Reserve Requirements and Real Exchange Rate Misalignments in Emerging Market Economies

• DOI: http://doi.org/10.1111/rode.12164
• Date: 01 August 2015
• Author: Axel Loeffler
• Published date: 01 August 2015

Reserve Requirements and Real Exchange Rate

Misalignments in Emerging Market Economies

Axel Loeffler*

Abstract

A popular policy target in emerging markets is the real exchange rate as an undervalued real exchange rate

is seen to enhance international competitiveness. Within an augmented Dornbusch model it is shown that

the implicit tax of low remunerated reserve requirements represents an efficient tool to depreciate the real

exchange rate. The model is empirically tested for a panel of Latin American, East Asian and Eastern

European countries. Controlling for the impact of fiscal policies and direct capital controls, the reserve

requirement tax significantly explains real exchange rate misalignments.

1. Introduction

The well known impossible trinity suggests that in a world with free capital mobility

either an external or an internal target can serve as the nominal monetary anchor. In

practice, however, policy makers are often tempted to target real variables to stimu-

late economic growth. A popular target, particularly in emerging markets, is the real

exchange rate. By improving the international competitiveness of export industries an

undervalued real exchange rate is regarded to generate economic stimulus.

In this paper it is shown that a depreciated real exchange rate, defined here as the

relative price of domestic vs foreign goods, can be achieved through low or

unremunerated reserve requirements. In a competitive banking market, banks trans-

fer the implicit reserve tax1of low remunerated reserve requirements to their clients,

either in the form of higher lending rates and/or lower deposit rates. Because of the

impact on the bank interest rate spread the reserve requirement tax represents an

additional instrument of monetary control. With two instruments, the policy rate and

the reserve requirement tax, the central bank can target the real exchange rate by

steering both inflation (via the policy rate transmission to market rates and the impact

of the reserve requirement tax on lending rates) and capital flows and therefore the

nominal exchange rate (via the impact of the reserve requirement tax on deposit

rates).

Although reserve requirements are a frequently used policy tool2in many emerging

markets the impact of reserve requirement changes on the level of the real exchange

rate is hardly researched. While reserve requirements are discussed as a potential tool

to prevent capital inflows (Gray, 2011) and thereby may represent a tool to target the

nominal exchange rate, theoretical studies on this issue are rare. Given imperfect

capital mobility Reinhart and Reinhart (1999) show that (unremunerated) reserve

requirements in a monetary targeting framework can influence the real exchange rate

* Loeffler: Deutsche Bundesbank, Wilhelm-Epstein-Straße 14, 60431 Frankfurt am Main, Germany. Tel:

+49-(0)69-9566-2966; E-mail: axel.loeffler@bundesbank.de. The findings, interpretations and conclusions

are those of the author and do not necessarily represent the views of the Deutsche Bundesbank. The

author is grateful to Gunther Schnabl (University of Leipzig), Franziska Schobert (Deutsche Bundesbank)

and Ronald McKinnon (Stanford University) for useful discussions on the topic and helpful suggestions.

Review of Development Economics, 19(3), 516–530, 2015

DOI:10.1111/rode.12164

© 2015 John Wiley & Sons Ltd