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Exchange Rate Volatility

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Exchange Rate Volatility

Over the last two decades, most developing countries have moved towards greater exchange-rate flexibility and deeper financial integration. At the same time, buffered by sizable reserve holdings, they have also retained a fair degree of monetary autonomy, even as financial integration has continued. This has allowed them a sort of middle ground within the policy trilemma', which rules that countries may choose any two but not all three of the goals of monetary independence, exchange-rate stability and financial integration. But excessive and myopic focus on the question of whether reserves are actively deployed misses a key point: countries adjust their policy frameworks and macroeconomic strategies dynamically to best fit the challenges of the day. Indeed many developing countries have allowed the real exchange rate and monetary policy to take the first brunt of the adjustment. Considering the severity of the crisis in the industrialised economies, the absence of deeper adjustment in emerging markets (so far) is a testament to the degree to which this new middle ground in the trilemma, with proper governance and management, allows for a softer landing in the aftermath of major external events.
In hindsight, earlier concerns about excessive hoarding of forex reserves by most developing countries now seem grossly overblown. The crisis has shown the importance of the self insurance provided by reserves. While sizeable reserve accumulation is not a panacea, substantial reserves holdings may be the critical differentiator in determining whether a country has a soft landing or a hard one. In a scenario where capital flows are volatile, reserve accumulation provides domestic authorities with access to hard currency to cover essential expenses and mitigate the adverse consequences of capital flight at a time when the country is unable to borrow internationally. However, the willingness to draw down on reserves and the speed at which this is done, is the result of a complex interaction between structural and political economy factors, says a recent NBER paper. It hinges, amongst other things, on the anticipated future course of the global economy, the domestic adjustment capacity and the degree of financial integration of the country in question.
Countries that are only partially integrated with the global financial system tend to be less exposed to capital flight and deleveraging. Thus the trade-offs for a country like India which is less integrated to the global financial system and having less room for fiscal adjustment due to its significant and growing fiscal deficits differ from those of, say, Chile. Having said that, most emerging markets have relied on exchange-rate and interest-rate adjustments to accommodate the shocks unleashed by the crisis, making only limited use of reserves to cushion sharp adjustment in their real exchange rate and to signal their credit worthiness in turbulent times.
The response, however, has varied from country to country, depending on the individual circumstance. While commodity-exporting countries with relatively low savings rates and/or little room for fiscal expansion have been reluctant to draw down their reserves to cushion the inevitable adjustment, countries like Korea and Russia have actively dipped into their reserves. This is not surprising. As of now, there is no certainty either about the depth or about the duration of the global liquidity crisis/recession. There is also the fear that the mere act of using reserves to defend a particular exchange rate would lead to expectations of further depreciation. Hence, many countries might prefer to play it safe. Available evidence suggests the crisis has had little discernable impact on China's reserves (so far) relative to India, which has accommodated the crisis with sizable downward adjustment in reserves and a significant depreciation of the rupee, both by about 20% as of December 2008 from their respective peaks earlier in the year. The paper warns that the brunt of the adjustment may yet await us. While exchange rate and interest-rate adjustments can cushion the landing, a deep crisis frequently ends by testing the fiscal and institutional capacity of countries. Are we gearing up our institutions for the challenge?

Aqeel Anjum
Management Sciences Department,
Lahore Campus.

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