Exchange Rate Crisis among Inflation Targeting Countries

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This entry is adapted from the peer-reviewed paper 10.3390/risks10050094

The exchange market pressure index has proven to be a major indicator in identifying exchange rate crises in economies; however, due to the complexities surrounding developing economies, the efficacy of the index has been called to question. Specifically, the selection of an appropriate index and the problem of selecting the appropriate threshold for identifying exchange market pressure.

monetary policy FX rate regimes Sub-Saharan Africa exchange market pressure index

1. Introduction

The exchange rate is an important indicator in the monetary policy assessments of many countries (Bank of England 1999; Baqueiro et al. 2003). Usually, the exchange rate provides a link between the interest rates of two trading countries through the appreciation or depreciation of their exchange rate (Frenkel and Levich 1975; Dornbusch 1976). Its effects are wide and varying—it affects the flow of exports and imports, as well as the passing through of the price of foreign goods to domestic prices (Taylor 2001). These effects can erode the purchasing power of domestic citizens, and affect the allocation of resources by the government, leading to political and economic problems, as well (Fischer 2001).

Excess liquidity, traditionally, is known to be the main cause of increases in domestic prices and depreciation of the exchange rate, partly because of their inter-connectedness (see, for example, the phenomenon of imported inflation). Indeed, the relationship between the exchange rate and inflation is of utmost importance in a monetary environment in which shocks affect both inflation and the exchange rate (López-Villavicencio and Mignon 2017).

2. Exchange Rate Crisis

The financial crises of the past (the late 1960s and early 1970s, the 1980s, 1992 and 1993, and 1994 and 2000) all implied that an exchange rate crisis is intense for countries that are exposed to international capital flows (Fischer 2001). Most of the major exchange rate crises linked to the international capital market have either involved countries with a fixed or a non-flexible exchange rate regime (Cavdar and Aydin 2015). At the same time, as argued by Obstfeld and Rogoff (1995), countries that had flexible exchange rates—including South Africa—avoided this type of crisis that affected emerging countries (Fischer 2001). The currency crisis theories of Salant and Henderson (1978) and Krugman (1979) employ models that have countries anchoring their currencies with gold sales and foreign exchange reserves, respectively, to mitigate the risk of currency devaluation.

Friedman (1953) led the argument for flexible exchange rates, pointing to the fact that supply or demand shocks in the exchange rate will require the adjustment of inflation between countries that are connected through trade. To this end, a flexible exchange rate, according to Friedman (1953), allows prices to adjust instantaneously. This argument will mean that authorities in open developing economies should adopt flexible exchange rate regimes. The above-mentioned course of policy also relies on the notion that exchange rate movements immediately affect domestic prices. Recent studies (Bank of England 1999; Devereux and Engel 2003; Baqueiro et al. 2003; Gali and Monacelli 2005); however, find that this effect may be negligible in the short run. López-Villavicencio and Mignon (2017), in estimating the link between the exchange rate and inflation, found that the adoption of an inflation-targeting framework reduces the effect of depreciation pressures on consumer prices.

3. Dealing with Exchange Rate Crisis

As a result, policymakers recommend that countries choose to either peg their currencies or adopt a flexible exchange rate regime, since intermediate exchange rate regimes are not sustainable (Fischer 2001). This indicates that scholars are divided in terms of what the optimum policy option should be (Latter 1996).

Certain structural characteristics make emerging economies more vulnerable to external shocks (Devereux et al. 2006). This will leave emerging economies more concerned about the appreciation or depreciation of their exchange rate. Thus, they will often have what Calvo and Reinhart (2002) refer to as a “fear of floating,” because they are not willing to tolerate sharp movements in their exchange rate—a situation that can occur under a flexible exchange rate regime.

The effect of monetary policy shocks on the exchange rates has also been a debatable issue among scholars over the years. Most studies have found that the maximum response of the exchange rate to shocks could only be observed with substantial delays (Kim and Lim 2018). Eichenbaum et al. (2017) studied this phenomenon and found that the exchange rate could not predict inflation effectively. When they extended their analysis by introducing an open-economy model, they discovered a significant role of dollar-denominated bonds in this regard. Fratzscher (2009) found that countries with low foreign exchange reserves and high dollar-denominated bonds witnessed larger exchange rate depreciations during the 2009 financial crisis in general (Fratzscher 2009).

4. Inflation Targeting (IT) Framework as a Cure to Exchange Rate Crisis

Nakatani (2018) analyzed FX rate shocks, FX regimes, and capital controls in relation to the occurrence of an exchange rate crisis. He found that exchange rate crises are more probable in countries that adopt flexible exchange rate regimes. In pegged exchange rate regimes, Nakatani (2018) discovered that productivity shocks are reduced in the presence of capital controls. Soe and Kakinaka (2018) discovered the opposite by finding that countries committed to an IT regime would not be required to intervene in reducing pressure on their currencies. Goldfajn and Gupta (2003) confirmed the findings of Soe and Kakinaka (2018) in their study.

Few studies, such as Fiador and Biekpe (2015), have considered Sub-Saharan African (SSA) countries by applying the EMP index to these countries. They studied the impact of the EMP index proposed by Girton and Roper (1977) on the monetary policy of 20 SSA countries. They found this impact to be negative and significant—the discount rate was used as a proxy for non-IT framework countries. The problem with this application of the index is that it assumed indirectly that all the 20 SSA countries use the monetary policy rate as the main variable for policy action, as would have been the case under an IT framework.

5. Measuring Pressure on the Exchange Rate, Possibly Leading to an Exchange Rate Crisis

According to Krušković (2017), intervention by the central bank to reduce depreciation pressures is dependent on the level of a country’s foreign exchange reserves, which introduces a limit to the level of intervention. Krušković (2017) argues that if the depreciation was arising from weak fundamentals (i.e., large accumulated fiscal deficit), then foreign exchange intervention will not be enough to reduce depreciation pressures unless the main interest rate is increased. This argument influenced Girton and Roper (1977) to develop an exchange market pressure (EMP) index to identify periods where there was excess pressure on a country’s exchange rate. This idea was modified by subsequent authors to capture the reaction function of monetary authorities by adding the interest rate variable to the index developed by Girton and Roper (1977). Since then, a substantially large number of studies, for example, Sachs et al. (1996), Hegerty (2018), Kaminsky and Reinhart (1999), Hossfeld and Pramor (2018), Eichengreen et al. (^[1] 1996), and Stavarek (2010), have used the EMP index to identify crisis episodes in different economies. Eichengreen et al. (1994) employed extreme values to the formula of the EMP index to identify a contagious currency crisis. Accordingly, a crisis is detected when the index exceeds 1.5 of the standard deviation and the sample mean of the index. Similarly, some other studies used various unconventional methods to determine periods of exchange market pressure.

References

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Judit Sági

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Update Date: 27 May 2022

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