Financial Constraints and Exchange Rate Flexibility in Emerging Market Economies

Abstract

Empirical evidence from the Asian financial crisis of 1997-1998 suggests that exchange rate depreciation may have had a contractionary effect on the traded good sector of the worst-hit economies. Many writers have suggested that this was caused by exchange rate sensitive credit constraints affecting the production sector. This paper documents some of this evidence, and uses it to develop a structural model that features an important role for credit constraints in the financing of traded goods production. We show that this model can explain why emerging market governments would be more concerned with variations in exchange rates than would be implied by standard 'optimal currency area' criteria. Moreover, the model implies that monetary policy may be a very ineffective tool in emerging market economies.