Some thoughts on how choices between monetary autonomy, exchange rate stability and capital account openness and reserve accumulation/decumulation relate to macro outcomes.

By now, everybody is aware of the turmoil in emerging markets. Several emerging market currencies have come under severe pressure, with fresh blows coming fast and furious [0]

Figure 1: Log exchange rates against US dollar for India (blue), Brazil (red), South Korea (green), Turkey (teal), and South Africa (purple), normalized on 2013M05=0. August data for 8/22. Source: St. Louis Fed FRED, IMF International Financial Statistics. and Pacific Exchange Service for August data, and authors calculations.

At the same time, several countries have witnessed their foreign exchange reserves decline, partly due to intervention, partly due to an outflow of financial capital.

Greater

monetary independence is associated with lower output volatility

while greater exchange rate stability implies greater output volatility,

which can be mitigated if a country holds international

reserves (IR) at a level higher than a threshold (about 20% of

GDP). Greater monetary autonomy is associated with a higher level

of inflation while greater exchange rate stability and greater financial

openness could lower the inflation rate. We find that trilemma

policy configurations affect output volatility through the investment

or trade channel depending on the openness of the economies.

Our results indicate that policy makers in a more open

economy would prefer pursuing greater exchange rate stability

while holding a massive amount of IR. Asian emerging market

economies are found to be equipped with macroeconomic policy

configurations that help the economies to dampen the volatility

of the real exchange rate. These economies’ sizeable amount of IR

holding appears to enhance the stabilizing effect of the trilemma policy choices, and this may help explain the recent phenomenal

buildup of IR in the region.

The usefulness of reserves is notable. Referring to Figure 1, the reader will see that the Korean won is one currency that has not been subject to substantial downward pressure. Thats likely attributable in part to the relatively large stock of foreign exchange reserves.

The results in Aizenman, Chinn and Ito (2011) pertain to the first and second moments of inflation, and the second moment of output growth. What about output growth in times of crisis. In another paper, Bussiere, Cheng, Chinn and Lisack (2013) (in the process of being revised), we find that higher reserves to short term debt ratios on the eve of the global financial crisis of 2008-09 are associated with higher growth rates in non-advanced economies. From the abstract:

we can make a three-fold conclusion. First, the

pre-crisis level of foreign reserves has a positive and significant impact on the real GDP

growth during the most recent financial crisis. Although the explanatory power of foreign

reserves is sensitive to the scaling variable, we provide evidence that international reserves

may act as a buffer during crises. In line with the existing literature on early warning

signals, the reserves-to-short-term-debt ratio works best as a reserve indicator.

Second, countries that have accumulated foreign reserves before the crisis have actively

used them either to defend the domestic currency from massive devaluation, to finance

weapons’ but also ‘barrels of gunpowder’ which can be actively mobilized during a crisis

In the paper we note that India was one of the countries that did not rebuild their reserves in the wake of the global financial crisis. Combined with a current account deficit, its not terribly surprising that the Indian rupee was so vulnerable.

Some Observations

The reader will note that I have not appealed to special conditions due to the fact that the advanced economies are perceived to be withdrawing un conventional monetary stimulus, rather than conventional stimulus (i.e. raising policy rates). Thats because Im somewhat old-fashioned in my views: easing or tightening monetary policies in core advanced economies forces difficult decisions on emerging market economies, regardless of whether its done via policy rates or via quantitative easing and/or forward guidance. Its true that the magnitude of effects is less understood, but the impact is conceptually the same. After all, there were similar concerns about push and pull factors in capital flows to emerging markets in the 1990s. (I trace out this argument in this paper presented at the BIS annual conference, and discussed at Free Exchange (Avent) ).

I agree with Ryan Avent that one key danger is over-reaction on the part of emerging market policymakers (of course, one only knows that ones over-reacted after the fact). Our results in Aizenman, Chinn and Ito suggest that exchange rate stabilization should not be slavishly adhered to (in this context, would entail raising policy rates). Of course, our cross-country time series study could not incorporate all sorts of important factors that have to be incorporated into the decisionmaking process the most important I think is balance sheet effects. Paul Krugman has noted in the Indian case, its not clear that this is a big worry, given the relatively small amount of external debt (which is mostly denominated in foreign currency). For some other indicators for the East Asian economies, see here. Currency depreciation will also help offset the negative impact of diminished capital inflows.

Finally, a digression. My research suggests that holding large foreign exchange reserves is beneficial for some aspects of macroeconomic performance, and particularly helpful in sustaining growth in times of financial crisis. However, this does not mean that its always better to have more and more after all there are costs to holding large stocks of low-yield foreign exchange. And the (rational on an individual basis, in this context) accumulation of reserves has imposed distortions in the global economy. So, the foregoing should not be taken as a prescription for unrestrained reserve accumulation.