Chapter

Chapter 5. The Impact of External Developments on Emerging Market and Developing Economies: The Role of Exchange Rate Flexibility

Author(s):
R. Gelos
Published Date:
March 2014
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Author(s)
Jorge Iván Canales-Kriljenko

External macroeconomic and financial conditions significantly affect domestic macroeconomic and financial outcomes in emerging market and developing economies. These external conditions go through cyclical movements that filter into domestic cycles. This should not be surprising because most emerging market and developing economies are small open economies. Exchange rate flexibility seems to have helped diffuse the transmission of the cycles originated from abroad. For example, it appears to have contained growth in domestic demand associated with easy external financial conditions. It also may have reduced the intensity of capital flows and current account deterioration, which often raise macroeconomic and financial vulnerabilities.

This chapter presents evidence of the impact of external developments in emerging market and developing economies and explores whether exchange rate flexibility makes a difference.

External and Domestic Developments in Emerging Market and Developing Economies: 1990–2009

The last two decades witnessed at least two full global macroeconomic cycles that can help shed light on the effect of external conditions on emerging market and developing economies and the role that exchange rate flexibility played.

External Environment

The external environment for emerging market and developing economies during the last two decades was favorable up to the Lehman events in late 2008. The cyclical swings in economic activity were mild, and world GDP grew on average about 3 percent.1 Deviations from the average were relatively small as world growth ranged between 2 percent and 5 percent before contracting by 1 percent in 2009. World growth was on the high side during the 2004–07 easy external financial conditions (Figure 5.1).

Figure 5.1World Growth

(Percent a year)

Source: IMF, World Economic Outlook database.

External financial conditions shifted from easy to tight several times in the last two decades. Financial conditions are easy when both global real interest rates and risk aversion are low (Canales-Kriljenko, 2010). On these occasions, emerging market and developing economies tend to take advantage of low interest rates and investors are willing to take the risk. Using the Chicago Board Options Exchange Volatility Index (VIX) as a proxy for global risk aversion, financial conditions were easy during 1991–96 and 2004–07 (Figure 5.2).

Figure 5.2Chicago Board Options Exchange Volatility Index

Source: Chicago Board Options Exchange.

For the median country, terms of trade showed cycles similar to those in economic activity and risk aversion, with persistent improvements between 1994–96 and 2003–08 (Figure 5.3). The terms of trade improvement during the cycle of the 2000s was larger and more persistent than during the 1990s (Figure 5.4). Yet the cross-country variation in each cycle was large. The terms of trade for individual countries did not change at the same time or in the same direction for all countries in the sample. At any moment, the terms of trade improved for some countries and worsened for other emerging market and developing economies. Yet the terms of trade for net commodity exporters clearly improved sharply during 2004–08, while that of net commodity importers weakened.

Figure 5.3Terms of Trade

(Percent a year; median)

Source: IMF, World Economic Outlook database.

Figure 5.4Terms of Trade

(Percent a year)

Source: IMF, World Economic Outlook database.

Domestic Impact

The median emerging market and developing economy in the sample also experienced cycles in its macroeconomic variables. Domestic demand, GDP, and credit growth arguably went through two full cycles in the last two decades. The amplitude of the cycle was larger for credit than for domestic demand and GDP growth. External trade activity was more intense in the second cycle, with similar patterns in the growth rates of real exports and imports. Real exports, however, increased more, and the current account moved from a deficit to a surplus in the median country. The improved current account balance also reflected the persistent terms-of-trade improvement in the second third of the last decade. Important differences in macroeconomic developments across countries took place (Figures 5.5 and 5.6).

Figure 5.5Selected Emerging Market Macroeconomic Indicators

(Percent a year; median)

Source: IMF, World Economic Outlook database.

Figure 5.6Selected Emerging Market Macroeconomic Indicators

(Percent a year; distribution)1

Source: IMF, World Economic Outlook database.

1 Shaded areas represent the quintiles of the distribution. The white line represents the median.

Econometric Regression

To incorporate the diversity of country experiences during the period 1990–2009, the following sections include an analysis based on multivariate pooled regressions for the 29 emerging market economies in the sample. The analysis uses annual data mainly from the IMF’s World Economic Outlook database, complemented with information from JPMorgan and country authorities as compiled by Haver Analytics, Inc. The Monetary and Capital Markets Department of the IMF provided the data on exchange rate regimes.

Domestic demand growth in emerging market and developing economies increases with faster world growth, better terms of trade, and more tolerance for risk (as proxied by a decline in the VIX). It often grows faster than world GDP during upswings and falls more sharply during downturns. The sensitivity to external conditions, however, is not uniform across demand components. Private investment reacts much more than private consumption to each external factor. In turn, government consumption does not react systematically to external conditions in the sample. The effect on GDP growth is qualitatively the same as that on domestic demand, but milder (Table 5.1).

Table 5.1Pool Regressions: Effect of External Variables on Domestic Demand, GDP, and Credit Growth1
Domestic

Demand
Consumption
TotalPrivateGovernmentInvestmentGDPReal Private Credit
VIX (index)−0.16***−0.05−0.09**0.05−0.19**−0.09***−0.57***
Terms of trade (growth rate)0.14***0.12***0.15***0.040.090.06***−0.01
World growth1.28***0.86***1.02***0.34−0.471.01***0.67
Adjusted R-squared0.170.140.150.05−0.010.230.11
Observations535525535539545544522
Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

Real credit growth responds to external financial conditions. In particular, real credit increases with declines in the VIX—in other words, with increases in risk tolerance or declines in risk aversion. Thus, easy external financial conditions increase the risk of credit booms and could call for policy action depending on the country’s position in the cycle. Real credit does not respond strongly to either changes in world growth or the terms of trade: the latter has the right sign but is not statistically significant.

External conditions directly affect a country’s balance of payments (Table 5.2). The current account balance in percent of GDP improves with better terms of trade and lower risk tolerance. The income effect compensates for the effect from developments in the real trade balance. In particular, better terms of trade have often lowered real export growth and increased real import growth. Lower risk tolerance (increases in the VIX) reduces both real exports and imports, but has a stronger effect on the latter. Thus, it often improves the trade balance and the current account. Faster world growth increases both real exports and imports, and although the effect on real exports appears larger, the improvement in the current account is not statistically significant. On the financial side of the balance of payments, faster world growth has been associated with higher capital inflows—both gross and net. In turn, higher risk aversion has come with lower gross inflows, whereas the link to net inflows is not statistically significant.

Table 5.2Pool Regressions: Effect of External Variables on the Balance of Payments
Real

Exports1
Real

Imports1
Current

Accounts2
Gross

Inflows2
Net

Inflows2
Reserve

Buildup3
Real Exchange

Rate1
VIX−0.26***−0.62***0.09**−0.23***−0.20**−0.09***−0.19**
Terms of trade−0.09*0.62***0.12***−0.06−0.030.030.09
World growth2.32***1.180.101.30***2.43***0.16−0.47
Adjusted R-squared0.220.110.460.340.340.12−0.01
Observations539539547520476545545
Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

Percent a year.

Annual flow over U.S. dollar GDP of the earlier year.

Annual change in stock over U.S. dollar GDP of the earlier year.

Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

Percent a year.

Annual flow over U.S. dollar GDP of the earlier year.

Annual change in stock over U.S. dollar GDP of the earlier year.

External financial conditions have an important effect on the real exchange rate and reserve buildup for the whole country sample. In particular, periods of easy external financial conditions associated with a decline in the VIX have often led to real exchange rate appreciation and reserve buildup. In turn, periods of tight external conditions often result in real exchange rate depreciation and drops in international reserve coverage. Figures 5.7 and 5.8 show changes in the real exchange rate and reserve buildup for the median country, which is consistent with this interpretation. One question that comes up is whether there are systematic differences across exchange rate regimes.

Figure 5.7Real Effective Exchange Rate

(Percent a year; median)

Source: IMF, Information Notice System database.

Note: Increase means appreciation.

Figure 5.8International Reserve Buildup

(Flow over earlier period GDP; median)

Source: IMF, International Financial Statistics and World Economic Outlook database.

Evolution of Exchange Rate Regimes: 1990–2009

Did exchange rate flexibility matter? If so, how did it make a difference? The question warrants answers from different points of view and methods. The evidence presented here suggests that it matters and that more flexible exchange rate regimes help isolate the domestic economy from external developments.

The IMF’s de facto exchange rate regime classification database suggests that more emerging market and developing economies have flexible exchange rate regimes than do not. However, it also suggests that the number of countries following flexible exchange rate regimes has decreased over the last two decades (Figure 5.9). In this exercise, the cutoff exchange rate regime is a crawling peg. In other words, for the following exercises, flexible regimes are crawling pegs and all other exchange rate regimes that allow more exchange rate flexibility.

Figure 5.9Flexible Exchange Rate Regimes

(Percent of total regimes)

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions database.

Empirical Analysis

The econometric strategy consists of three tactics. First, divide the sample into observations of flexible exchange rate regimes and observations of those that are not. Second, test if each external variable matters for each subsample in a single panel regression. Finally, test if the parameters for each external variable differ in the two subsamples. This can be achieved by interacting each of the external variables with a dummy of flexible regimes and another for those that are not flexible (1 – the flexible dummy) in a pooled regression.

The analysis suggests that exchange rate flexibility shields domestic demand from external developments. The effect of the three external variables on domestic demand growth is larger for less flexible exchange rate regimes than it is for more flexible regimes. Also, the difference is statistically significant under a Wald test. The effect results mainly from the behavior of the private agents, as government consumption does not react as much to external variables, except perhaps to world growth under less flexible exchange rate regimes. As expected, the effect on investment is stronger than for other components of domestic demand. These qualitative results on domestic demand carry onto GDP growth (Table 5.3).

Table 5.3Pool Regressions: Effect of External Variables on Domestic Demand, GDP, and Real Credit1
Domestic

Demand
Consumption
TotalPrivateGovernmentInvestmentGDPReal Credit
VIX * flexible dummy2−0.11**−0.03−0.050.03−0.25***−0.07**−0.61***
Terms of trade * flexible dummy0.050.07**0.09***0.000.12*0.02−0.19
World growth * flexible dummy0.84***0.61***0.68***0.18−0.200.81***0.57
VIX * (1–flexible dummy)−0.22***−0.08*−0.16***0.11*−0.10−0.12***−0.49*
Terms of trade (1 – flexible dummy)0.37***0.25***0.30***0.090.020.15***0.31
World growth * (1 – flexible dummy)1.84***1.24***1.44***0.65**−0.82*1.28***0.74
Adjusted R-squared0.230.180.180.070.000.250.11
Observations535525535539545544522
Wald test of equal coefficients across regimes
VIX******
Terms of trade*************
World growth***********
Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

The flexible dummy takes a value of 1 for the more flexible exchange regimes under the IMF classification, defined as crawling pegs and above.

Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

The flexible dummy takes a value of 1 for the more flexible exchange regimes under the IMF classification, defined as crawling pegs and above.

Exchange rate flexibility also matters for the balance of payments (Table 5.4). Gross and net capital inflows respond more to external financial developments and world growth in less flexible exchange rate regimes. Capital flows do not respond as much to terms-of-trade changes, except perhaps for gross inflows for less flexible exchange rate regimes. The results of net inflows carry through to the current account balance, although the effect of world growth on the current account is not strong. The impact on real imports of external financial conditions is strong under all exchange rate regimes, and this exercise cannot detect statistically significant differences in the parameters across regimes. Real exports also respond to external conditions under both regimes, but the effect of external financial conditions is stronger under less flexible regimes. In particular, a decline in risk aversion increases real exports more under less flexible exchange regimes than under more flexible ones.

Table 5.4Pool Regressions: Effects of External Variables on the Balance of Payments
Real

Exports1
Real

Imports1
Current

Account2
Gross

Inflows2
Net

Inflows2
Reserve

Buildup3
Real Exchange

Rate1
VIX * flexible dummy2−0.20***−0 55***0.06−0.12*−0.06−0.08***−0.25***
Terms of trade * flexible dummy−0.10*0.65***0.13***−0.030.000.04*0.12*
World growth * flexible dummy2.37***0.590.280.59*1.41***0.02−0.20
VIX * (1 – flexible dummy)−0.38***−0.72***0.13***−0.37***−0.37***−0.11***−0.10
Terms of trade (1 – flexible dummy)−0.020.55**0.11**−0.15**−0.110.000.02
World growth * (1 – flexible dummy)2.09***2.07**−0.152.57***4.23***0.38***−0.82*
Adjusted R-squared0.240.110.460.380.370.130.00
Observations539539547520476545545
Wald test of equal coefficients for
VIX***********
Terms of trade
World growth**********
Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

Percent a year.

Annual flow divided by U.S. dollar GDP of the earlier year.

Annual change in stock divided by U.S. dollar GDP of the earlier year.

Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

Percent a year.

Annual flow divided by U.S. dollar GDP of the earlier year.

Annual change in stock divided by U.S. dollar GDP of the earlier year.

Do more flexible exchange rate regimes end up with less reserve buildup and more real exchange appreciation during favorable external conditions? They arguably do in response to external financial conditions. When external financial conditions are easy, countries with more flexible exchange rate regimes end up with a more appreciated currency in real terms than those with lower exchange rate flexibility. The sensitivity of reserve buildup to the VIX is also lower in more flexible regimes, but the differences are not statistically significant. The answer is less clear when other external variables change independently. An increase in world growth increases reserve buildup in less flexible exchange rate regimes and depreciates the currency in real effective terms. Better terms of trade increase reserve buildup and real appreciation in more flexible regimes.

There is some evidence that the systematic differences across regimes can be credited to the regimes themselves. Crediting the empirical differences found across regimes to the regimes themselves assumes that other policies, such as fiscal measures, have not differed substantially across regimes. Otherwise, one could be crediting the insulation from external developments to exchange rate flexibility, when in reality the difference was a response to the fiscal policies in place in more flexible exchange rate regimes. The data suggest that this is not the case. Pooled regressions suggest that fiscal policies have not significantly varied across exchange rate regimes. Therefore, it would seem safe to credit the systematic differences in behavior of real and financial variables to the exchange rate regimes themselves.

At least in this sample, fiscal balances systematically responded to external developments, but in roughly the same way across exchange rate regimes (Table 5.5).

Table 5.5Pool Regressions: Effect of External Variables on Fiscal Accounts1
RevenueSpending
TotalTaxesTotalGoods and ServicesInterest BillOverall Balance
1. Total impact
VIX0.000.020.01−0.01−0.26*−0.04
Terms of trade0.05***−0.01−0.01−0.010.28***0.09***
World growth0.080.11−0.26**−0.07*3.17***0.41***
Adjusted R-squared0.920.570.920.990.220.41
Observations418446354220352224
2. Impact by regime
VIX * flexible dummy2−0.020.04**−0.01−0.01−0.16−0.03
Terms of trade * flexible dummy0.04**0.00−0.020.000.24**0.09***
World growth * flexible dummy0.120.14*−0.31**−0.09**2.46***0.47***
VIX * (1 – flexible dummy)0.030.010.050.00−0.43***−0.04
Terms of trade (1 – flexible dummy)0.06***−0.03*0.01−0.02*0.36**0.10***
World growth * (1 – flexible dummy)0.030.07−0.20−0.014.25***0.33**
Adjusted R-squared0.920.580.930.990.230.41
Observations418446354220352224
Wald test of equal coefficients across regimes
VIX********
Terms of trade
World growth
Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

The flexible dummy takes a value of 1 for the more flexible exchange regimes under the IMF classification, defined as crawling pegs and above.

Sources: IMF, World Economic Outlook database; Chicago Board Options Exchange; and Haver Analytics.

The sample includes Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela.

The flexible dummy takes a value of 1 for the more flexible exchange regimes under the IMF classification, defined as crawling pegs and above.

Overall balances in percent of GDP improved with terms-of-trade gains and increases in world growth. No systematic change in overall balances in percent of GDP took place in response to changes in the VIX. Fiscal revenue improved with terms-of-trade gains in the sample, while fiscal spending remained unaffected. Thus, fiscal authorities have systematically saved part of the bonanza arising from favorable external prices. In turn, world growth had no systematic relationship with fiscal revenue, but significantly increased the interest rate bill and reduced fiscal spending, resulting in an improvement in overall balances.

Conclusion and Policy Implications

The experience of emerging market and developing economies during 1990–2009 suggests that external developments have played an important role in determining their macroeconomic conditions. In particular, domestic demand, GDP, and current account balances in individual emerging market and developing economies have responded to changes in world GDP, global risk tolerance, and the terms of trade.

Exchange rate flexibility has helped insulate countries from external developments. The pickup in domestic demand has usually been smaller in countries with more flexible exchange rate regimes during periods of easy global money. Conversely, domestic demand growth has fallen less in more flexible regimes during periods of tight external liquidity.

Domestic demand growth is often less volatile in more flexible exchange rate regimes. Analysis based on multivariate pooled regressions for 29 emerging and advanced economies shows that domestic demand rises when (1) global risk aversion (VIX) falls; (2) terms of trade improve; and (3) world growth increases. The effects of external developments, however, are often milder in more flexible exchange rate regimes.

Although exchange rate flexibility could help smooth economic cycles that originated abroad, it requires a monetary anchor not based on exchange rate management. Setting up a monetary policy framework that provides an alternative to exchange rate management could take time and requires investment in operational expertise.

Reference

    Canales-KriljenkoJorge Iván2010Challenges Arising from Easy External Financial Conditions,” in Regional Economic Outlook: Western Hemisphere—Crisis Averted—What’s Next? (Washington: International Monetary FundMay).

The countries in the sample comprise Argentina, Brazil, Bulgaria, Chile, Colombia, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Indonesia, Israel, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Panama, Peru, Philippines, Poland, Russia, South Africa, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela. China is explicitly excluded given its size.

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