Goodbye Price Stability, Hello Exchange Rate Volatility

Erinç Yeldan

Over the last six months, many developing emerging market economies had witnessed large, unforeseen, and unpredictable swings in their exchange rates.  With rumors, and counter-rumors of likely tapering of the U.S. Federal Reserve’s Quantitative Easing (QE) programme, such swings resulted in abrupt depreciations by 16.7% in Indonesia, 7.3% in Thailand, 10.4% in Turkey, 9.3% in Brazil, 13.4% in India, and 8.8% in South Africa…

A recent policy brief by the Peterson Institute for International Economics provided Estimates of Fundamental Equilibrium Exchange Rates and revealed that many of these depreciations were, in fact, overshooting the fundamental equilibrium exchange rates that are consistent with the current account balances of these economies.  Now it is found that Indonesia needs its currency to appreciate by 3.9%; Thailand, by 2.4%; the Philippines, by 3.8%; Malaysia, by 4.3%. Meanwhile, Turkey has to let its currency depreciate by 18.1%; South Africa, by 6.8%; Poland, by 4%; Brazil, by 3.4%.  Table 1 below summarizes the relevant data.

Table 1

All these revelations point to an excessively volatile environment for exchange rates, the most important macroeconomic price for a national economy. These findings suggest that central banks (CBs) have now moved from the objective of price stability (and by extension exchange rate stability by way of interest rate volatility as the main instrument) over the period 2002-2008, to the new policy of exchange rate volatility to pursue interest rate stability. Interest rates all over are forced to the 0% lower bound in response to the pressures and whims of the global finance capital, a phenomenon to which Cömert and Yeldan (2008) referred as “interest rate smoothing.”

But all these lead to a dangerous game: volatility of exchange rates leads to volatility and excessive swings in national output, employment, and productivity.

The immediate policy concern, then, is to devise measures to manage/regulate “hot” forms of finance capital. It has to be underlined that long-term structural imbalances and external fragility arise, to a great extent, from the volatility of short-term capital flows against which central banks have taken a passive role to virtually stabilize interest rates, accommodating buoyant bond and equity prices through excessive exchange rate volatility.

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