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.
Highlights
The insulating properties of flexible exchange rates have long been a contentious issue in emerging markets—not least in Asian emerging markets
The negative impact of the VXO is larger on real domestic credit growth, real house price growth, the change in loan-to-deposit ratios, net capital flows, liability flows, and real gross domestic product (GDP) growth in economies with pegged exchange rates, where free floating is the alternative
This is because fixed rate regimes increase the sensitivity of price to the VXO, but intermediate regimes significantly reduce that sensitivity relative to the omitted alternative of floating rates
Summary
The insulating properties of flexible exchange rates have long been a contentious issue in emerging markets—not least in Asian emerging markets. In the 1990s, Asia’s emerging markets resisted international calls to move to greater exchange rate flexibility and experienced large financial inflows from abroad before being hit by an appreciating dollar–yen rate, higher oil prices, and a weakening global semiconductor market, resulting in the Asian financial crisis. This experience accentuated calls for greater exchange rate flexibility in Asia and in emerging markets generally (Eichengreen 1999). These costs can be reductions in exports and export-led growth if a competitively valued peg is sacrificed or financial fragility in the presence of currency mismatches on corporate, bank, and public balance sheets
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