Exchange rate pass-through in developing and emerging markets
Janine Aron, John Muellbauer 14 September 2014
Due to the adoption of inflation targeting and floating exchange rates, and the elimination of capital controls, exchange rate pass-through – the transmission of exchange rate movements to changes in the domestic price level – has become an increasingly important issue in developing and emerging market economies. This column discusses recent research on this topic, and highlights the frequent misspecifications that produce unreliable empirical estimates.
The interest in exchange rate pass-through (ERPT) in developing and emerging market (DEM) countries has burgeoned in the last two decades. By contrast, in the earlier comprehensive empirical survey of ERPT by Menon (1995), the majority of studies covered industrialised countries – largely the US, Japan and European countries – with only a handful of less developed countries, mainly reported in a single cross-country study.
exchange rates, exchange rate pass-through, developing countries, emerging markets, model misspecification
Political booms, financial crises: Why popular governments are not always a good sign
Christoph Trebesch, Helios Herrera, Guillermo L. Ordoñez 06 September 2014
Financial crises are often credit booms gone bust. This column argues that ‘political booms’, defined as an increase in government popularity, are also a good predictor of financial crises. The phenomenon of ‘political booms gone bust’ is, however, only observable in emerging markets. In these countries, politicians have more to gain from riding the popularity benefits of unsustainable booms.
Financial crises: the search for early warning indicators
Financial crises are a recurrent phenomenon in the history of emerging markets and advanced economies alike. To understand the common causes of these crises and to prevent future ones from developing, economists have a long tradition of studying early warning indicators. Two well-documented predictors of financial crises are credit booms and capital flow bonanzas.
Financial markets Politics and economics
credit booms, financial crisis, politics, emerging markets, capital flows, public opinion, popularity
‘Leaning against the wind’: exchange rate intervention in emerging markets works
Christian Daude, Eduardo Levy Yeyati 01 September 2014
Central banks’ exchange rate interventions are typically attributed to precautionary, prudential, or mercantilist motives. This column documents the prevalence of an alternative motive – that of stabilising the exchange rate – in emerging markets, where, despite heavy intervention, the Global Crisis saw important deviations of the real exchange rate from its equilibrium value. Exchange rate intervention is shown to be effective, but more so at containing appreciations than depreciations.
The economic debate has typically downplayed the exchange rate-smoothing nature of central bank foreign exchange intervention, attributing it to precautionary or prudential motives, or to the goal of keeping the exchange rate undervalued for mercantilist reasons.
Exchange rates Monetary policy
Central Banks, exchange rates, exchange rate smoothing, emerging markets, Leaning against the wind
New-breed global investors and emerging-market financial stability
Gaston Gelos, Hiroko Oura 23 August 2014
The landscape of portfolio investment in emerging markets has evolved considerably over the past 15 years. Financial markets have deepened and become more internationally integrated. The mix of global investors has also changed, with more money intermediated by mutual funds. This column explains that these changes have made capital flows and asset prices in these economies more sensitive to global financial shocks. However, broad-based financial deepening and improved institutions can enhance the resilience of emerging-market economies.
The investor base matters since different investors behave differently. During the emerging-market sell-off episodes in 2013 and early 2014:
- Retail-oriented mutual funds withdrew aggressively, but investors from different regions also tended to behave differently;
- Institutional investors such as pension funds and insurance companies with long-term strategies broadly maintained their emerging-market investments.
Figure 1 shows the facts.
Figure 1. Bond flows to emerging-market economies
Financial markets International finance
Pension Funds, financial stability, capital flows, investment, emerging markets, financial deepening, herding, original sin, mutual funds, institutional investors
Central banks in developing countries should consider targeting nominal GDP
Pranjul Bhandari, Jeffrey Frankel 21 August 2014
Central banks, especially in developing countries, still seek transparent and credible communication. Yet signalling intentions through forward guidance or commitment sometimes creates undesirable constraints. This column argues that central bank pronouncements phrased in terms of nominal GDP are less likely to run afoul of the supply and trade shocks so common in developing countries, compared to pronouncements phrased in terms of inflation.
Central banks still seek transparent and credible communication. But signalling intentions, through forward guidance or some degree of commitment to an intermediate target, poses a difficult tradeoff. The advantages of transparency and credibility versus the disadvantages of waking up one day to find that unexpected developments have turned past statements into unwanted constraints on current monetary policy.
inflation targeting, emerging markets, NGDP targeting
The transmission of Federal Reserve tapering news to emerging financial markets
Joshua Aizenman, Mahir Binici, Michael M Hutchison 04 April 2014
In 2013, policymakers began discussing when and how to ‘taper’ the Federal Reserve’s quantitative easing policy. This column presents evidence on the effect of Fed officials’ public statements on emerging-market financial conditions. Statements by Chairman Bernanke had a large effect on asset prices, whereas the market largely ignored statements by Fed Presidents. Emerging markets with stronger fundamentals experienced larger stock-market declines, larger increases in credit default swap spreads, and larger currency depreciations than countries with weaker fundamentals.
The quantitative easing (QE) policies of the US Federal Reserve in the years following the crisis of 2008–2009 included monthly securities purchases of long-term Treasury bonds and mortgage-backed securities totalling $85 billion in 2013. The cumulative outcome of these policies has been an unprecedented increase of the monetary base, mitigating the deflationary pressure of the crisis.
Exchange rates International finance Monetary policy
exchange rates, Federal Reserve, asset prices, emerging markets, stock markets, Credit Default Swaps, tapering
Managing the exchange rate: It's not how much, but how
Atish R Ghosh, Jonathan D Ostry, Mahvash Saeed Qureshi 02 April 2014
In a world of volatile capital flows, emerging markets are increasingly resorting to managing their exchange rates. But does this strategy increase their susceptibility to crisis? This column argues that while intermediate regimes as a class are the most susceptible to crises, ‘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 characterisation of more crisis prone regimes suggests that it is not the degree of exchange rate management alone, but the way the exchange rate is managed, that matters. Greater against-the-wind intervention by the central bank to prevent currency overvaluation reduces, while greater intervention to defend an overvalued currency raises, the crisis likelihood.
The choice of exchange rate regime is a perennial issue faced by emerging markets. Conventional wisdom, especially after the emerging markets crises of the late 1990s, was the bipolar prescription: countries should choose between either floats (the soft end of the prescription) or hard pegs (monetary union, dollarisation, currency board). The thinking was that intermediate regimes (conventional pegs, horizontal bands, crawling arrangements, managed floats) left countries more susceptible to crises.
exchange rates, emerging markets, managing floats
Political connections in turbulent times
Daron Acemoglu, Simon Johnson, Amir Kermani, James Kwak, Todd Mitton 25 February 2014
Political connections affect economic outcomes in emerging markets. This column discusses new evidence showing that something similar goes on in the US. Over the ten trading days following the announcement of Timothy Geithner as Treasury Secretary, financial firms with a connection to Geithner experienced a cumulative abnormal return of about 12% relative to other financial sector firms. This reversed when his nomination ran into trouble due to unexpected tax issues.
When assessing the political situation in many countries, it is common practice, and entirely reasonable, to consider who has what kind of personal connection to people in, or contending for, power.
Politics and economics
US, emerging markets, political connections
Turmoil in emerging markets: What’s missing from the story?
Kristin Forbes 05 February 2014
The Federal Reserve’s ‘taper talk’ in spring 2013 has been blamed for outflows of capital from emerging markets. This column argues that global growth prospects and uncertainty are more important drivers of emerging-market capital flows than US monetary policy. Although crises can affect very different countries simultaneously, over time investors begin to discriminate between countries according to their fundamentals. Domestic investors play an increasingly important – and potentially stabilising – role. During a financial crisis, ‘retrenchment’ by domestic investors can offset foreign investors’ withdrawals of capital.
Emerging markets are going through another period of volatility – and the most popular boogeyman is the US Federal Reserve.
The basic storyline is that less accommodative US monetary policy has caused foreign investors to withdraw capital from emerging markets, causing currency depreciations, equity declines, and increased borrowing costs. In many cases, these adjustments will slow growth and increase the risk of some type of crisis.
Federal Reserve, capital flows, emerging markets, global financial crisis, tapering
Why fiscal sustainability matters
Willem Buiter 10 January 2014
Fiscal sustainability has become a hot topic as a result of the European sovereign debt crisis, but it matters in normal times, too. This column argues that financial sector reforms are essential to ensure fiscal sustainability in the future. Although emerging market reforms undertaken in the aftermath of the financial crises of the 1990s were beneficial, complacency is not warranted. In the US, political gridlock must be overcome to reform entitlements and the tax system. In the Eurozone, creating a sovereign debt restructuring mechanism should be a priority.
Does fiscal sustainability matter only when there is a fiscal house on fire, as was the case with the Greek sovereign insolvency in 2011–12? Far from it.
Financial markets Global crisis International finance Macroeconomic policy
eurozone, sovereign debt, capital flows, financial crisis, credit booms, fiscal policy, emerging markets, global financial crisis, banking, banks, Eurozone crisis, Currency wars, fiscal sustainability, banking union, sovereign debt restructuring, balance-sheet recession