More flexible exchange rates should not be viewed as a 'panacea' for correcting external imbalances, Monetary Authority Chief Executive Joseph Yam says.

In his weekly Viewpoint column, Mr Yam said the US's external imbalance has been the focus of international attention for some time. It has been there for longer than anyone expected and keeps expanding, he added.

But the US current-account balance continues to be financed quite easily through borrowing from overseas because those with domestic savings exceeding domestic investments are willing to hold claims against US residents.

'Xenophilia' mentality leads to 'developed-economy bias'

Mr Yam said he has observed a 'xenophilia' mentality in the developing world that shows up in a 'developed-economy bias' in their assets, as there is a large gap between the developed and the developing economies at the social, political, economic and technological levels.

Asian economies' international investment position, measured against GDP, is fairly high, with Hong Kong being the highest in the world in 2004. And much of those international investments is in the developed markets.

As the developing economies progress and the risk-adjusted expected rate of return in domestic investments, or investments within the region, rises relative to those of the developed economies, the growing concentration of claims against US residents leads logically to diversification.

Mr Yam noted a significant correction in the external imbalance may eventually occur. This phenomenon could be described as a reversal of the decline of the home bias.

He said the debate on the external imbalance suggests there is inadequate domestic consumption or investment, or the exchange value of the surplus economy's currency is too low.

That leads to a tendency to prescribe more flexible exchange rates as a panacea for correcting external imbalances.

Mr Yam said this is not the only alternative to adjustment, if adjustment is needed. As there is a tendency for exchange rates to overshoot their equilibrium values, the adjustment process may create unnecessary volatility.

Allowing market forces to work through the internal cost and price structure may be a better alternative, as it may involve less risk to monetary and financial stability than exchange-rate adjustments.

Mr Yam added this alternative process may take a little more time, but as long as the economy is adequately flexible, it may be the safer route.