Flexible Exchange Rates and Emerging Markets
Starting in the 1990s – and faster since 2000 – emerging-market economies floated their currencies, hoping to insulate themselves from external shocks and gain the ability to set interest rates according to domestic objectives. The verdict is in: the new regime has been only partly successful.
LONDON – Half a century ago, the Bretton Woods system collapsed, and by March 1973 the world’s major currencies had floating exchange rates. Starting in the 1990s – and faster since 2000 – emerging-market economies (EMs) also floated their currencies, hoping to insulate themselves from external shocks and gain the ability to set interest rates according to domestic objectives.
For EMs, however, the new regime has provided only partial insulation. Hélène Rey of the London Business School has found that domestic financial conditions remain very much correlated with US interest rates and the value of the dollar, even in countries with flexible exchange rates. Central banks in EMs can face a boom in capital inflows at a time when they are trying to tighten policy to reduce inflation, and vice versa. The upshot is that the monetary-policy independence EMs were expecting has yet to materialize.
Moreover, as economists Guillermo Calvo, Carmen M. Reinhart, and Leonardo Leiderman pointed out long ago, for EMs, external conditions are the main driver of inward capital flows. Domestic policies are of secondary importance, unlike the textbook model, in which capital flows fill whatever current-account gap emerges from local savings and investment decisions.
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