Say one thing and then do something else. That pretty much sums up current orthodoxy in emerging economies regarding exchange-rate management. Countries are supposed to use the interest rate to achieve an inflation target and let the exchange rate float freely. In practice, Asian and Latin American central banks often intervene in currency markets by buying and selling international reserves, and use a host of other measures to limit their currencies’ volatility.
That exchange-rate make-believe will be harder to keep up after a landmark speech last week by Agustín Carstens, General Manager of the Bank for International Settlements (BIS), at the School of Public Policy at the London School of Economics. In the past, the BIS has been regarded as a bastion of orthodoxy. But now the BIS is arguing that orthodoxy should be updated. Markets are bound to listen.
Inflation targeting can claim important achievements, which Carstens duly listed. It has helped bring inflation rates down in most emerging markets. It has also helped reduce what economists call exchange-rate pass-through – the immediate impact of exchange-rate depreciations on domestic inflation.
But this does not mean that when confronted with massive capital flows, emerging markets can or should exercise benign neglect of the exchange rate, as prevailing orthodoxy suggests. This standard dictum “is honored more in its breach than in its observance as a guide for monetary policy,” Carstens observed dryly.
A key fact explains the gap between theory and practice. Emerging economies’ financial conditions tighten when their currencies depreciate, and vice versa. It was not supposed to happen that way. Letting their currencies float was supposed to allow countries to seize control of their domestic interest rates, which could then be adjusted as necessary to smooth domestic economic fluctuations. Alas, reality has turned out to be considerably more vexing.
One problem is well understood. Because of emerging economies’ checkered financial history, their governments, banks, and firms often have no choice but to borrow abroad in dollars. When the exchange rate depreciates, the domestic-currency value of those loans increases. In a mild scenario, this can cause a slowdown in domestic lending, investment, and growth; in extreme cases, it can cause defaults, bankruptcies, and a financial crisis. Those adverse balance-sheet effects are one reason why emerging-market central banks are allergic to sharp exchange-rate movements.
The good news is that the original sin that prevented emerging markets from borrowing in their own currencies seems to have been forgiven. Today, foreign investors hold large portfolios of local-currency bonds in Colombia, Mexico, South Africa, and Turkey, among other countries. The bad news, argue BIS economists, is that borrowing in local currency helps, but is no panacea. Their research shows that a sharply depreciating exchange rate is associated with widening sovereign interest-rate spreads: when the peso, rand, or lira tank, domestic long-term interest rates rise! This is certainly not what received wisdom on the transmission mechanisms of monetary policy would predict.
The reason for this paradoxical behavior is that global investors are bound by value-at-risk rules and care about returns in dollars. When they suffer exchange-rate losses, they automatically restrict credit to that country, causing the exchange rate to fall further and local interest rates to spike.
The BIS concludes that when changes in advanced-economy monetary policy or shifts in investor appetite cause massive capital outflows, “the exchange rate may … act as a transmitter and amplifier of financial shocks, rather than an absorber of real shocks.”
This is a big problem for central banks that worry – as they should – about financial stability. But even for central banks that claim to care about inflation and nothing else, exchange-rate volatility poses a dilemma. An appreciating currency puts downward pressure on inflation, but it also loosens domestic financial conditions. As debts and risk pile up, the stage is set for a sharp devaluation and upward price pressures in the future.
What should central bankers do about this inflation-today-versus-inflation-tomorrow tradeoff? One possibility is to include the exchange rate among the factors they consider when setting interest rates. This could be achieved through a modified Taylor rule – named after Stanford University economist John Taylor – that added the deviation of the exchange rate from some target level to the standard targets for inflation and the output gap.
Many emerging-market central banks do this already. After a depreciation, they often tighten monetary policy in order to contain so-called second-round effects (whereby the weaker exchange rate contaminates expectations and wage-setting behavior). The problem is that when investors panic and the exchange rate becomes unhinged, there be may be no interest rate sufficiently high to calm things down. Even worse, a sky-high interest rate that sinks the economy and causes central-bank short-term debt to pile up may reduce credibility, rather than enhancing it.
Witness Argentina today: the central bank has vowed to keep the money supply constant (and is keeping its word), short-term interest rates are 70%, and the government is slashing the fiscal deficit. But inflation keeps rising (it is near 55% over the last 12 months) and the peso remains under pressure.
An alternative is to use sterilized exchange-market intervention, as many Asian countries routinely do, and as Argentina is close to doing, despite earlier vows to the contrary. Intervention during the exchange rate’s upswing allows the central bank to accumulate international reserves, which is a desirable macroprudential policy. And during the downswing, when global investors withdraw their funds, exchange-market intervention via the sale of reserves can be stabilizing, because it supplies the dollar liquidity the local economy desperately needs.
Skeptics will claim that sterilized exchange rate intervention is not supposed to have any effects. Those skeptics are wrong, BIS researchers counter. Their work, Carstens noted, shows that “sterilized FX purchases in EMEs [emerging-market economies] exert a statistically and economically significant depreciating effect on exchange rates, at least temporarily.”
Should this intervention be guided by discretion or rules? If the latter, can rules be sufficiently flexible to avoid establishing a quasi-fixed exchange rate against which markets will inevitably bet? These questions and many others remain to be answered.
But one thing is clear: clean floating is out and dirty floating is in. Theory is at last catching up with practice.
(Author 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.)
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