Elasticity of Substitution and the Persistence of the Deviation of the Real Exchange Rates

Empirical evidence suggests (i) that the real exchange rates of developing economies show less persistence than do those of more advanced economies, and (ii) that the elasticity of substitution between capital and labor tends to increase from below unity for less developed economies to above one for more advanced economies. This paper shows how the introduction of sectoral adjustment costs in a two‐sector model of a small open economy, together with CES production functions, provides a very natural explanation of this empirical regularity. Other aspects of the relationship between the technologies and the speed of convergence of the real exchange rate are also discussed.     

Financial conditions and the well-being of the real estate sector—A bottom-up default analysis on five ASEAN economies

This paper investigates the impact of financial conditions, for example, cross-border capital flows, interest rates and foreign exchange rates, on the well-being of the real estate developers in five Association of Southeast Asian Nations economies. The study uses a Bottom-up Default Analysis model to stress test their creditworthiness by reproducing the financial shocks during the global financial crisis, taper tantrum, and the U.S.-China trade war and COVID-19 pandemic. The median developers remain sound under the prescribed adversities. The performance is underpinned by their strong fundamentals and a conducive mix of monetary, foreign exchange, and open capital account policies by national authorities.     

On the Transmission Mechanism of Monetary Constraints to the Real Side of the Economy

Contrary to the predictions of the theory underlying international finance, inflows of capital triggered by financial liberalisation have neither equalised real interest rates nor increased income growth in many emerging economies. We explain this puzzle by developing a model that combines the balance‐of‐payments constraint approach to economic growth with a less stringent version of the real interest rate parity hypothesis. The model’s foundations are based on robust empirical findings or well‐established macroeconomic models. We show that a perverse combination of income elasticities of demand for imports and exports generates slow income growth and high real interest rates. As domestic income grows and imports rise faster than exports, the real exchange rate is expected to depreciate in order to clear the balance of payments (or the foreign exchange rate market). An incipient capital outflow arises and interest rates increase. Faster adjustment in capital rather than in the goods market therefore generates a higher real interest rate differential between the domestic small open‐economy and the rest of the world. The long run analysis shows that a constant degree of risk aversion implies a positive equilibrium real interest rate differential that affects economic growth. A permanent increase in default risk driven by persistent current account imbalances thus impacts on long run growth. The model’s results are illustrated with evidence from the three major Latin America economies: Argentina, Brazil and Mexico.     

Inflation,interest and exchange rates in the transition1

Central and Eastern European economies have made extraordinary progress in their trade and exchange regimes. Surprisingly, instant convertibility was established for a great variety of exchange rate regimes. In spite of diversity, all these countries have followed a common pattern: severe initial undervaluation - the cost of speed and unrestricted trade - followed by rapid real revaluation and incipient protectionism. Since 1994 in many cases an embarrass de richesse has appeared: high capital inflows which are either inflationary or costly to sterilize. A major cause of these flows - or at any rate of the high cost of sterilization - is the presence of significant interest rate differentials higher than required to cover the risk of devaluation. These are the necessary consequence of a policy of positive real interest rates and of real revaluation from excessively undervalued exchange rates. Lower interest rates are recommended, both to stem financial capital inflows and to reduce the cost of their sterilization.     

THE EAST ASIAN CURRENCY CRISIS: CAUSES AND LESSONS

Financial deregulation and capital-account liberalization preceded speculative currency attacks in Thailand. A combination of de facto fixed exchange rates and high rates of interest generated excessive capital inflows, which led to too much liquidity chasing bad investments. The under-supervised and over-guaranteed financial sector extended loans excessively, particularly for non-productive, speculative purposes. Non-transparent practices, in the form of weak disclosure of institutions' true balance sheets and insider relations, masked these poor investments. The buildup of short-term, unhedged debt left East Asian economies vulnerable to a sudden collapse of confidence. Currency attacks ran down official foreign exchange reserves. Rapid capital outflows and the consequent depreciation of currencies exacerbated the strains on private sector balance sheets. The policy lessons are to (i) use macroeconomic policy to avoid excessive capital inflows and currency overvaluation, (ii) strengthen the financial system, with proper disclosure and accounting requirements, stringent loan classification and provisioning rules, and capital adequacy requirements, prior to capital-account liberalization, (iii) stabilize exchange rates based on currency baskets that reflect trade and investment linkages, and (iv) develop regional. financial cooperation with regional surveillance and peer pressure to maintain policy discipline.     

Capital Inflows,Exchange Rate Flexibility and Credit Booms

Historically, capital flow bonanzas have often fueled sharp credit expansions in advanced and emerging market economies alike. Focusing primarily on emerging markets, this paper analyzes the impact of exchange rate flexibility on credit markets during periods of large capital inflows. It is shown that bank credit is larger and its composition tilts to foreign currency in economies with less flexible exchange rate regimes, and that these results are not explained entirely by the fact that the latter attract more capital inflows than economies with more flexible regimes. The findings thus suggest countries with less flexible exchange rate regimes may stand to benefit the most from regulatory policies that reduce banks' incentives to tap external markets and to lend/borrow in foreign currency; these policies include marginal reserve requirements on foreign lending, currency‐dependent liquidity requirements and higher capital requirement and/or dynamic provisioning on foreign exchange loans.     

The Effects of Capital Controls on Exchange Rate Volatility and Output *

This paper extends the Dornbusch model of overshooting exchange rates to discuss both exchange rate and output effects of capital controls that involve additional costs for International asset transactions.We show that, on the one hand, such capital controls have the merit of reducing the volatility of exchange rate volatility in the sort run and induces costs for the real sector in the form of lower equilibrium output levels. [F32, F41]     

Equilibrium Exchange Rates in New EU Members: External Imbalances versus Real Convergence

In new EU members, the accumulation of net foreign liabilities has gone hand-in-hand with real exchange rate appreciations, contrary to intuition. This may be due to the induced effect that capital inflows on productivity and competitiveness (Balassa-Samuelson effect). An extended empirical model comprising relative productivity and net foreign assets is well-suited to capture this indirect, opposite effect of liabilities accumulation on the equilibrium exchange rates for the three largest economies: Poland, Hungary and Czech Republic. The model makes it possible to estimate equilibrium exchange rates and misalignments. Going forward, sustaining high productivity growth will be essential to ensure a smooth transition towards euro membership.     

How should emerging economies float their currencies?

Floating exchange rates seem to be gaining ground in Latin America, East Asia and the transition economies. The recent crises left many economies with no alternative but to float. Others have moved toward floating, searching for greater flexibility and insulation from external shocks. The question for most emerging market economies, then, is no longer to float or not to float, but how to float. Four issues arise in this regard. The first is how to float and have low inflation. The second is whether floating provides as much insulation as conventional theory predicts, especially in the presence of dollarized liabilities. Which leads to the third point: the relationship between the stability of the exchange rate and that of the financial system. The fourth is how to conduct monetary policy under a float, and the role of inflation targeting. We consider each of these points in turn, and conclude that a workable model of how to float seems to be emerging from the so‐far successful experience of countries like Chile and Brazil. It involves the adoption of an inflation target as the main anchor for monetary policy, coupled with a monetary policy reaction function that — aside from reacting to the output gap and other determinants of the inflation rate — reacts also partially to movements in the nominal exchange rate. JEL classification: F3, F4, E4, E5     

The real exchange rate and economic development

Recent empirical studies have found a robust correlation between competitive exchange rates and economic growth in developing economies. This paper presents (i) a formal model to help explain these findings and (ii) econometric evidence on the relation between investment and the real exchange rate. The model emphasizes the existence of (hidden) unemployment as a source of endogenous growth, even under constant returns to scale. Growth promoting policies, however, affect the external balance, and two instruments are needed in order to achieve targets for both the growth rate and the trade balance. The real exchange rate can serve as one of those instruments. The implications of the model for the relation between real exchange rates and the rate of capital accumulation find support in our econometric analysis.     

Currency Regime and Monetary Autonomy. Empirical Evidence Using Recent and Global Data from 1990 to 2007

This paper analyzes the exchange rate regimes from the perspective of monetary independence. To be specific, using recent and global data, we examine the sensitivity of domestic interest rates to the international interest rate, by conducting co-integration tests and by estimating the adjustment speeds through error-correction model, for different de facto currency regimes and for different types of capital markets. Our estimation results basically support the traditional views of ‘impossible trinity’, as far as the cases with open capital markets are concerned. The floating regime shows the less sensitivity of domestic interest rates to the international interest rate than the fixed regime does, which implies some capacity for domestic monetary autonomy under the floating regime. The cases with closed capital markets, on the other hand, include the cases showing high sensitivity of interest rates in some emerging market economies, which might imply the ‘fear of floating’ hypothesis.     

Exchange rate volatility–economic growth nexus in Uganda

The global financial crisis has disrupted trade and capital flows in most developing economies, resulting in an increased volatility of exchange rates. We develop an autoregressive distributed lag model to investigate the effect of exchange rate volatility on economic growth in Uganda. Using data spanning the period 1960–2011, we find that exchange rate volatility positively affects economic growth in Uganda in both the short run and the long run. However, in the short run, political instability negatively moderates the exchange rate volatility–economic growth nexus. These results are robust to alternative specifications of the economic growth model.     

Welfare Effects of Transparency in Foreign Exchange Markets: the Role of Hedging Opportunities

The paper studies the impact of more transparency on the risk‐sharing opportunities in the foreign exchange market and the associated implications on ex ante welfare. Transparency is measured in this model by the informational content of publicly observable signals about exchange rate developments. The authors find that in this model more transparency improves welfare in economies that are poorly endowed with capital and/or where investors are not very risk‐averse, while welfare is reduced in economies with large capital endowments and/or where investors are highly risk‐averse.     

Managing Capital Inflows Indirectly? On the Determinants of Monetary Sterilization with Reference to East Asia

This paper derives a time‐varying sterilization coefficient to examine those factors that determine the extent to which central banks might engage in monetary sterilization. There appear to be good reasons to do so: Sterilization neutralizes the monetary impact of reserve accumulation, which is an endogenous consequence of sustained capital inflows under some degree of management of exchange rates. A pooled sample of Asian economies incorporating Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand, for 1994–2012 is employed. We find that this method does help to directly uncover the determinants of sterilization, and while capital inflows do not appear to influence the sterilization directly, there is substantial evidence to suggest it does so indirectly—particularly through domestic interest rates.     

Countercyclical capital rules for small open economies

The growing literature on macroprudential regulation focuses on how a combination of monetary and macroprudential policies can boost macroeconomic and financial stability. We contribute to this literature by developing a DSGE model that assesses the effectiveness of countercyclical capital regulation in small open economies, in monetary unions or with exchange rate pegs, where policymakers do not have full control over traditional stabilisation instruments such as nominal interest and exchange rates. In such economies, macroprudential policy could potentially play an even more relevant role in mitigating the adverse effects of macro-financial feedback loops. To validate the model’s ability to replicate the stylised facts of financial crises, we calibrate using data for the Irish economy, the scene of a recent housing crash. Our results demonstrate that the pro-active use of countercyclical capital regulation – in the form of Basel III-type rules – can help attenuate boom-bust cycles driven by over-optimistic expectations. We also find that more aggressive action by regulators during the release phase can bolster the economy’s ability to absorb a negative shock.     

COVID-19, asset markets and capital flows

This paper empirically examines the reaction of global financial markets across 38 economies to the COVID-19 outbreak, with special focus on the dynamics of capital flows across 14 emerging market economies. The effectiveness of fiscal and monetary policy responses to COVID-19 is also tested. Using daily data over the period January 4, 2010 to August 31, 2020, and controlling for a host of domestic and global macroeconomic and financial factors, we use a fixed effects panel approach and a structural VAR framework to show that emerging markets have been more heavily affected than advanced economies. In particular, emerging economies in Asia and Europe have experienced the sharpest impacts on stock, bond and exchange rates due to COVID-19, as well as abrupt and substantial capital outflows. Quantitative easing and fiscal stimulus packages mainly helped to boost stock prices, notably for advanced and emerging economies in Asia. Our findings also highlight the role that global factors and developments in the world's leading financial centers have on financial conditions in EMEs. Importantly, the impact of COVID-19 related quantitative easing measures by central banks in advanced countries extended to EMEs, with significant positive spillovers to EME stock markets in Asia, Europe and Latin America. Going forward, while the ultimate resolution of COVID-19 may be expected to lead to a market correction as uncertainty declines, our impulse response analysis suggests that there may be persistent effects on bond markets in emerging Europe and on EME capital flows.     

Optimum currency areas and the European experience

Across nations or regions, the debate on optimum exchange rate cum monetary policies is not yet resolved on three levels. First is the optimum domain of fixed exchange rates versus keeping them flexible. Second is the subordinate debate on whether one needs full monetary union (as in continental Europe) to secure an optimum currency area's internal domain; or, whether virtually fixed exchange rates — where national currencies remain in circulation — can be sufficient. Third is whether a regional grouping of economies with close trade ties (as in East Asia) gain by collectively pegging to an outside currency such as the US dollar. Using an axiomatic approach, which limits the set of cross‐country financial claims to what is feasible, I analyse how best to both share and reduce macroeconomic risks on these three levels. JEL classification: F31, F36.     

Alternate instruments to manage the capital flow conundrum: A study of selected Asian economies

Capital inflows to and outflows from emerging market economies (EME) have increased significantly since 2000. This rapid increase, accompanied by a sharp rise in volatility, has amplified the complexity of macroeconomic management in EME. While foreign capital provides additional financing for productive investment and offers avenues for risk diversification, unbridled flows exacerbate financial and macroeconomic instability. In this paper, we focus on the experience of six emerging Asian economies (EAE) in dealing with capital flows. Using quarterly data, we identify the waves of capital flows experienced by these EAE and the efficacy of the various policy measures taken. The policy choices include negotiating the trilemma (i.e. balancing the need for monetary policy autonomy, exchange rate flexibility and capital account openness), as per the demands of the macroeconomic situation. The paper also analyses the extent to which intervention in the foreign exchange market and imposition of short‐term capital flow management measures have aided countries to negotiate the trilemma. The efficacy of these responses have been varied across countries, implying that a judicious mix of these measures, along with improvement in financial and institutional development, is required to effectively counter the vagaries of capital flows.     

Two-sector perspectives on the effects of payroll tax cuts and their financing

This paper analyzes the consequences of lifting from labor some of the burden of taxation in a life-cycle two-sector setup where a consumption good is produced alongside a capital good. The analysis focuses on the implications of alternative ways of financing payroll tax cuts in closed and small-open neoclassical economies. In our models payroll tax cuts do not necessarily stimulate hours worked in the stationary state. We show, for example, that in the closed economy –paradoxically– long-run aggregate labor hours and the capital stock will be reduced if labor tax proceeds are replaced by capital taxation. If instead government purchases of the capital good (or government labor services) are decreased, manhours are left unchanged in the long-run, while capital formation is spurred. In the small-open economy it is only if the offsets are a fall in entitlement spending or a rise in the wealth tax that aggregate manhours are increased —otherwise steady state hours worked are invariant.     

Dynamic linkages between exchange rates and stock prices: Evidence from East Asian markets

This study examines dynamic linkages between exchange rates and stock prices for seven East Asian countries, including Hong Kong, Japan, Korea, Malaysia, Singapore, Taiwan, and Thailand, for the period January 1988 to October 1998. Our empirical results show a significant causal relation from exchange rates to stock prices for Hong Kong, Japan, Malaysia, and Thailand before the 1997 Asian financial crisis. We also find a causal relation from the equity market to the foreign exchange market for Hong Kong, Korea, and Singapore. Further, while no country shows a significant causality from stock prices to exchange rates during the Asian crisis, a causal relation from exchange rates to stock prices is found for all countries except Malaysia. Our findings are robust with respect to various testing methods used, including Granger causality tests, a variance decomposition analysis, and an impulse response analysis. Our findings also indicate that the linkages vary across economies with respect to exchange rate regimes, the trade size, the degree of capital control, and the size of equity market.