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Exchange Rates and Insulation in Emerging Markets

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Abstract

The insulating properties of flexible exchange rates have long been a highly contentious issue in emerging markets—not least in Asian emerging markets. A number of recent theoretical and empirical studies question whether a trade-off exists between rigid exchange rate regimes and insulation from foreign shocks when the degree of international capital mobility is high. On the other hand, Obstfeld et al. (2017) find that countries with flexible exchange rate regimes experience less real and financial instability in the face of global financial volatility. We contribute to this empirical debate by significantly extending their analysis. Overall, our findings are broadly consistent with their results, suggesting that flexible exchange rate regimes are better at insulating emerging markets from external shocks. There are, however, a few subtle differences. In particular, we find somewhat less robust evidence that limited flexibility is enough to insulate emerging markets from shocks.

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Notes

  1. Most nonproprietary data are from Obstfeld et al. (2017), and we greatly appreciate the authors sharing their data and program.

  2. Regression results available on request.

  3. Although the absence of an effect may also reflect the endogeneity of the Federal Reserve’s policy for other US economic conditions that work in an offsetting direction.

  4. For the International Monetary Fund’s classification of exchange rate regimes and monetary policy frameworks, see https://www.imf.org/external/np/mfd/er/2006/eng/0706.htm.

  5. Regressions available from the authors on request.

  6. For example, Cushman and De Vita (2017) examine whether fixed exchange rates encourage more inward foreign direct investment by using propensity-score matching methods.

  7. Additional results for other specifications available on request.

  8. In Table 14, we do not report the results in column (4) because the real shadow funds rate is also included as a regressor. While the federal funds rate used as a proxy for a global shock is nominal, the correlation between them is high, which makes the regression results unreliable.

  9. Again, we do not report the results in column (4) as the real shadow funds rate is also included as a regressor.

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Acknowledgements

This paper was prepared as background material for the Asian Development Outlook 2018 Update: Maintaining Stability amid Heightened Uncertainty. For comments we thank Ila Patnaik and other workshop participants in the Asian Development Outlook Update Mid-Term Workshop. We also thank Dohoon Kim for excellent research assistance; the Asian Development Bank for financial support; and Mahvash S. Qureshi, Beth Anne Wilson, and Andrea Raffo for help with data. Kwanho Shin acknowledges support by a Korea University Grant (K2009011). Barry Eichengreen thanks the Clausen Center of the University of California, Berkeley.

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Authors and Affiliations

  1. Department of Economics, University of California Berkeley, Berkeley, CA, USA

    Barry Eichengreen

  2. Economic Research and Regional Cooperation Department, Asian Development Bank, Manila, Philippines

    Donghyun Park & Arief Ramayandi

  3. Department of Economics, Korea University, Seoul, South Korea

    Kwanho Shin

Authors
  1. Barry Eichengreen
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  2. Donghyun Park
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  3. Arief Ramayandi
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  4. Kwanho Shin
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Correspondence to Kwanho Shin.

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Appendices

Appendix

Table 19 Description and Sources for the Variables Used by Obstfeld, Ostry, and Quereshi
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Table 20 Description and Sources for Variables Used by Londono and Wilson
Full size table

Blurb

This paper empirically reexamines the contentious issue of whether flexible exchange rates can insulate emerging markets from external shocks. The results are broadly consistent with the insulating properties of flexible exchange rate systems. But they are somewhat less supportive of the notion that even intermediate exchange rate regimes with limited flexibility can help cushion the effect of global volatility.

100-World Blurb

Whether or not flexible exchange rates can protect emerging markets from external shocks has long been a highly contentious issue in international economics. A number of recent theoretical and empirical studies cast doubt on the shock-mitigating benefits of exchange rate flexibility. On the other hand, a 2017 paper by Maurice Obstfeld, Jonathan Ostry, and Mahvash Qureshi finds that flexible exchange rates promote output and financial stability in the face of global shocks. The authors of this paper join the debate by significantly extending and performing sensitivity checks on the 2017 paper. Overall, their findings confirm that flexible exchange rate regimes are better at insulating emerging markets from external shocks.

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Eichengreen, B., Park, D., Ramayandi, A. et al. Exchange Rates and Insulation in Emerging Markets. Open Econ Rev 31, 565–618 (2020). https://doi.org/10.1007/s11079-020-09587-2

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