Non-technical summary of ESM Working Paper 57 "Fear (no more) of Floating: Asset Purchases and Exchange Rate Dynamics"

Monetary policy in many emerging market economies (EMEs) has often been pro-cyclical in order to contain inflation and mitigate the adverse effects of currency depreciation on the balance sheets of banks and non-financial corporations. Although some EMEs claim to allow their exchange rates to float freely, they do not actually do so because of fears that excessive exchange rate volatility could lead to large fluctuations in inflation, which could jeopardise the credibility of inflation-targeting central banks. The resulting fear of floating exists despite the fact that de jure (legal) flexible exchange rate regimes endorse currency fluctuations as shock absorbers. 

This paper examines whether central bank asset purchases of local currency government bonds in EMEs could help to absorb capital outflows caused by government bond sell-off shocks triggered by foreign investors during financial distress episodes and mitigate the fear of floating, while conventional monetary policy focuses on price and output stability. The question is new to the literature, as EME central banks embarked on asset purchases for the first time in response to the COVID-19 crisis, which – in addition to positive spillovers from monetary policy easing in advanced economies – may have facilitated policy rate cuts, in contrast to their experience during the global financial crisis.

Using an estimated small open economy macroeconomic model for EMEs with a banking sector facing currency mismatch, our results show that local currency asset purchases by EME central banks ease financial conditions and increase banks’ external borrowing capacity. They therefore reduce the magnitude of the impact of government bond sell-off shocks, which are magnified by financial market developments, by mitigating private sector capital outflows and the associated exchange rate depreciation. The resulting limited rise in inflation increases the space for conventional monetary policy and reduces its procyclicality. These beneficial effects of asset purchases are substantially reduced in the case of country risk premium shocks, which raise the cost of foreign currency borrowing more directly by increasing country spreads. Our framework sheds light on why exchange rates in EMEs remained stable following the unprecedented asset purchase announcements by EME central banks during the COVID-19 crisis.