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Exchange Rate Pegs and Foreign Exchange Exposure in East and South East Asia - page 2 / 33

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I.

Introduction

As recent international financial events have demonstrated, an exchange rate crisis

can expand quickly into a broader financial and economic crisis. The rapid expansion of

exchange rate crises beyond the foreign exchange markets reflects in part the importance

of the exchange rate to firm profitability. Exchange rates affect profitability through many

routes. First, they affect directly those firms with financial assets and liabilities (most

notably debt) denominated in foreign currency and those firms with foreign operations. In

addition, through their effect on foreign competition and domestic macroeconomic

conditions, exchange rates also can impact the profitability of firms with no foreign

currency revenues at all.1 Thus, a potentially wide range of firms could be exposed to

movements in foreign exchange rates, regardless of their direct financial exposure.

Most empirical studies of exchange rate exposure to date have focused on western

industrial countries, and most have found only modest exposure. In contrast, we focus on

Asia-Pacific countries, and we find that their experience has been different. Our sample of

countries includes some that differ markedly from the large, western economies in terms of

their size, participation in international trade and borrowing, and financial development.

These countries also differ among themselves in terms of how they experienced the Asian

financial crises. Just as importantly, they provide variation in exchange rate arrangements

both across countries and during the sample period. A country’s exchange rate

arrangement fundamentally defines the terms on which its economic interactions with the

rest of the world are conducted, and it determines the course of domestic monetary policy.

Hence, at a most basic level, the arrangement can impact exchange rate exposure. For all

1 Marston (2001) provides a model that focuses carefully on cash flows and industry structure to explain when exposure depends only on its net foreign currency revenues and when it depends on other variables.

1

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