Tag Archives: exchange rates

Assigned Readings: February 8, 2014

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Based on a dataset of 112 emerging economies and developing countries, this paper addresses two key questions regarding the accumulation of international reserves: first, has the accumulation of reserves effectively protected countries during the 2008-09 financial crisis? And second, what explains the pattern of reserve accumulation observed during and after the crisis? More specifically, the paper investigates the relation between international reserves and the existence of capital controls. We find that the level of reserves matters: countries with high reserves relative to short-term debt suffered less from the crisis, particularly if associated with a less open capital account. In the immediate aftermath of the crisis, countries that depleted foreign reserves during the crisis quickly rebuilt their stocks. This rapid rebuilding has, however, been followed by a deceleration in the pace of accumulation. The timing of this deceleration roughly coincides with the point when reserves reached their pre-crisis level and may be related to the fact that short-term debt accumulation has also decelerated in most countries over this period.

We explore the role of financial openness – capital account openness and gross capital inflows – and a newly constructed gravity‐based contagion index to assess the importance of these factors in the run‐up to currency crises. Using a quarterly data set of 46 advanced and emerging market economies (EMEs) during the period 1975Q1‐2011Q4, we estimate a multi‐variable probit model including in the post‐Lehman period. Our key findings are as follows. First, capital account openness is a robust indicator, reducing the probability of currency crisis for advanced economies, but less so for EMEs. Second, surges in gross (but not net) capital inflows in general increase the risk of a currency crisis, but looking at a disaggregated level, gross portfolio flows increase the risk of a currency crisis for advanced economies, whereas gross FDI inflows decrease the risk of a crisis for EMEs. Third, contagion has a very strong impact, consistent with the past literature, especially during the post‐ Lehman shock episode. Last, our model performs well out‐of‐sample, confirming that early warning models were helpful in judging relative vulnerability of countries during and since the Lehman crisis.

This paper revisits the bipolar prescription for exchange rate regime choice and asks two questions: are the poles of hard pegs and pure floats still safer than the middle? And where to draw the line between safe floats and risky intermediate regimes? Our findings, based on a sample of 50 EMEs over 1980-2011, show that macroeconomic and financial vulnerabilities are significantly greater under less flexible intermediate regimes—including hard pegs—as compared to floats. While not especially susceptible to banking or currency crises, hard pegs are significantly more prone to growth collapses, suggesting that the security of the hard end of the prescription is largely illusory. Intermediate regimes as a class are the most susceptible to crises, but “managed floats”—a subclass within such regimes—behave much more like pure floats, with significantly lower risks and fewer crises. “Managed floating,” however, is a nebulous concept; a characterization of more crisis prone regimes suggests no simple dividing line between safe floats and risky intermediate regimes.

This paper examines the effectiveness of capital outflow restrictions in a sample of 37 emerging market economies during the period 1995-2010, using a panel vector autoregression approach with interaction terms. Specifically, it examines whether a tightening of outflow restrictions helps reduce net capital outflows. We find that such tightening is effective if it is supported by strong macroeconomic fundamentals or good institutions, or if existing restrictions are already fairly comprehensive. When none of these three conditions is fulfilled, a tightening of restrictions fails to reduce net outflows as it provokes a sizeable decline in gross inflows, mainly driven by foreign investors.

Desperate Times, Desperate Measures

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The selloff of emerging market currencies and equities continued last week. A Bank of America report noted that investors withdrew $6.4 billion last week from emerging market stock funds, while bond investors are also showing signs of retreating. Moreover, the declines in currency values have expanded outside the “Fragile Five” of Brazil, India, Indonesia, South Africa and Turkey to include Argentina and Russia. What can policymakers do to offset the declines?

Kristin J. Forbes and Michael W. Klein have examined the policy options available to governments that face crises due to contracting capital flows and their impact on GDP growth, inflation and unemployment. The measures include a rise in interest rates, currency depreciation, the sale of foreign exchange reserves and new controls on capital outflows. They report that currency depreciations and reserve sales will provide support for GDP growth, while increases in interest rates and or imposing capital controls do not. But the beneficial impacts of the first two sets of policies appear with a lag and may generate higher inflation. None of the measures improve unemployment.

Christian Saborowski, Sarah Sanya, Hans Weisfeld and Juan Yepez of the IMF also looked at the effectiveness of capital outflow restrictions. They report that controls on outflows can be effective in reducing net outflows only when countries have good macroeconomic fundamentals, as measured by their records of GDP growth, inflation, fiscal policy and their current account balances, or good institutions. Iceland’s use of controls in 2008 is cited as a recent example of a successful use of controls. Of course, an economy with strong macroeconomic conditions is less likely to face substantial outflows.

We can use the indicators used in the IMF study to assess macroeconomic conditions in the countries in the headlines last week. The data are from 2013:

GDP Growth Inflation Fiscal Budget/GDP Current Acct/GDP
Argentina 5.1% ? -3.3% -0.6%
Brazil 2.2% 6.2% -2.7% -3.7%
India 4.9% 10.1% -5.1% -3.1%
Indonesia 5.6% 7.0% -3.3% -3.9%
Russia 1.5% 6.8% -0.5% +2.3%
South Africa 1.9% 5.8% -4.8% -6.5%
Turkey 3.9% 7.5% -1.2% -7.5%

All the countries had rising inflation rates, with India’s hitting double digits. The current account deficits were particularly high for South Africa and Turkey, while India and South Africa had fiscal deficits of about 5%.  Russia’s growth rate was the lowest in this group.

And then there is Argentina. No one believes the inflation rate that the government reports; unofficial estimates place it at around 28%. The government has sought to restrict capital flows while also pegging the exchange rate. But foreign exchange market intervention by the central bank has not stopped an unofficial market from springing up. Last week the central bank, which saw its foreign exchange reserves shrinking precipitously, stepped back and allowed the peso to fall by more than 15%. The government also enacted a partial liberalization of the controls on the purchase of foreign exchange. But there are no signs of a response to inflation, and President Cristina Fernandez de Kirchner, who faces a term limit, has little incentive to take measures that in the short-term could further anger Argentine citizens.

Turkey’s central bank also acknowledged the strength of the forces arrayed against it when it announced a sharp rise in interest rates.  But foreign investors are concerned about corruption and political instability, and the Turkish currency has continued to slump. The Prime Minister’s opposition to the higher interest rates was not reassuring.

When will the withdrawals of money from the emerging markets end, and how will all this play out? The governments of the affected countries are using combinations of all the measures that Forbes and Klein list. But the most diligent central bank can not neutralize the impact of a weak or conflicted government. The financial volatility will continue until some sort of resolution is found to the political volatility.

Be Careful What You Wish For

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Policymakers, including finance ministers and central bank governors, are as entitled to have holiday wishes as much as anyone else. But they should be careful with their wish list. Sometimes the law of unintended consequences leads to unexpected and undesirable side effects.

The expansion of domestic financial markets can promote economic growth through a more efficient allocation of savings and other mechanisms.  Foreign participation in these markets can contribute to their development in several ways. Foreign investors, for example, can provide more liquidity that leads to lower yields. Shanaka Pereis found that a 1% increase in the share of foreign investors in government bond markets in ten emerging markets led to a decrease of about 6 basis points in the yield on those bonds. All this suggests that capital flows benefit financial markets.

But larger financial markets can also bring unanticipated consequences. After Federal Reserve Chair Ben Bernanke spoke last spring of tapering the Fed’s asset purchases, the exchange rates of many emerging markets depreciated while their central banks used their foreign reserves to slow the changes. Barry Eichengreen and Poonam Gupta have investigated these reactions. They find that the magnitude of the changes in exchange rates and reserves were linked to the size and openness of a country’s financial markets. They interpret this as evidence that foreign investors rebalanced their portfolios in those markets with the most largest and liquid financial systems. They conclude that “success at growing the financial sector can be a mixed blessing.” Financial regulators need to be ready for the volatility that increased capital flows can bring along with all their benefits.

Hobglobins and Hypocrites

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“A foolish consistency is the hobglobin of little minds…”

Ralph Waldo Emerson

Before this week’s announcement by Federal Reserve Chairman Ben Bernanke that the Fed would continue its asset purchases under Quantitative Easing 3, finance ministers and other leaders in emerging market nations had been voicing their concerns over the prospect of U.S. policymakers winding down their operations (see here). They feared that higher interest rates in the U.S. would bring back the capital that had flowed out in search of higher returns, which would leave the emerging market officials in the uncomfortable position of raising their own interest rates or watching their currencies depreciate. The calls for the Federal Reserve to exercise caution peaked at the G20 leaders summit in St. Petersburg, where the final communiqué called for “Further changes to monetary policy settings…to be carefully calibrated and clearly communicated.”

It would be easy to dismiss the foreign reaction on the grounds that there was a large measure of hypocrisy in these exhortations to the Federal Reserve to move slowly.  Many of these officials had previously castigated the Federal Reserve for the currency appreciations that accompanied the earlier capital inflows. Surely, it can be claimed, they should welcome a reversal in Federal Reserve policy.

But the calls for caution demonstrate that a country’s economic welfare incorporates many diverse interests that exercise influence at different times. The worries voiced earlier about currency appreciation were based on the fears of exporters that they would be adversely affected by the resulting increases in prices in foreign markets. Their grievances were heard sympathetically by domestic policy officials who have been dealing with an unsteady recovery from the Great Recession of 2008-09. The decline in import prices was of little import, as inflation has not been a concern. Human nature dictates that we resent adverse changes and take for granted those that benefit us. Moreover, Mancur Olson pointed out that when the benefits are diffuse and the “pain” concentrated, it is not surprising that the voices of those who feel threatened are predominant.

Capital outflows and currency depreciations, on the other hand, will affect other interest groups. Those who have liabilities denominated in dollars fear a rising burden in repaying their debts. Domestic firms dependent on imports worry about their higher costs. Regulators of domestic financial markets are anxious about financial volatility and declines in asset prices. Finance ministry and central bank officials fret about the financing of current account deficits. It would be surprising if their calls for protective actions were offset by a wave of messages from exporters jubilant at regaining market share.

When U.S. interest rates do rise, those outside the U.S. who are adversely affected will register their complaints. Their government representatives will respond by criticizing the Federal Reserve for ignoring the global impact of their policies. It may be inconsistent, but not hypocritical, for them to serve whichever domestic interests have the largest megaphones.

Nurske and Lagarde

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The outflows of capital from emerging market economies such as Brazil, India, Turkey and Indonesia and accompanying currency depreciations have led to discussions of what has caused the reversals in fortune of these countries (see, for example, here and here and here.). Higher U.S. interest rates and signs of an improving U.S. economy are seen as “pull factors” that lure investors to the U.S.. Deteriorating fundamentals in the crisis countries, such as rising current account deficits or falling growth rates, are portrayed as push factors that drive foreign investors away.

Capital volatility is a familiar and possibly systemic problem. Seventy years ago, Ragnar Nurske (1907-2007) blamed capital flows for destabilizing exchange rates. Nurske served in the Financial Section and Economic Intelligence Service of the League of Nations from 1934 to 1945. While there he wrote most of International Currency Experience: Lessons of the Interwar Period (1944). In this study, Nurske blamed the exchange rate depreciations of the 1930s on destabilizing capital flows:

…As funds moved out to take refuge abroad, pressure on the exchange market was increased and the rate of depreciation accelerated, which resulted in a further loss of confidence and a further flight of capital. In its effects on the balance of payments the capital flow became disequilibrating instead of equilibrating.       (League of Nations 1944:114)

Nurske’s views appear more relevant today than they did during the last decade, when financial globalization was generally viewed as a positive force, despite a lack of supporting evidence. The IMF, which had regarded an unregulated capital account as a suitable long-term goal for developing economies, reversed its stance during the 2008-09 crisis. The IMF now regards capital controls as an appropriate macroprudential tool (see, for example, here.).

Ben Bernanke, then a Federal Reserve Board Governor, issued a now-famous apology to Milton Friedman on the occasion of Friedman’s ninetieth birthday in 2002. Bernanke referred to Friedman’s work with Anna J. Schwarz that showed that the Federal Reserve had exacerbated the Great Recession of 1929 through its monetary policies, and promised: “You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”  Perhaps it is time for a new (albeit belated) apology, in this case from the IMF’s Managing Director Christine Lagarde to Nurske.  Friedman, who believed that successful speculators would return a misaligned exchange rate to its fundamental value, would be aghast. But perhaps the passage of time would allow the views of both Nobel Prize-winners to co-exist and guide current-day policy.

Correction: An alert reader has pointed out that Ragnar Nurske did not win the Nobel Prize. Perhaps I was confusing him with Ragnar Frisch, who shared with Jan Tinbergen the first Nobel prize in economics to be awarded in 1969.