Speculative capital inflows and exchange rate targeting in the Pacific Basin

This paper studies the process of capital inflow management and speculative inflows for countries pursuing the joint goals of monetary and exchange rate management. We introduce a sticky-price model with imperfect asset substitutability in which a central bank engages in costly sterilization to mitigate the influence of capital inflows on its policy targets. The costs of sterilization, often referred to as \"quasi-fiscal costs\" in the literature, reflect the loss experienced by the central bank by holding foreign securities whose nominal yields are inferior to those paid on domestic bonds. Our model demonstrates that if the sterilization process reflects a real cost to the central bank, it will rationally choose to limit its sterilization activity. However, we argue that the true quasi-fiscal costs of sterilization to the central bank may not be as large as they appear if the spreads between yields on domestic and foreign securities reflect true default risk premia. ; We then obtain upper bound estimates for the quasi-fiscal costs of sterilization borne by six developing country nations which experienced large capital inflows. Our results indicate that even our upper bound estimates of these costs are quite small, but can become non-trivially large during brief periods of capital inflow surges. We then conduct parametric and time series studies to examine whether central bank behavior responded to these quasi-fiscal costs over the course of our sample. Our results fail to indicate much of a role for quasi-fiscal costs during tranquil periods, but we find that some of the nations in our sample responded to large increases in quasi-fiscal costs by easing domestic credit.