• Exchange rates and currency crises

Exchange rates and currency crises

Volatility in the exchange rate can reduce growth for countries with relatively low levels of financial development. Exchange rates in developing country economies can be particularly vulnerable to economic shocks from rapid falls in the terms of trade (the price of a country’s exports relative to its imports) and from changes in short- and long-term flows of capital into the economy. Through a statistical comparison of developing and OECD countries’ economies, this paper examines the extent to which holdings of international reserves, openness, and the depth of financial markets might mitigate the effects of such potential shocks on real effective exchange rates.

The analysis finds that the effects of economic and political structures vary across regions and between developing and developed economies. Key findings include:

• international reserves holdings cushion the impact of terms of trade shocks, and this effect is important for developing but not for industrial countries. This buffer effect is especially significant for Asian countries, and for countries exporting natural resources
• the depth of financial markets reduces the significance of the buffer role of international reserves holdings in developing countries
• short-term capital inflows and increases in foreign reserves are associated with appreciated real exchange rate
• exchange rates in developing countries seem to be more sensitive to changes in reserve assets, whereas the paper finds no effect in industrialised countries
• industrialised countries display a significant relationship between short-term capital inflows and exchange rates
• the reported negative effect of long term capital inflows on exchange rates is only consistently found in manufactures exporters and Latin American economies. On the other hand, foreign direct investment inflows tend to appreciate exchange rates in industrial countries even though at a slower rate than other types of capital

The paper suggests that, to mitigate against the impacts of external shocks on the exchange rate, countries exposed to terms of trade volatility may benefit from active management of international reserves in ways that go well beyond the conventional prerogative of a central bank. The authors argue that international reserves should be managed cooperatively by the central bank and the treasury.

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