21 May 2019 01:22 PM
Editing: Sally Ismail
Mubasher: To say something and then to do something else, this statement sums up a lot about the current creed in emerging economies given the ways of managing the exchange rate.
Countries should use the interest rate to meet the inflation target and allow the exchange rate to move freely, according to an analytical vision written by former presidential candidate and former Chilean finance minister Andres Velasco and carried by Project Syndicate.
But in practice, central banks in Asia and Latin America often intervene in currency markets by buying and selling international reserves and using a range of other measures to curb their currency volatility, known as "dirty float."
The dirty float is the managed float of the exchange rate; it means the intervention of central banks in influencing the value of the currency in the exchange market and not leaving it only for demand and supply.
It will be difficult to maintain this deceptive exchange rate after a historic speech by the Director-General of the Bank for International Settlements, Agustin Carstens, at the School of Public Policy at the University of London.
Carstens says that in the past the Bank for International Settlements was a bastion of this doctrine but now demands that it be updated, and markets must pay attention to such an issue.
An inflation target could be seen as an important achievement, as it helped to reduce inflation in most emerging markets and also to reduce what economists call the transit rate or the immediate effect of the exchange rate on domestic inflation.
But this does not mean that when faced with massive capital inflows, emerging markets must stand on the sidelines and pursue "benign neglect" of the exchange rate, as the prevailing belief suggests.
The real gap between the theoretical and practical sides explains the financial situation in emerging economies when their currencies depreciate and vice versa.
But this was not supposed to happen in such a way: allowing free circulation of emerging countries' currencies was supposed to allow countries to control domestic interest rates that could be adjusted when necessary to mitigate domestic economic volatility.
Unfortunately, the reality has become more disturbing.
One well-understood problem: governments, banks and companies often had no choice but to borrow from abroad in dollars because of the volatile financial history of emerging economies.
When the exchange rate falls, the value of these loans rises in local currency. In a mild scenario, this can slow down domestic lending, investment and growth, and in extreme cases can lead to default, bankruptcy and a financial crisis.
These adverse effects are one reason why central banks in emerging markets are severely affected by sharp movements in the exchange rate.
The good news is that emerging markets are now able to borrow in their own currencies. Today, foreign investors have large portfolios of local currency bonds in Colombia, Mexico, South Africa and Turkey among others.
The bad news is that economists at the Bank for International Settlements (BIS) argue that borrowing in local currency helps but is not the best solution.
These economists' research shows that the sharply low exchange rate is linked to widening interest-rate differentials on sovereign debt. When the price of the peso, rand or lira falls, long-term local interest rates rise, which is certainly not what traditional wisdom about monetary policy mechanisms might expect.
The reason for this paradoxical behavior lies in the fact that global investors are committed to the rules of value at risk as well as to dollar returns.
When they suffer losses in the exchange rate, they automatically deduct the loans granted to that country, causing an additional exchange rate drop as well as increasing domestic interest rates.
The Bank for International Settlements (BIS) concludes that when changes in monetary policy cause advanced economies or shifts in investors' appetite for massive outflows of capital, the exchange rate may act as a tool for sending and amplifying financial shocks rather than absorbing real shocks.
This is a major problem for central banks worried about financial stability.
But even for central banks that claim to be paying attention to inflation and nothing else; exchange rate volatility is a dilemma.
The currency's rise puts pressure on the downward trend on inflation but also eases domestic financial conditions.
With the accumulation of debt and risk, the situation is created for a sharp devaluation of the currency and upward price pressures in the future.
What do we do?
What should central bankers do about inflation swaps today versus inflation tomorrow? One possibility is to include the exchange rate between the factors taken into account when determining interest rates.
This can be achieved through Taylor's modified rule, named after a quote from Stanford University economist John Taylor, which added the exchange rate deviation from a target level to the inflation targets and the gross domestic product gap.
Many emerging market central banks are already implementing this. After devaluation they often tighten monetary policy in an effort to contain so-called second-round effects (where the weaker exchange rate causes expectations to fail and wage-fixing behavior).
The problem is that when investors panic and the exchange rate becomes unbalanced, there may not be enough interest rates to cool things down.
Worse still, the extremely high interest rate that leads to a decline in economic activity and causes the accumulation of short-term debt of the central bank may reduce the credibility rather than strengthen it.
The central bank has pledged to keep the money supply stable (and it keeps its promise), short-term interest rates stand at 70 percent, and the government is working to reduce the fiscal deficit, but inflation continues to rise (near 55 percent in the 12 months). Past) as the peso is still under pressure.
The alternative is the "sterile intervention" in the exchange rate as many Asian countries will routinely do, and Argentina is about to do so despite previous commitments to reverse it.
The sterile intervention in the exchange rate is the intervention of the central bank in the market without affecting the monetary base (buy or sell foreign currencies and then use this proceeds in the purchase of other assets)
Intervention in the exchange rate, which takes an upward trend, allows the central bank to accumulate its international reserves, which are considered a desirable hedge policy.
During the declining exchange rate period, when global investors withdraw their money, intervention in the exchange market through the sale of reserves could be a tool for stabilizing the situation as it provides the dollar liquidity that the local economy desperately needs.
Skeptics will argue that sterile intervention in the exchange rate is not supposed to have any effects, but they are wrong, according to the Bank for International Settlements.
Carstens said that their work shows that the purchase of sterile foreign exchange in emerging market economies has a significant statistical and economic impact in reducing exchange rates at least temporarily.
Should such interference be driven by discretion or specific rules? If the latter is the choice, can the rules be flexible enough to avoid creating a quasi-fixed exchange rate against what markets will inevitably see? Such questions and many others still need to be answered.