Capital Infows and Real Exchange Rate Appreciation – theory
The very purpose of having a local currency pegged to a base currency (usually the US dollar) is to provide a foundation for economic and financial stability. A currency peg reduces or even eliminates the issue of currency risk, and therefore attracts capital inflows. Those capital inflows become a self-fulfilling prophecy, since they help generate ever higher growth rates, which in turn attract further capital inflows. There are two monetary effects of these inflows. First, the local currency comes under mounting upward pressure. Second, interest rates paradoxically are forced lower. On the first of these, the currency is pegged so it cannot appreciate beyond a certain point. In order to maintain the peg, the central bank intervenes, selling its own currency for the base currency. In the money market, the central bank also conducts open market operations, sterilizing the effect of these inflows by withdrawing excess liquidity. Relative to the size of the inflows coming in, the ability of an emerging market central bank to conduct both of these monetary operations indefinitely is clearly limited. Meanwhile, precisely because interest rates are low and emerging market economies are not fully open, inflation rates are relatively high, higher that is than the inflation rate of the base currency. This should ordinarily mean that the local currency depreciates on a real basis in order to offset the higher inflation rate. The sheer weight of the capital inflows means this cannot happen. Indeed, the opposite happens. The local currency continues to appreciate on a real, inflation-adjusted basis. In turn, this causes widening external imbalances and loss of export competitiveness.
Tags: Business, Exchange rate
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