market globalization. Until we develop a more stable currency framework, you can expect volatility to play out via FX.
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