The global financial crisis has reminded emerging market economies, if they needed reminding, that capital flows can be highly volatile and that crises need not be home grown. Emerging markets have been affected in a variety of ways, not least by the sharp ups and downs in exchange rates that volatile capital flows engender. These ups and downs may be less benign in emerging markets than they might be in advanced economies for a number of reasons:
- First, emerging markets may have more fragile balance sheets—essentially they are less well hedged against currency risk—so depreciations may engender financial distress and even bankruptcies and adverse effects on economic activity.
- Second, they may be less flexible, so that when the exchange rate strengthens and the traded goods sector loses competitiveness, this may have permanent effects on the economy even if the exchange rate later reverts to its initial level.
These factors mean that emerging markets are likely to care a lot about exchange rate volatility. They also care about macroeconomic stability and maintaining low inflation. This is one reason a number of them have adopted inflation targeting frameworks in recent years to guide their monetary policy. Inflation targeting (IT) is helpful because it can anchor expectations, which may have become unhinged during earlier periods of high or even hyper-inflation. But is inflation targeting compatible with concern about the exchange rate?
One concern is the possible inconsistency between the two. Inflation targeting implies that the monetary policy instrument—the policy interest rate—must be adjusted whenever the path of inflation diverges from the inflation target. If inflation looks to be getting out of control but the exchange rate is already too strong, the central bank can’t be worried about the latter when setting monetary policy. Conversely, if the economy is in a recession and a lot of firms are going under, the central bank will want to lower interest rates to get inflation back up to target even if this might cause more trouble for firms with unhedged dollar or euro debt. These kinds of scenarios have led some to conclude that inflation targeting is not compatible with a concern about the exchange rate since the policy interest rate will not in general be able to hit both the inflation and exchange rate targets. This has led to the presumption that emerging market central banks, if they want to be serious inflation-targeters, should also refrain from intervening in the FX market—especially since their price-stability credentials might be less firmly established (Masson et al., 1997). But as explained above, FX volatility also matters more for emerging market economies than for advanced economies.
So can EMEs have their cake and eat it too?
In a recent paper, we argue that they can. In particular, because most EMEs are less financially integrated (in terms of capital mobility and asset substitutability) than advanced economies, and because the outstanding stock of assets denominated in their currencies is typically a small fraction of those denominated in major reserve currencies, EME central banks have a second policy instrument, namely foreign exchange intervention. With two instruments, having two policy goals (low inflation, low exchange rate volatility) becomes much more feasible. But do EMEs have this second instrument?
First off, one should look at the actions of policymakers in emerging market economies, rather than any rhetoric. These strongly suggest emerging markets believe they can influence exchange rates through their policy actions. Interest rates and FX intervention respond systematically to periods of overly strong or overly weak exchange rates, and policymakers seem to lean against the wind when the exchange rate strays too far from levels that are consistent with medium-run fundamentals (Tables 1 and 2).
Table 1 Taylor Rules in emerging market inflation targeters: panel regression1
Table 2 Change in reserves as a function of the change in the REER1
Of course it is possible that policymakers are just spinning their wheels, and that their actions do not in the end help to smooth out the ups and downs of exchange rates. Here the evidence is more mixed (Table 3), but is certainly more favorable for emerging market economies than for advanced economies (which are more integrated in global markets and, as such, less able to influence exchange rates when the central bank acts to buy or sell foreign currency).
Table 3 Studies on sterilised intervention in emerging market economies
Squaring the circle
In our view, use of this second policy instrument is likely to make central banks more, rather than less, credible. The reason is that when the exchange rate gets too far out of line (in relation to medium-run fundamentals, and looked at from a multilateral, rather than a unilateral perspective), obstinately refusing to acknowledge the issue is not tenable. Much better to adjust both policy instruments in an effort to achieve dual targets.1 As an example, consider a capital inflow shock to emerging market economies driven by temporarily low interest rates in advanced economies. Compared to a regime with FX intervention, when the central bank does not intervene in the FX markets, it must reduce its policy interest rate by more (to diminish the incentive for capital to flow to the country) but then tolerate a large real exchange rate appreciation (to choke off aggregate demand and meet its inflation target). In both cases, the central bank achieves its primary target of price stability but, when it refrains from FX intervention, it must tolerate a larger real appreciation (Figure 1). And to the extent that real appreciations are costly (because of the loss of competitiveness and the possible financial-stability risks when the exchange rate depreciates again), use of the two instruments leads to better outcomes.
Figure 1 Policy response to the capital inflow shock
Notes: 1/ The capital inflow shock is based on a five percentage point decline in the world interest rate. 2/ An increase in the exchange rate is an appreciation of the domestic currency.
The idea of using more tools to address economic problems is one that has been gaining traction in the wake of the financial crisis, which has brought home that a narrow view in which all will be well as long as central banks deliver stable consumer prices simply doesn’t hold water. Policymakers need to target many aspects of economic performance, and make use of a broad array of tools (including macroprudential regulation, capital controls, etc.) to deliver macro-financial stability. To be sure, excessive policy activism has its costs (and those lessons should not be forgotten), but the crisis suggests that leaving available policy instruments on the table is not the right answer either.
Is FX intervention costless? Of course not, and the costs (both for the country, and for the system as a whole) need to be factored in. This is why, for example, the optimal response to a mean-reverting shock never involves sustained one-way intervention in the FX market (which would be too costly), but rather initial official purchases of foreign exchange followed by sales (in the case of favorable shocks, and conversely for adverse ones), with reserves returning to their initial level in the long run. In the face of permanent shocks, of course, the central bank should simply allow the exchange rate to adjust. And, in general, the optimal amount of FX intervention depends negatively on the persistence of the shock (Figure 2). The degree of reliance on FX intervention (relative to the use of the policy interest rate) should also depend on the effectiveness of sterilized intervention (Figure 3). In the limiting case where uncovered interest rate parity holds perfectly, sterilized intervention is impossible, and in the face of a capital inflow shock, for example, the central bank would need to rely on its policy interest rate (or controls on capital inflows) rather than FX intervention.
Figure 2 Policy response and sensitivity of inflows with respect to return differential
Figure 3 Policy response and persistence of inflow shock
Our paper is part of a broader effort to re-think macroeconomic—especially monetary policy—in the aftermath of the crisis. In advanced economies, this debate centers on whether the central bank should care about asset prices in addition to consumer prices. In most EMEs, the exchange rate is the most important asset price. Our basic message is that EME central banks should care about disequilibrium exchange rate movements—and deploy all available instruments to achieve their twin targets of price and exchange rate stability.
Simply put: two instruments are better than one in achieving two policy targets.
The views expressed in this column are those of the authors and not necessarily those of the institutions to which they are affiliated.
Masson, Paul R, Miguel Savastano, and Sunil Sharma (1997), “The Scope for Inflation Targeting in Developing Countries”, IMF Working Paper 97/130.
Stone, Mark, Scott Roger, Anna Nordstrom, Seiich Shimizu, Turgut Kisinbay, and Jorge Restrepo (2009), “The Role of the Exchange Rate in Inflation-Targeting Emerging Economies”, IMF Occasional Paper 267.
Ostry, Jonathan David, Atish R Ghosh, and Marcos Chamon (2012), “Two Targets, Two Instruments: Monetary and Exchange Rate Policies in Emerging Market Economies”, IMF Staff Discussion Note No. 12/01, International Monetary Fund.
1Stone et al. (2009) argue that even ITers would be better off allowing their policy interest rate to respond to the exchange rate, but do not consider the possibility of Forex intervention.