Explaining the Volatility of the Real Exchange Rate in Emerging Markets

This paper attempts to explain real effective exchange rate (REER) volatility in the world economy and particularly in emerging economies. Our first finding is that REER volatility is significantly higher in emerging and other developing countries than it is in advanced economies. The second, and perhaps the most important contribution of the paper, is that the variable that explains a significant percentage of the variability of REER volatility is the correlation between gross capital inflows (increases in liabilities with the rest of the world) and the return of gross capital outflows (decreases in assets held by domestic agents in the rest of the world). This correlation (with increases both in foreign liabilities and declines in assets held abroad expressed as positive magnitudes) is much higher in advanced economies – where, in fact, it approaches unity – than in emerging and other developing economies. The correlation between gross capital outflows and gross capital inflows is negatively and significantly associated with REER volatility. This result is robust to three types of estimation procedures: panel regressions of advanced and emerging economies; a dynamic panel data model that considers the persistence of REER volatility over time; and a logistic regression to model the propensity of having high REER volatility. All three procedures use a variety of control variables such as the exchange rate regime, the inflation rate, the real interest rate, and the volatility in the terms of trade. The major policy conclusion is that, regardless of their exchange rate regime, emerging economies that wish to open their financial account and do not have large institutional investors with assets abroad would do well to maintain sufficient cushions of foreign exchange reservesin order to counteract the negative effects of sudden capital flight. Another interesting finding of the paper is that countries adopting a floating exchange rate regime experience larger REER volatility that those who adhere to other regimes.