Exchange Rate Challenges in Emerging Markets and Developing Countries—Introduction

• Date: 01 August 2015
• Published date: 01 August 2015
• DOI: http://doi.org/10.1111/rode.12166
• Author: Gunther Schnabl,Ansgar Belke

Exchange Rate Challenges in Emerging Markets and

Developing Countries—Introduction

Ansgar Belke and Gunther Schnabl*

Since the 1990s recurring financial crises in Japan, the USA and Europe have trig-

gered an unprecedented monetary expansion in the large industrialized countries.

This monetary expansion took the form of money market interest rates converging

towards zero and unconventional monetary policies inflating the balance sheets of the

central banks in the core of the international monetary system that issues the leading

international currencies (dollar, euro and yen).

With the low-cost liquidity issued in the large industrialized countries the emerging

market economies and developing countries became destinations for increasingly

speculative capital flows (hunt for yield), which undermined more independent mon-

etary policy making (Belke and Verheyen, 2014). As within an environment of very

benign global liquidity conditions the move towards a flexible exchange rate is equiva-

lent to a quasi-announced appreciation of the national currency (McKinnon and

Schnabl, 2009), the famous trilemma in international economics has become trans-

formed into a dilemma: Emerging market economies and developing countries have

de facto lost a degree of freedom in choosing between exchange rate stability and

monetary policy independence (Rey, 2013).

The resulting tremendous foreign reserve accumulation of emerging markets and

developing countries, which has become widely independent from the exchange rate

regime, is the breeding ground for financial instability as observed in the wake of the

1997/98 Asian crisis. By then, buoyant capital inflows, widely unsterilized foreign

reserve accumulation and undue credit growth had become the source of

unsustainable financial market exuberance, overinvestment, rising current account

deficits, and balance of payments and financial market crisis.

To prevent a recurrence of the Asian crisis, East Asian countries moved towards

extensive sterilization policies. Sterilization operations can be market based or non-

market based. In the case of market-based sterilization central banks absorb liquidity

from financial markets at market rates. The benefit is that the market mechanism

remains in place, but interest rates are pushed upwards, which attracts additional

(speculative) capital inflows. In addition, substantial sterilization costs can accrue,

which undermines the independence of the central bank.

Therefore non-market-based sterilization operations have become more prevalent,

which keeps the sterilization costs low. For instance, the Peoples Bank of China is

forcing commercial banks to keep increasing reserves with the central bank, with the

growing reserve requirements being remunerated below market rates. The benefit of

non-market-based sterilization is that sterilization costs for the central bank are low

* Belke: Jean Monnet Professor for Macroeconomics, University of Duisburg-Essen, Universitaetsstraße

12, 45117 Essen, Germany. Tel: +49-(0)201-1832277; E-mail: ansgar.belke@uni-due.de. Also affiliated to

CEPS Brussels and IZA Bonn. Schnabl: University of Leipzig, Institute for Economic Policy, Grimmaische

Straße 12, 04109 Leipzig, Germany. Also affiliated to CESifo Munich.

Review of Development Economics, 19(3), 449–454, 2015

DOI:10.1111/rode.12166

© 2015 John Wiley & Sons Ltd