The East Asian exchange rate trap

After the East Asian financial crisis in 1997, most East Asian economies switched their exchange rate arrangements back to soft dollar pegs (except Japan) and have been running current account surpluses consistently (including Japan). However, due to the prevailing dollar standard in international capital markets, these creditor economies are forced into investing their current account surpluses in foreign-currency claims (largely in dollars), both privately held and as official exchange reserves. As a result, their trade surpluses and the rapid accumulation of official foreign exchange reserves are alleged to be evidence of currency "undervaluation". Thus these high-saving East Asian economies are subject to foreign pressures to appreciate or freely float their currencies.; We first analyze the medium-term impact of maintaining "soft" dollar pegs on portfolio investment and its macroeconomic consequences in a country with "conflicted virtue" before any discrete exchange rate change occurs. In this sense, it is an "ex ante" model. It establishes that, over time, the accumulation of dollar assets in creditor countries generates negative risk premia in domestic interest rates, which in the extreme case, can lead to a zero-interest liquidity trap---as in Japan. The portfolio-balance model with ongoing economic growth at a fixed dollar exchange rate is then used to evaluate the policy options of sterilized versus unsterilized foreign exchange interventions.; We then consider the ex post impact of a discrete change in the dollar exchange rate of a peripheral country under the dollar standard, and the implications for its net trade balance. The asymmetry of the dollar standard requires a detailed investigation of the differential impact on dollar debtors versus creditor countries. A devaluation may well improve the trade balance of a debtor economy by depressing domestic absorption; but an appreciation has an ambiguous effect on the trade balance of a creditor economy. Because exchange rate changes can no longer be separated from domestic price-level and absorption effects, they cannot be used predictably, except in special cases, to adjust the trade balance.