Under the right conditions, it can reduce unwarranted currency volatility
SUKUDHEW SINGH was a deputy governor at Bank Negara Malaysia from 2013 to 2017.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
When central banks in the world’s large economies slashed interest rates after 2008, smaller emerging market economies, especially in Asia, faced a flood of capital that caused their currencies to appreciate and interest rates to fall. Now that major central banks are rapidly tightening policy, financial flows have reversed: emerging market currencies are depreciating, inflation is increasing, and central banks are under pressure to raise interest rates even as growth stalls.
Global economic and financial integration has weakened the national transmission of monetary policy and made international factors a stronger driver of domestic prices and economic conditions. Free-floating currencies are ideal for most emerging market economies, but external developments can soon throw exchange rates out of kilter with economic fundamentals. Policy autonomy is guaranteed only if economies are strong enough to withstand volatile exchange rates and significant misalignment.
Intervention in the foreign exchange market allows policymakers to moderate the pace and extent of currency appreciation or depreciation. It can also counter pressure on the exchange rate by reducing one-sided expectations about the currency’s future value. A deeper financial system helps with intermediation but can be a double-edged sword: increased availability of financial instruments and greater liquidity may attract more capital inflows. Open emerging market economies with large globally integrated financial systems must hold more foreign exchange reserves and intervene more aggressively to avoid excessive volatility. Successful intervention is not guaranteed, however.
Several factors make intervention more likely to work. For brevity, I will focus here on those that determine success when defending a depreciating currency.
The level of reserves is important not only for intervention but also for instilling confidence in a country’s ability to pay its way in the world. Maintaining a sufficiently large stock of reserves is an important policy consideration.
One way to reduce demand on the central bank’s reserves is to develop the local foreign currency market, providing more opportunity for private intermediation of foreign exchange flows and for new hedging instruments. This should reduce the frequency of central bank intervention. A common problem in times of uncertainty is that foreign currency dries up due to excess demand or hoarding. Ultimately, the central bank’s reserves must again provide the safety mechanism.
The sustainability of reserves also depends on the sources from which they are built. Reserves built from current account surpluses and flows of foreign direct investment are generally more reliable than reserves from short-term portfolio flows. Reserves should be built during good times. Central banks in emerging market economies are often vulnerable to political pressure that diverts existing reserves to other purposes. This leaves countries vulnerable and limits central banks’ capacity to intervene when they need to.
There are emergency sources of reserves. Funding from the IMF is an option, but it is an option of last resort for many countries, especially in Asia. Countries also have bilateral swap arrangements to provide emergency liquidity in dollars or local currencies. Among the ASEAN+3 economies, a $240 billion resource-pooling arrangement known as the Chiang Mai Initiative Multilateralisation Agreement provides liquidity support to regional economies in times of external stress. However, it has not diminished member economies’ desire to build their own reserves for various reasons, including policy independence.
When reserves are running low, or capital flows are so large that intervention is unlikely to succeed, more direct intervention is needed to restore stability. Policymakers can rightfully consider measures to restrict financial flows. Many factors that make for successful intervention will also come into play in determining the success of capital controls. Policymakers who impose capital controls must also be cautious in timing their removal—doing so prematurely can be as risky as keeping them in place too long.
Done right, capital controls can act as a circuit breaker to preserve foreign reserves and provide policymakers with temporary breathing room for reforms to reduce vulnerabilities and support the economy, without the worry of external instability. Confidence in the local economy must be restored through credible policies, after which the controls can be gradually relaxed and removed.
