Originally published at Project-Syndicate | Jun 23rd, 2023
Starting in the 1990s – and faster since 2000 – emerging-market economies floated their currencies, hoping to insulate themselves from external shocks and gain the ability to set interest rates according to domestic objectives. The verdict is in: the new regime has been only partly successful.
LONDON – Half a century ago, the Bretton Woods system collapsed, and by March 1973 the world’s major currencies had floating exchange rates. Starting in the 1990s – and faster since 2000 – emerging-market economies (EMs) also floated their currencies, hoping to insulate themselves from external shocks and gain the ability to set interest rates according to domestic objectives.
For EMs, however, the new regime has provided only partial insulation. Hélène Rey of the London Business School has found that domestic financial conditions remain very much correlated with US interest rates and the value of the dollar, even in countries with flexible exchange rates. Central banks in EMs can face a boom in capital inflows at a time when they are trying to tighten policy to reduce inflation, and vice versa. The upshot is that the monetary-policy independence EMs were expecting has yet to materialize.
Moreover, as economists Guillermo Calvo, Carmen M. Reinhart, and Leonardo Leiderman pointed out long ago, for EMs, external conditions are the main driver of inward capital flows. Domestic policies are of secondary importance, unlike the textbook model, in which capital flows fill whatever current-account gap emerges from local savings and investment decisions.
So, for EMs, the reality of flexible exchange rates is less rosy than Milton Friedman, an enthusiastic advocate, once argued. But this does not mean that flexible rates are useless.
A recent paper by Maurice Obstfeld of the University of California, Berkeley, and Hoanan Zhou of Princeton University, makes the point. They argue that the way changes in international conditions affect EM financial markets depends on the exchange-rate regime, and that GDP, investment, and the stock market fall more sharply in response to dollar appreciation in countries with pegged exchange rates.
The reason is straightforward: maintaining the peg requires larger domestic interest-rate increases in response to dollar appreciation. Moreover, dollar appreciation tends to coincide with lower risk appetite and a higher required return on EM bonds. Under flexible rates, the adjustment is achieved via currency depreciation, rather than a damaging domestic interest-rate spike. So, while a system of flexible rates does not allow EMs to survive episodes of dollar appreciation unscathed, it does provide partial – and welcome – insulation.
After the Tequila crisis of 1994 and the Asian crisis three years later, EM policymakers worried that whenever a shock hits and the nominal and real exchange rates depreciate sharply, the domestic-currency cost of debt service would surge, and firms that have income in domestic currency would suffer. As a result of this so-called balance-sheet effect, depreciation could be contractionary, and flexible exchange rates would not necessarily provide adequate insulation.
This line of argument seemed persuasive back then, but it has not withstood the test of time. During the COVID-19 pandemic, EM currencies tanked and no financial crisis followed. The same seems to have been true in the most recent episode of dollar appreciation. One reason is that hedging markets have turned out to be deeper and more affordable than anyone anticipated, and many EM corporates and banks are using them.
Another factor is that domestic financial markets, where liabilities tend to be denominated in domestic currency, are now much deeper. As a result, liabilities in many countries – including Brazil, Colombia, Chile, Mexico, South Africa, and Turkey – have shifted massively toward domestic currency.
So, the balance-sheet problem is manageable, but it has not gone away. Borrowing in domestic currency, as Agustín Carstens and his colleague Hyun Song Shin of the Bank for International Settlements have argued, simply shifts the currency risk to lenders, who may head for the exits in the aftermath of a large depreciation. Carstens and Shin report that dollar appreciation amplifies the sell-off in local-currency EM bonds, but not dollar-denominated bonds – what they call “original sin redux.”
Given that flexible exchange rates are no panacea, and that some version of original sin persists, EM authorities need to take additional steps to maintain domestic financial stability. An important one is to continue stimulating local savings and developing domestic capital markets, so that more borrowing can take place at home. This also requires a reasonably tight fiscal policy: a too-large fiscal deficit is likely to induce a too-large current-account deficit and excessive reliance on foreign savings.
Two other kinds of policies are available. One falls under the general heading of macroprudential policies. Since the most dangerous consequence of “irrational exuberance” abroad is a lending boom at home that sows the seeds of the next crisis, it makes sense to regulate local banks’ leverage and risk-taking directly.
Capital buffers, maximum loan‐to‐value ratios, and requiring that assets and liabilities in the same currency be matched can play useful roles. But beware: lending can migrate to the shadow banking sector, which is much tougher to regulate.
The other set of tools includes various forms of capital controls, including taxes on short-term inflows. Such policies remain contentious, owing partly to ideological prejudice and partly to the difficulties of assessing their effectiveness empirically. Nonetheless, ex-ante controls on inflows (as opposed, crucially, to ex-post limits on outflows) should remain in prudent policymakers’ toolkits.
Now, if the dollar cycle is here to stay, and the insulating properties of flexible rates are limited, then EMs will need access to dollars in at least three sets of circumstances: during risk-off episodes, when dollar liquidity is king; when exchange rates become grossly misaligned and central bankers must intervene in the currency market; and when bank failures force EM central banks to act as lenders of last resort in foreign currency.
Today, many EMs self-insure and sit on a pile of their own international reserves. But self-insurance is inefficient. The current approach may be individually rational (countries accumulate reserves until they feel safe), but it makes little collective sense.
The handful of EMs that qualify for a currency-swap arrangement with the US Federal Reserve can engage in some risk-sharing with the rest of the world. So can the handful of countries that have qualified for a precautionary liquidity arrangement with the IMF. But opportunities for risk-sharing are limited for the remaining EMs, because the global financial safety net is geographically fragmented, full of holes, and not fit for purpose.
The COVID-19 crisis is a case in point. Initially, the IMF estimated that EMs and developing countries would need access to $2 trillion, but the Fund’s own additional lending was just $160 billion. We can surely do better.
Andrés Velasco: A former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities.
