& Fabio Kanczuk
According to the International Monetary Fund (IMF), the last decade has seen a number of countries actively managing their exchange rates. Brazil, Chile, Colombia, Turkey and other emerging markets with announced inflation-targeting regimes have engaged in considerable intervention of their exchange rates and have accumulated substantial reserves as the flow of foreign capital into these countries has increased. Are these policies a good way for emerging countries to protect themselves from the large swings of international markets?
Large external debts
Some of the countries accumulating substantial reserves hold large external debts despite the interest rate differential (see figure). For example, the Brazilian government’s net asset position has increasingly been dominated by the accumulation of close to $352 billion in reserves, as of December of 2011, against an external debt of $298 billion. Can the accumulation of reserves in conjunction with external debt be justified? Would it not be better to cancel out the one with the other?
Capital flows into emerging markets have also been characterised by a dramatic increase in carry-trade activity and foreign participation in local-currency-bond markets. As data from the Bank for International Settlements (BIS) shows, this practice became quantitatively relevant only in the last decade. On the whole, the share of domestic bonds in emerging markets increased between 2000 and 2010 (see table). And as documented by Burger, Warnock and Warnock (2012), participation by foreign residents in the emerging markets’ domestic-bond markets has increased. Are these carry-trade activities necessarily harmful to the recipient emerging countries or can emerging markets take advantage of this development of an international market for local-currency-denominated debt—a kind of redemption from the original sin?
In Alfaro and Kanczuk (2013), we revisited these questions related to the optimal exchange-rate regime and its implications in light of the new reality of capital flows to emerging markets. More than a decade ago, Calvo and Reinhart (2002) coined the term ‘fear of floating’ for the authorities’ reluctance to allow free fluctuations in the nominal (or real) exchange rate. But the debate over the optimal exchange-rate regime keeps coming back in new forms in response to new conditions. Indeed, the conclusions reached by the literature on optimal exchange-rate regimes vary with their hypotheses.
To account for current conditions, we construct and calibrate a dynamic equilibrium model of a small open economy in which the government issues foreign debt in both domestic and international currencies. Domestic and international