External Shocks, Policies, and Tail-Shifts in Real Exchange Rates

ExternalShocks,Policies,andTail-ShiftsinRealExchangeRates NicolásE.MagudandSamuelPienknaguraWP/23/129 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2023 JUN ©2023InternationalMonetaryFundWP/23/129 IMFWorkingPaper WesternHemisphereDepartment ExternalShocks,Policies,andTail-ShiftsinRealExchangeRatesNicolásE.MagudandSamuelPienknagura* AuthorizedfordistributionbyGustavoAdlerJune2023 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Weusepanelquantileregressionstostudyextreme(ratherthanaverage)movementsinthedistributionoftherealeffectiveexchangerate(REER)ofsmallopeneconomies.Wedocumentthatglobaluncertainty(VIX)andglobalfinancialconditions(U.S.monetarypolicy)shockshaveastrongimpactonthedistributionoftheREERchanges,withlargerimpactsinthetailsofthedistribution,andespeciallyineconomieswithshallowerFXmarkets,lowercentralbankcredibility,andhighercreditrisk(i.e.,weakermacrofundamentals).Foreignexchangeintervention(FXI)partiallyoffsetstheimpactoftheseshocks,especiallyinthelefttail(largedepreciations)andparticularlyineconomieswithweakerfundamentalsbut,moreimportantly,whenFXIisusedsporadically.Thus,ourresultshighlighttheimportanceofdeepeningFXmarkets,improvingcentralbankcredibility,andstrengtheningmacrofundamentalsagainstthepotentialdynamictrade-offsofoverrelianceonapolicythatwouldexacerbatethepreviouslymentionedfrictions.WhileourresultspointtoloweffectivenessofcapitalflowmanagementinpreventinglargeREERmovements,theyseemtoenablemoreimpactfulforeignexchangeinterventionintheimmediateaftermathofshocks. RECOMMENDEDCITATION:Magud,NicolasE.andPienknagura,Samuel(2023),“ExternalShocks,Policies,andTail-ShiftsinRealExchangeRates,”IMFWorkingPaper23/129(InternationalMonetaryFund:Washington,DC) JELClassificationNumbers: F31,F38,F41 Keywords: Realexchangerates;externalshocks;foreignexchangeintervention;capitalcontrols Author’sE-MailAddress: nmagud@imf.org;spienknagura@imf.org *WethankYoshikiAndofordatapreparationandJingXieforsuperbresearchassistance,andGustavoAdler,CianAllen,AndrewBerg,MariarosariaComunale,PabloDruck,AndrésFernández,AlejandroGuerson,GeoffHeenan,LuisJácome,RuyLama,LeonardoMartinez,PauRabanal,FelipeSaffie,RodrigoValdés,CarlosVegh,andFrankWuforexcellentcommentsanddiscussions.TheviewsexpressedinthepaperarethoseoftheauthorsanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard, WORKINGPAPERS ExternalShocks,Policies,andTail-ShiftsinRealExchangeRates PreparedbyNicolásE.MagudandSamuelPienknagura1 1WethankYoshikiAndofordatapreparationandJingXieforsuperbresearchassistance,andGustavoAdler,CianAllen,AndrewBerg,MariarosariaComunale,PabloDruck,AndrésFernández,AlejandroGuerson,GeoffHeenan,LuisJácome,RuyLama,LeonardoMartinez,PauRabanal,FelipeSaffie,RodrigoValdés,CarlosVegh,andFrankWuforexcellentcommentsanddiscussions.TheviewsexpressedinthepaperarethoseoftheauthorsanddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. I.Introduction Financialintegrationcanhavepro-growtheffects,butitcanalsoleadtoshort-termchallenges.Integrationeasescountries’financingneeds,whichcanfosterlong-terminvestmentandhelpsmoothdomesticandexternalshocks.Itcanalsohelpincreasesexportsandimports,whichcanraisegrowthprospects.However,globallyintegratedeconomies,especiallysmallopeneconomies(SOEs),areexposedtotransitoryexternalfinancialshocks,whichcanresultinexcessivemovementsinkeyeconomicvariables.Inparticular,financialintegrationexposescountriestoglobaluncertainty,asreflectedinhigherVIXlevels,andtochangesinglobalfinancialconditions,suchasthosestemmingfromU.S.monetarypolicyactions.Theseshockscanleadtotemporaryswingsincapitalinflows,increasefundingcosts,andresultinexcessivemovementsinexchangerates. Thechallengesandopportunitiesbroughtaboutbyglobalintegrationhavesparkedalivelydebateabouttheappropriatedesignofpoliciestosustainablyreapthebenefitsofamoreinterconnectedglobaleconomy.Onesideofthatdebate,whichhasgarneredgrowingattentioninbothacademicandpolicycircles,regardstheusefulnessandeffectivenessofforeignexchangeintervention(FXI)andcapitalflowmanagement(CFM)policiesinmitigatingtheadverseeffectsofexcessivemovementsofkeyeconomicvariablesinresponsetotemporaryshocks.Partofsuchdebate,however,oftentimeslacksaproperdefinitionofthespecificobjectivethatsuchpoliciesaimatachieving—akeyconsiderationinpolicydesign. Inthispaper,takingasthepolicyobjectivetosmoothexchangeratevolatility(asSOEtypicallyaimat2),firstwefocusontheimpactthatfinancialexternal(VIXandUSMonetarypolicy)shockshaveonthedistributionofrealexchangeratechanges,andespeciallyextrememovementsinrealexchangerates.Then,weexploretherolethatFXIandCFMs(bothofinflowsandoutflows)haveinmitigatingthei