Exchange Market Pressure and Absorption by International Reserves: Emerging Markets and Fear of Reserve Loss During the 2008-09 Crisis

This paper evaluates how the global financial crisis emanating from theU.S. was transmitted to emerging markets. Our focus is on the extent thatthe crisis caused external market pressures (EMP), and whether theabsorption of the shock was mainly through exchange rate depreciation orthe loss of international reserves. Controlling for variety of factorsassociated with EMP, we find clear evidence that emerging markets withhigher total foreign liabilities, including short- and long-term debt,equities, FDI and derivative products—had greater exposure and weremuch more vulnerable to the financial crisis. Countries with large balancesheet exposure -- high external portfolio liabilities exceeding internationalreserves—absorbed the global shock by allowing greater exchange ratedepreciation and comparatively less reserve loss. Despite the remarkablebuildup of international reserves by emerging markets during the periodprior to the financial crisis, countries relied primarily on exchange ratedepreciation rather than reserve loss to absorb most of the exchangemarket pressure shock. This could reflect a deliberate choice (“fear ofreserve loss” or competitive depreciations) or market actions that causedvery rapid exchange rate adjustment, especially in emerging markets withopen capital markets, overwhelming policy actions.