One of the few matters on which there is near-consensus in economics is that in a world of globalized capital, countries benefit from having floating currencies and a central bank targeting inflation. A growing number of countries have adopted these policies in the aftermath of the financial crises of the 1990s and early 2000s. For developed countries, this is an effective strategy, but less so for emerging markets, as we show in this paper: Developing countries can rarely afford to ignore the exchange rate because they are affected by global markets irrespective of their own choices. Based on a sample of emerging markets with floating exchange rates, we estimate the reaction of official interest rates to global volatility shocks using vector autoregressions (VARs). The results clearly show that many emerging market governments raise interest rates in a pro-cyclical manner when hit with global volatility shocks—unlike developed countries that let adjustment run its course. We hypothesize that three factors drive this decision: the degrees of public and private indebtedness in foreign currency and the financial strength of the central bank. The more challenged a country is in servicing its foreign currency debt, the more it will be forced to raise interest rates, but a well-capitalized, strong central bank can afford to cushion the blow. In this case, even emerging market countries can partially avoid a pro-cyclical policy that hurts their economies. Nonetheless, the benefits of flexible exchange rate regimes appear as a mirage as long as developing countries have to rely on external borrowing in foreign currency.
About the speaker
Mark S. Manger (PhD UBC) is an Associate Professor at the Munk School of Global Affairs specializing in Political Economy. His prior appointments were Lecturer for International Political Economy at the London School of Economics, Assistant Professor in the Department of Political Science at McGill, and Advanced Research Fellow in the Program on US-Japan Relations at the Weatherhead Center for International Affairs at Harvard University. His research focuses on the political economy of trade and macroeconomics and the Asia Pacific region.
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