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Re-thinking exchange rate management.

OVER the last two decades, most developing countries have moved towards greater exchange-rate flexibility and deeper financial integration. At the same time, buffered by sizable reserve holdings, they have also retained a fair degree of monetary autonomy, even as financial integration has continued. This has allowed them a sort of middle ground within the policy trilemma’, which rules that countries may choose any two—but not all three —of the goals of monetary independence, exchangerate stability and financial integration.

But excessive and myopic focus on the question of whether reserves are actively deployed misses a key point: countries adjust their policy frameworks and macroeconomic strategies dynamically to best fit the challenges of the day.

Indeed many developing countries have allowed the real exchange rate and monetary policy to take the first brunt of the adjustment. Considering the severity of the crisis in the industrialised economies, the absence of deeper adjustment in emerging markets (so far) is a testament to the degree to which this new middle ground in the trilemma, with proper governance and management, allows for a softer landing in the aftermath of major external events.

In hindsight, earlier concerns about excessive hoarding of forex reserves by most developing countries now seem grossly overblown. The crisis has shown the importance of the self insurance provided by reserves. While sizeable reserve accumulation is not a panacea, substantial reserves holdings may be the critical differentiator in determining whether a country has a soft landing or a hard one.

In a scenario where capital flows are volatile, reserve accumulation provides domestic authorities with access to hard currency—to cover essential expenses and mitigate the adverse consequences of capital flight at a time when the country is unable to borrow internationally.

However, the willingness to draw down on reserves and the speed at which this is done, is the result of a complex interaction between structural and political economy factors, says a recent NBER paper*.

It hinges, amongst other things, on the anticipated future course of the global economy, the domestic adjustment capacity and the degree of financial integration of the country in question.

Countries that are only partially integrated with the global financial system tend to be less exposed to capital flight and deleveraging. Thus the trade-offs for a country like India which is less integrated to the global financial system and having less room for fiscal adjustment due to its significant and growing fiscal deficits differ from those of, say, Chile.

Having said that, most emerging markets have relied on exchangerate and interest-rate adjustments to accommodate the shocks unleashed by the crisis, making only limited use of reserves to cushion sharp adjustment in their real exchange rate and to signal their credit worthiness in turbulent times.

The response, however, has varied from country to country, depending on the individual circumstance. While commodity-exporting countries with relatively low savings rates and/or little room for fiscal expansion have been reluctant to draw down their reserves to cushion the inevitable adjustment, countries like Korea and Russia have actively dipped into their reserves.

This is not surprising. As of now, there is no certainty either about the depth or about the duration of the global liquidity crisis/recession. There is also the fear that the mere act of using reserves to defend a particular exchange rate would lead to expectations of further depreciation. Hence, many countries might prefer to play it safe.

Available evidence suggests the crisis has had little discernable impact on China’s reserves (so far) relative to India, which has accommodated the crisis with sizable downward adjustment in reserves and a significant depreciation of the rupee, both by about 20% as of December 2008 from their respective peaks earlier in the year.

The paper warns that the brunt of the adjustment may yet await us. While exchange-rate and interestrate adjustments can cushion the landing, a deep crisis frequently ends by testing the fiscal and institutional capacity of countries. Are we gearing up our institutions for the challenge?

(*On the paradox of prudential regulations in the globalised economy: international reserves and the crisis: a re-assessment: Nber Working Paper 14779, Joshua Aizenman, University of California, Santa Cruz)

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Why the US dollar is still resilient.

TRILLION-dollar bailouts, trillion-dollar deficits, and the largest spending bill in US history. No matter how dire the news out of the US, the dollar strengthens. It has carried on rising in spite of new bailouts for two leading financial institutions — Citigroup and AIG — a catastrophic fall in US gross domestic product and more dreadful news about the US housing market. The dollar has risen 10% against the euro so far this year, and by 7.4% against the yen. The dollar just a fortnight ago had its best performance against the yen for 13 years — rising 4%.

Plans by the US Fed to buy $300 billion of US government debt has triggered on March 18 a fall of 3.01% for the dollar — the greatest, on a tradeweighted basis, since the signing of the Plaza accord in September 1985. The dollar had rallied since summer of 2008 largely on the perverse effects of ‘deleveraging’, as investors paying down debts often sold assets outside the US and bought dollars.

With the dollar suddenly cheaper, and US goods, therefore, more competitive, other central banks are in a dilemma. In the eurozone, where the European Central Bank continues to face criticism that it is “behind the curve”, the fate of beleaguered exporters who are facing 10% rise for the euro against the dollar in March 2009 could force the central bank to intervene to pull down the single currency . Similarly, in Japan, where the Bank of Japan has already intervened in the bond market, it is likely that the BOJ may intervene directly to weaken the yen. The yen is some 35% stronger than it was in July 2007, at the dawn of the credit crisis.

The US Dollar Index, which tracks the US currency’s progress against a basket of six leading currencies, has risen to a three-year high of 88.969 on a trade-weighted basis. Longer term, however, the US Dollar Index remains well off its highs of this decade, or even the last six years. As recently as 2003, the index traded above 100, which is about 12.5% above current levels.

A number of analysts had predicted the continued demise of the US dollar, thanks to the financial-sector bailout and weakening economy but its sharp upside has surprised many. The dollar’s recent climb is part of a massive reversal of long-standing investing trends (due to the global economic slowdown) such as buying emerging-market stocks or wagering on rising commodity prices.

Besides, many European banking systems built up long US dollar positions vis-à-vis non-banks and funded them by inter-bank borrowing and via FX swaps, exposing them to funding risk. When heightened credit risk concerns crippled these sources of short-term funding, the chronic US dollar funding needs became acute.

Given the dollar’s credentials as safe haven, its unchallenged role as global reserve currency, plus the fact that the market continues to give US fiscal and monetary policy action the benefit of the doubt, buying the dollar on dips remains the strategy of choice.

The dollar’s strength partly reflects the weakness of other currencies. Faith in the yen as a haven has been eroded by a flurry of dismal Japanese economic data while concerns over European banks and their exposure to problems in central and eastern Europe have seen the euro and, to some extent, the Swiss franc fall from grace.

The ability of central banks in Brazil, Russian, India, China and Saudi Arabia, which over the past few years have accounted for at least 30% of net treasury buying, to finance the ballooning US budget deficit is limited by the fact that their currency reserves are either falling — as in Brazil and Russia —or no longer rising, as in China.

Aside from the actions of global reserve managers, activity from US mutual funds shows an unwillingness to increase their allocations to foreign markets. This matters because US fund managers hold $30,000 billion of domestic and foreign securities, compared with the estimated $7,000 billion of foreign currency reserves managed by the world’s central banks.

Having increased their share of overseas assets from about 12.5% at the start of the decade to a high of 26% last summer, risk averse US funds reduced that share to 23%, where it has remained so far in 2009. I see further reductions in the proportion of their portfolios held in overseas markets and the subsequent repatriation of capital will help the US to continue to fund its current account deficit and thus support the dollar this year.

Besides, long-term portfolio allocation data for all US investors shows global shocks historically have caused US investors to steer away from overseas markets for several years. This time risk-averse American fund managers are unlikely to behave any differently in their response to the global economic slump.

The process of European banking sector de-leveraging is likely to generate significant US dollar demand over the months ahead, which will lend support to the US dollar against many other currencies. Dollar demand has also been reflected in the rise in purchases (and hence the price) of US treasury bonds, seen as the safest haven of all. The most recent data shows that such holdings of treasury bonds increased by about $100 billion over the past four weeks. Other countries are also feeling the effects (even more than the US) and so are slashing interest rates to try and boost domestic economic activity; so, the expected yield differential with the US is falling. With this trend set to continue, investors will continue to flock to the dollar.

I believe the world could see some growth return by the last quarter of 2009 and continuing through the first half of 2010. The actions of the Federal Reserve could stoke US inflation and ultimately undermine the dollar. However, this is probably a story which will continue to play itself out till 2010. Currently, the Fed thinks a rise in inflation is a lesser evil than further falls in house prices. When you’re competing against the likes of Europe, the US dollar suddenly doesn’t look so bad. Or rather, the US dollar is the prettiest pig in the herd.