Preemptive Policies and Risk-Off Shocks in Emerging Markets

IMF Working Papers, January 7, 2022

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Preemptive capital flow management measures (CFM) can reduce emerging markets and developing countries’ (EMDE) external finance premia during risk-off shocks, especially for vulnerable countries.
Countries with preemptive policies in place during the five year window before risk-off shocks experienced relatively lower external finance premia and exchange rate volatility during the shock compared to countries which did not have such preemptive policies in place.
By reducing the impact of risk-off shocks on countries’ funding costs and exchange rate volatility, preemptive policies enable countries’ continued access to international capital markets during troubled times.
The analysis uses the episodes of Taper Tantrum and COVID-19 as risk-off shocks.

Identification strategy: difference-in-differences methodology with country fixed effects.
Key identification feature: preemptive policies are ex-ante by construction and cannot be put in place as a response to the shock ex-post.
Controls included: other policies such as monetary policy, foreign exchange interventions (FXI), easing of inflow CFMs, and tightening of outflow CFMs that are used in response to the risk-off shocks.

Subject: Balance of payments, Capital flow management, Capital inflows, Financial sector policy and analysis, Financial services, Foreign exchange, Interest rate parity, Macroprudential policy instruments
Keywords: Africa, Capital flow management, Capital inflows, exchange rate volatility, external finance premia, FX debt, Global, Interest rate parity, Macroprudential policy instruments, MPM policy, Preemptive policies, risk-off shock, Risk-Off shock, risk-off shocks, UIP

Preemptive CFMs can act as insurance against spikes in external finance premia and exchange rate volatility during global risk-off episodes.
Vulnerable EMDEs stand to gain more from preemptive adoption of CFMs, as these measures are associated with relatively better outcomes during shocks.
Policy evaluation should account for interactions with contemporaneous responses such as FXI, monetary policy adjustments, and targeted adjustments to inflow and outflow CFMs.

Preemptive Policies and Risk-Off Shocks in Emerging Markets — Mitali Das, Gita Gopinath, Sebnem Kalemli-Ozcan