That this situation may cause a bank run under a fixed rate with no domestic credit (a currency board) is not very surprising. What may be surprising is that the Central Bank cannot fully succeed as a lender of last resort. This happens because, although the Central Bank can print pesos, it cannot print the dollars that are effectively needed to back the whole amount of demand deposits. By printing domestic currency to save the banks it only ensures the demise of the peg, as central banks in Mexico, Indonesia, Korea and Thailand, among others, have recently learned. Source
Other exchange rate arrangements
The analysis of this section so far assumes that the Central Bank fights a devaluation like a dog.Sb This is implied, in particular, in the assumption that the Central Bank stops selling dollars in the first period only after the domestic asset has been liquidated to the maximum consistent with external debt being serviced. One may ask what would happen with a less committed Central Bank. For example, a Central Bank procedure may could for stopping the sale of dollars before using up the maximum amount of dollars available in the short run, and allowing the market to clear via an exchange rate adjustment. That would be, effectively, a system of flexible rates.
We have studied that question (and several others having to do with the design of exchange rate systems under bank fragility) in Chang and Velasco (1998a). Our main conclusion is that flexible exchange rates, coupled with a Central Bank that acts as a lender of last resort, can reduce financial fragility in a way fixed exchange rates cannot.
Rather than restating our analytical results, we conclude by underscoring the main policy implications of our analysis.
The short maturity of capital inflows, more than their absolute size, can contribute to bank fragility. Therefore, disincentives for short-term foreign borrowing by banks may well be justified. High required reserves on bank liquid bank liabilities (whether in domestic or foreign currency, and whether owed to locals or foreigners) is an obvious choice . It may be sound policy even if it has some efficiency costs or if causes some disintermediation. An obvious caveat is that, if banks are constrained, firms will do their own short-term borrowing, as it happened massively in Indonesia. A policy that is not subject to this caveat is taxes on all capital inflows, where the tax rate in inverse proportion to the maturity of the inflow (and where long term flows such as FDI go untaxed at the border) -as employed by Colombia and Chile in the 1990s. But this advantage is also a potential cost, in that the inefficiencies associated with a restricted set of borrowing options apply to a larger share of the economy.