Exchange Rate Stability, Financial Stability, and Financial Integration

Dear Colleagues,

(1) Focus: Exchange rate stability, financial stability, and financial integration

Nominal exchange rates are an autonomous source of instability and a transmission channel of regional or global shocks, that is, financial market-related crises in neighbouring countries, or changes of both interest rates in financial centres and of the exchange rates of international creditor currencies—shocks that result in declining access for debtor countries to international capital markets. Spillover and contagion via fluctuating exchange rates may result in deep economic crisis and the destruction of financial wealth, even if countries display sound fundamentals. Negative balance sheet effects linked to depreciating exchange rates constitute a major vulnerability, particularly for net debtor countries using foreign currency. In addition, financial markets have undergone a tremendous transformation within the last few decades as a result of the rapidly changing global environment, involving the widespread liberalisation of capital flows, the emergence of new market participants, and the creation of highly sophisticated financial instruments. Hence, boom–bust cycles with seemingly unfounded sudden U-turns in capital flows enforcing exchange rate misalignments create vulnerable segments of domestic financial markets and pose serious challenges to the risk management of central banks, as well as domestic regulators and international financial institutions. 

Scope and purpose:

Contributions based on the following topics are very welcome:

–the analysis of the interdependencies of the operation of exchange rates, the stability of financial systems, and financial integration into the global economy;

–the risks of the contagion and spillover of financial instabilities and financial-sector related crises;

–on the exploration of unilateral, regional, or global response(s) to possible trade-offs between exchange rate stability, financial stability, and financial integration;

–addressing regulatory gaps in these fields;

–in the form of theoretical elaborations or country case-studies, including on the emergence of new reserve currencies of the Euro and the RMB.

(2) There are three theoretical approaches to exchange rates and financial integration, namely:

(1) Mainstream arguments state that rather flexible exchange rates prevent imported inflation, cushion the impacts of exogenous shocks, and provide monetary authorities and policy makers with monetary and fiscal sovereignty. However, there is only very limited empirical evidence for this line of reasoning. In contrast, both advanced countries and developing countries display vast experiences that give comprehensive testimony for fluctuating exchange rates bringing about even higher instability and seriously harmed trade relations. These are the reasons that, during the 20^th century, Western Europe had flexible exchange rates for a time span of only six years, between 1973 (marking the collapse of the global fixed, but adjustable exchange rate system of Bretton Woods) and 1979 (when Western Europe established the regional fixed, but adjustable exchange rate regime of the European Monetary System).

(2) In the 1960s, Robert Mundell and Markus Fleming showed that it is rather impossible for a country to achieve the three policy goals—fixed exchange rates, capital mobility, and monetary autonomy—at the same time; according to this impossible trinity, countries have to sacrifice at least one of these goals. Aizenman (2011) and Aizenman, Chinn, and Ito (2010) presented a modern version of this trilemma in the form of exchange rate stability, financial integration, and monetary independence, and advanced it to a quadrilemma by incorporating financial stability.

(3) The impossible trinity and the quadrilemma apply to all countries, both advanced and developing countries,

emerging markets, and both net creditor and net debtor countries. However, developing countries and emerging markets are plagued with original sin (Eichengreen, Hausmann and Panizza, 2002) and thus a fear of floating (Calvo and Reinhart, 2000), when depreciations of exchange rates cause negative balance sheet effects as a result of their net indebtedness in foreign currency, risking the stability of their domestic financial system. Given the deficiencies of the current global monetary architecture (e.g., a lack of multilateral rules referring to the exchange rate management, capital flow governance, or sovereign debt insolvencies), developing countries and emerging markets are increasingly falling back on unilateral measures (forex accumulation and capital account measurements) or exploring opportunities for regional monetary and financial co-operation intended to mitigate the negative impacts of spillover and contagion.

In total, the proposed Special Issue will draw on the trilemma/quadrilemma arguments, as well as on the original-sin line of reasoning. It will also invite papers based on rather mainstream lines of reasoning, although assuming that they advance the old theoretical and empirical frameworks.

Aizenman, J., M. Chinn, H. Ito, (2010) “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma's Configurations,” Journal of International Money and Finance (June), pp 615-641.

Calvo, G.A., Reinhart, C.M. (2000), Fear of Floating, NBER Working Papers No. 7993 (November).

Eichengreen, B., Hausmann, R. and U. Panizza, Original Sin: The Pain, the Mystery, and the Road to Redemption," Working Papers, Paper prepared for the conference \Currency and Maturity Matchmaking: Redeeming Debt from Original Sin," Inter-American Development Bank 2002.

Eichengreen, B. and A. K. Rose (1998), Staying Afloat When the Wind Shifts: External Factors and Emerging Market Banking Crises, NBER Working Paper no. 6370 (January).

Mundell, R. A. (1963). “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates. Canadian Journal of Economic and Political Science, Vol. 29, no. 4 (November), pp. 475-485.

Prof. Martina Metzger
Prof. Xue Li
Guest Editors

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• exchange rate stability
• financial stability
• financial integration
• exchange rate regimes
• balance sheet effects
• boom–bust cycles
• capital account management
• reserve currencies
• quadrilemma
• global monetary architecture