Financial shocks and exchange market pressure

Patnaik, Ila; Pundit, Madhavi Working Paper Financial shocks and exchange market pressure ADB Economics Working Paper Series, No. 581 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Patnaik, Ila; Pundit, Madhavi (2019) : Financial shocks and exchange market pressure, ADB Economics Working Paper Series, No. 581, Asian Development Bank (ADB), Manila, https://doi.org/10.22617/WPS190161-2 This Version is available at: https://hdl.handle.net/10419/203422 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/3.0/igo/ ASIAN DEVELOPMENT BANK FINANCIAL SHOCKS AND EXCHANGE MARKET PRESSURE Ila Patnaik and Madhavi Pundit ADB ECONOMICS WORKING PAPER SERIES NO. 581 May 2019 ASIAN DEVELOPMENT BANK ADB Economics Working Paper Series Financial Shocks and Exchange Market Pressure Ila Patnaik and Madhavi Pundit No. 581 | May 2019 Ila Patnaik ([email protected]) is a professor at the National Institute of Public Finance and Policy, Delhi. Madhavi Pundit ([email protected]) is an economist at the Economic Research and Regional Cooperation Department, Asian Development Bank. Creative Commons Attribution 3.0 IGO license (CC BY 3.0 IGO) © 2019 Asian Development Bank 6 ADB Avenue, Mandaluyong City, 1550 Metro Manila, Philippines Tel +63 2 632 4444; Fax +63 2 636 2444 www.adb.org Some rights reserved. Published in 2019. ISSN 2313-6537 (print), 2313-6545 (electronic) Publication Stock No. WPS190161-2 DOI: http://dx.doi.org/10.22617/WPS190161-2 The views expressed in this publication are those of the authors and do not necessarily reflect the views and policies ofthe Asian Development Bank (ADB) or its Board of Governors or the governments they represent. ADB does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. The mention of specific companies or products of manufacturers does not imply that they are endorsed or recommended by ADB in preference to others of a similar nature that are not mentioned. 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Please contact [email protected] if you have questions or comments with respect to content, or if you wish toobtain copyright permission for your intended use that does not fall within these terms, or for permission to use theADB logo. Corrigenda to ADB publications may be found at http://www.adb.org/publications/corrigenda. Notes: In this publication, “$” refers to United States dollars. ADB recognizes “China” as the People’s Republic of China. The ADB Economics Working Paper Series presents data, information, and/or findings from ongoing research and studies to encourage exchange of ideas and to elicit comment and feedback about development issues in Asia and the Pacific. Since papers in this series are intended for quick and easy dissemination, the content may or may not be fully edited and may later be modified for final publication. CONTENTS TABLES AND FIGURES iv ABSTRACT v I. INTRODUCTION 1 II. MOTIVATION AND QUESTIONS 4 III. DATA AND METHODOLOGY 8 A. Data 8 B. Methodology 9 IV. RESULTS 10 A. Determinants of Exchange Rate Changes 10 B. Determinants of Exchange Market Pressure 12 V. ROBUSTNESS CHECKS 17 A. Alternative Measures of Exchange Rate Regimes 17 B. Determinants of Exchange Market Pressure during Appreciation Pressures 18 C. Alternative Exchange Market Pressure Measures 18 VI. CONCLUSION 21 APPENDIX 23 REFERENCES 27 TABLES AND FIGURES TABLES 1 Regression Results for Exchange Rate Changes 11 2 Exchange Market Pressure Regression Results 13 3 Regression Results for Exchange Market Pressure Standardized Coefficients 15 4 Regression Results for Exchange Market Pressure Robust Coefficients 16 5 Alternative Measures of Exchange Rate Regimes Robust Coefficients 17 6 Regression Results for Quantitative Easing (Period 1) Robust Coefficients 19 7 Regression Results for Exchange Market Pressure Robust Coefficients 20 8 Summary Statistics 21 FIGURES 1 United States 10-Year Treasury Bill Rates, January--November 2013 1 2 Movements in Nominal Exchange Rates by Region, 2010–2018 2 3 Foreign Exchange Reserves by Region, 2000–2015 3 4 Mean Exchange Market Pressure by Region, 2010–2018 5 5 Median Exchange Market Pressure by Region, 2010–2018 6 ABSTRACT The taper tantrum episode induced a sudden outflow of capital from emerging markets back to the United States. This paper analyzes exchange market pressure in 93 developing and emerging market economies during this episode, drawing on recent methodological improvements in measuring exchange market pressure. We find that all economies in the sample that were integrated with global capital markets were heavily hit. Although popular discourse suggested that the extent of an economy’s fragility depended on its macroeconomic fundamentals, we find these fundamentals did not have much of a role in determining the level of pressure on a currency. Keywords: capital flows, exchange market pressure, financial shock, international trade and finance, macroeconomics, taper tantrum JEL codes: E52, F31, F32 I. INTRODUCTION The Federal Reserve responded to the financial crisis after Lehman Brothers’ bankruptcy by lowering interest rates to the zero lower bound (at or below 0.25%) and expanding liquidity. This was accompanied by unconventional monetary policy in the form of balance sheet expansion (or quantitative easing) by buying financial assets, thereby boosting money supply in the financial system and stimulating economic growth. These low interest rates affected emerging markets in the search for yield by global asset managers. Strong capital inflows to these markets ensued, causing emerging market currencies to appreciate. The United States (US) economy recovered slowly in the first half of 2013, growing 1.7% in the second quarter of that year. As growth was expected to be higher in the following quarters, the Federal Reserve announced its intention to reduce or wind down qualitative easing at the May 1 Federal Open Market Committee meeting. With the release of this meeting’s minutes and the testimony to Congress of then Federal Reserve Chair Ben Bernanke on May 22, the markets understood that the Federal Reserve would start tightening monetary policy by tapering quantitative easing (a period referred to widely as the taper tantrum). Figure 1: United States 10-Year Treasury Bill Rates, January–November 2013 Note: The dashed line is the taper tantrum in May 2013. Source: Federal Reserve Economic Data (accessed 1 August 2018). Despite the signaling that quantitative easing will be tapered, markets expected a rapid tightening in US monetary policy. The announcement triggered a drastic response in the US 10-year Treasury bill rate (Figure 1). In the months before May, markets had been expecting an extended soft interest rate scenario, at a time when the long rate was declining. After the first quantitative easing announcement in November 2008, developing and emerging market currencies underwent a mild appreciation, though they had been appreciating for some time since 2006 (except for a brief period from 2008 to 2009). In response to the taper announcement, however, the 10-year rate rose by 125 1.5 2.0 2.5 3.0 Percent Jan Mar May Jul Sep Nov 2 | ADB Economics Working Paper Series No. 581 basis points in 4 months. This triggered large capital flows out of emerging economies in all regions, resulting in a sharp depreciation. Central banks responded to the exchange market pressure during the taper tantrum through four main channels: (i) allowing freer movement of exchange rates, ∆ e t ; (ii) intervening in foreign exchange markets, I t ; (iii) changing domestic interest rates, ∆( i t − i * ); and (iv) imposing capital controls. In response to the global financial crisis, most countries had built up their foreign exchange reserves. Immediately after the taper tantrum, several countries sold their reserves to defend their currencies, while others allowed freer currency movements with limited intervention, as shown in Figures 2 and 3. Figure 2: Movements in Nominal Exchange Rates by Region, 2010–2018 Notes: The dashed line is the taper tantrum in May 2013. Green line is the taper tantrum in May 2013. Regional numbers were computed as the average of percentage changes in nominal exchange rates of component countries. Component countries include developing and emerging economies based on the International Monetary Fund’s classification. The Appendix lists the economies in the regional groupings. Source: CEIC Data Company (accessed 2 May 2018). This episode had a differential impact across developing and emerging market economies, with some currencies facing sharper depreciation and stronger bouts of volatility. Exchange rate movements, however, do not always reflect the actual pressure on a market, since policy makers can respond by intervening with foreign exchange reserves and interest rate changes. Patnaik, Felman, and Shah (2017) developed a new measure for exchange market pressure with consistent units: percentage change in the exchange rate. This permits cross-country and acrosstime comparisons. This measure adds the observed change in the exchange rate with the change that would have been expected to have occurred had there been no intervention. Their key formula for Appreciation Depreciation –5 0 5 10 Percent 2010 2012 2014 2016 2018 Asia –5 0 5 10 Percent 2010 2012 2014 2016 2018 Africa –5 0 5 10 Percent 2010 2012 2014 2016 2018 Latin America –5 0 5 10 Percent 2010 2012 2014 2016 2018 Europe Financial Shocks and Exchange Market Pressure | 9 We include economic size, measured by real GDP per capita in 2012 using WDI data, and the de facto capital openness indicator as controls. The variables used to account for the financial size of an economy as well as its exposure to currency shocks are average total private external financing during 2010–2012, sourced from the IMF’s Global Financial Stability Report, and the stock of portfolio liabilities and portfolio equity liabilities in 2012, sourced from Lane and Milesi-Feretti (2017).2 We construct the de facto capital account openness indicator, as defined in Lane and Milesi-Feretti (2007).3 Table 8 shows the summary statistics of the indicators. We also include the following categorical variables as controls: (i) whether the economy is an emerging market as indicted by its inclusion in the MSCI Emerging Markets Index, (ii) whether it is a global financial center, and (iii) exchange rate regime indicator.4 Emerging markets on the index experience bidirectional capital flows, and might be more susceptible to global shocks, given the criteria for market accessibility to investors. The data for global financial centers is from China Development Institute (2018). The exchange rate regime indicator is from the dataset in Ilzetzki, Reinhart, and Rogoff (2017). B. Methodology To evaluate the significant determinants of exchange market pressure during the taper tantrum, we follow Ahmed, Coulibaly and Zlate (2017) to do a cross-sectional regression across economies with the following specification: 𝐸𝑀𝑃=𝛽 +𝛽 𝑋 +𝜖   . We start with a set of k explanatory variables X j , and add others to determine their relation to exchange market pressure, EMP i in each country i . Dummy variables are included to account for the status of an economy as an emerging market; and as a global financial center, to account for any structural difference in the exchange market performance of the economies. We report coefficients with robust standard errors, followed by coefficients estimated from the standardized regression technique to ascertain the relative importance of significance variables. We then perform a robust regression to account for outliers or observations that do not follow the general structure of the dataset. We use a robust regression estimator, called MM-estimator, as described in Koller and Stahel (2011), which by default uses a bi-square descending score function and returns a highly robust and efficient estimator (with 50% breakdown and 95% asymptotic efficiency for normal errors). 2 Total external financing consists of the sum of private inflows in equities, bonds, and debt. 3 Capital account openness is the ratio of the sum of the stock of total external assets and liabilities to GDP. 4 The MSCI Emerging Markets Index consists of 24 economies representing 10% of world market capitalization. They are: Brazil; India; Chile; Colombia; the Czech Republic; Egypt; Greece; Hungary; Indonesia; Mexico; Pakistan; the People’s Republic of China; Peru; the Philippines; Poland; Qatar; Malaysia; the Republic of Korea; the Russian Federation; South Africa; Taipei,China; Thailand; Turkey; and the United Arab Emirates. 10 | ADB Economics Working Paper Series No. 581 To check for the robustness of the results for alternative specifications, we do the regressions with other measures of exchange market pressure as well as alternative exchange rate regime schemes. We also do the analysis for the first quantitative easing period to assess whether the main determinants of exchange market pressure differ in the case of appreciation shocks in relation to depreciation shocks. IV. RESULTS To identify the importance of macroeconomic and financial fundamentals on the exchange market performance of emerging and developing economies, it is essential to first analyze the behavior and determinants of exchange rate movements. Figure 2 shows the sharp depreciation experienced by these economies across all regions after the taper announcement. We complement this analysis with the results in the following section to understand the factors determining an economy’s exchange rate movements. As described in the Motivation and Questions section, changes in exchange rates do not encompass the pressure experienced by currencies. We give the results for the estimation of determinants of exchange market pressure during the taper tantrum in a later section. A. Determinants of Exchange Rate Changes Table 1 shows the estimation results for the determinants of percentage change in exchange rates during the taper talk; in other words, a depreciation shock. Specifications 1–6 of Table 1 show the estimated effects of macroeconomic fundamentals on exchange rate movements from May to August 2013. We find that the interest rate differential is not significant in explaining the percentage change in exchange rates in developing and emerging economies. None of the macroeconomic fundamentals are significant in explaining movements in exchange rates. We find that after accounting for macroeconomic fundamentals, economies in the MSCI Emerging Market Index experienced 5%–6% higher depreciation than other economies in the sample. To evaluate the impact of external fundamentals, we estimate the effects of the current account balance (as a percentage of GDP), trade openness, the size of total external private financing, and de facto capital account openness on the percent change in the exchange rate. We find that apart from capital account openness and total external private financing, none of the other variables explain the heterogeneity in exchange rate movements across economies. We observe this across specifications 7–11 in Table 1, where capital account openness is not only significant but also has a negative effect, implying that economies with higher capital account openness experienced lesser depreciation during the taper tantrum. We also find that economies with higher levels of private external financing experienced sharper depreciation, possibly because of the vulnerability of external borrowings to currency shocks. Our results also show that economies that were global financial centers also experienced larger depreciation. We also observe significance in the exchange rate variable. Our reference level for the exchange rate regime variable is a hard peg. Our results in Table 1 show that an economy with an intermediate exchange rate regime experienced significantly greater depreciation than hard-peg currencies. Financial Shocks and Exchange Market Pressure | 11 Table 1: Regression Results for Exchange Rate Changes Dependent variable: % change in exchange rates in May–August 2013 Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Interest rate dif f erential –0.373 (0.266) –0.549 (0.360) –0.439 (0.309) –0.557 (0.372) –0.455 (0.274) –0.346 (0.243) –0.292 (0.232) –0.269 (0.230) –0.130 (0.231) –0.383 (0.236) Domestic credit / GDP (% growth), 2012 –0.054 (0.096) –0.003 (0.104) –0.052 (0.095) –0.008 (0.103) –0.078 (0.100) Fiscal deficit (% of GDP), 2012 –0.065 (0.276) –0.082 (0.277) –0.150 (0.289) Gross public debt (% of GDP), 2012 –0.010 (0.025) –0.008 (0.027) Inflation rate, 2010–2012 0.069 (0.248) 0.494 (0.424) 0.048 (0.224) 0.447 (0.364) 0.039 (0.218) Current account balance (% of GDP), 2012 0.026 (0.072) 0.010 (0.089) 0.052 (0.084) 0.019 (0.101) 0.067 (0.073) 0.039 (0.066) Trade openness –0.017 (0.010) 0.007 (0.017) Log real GDP per capita –0.755 (1.063) –0.275 (1.014) Exchange rate regime = 2 3.330 (1.868) 4.228** (1.682) Log total private external financing, 2010–2012 0.786 (0.497) 1.244** (0.517) De facto capital account openness –0.171*** (0.054) –0.082** (0.034) –0.169*** (0.053) -0.061 (0.035) –0.171*** (0.043) Log total portfolio equity liability, 2012 0.308 (0.267) Log total portfolio liability, 2012 0.266 (0.284) 0.275 (0.252) GFC dummy 3.456 (2.222) 3.946** (1.920) 3.876 (2.159) 3.627 (2.131) 3.011 (1.830) MSCI dummy 6.614*** (1.855) 6.773*** (1.898) 6.995*** (1.861) 6.907*** (1.885) 5.212** (2.117) 5.413*** (1.923) Constant 3.673* (1.947) 2.563 (2.914) 10.254 (9.804) 5.026 (9.107) –1.112 (2.757) 6.037** (2.669) 2.822 (2.275) –3.535 (4.403) 2.529 (2.848) 6.153 (3.750) –3.978 (3.423) Observations 56 52 56 52 56 58 59 64 59 46 59 R 2 0.319 0.332 0.329 0.333 0.353 0.310 0.266 0.267 0.260 0.488 0.334 GDP = gross domestic product, GFC = global financial center. Notes: Exchange rate regime = 1 (omitted) is preannounced peg, currency board arrangement, and de facto peg. Exchange rate regime = 2 is preannounced crawling peg/band, and de facto crawling peg/band. Robust standard errors in parentheses. *** p<0.01 ** p<0.05. Source: Authors’ calculations. 12 | ADB Economics Working Paper Series No. 581 B. Determinants of Exchange Market Pressure Our primary dependent variable is quarterly exchange market pressure from May to August 2013.5 We look at various variables that might have affected exchange market pressure across all economies included in our sample during the taper tantrum. Table 2 shows the results of the estimation procedure, which enable us to answer the questions asked in the Motivation and Questions section. Specifications 1–6 of Table 2 show the estimated effects of macroeconomic fundamentals on the exchange market pressure from May to August 2013. Across all specifications, we find the interest rate differential has no significant effect on exchange market pressure for emerging and developing economies. Controlling for real GDP per capita and exchange rate regimes, we find that none of the macroeconomic fundamentals are significant in explaining exchange market pressure. Our results also imply that the depreciation pressure was stronger for economies in the MSCI Emerging Markets Index than other developing and emerging economies, by 8%–9%. We find that both trade openness and total external financing have a positive and significant impact on exchange market pressure, implying that an economy with a higher proportion of trade relative to GDP and a higher level of private external financing faced greater depreciation pressures. A higher proportion of trade relative to GDP, as well as larger external financing increased an economy’s exposure to external shocks, contributing to stronger depreciation pressures in the face of a financial shock. 5 𝐸𝑀𝑃– =∑𝐸𝑀𝑃   . Financial Shocks and Exchange Market Pressure | 13 Table 2: Exchange Market Pressure Regression Results Dependent variable: exchange market pressure May–August 2013 Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Interest rate dif f erential –0.552 (0.349) –0.728 (0.459) –0.549 (0.376) –0.696 (0.458) –0.632 (0.356) –0.369 (0.352) –0.352 (0.316) –0.312 (0.310) –0.048 (0.325) –0.415 (0.317) Domestic credit / GDP (% growth), 2012 –0.207 (0.174) –0.144 (0.186) –0.207 (0.175) –0.128 (0.188) –0.230 (0.171) Fiscal deficit (% of GDP), 2012 –0.018 (0.490) –0.017 (0.494) –0.101 (0.514) Gross public debt (% of GDP), 2012 –0.037 (0.045) –0.046 (0.049) Inflation rate, 2010–2012 0.292 (0.333) 0.702 (0.485) 0.293 (0.332) 0.875* (0.499) 0.262 (0.319) Current account balance (% of GDP), 2012 0.086 (0.127) 0.074 (0.148) 0.085 (0.130) 0.039 (0.160) 0.127 (0.122) 0.072 (0.125) Trade openness –0.009 (0.010) 0.058** (0.028) Log real GDP per capita 0.027 (1.074) 1.028 (1.302) Exchange rate regime = 2 3.264 (3.057) 3.823 (3.265) Log total private external financing, 2010–2012 1.707** (0.744) 2.333** (0.890) De facto capital account openness –0.259*** (0.067) –0.141** (0.054) –0.255*** (0.066) –0.072 (0.065) –0.257*** (0.058) Log total portfolio equity liability, 2012 0.483 (0.409) Log total portfolio liability, 2012 0.522 (0.408) 0.530 (0.398) GFC dummy 5.448 (3.714) 4.565 (3.146) 5.556 (3.517) 4.834 (3.521) 4.774 (3.311) MSCI dummy 9.875*** (3.239) 9.895*** (3.342) 9.861*** (3.368) 9.392** (3.502) 8.501** (3.300) 8.411*** (3.143) Constant 3.752 (3.027) 3.862 (4.719) 3.515 (9.639) –5.330 (11.526) –0.937 (5.710) 5.714* (3.216) 2.442 (2.850) –13.132** (6.559) 1.291 (3.561) –14.897** (6.710) –4.592 (7.182) Observations 56 52 56 52 56 58 59 64 59 46 59 R 2 0.297 0.309 0.297 0.315 0.311 0.241 0.237 0.268 0.239 0.472 0.263 GDP = gross domestic product, GFC = global financial center. Notes: Exchange rate regime = 1 (omitted) is preannounced peg, currency board arrangement and de facto peg. Exchange rate regime = 2 is preannounced crawling peg/band, de facto crawling peg/band. Robust standard errors in parentheses. *** p<0.01 ** p<0.05. Source: Authors’ calculations. 14 | ADB Economics Working Paper Series No. 581 Specifications 7–11 assess the impact of size and extent of integration of the financial economy. Here, we see that de facto capital account openness has a negative and significant effect. This implies that countries with more open and globally integrated financial markets would have faced weaker depreciation pressure. This might be because economies that are more open and integrated with the global financial system are able to diversify the risk. The depreciation effect of total private external financing indicates the higher vulnerability of domestic borrowers who rely on external financing. Financial shocks can not only cause volatility in these flows but also affect channels of credit for these borrowers.6 In addition to statistical significance, we look at the relative strength of possible determinants of exchange market pressure through standardized regression coefficients (Table 3). We find that most variables with the highest magnitude of coefficients are also the significant variables, as reported in Table 2. Specification 8 in Table 3 shows that although capital account openness is a significant determinant, in the face of a financial shock, short-term private external flows are a stronger factor affecting the extent of exchange market pressure experienced by an economy. The vulnerabilities of the financial sector intensify the effects of a depreciation shock, and institutional factors, such as capital account openness, can to some extent dampen this effect. On performing a robust regression, we find that trade openness loses its significance, whereas the exchange rate regime variable becomes significant with a depreciation effect (Table 4). This implies that compared with a hard-peg currency, an intermediate regime faces significantly higher depreciation pressure. Our results support the view that country-specific institutional factors, such as exchange rate regime and de facto capital account openness, significantly affect exchange market pressure, although in different directions. Further, an economy with higher average levels of private external financing would face stronger depreciation pressures because of the higher exposure of its financial sector to currency shocks. 6 An important difference between analyses of exchange market pressure and percentage change in exchange rates is the size of the estimated coefficients of the determinants. We find the effects of both capital account openness and total private external financing are stronger on exchange market pressure than exchange rate movements. Similarly, economies in the MSCI Emerging Markets Index faced stronger depreciation pressures than the realized depreciation. This further reflects how merely assessing the impact of macroeconomic and financial variables on changes in exchange rates can understate the effect of these variables. Financial Shocks and Exchange Market Pressure | 15 Table 3: Regression Results for Exchange Market Pressure Standardized Coefficients Dependent variable: exchange market pressure May–August 2013 Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Interest rate dif f erential –0.283 (0.349) –0.340 (0.459) –0.282 (0.376) –0.325 (0.458) –0.324 (0.356) –0.193 (0.352) –0.181 (0.316) –0.161 (0.310) –0.024 (0.325) –0.214 (0.317) Domestic credit / GDP (% growth), 2012 –0.176 (0.174) –0.113 (0.186) –0.176 (0.175) –0.100 (0.188) –0.196 (0.171) Fiscal deficit (% of GDP), 2012 –0.007 (0.490) –0.007 (0.494) –0.040 (0.514) Gross public debt (% of GDP), 2012 –0.094 (0.045) –0.117 (0.049) Inflation rate, 2010–2012 0.114 (0.333) 0.200 (0.485) 0.114 (0.332) 0.250* (0.499) 0.102 (0.319) Current account balance (% of GDP), 2012 0.093 (0.127) 0.078 (0.148) 0.092 (0.130) 0.041 (0.160) 0.137 (0.122) 0.079 (0.125) Trade openness –0.063 (0.010) 0.194** (0.028) Log real GDP per capita 0.003 (1.074) 0.112 (1.302) Exchange rate regime = 2 0.138 (3.057) 0.166 (3.265) Log total private external financing, 2010–2012 0.397** (0.744) 0.510** (0.890) De facto capital account openness –0.273*** (0.067) -0.134** (0.054) –0.268*** (0.066) –0.078 (0.065) –0.270*** (0.058) Log total portfolio equity liability, 2012 0.188 (0.409) Log total portfolio liability, 2012 0.192 (0.408) 0.194 (0.398) GFC dummy 0.256 (3.714) 0.200 (3.146) 0.261 (3.517) 0.224 (3.521) 0.224 (3.311) MSCI dummy 0.439*** (3.239) 0.437*** (3.342) 0.438*** (3.368) 0.415** (3.502) 0.378** (3.300) 0.385*** (3.143) Constant 56 0.297 52 0.309 56 0.297 52 0.315 56 0.311 58 0.241 59 0.237 64 0.268 59 0.239 46 0.472 59 0.263 Observations –0.283 –0.340 –0.282 –0.325 –0.324 –0.193 –0.181 –0.161 –0.024 –0.214 R 2 (0.349) (0.459) (0.376) (0.458) (0.356) (0.352) (0.316) (0.310) (0.325) (0.317) GDP = gross domestic product, GFC = global financial center. Notes: Exchange rate regime = 1 (omitted) is preannounced peg, currency board arrangement and de facto peg. Exchange rate regime = 2 is preannounced crawling peg/band, de facto crawling peg/band. Robust standard errors in parentheses. *** p<0.01 ** p<0.05. Source: Authors’ calculations. 16 | ADB Economics Working Paper Series No. 581 Table 4: Regression Results for Exchange Market Pressure Robust Coefficients Dependent variable: exchange market pressure May–August 2013 Variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) Interest rate dif f erential –0.089 (0.203) –0.143 (0.377) –0.044 (0.249) –0.118 (0.384) –0.267 (0.180) 0.043 (0.215) –0.048 (0.166) –0.011 (0.184) 0.349 (0.224) –0.201 (0.178) Domestic credit / GDP (% growth), 2012 –0.087 (0.086) –0.036 (0.108) –0.091 (0.092) –0.030 (0.103) –0.121 (0.077) Fiscal deficit (% of GDP), 2012 –0.236 (0.413) –0.235 (0.414) –0.384 (0.304) Gross public debt (% of GDP), 2012 0.027 (0.030) 0.019 (0.030) Inflation rate, 2010–2012 0.160 (0.322) 0.655 (0.486) 0.160 (0.327) 0.766 (0.477) 0.112 (0.231) Current account balance(% of GDP), 2012 0.085 (0.132) 0.072 (0.145) 0.074 (0.124) 0.047 (0.140) 0.173 (0.120) 0.007 (0.135) Trade openness 0.001 (0.008) 0.029 (0.021) Log real GDP per capita 0.448 (1.125) 0.765 (0.997) Exchange rate regime = 2 5.918*** (2.210) 6.953*** (2.650) Log total private external financing, 2010–2012 1.523*** (0.450) 2.442* (1.306) De facto capital account openness –0.242*** (0.066) –0.149** (0.061) –0.237*** (0.067) 0.651 (1.318) –0.243*** (0.049) Log total portfolio equity liability, 2012 0.337 (0.445) Log total portfolio liability, 2012 0.425 (0.410) 0.543 (0.426) GFC dummy 7.43 (4.326) 6.324 (4.477) 7.236 (4.036) 6.133 (4.239) 5.482 (3.004) MSCI dummy 12.800*** (3.344) 12.886*** (3.131) 12.582*** (3.261) 12.540*** (3.010) 11.007*** (3.821) 11.588*** (3.216) Constant 0.398 (2.242) –2.946 (3.307) –3.482 (9.974) –9.685 (9.133) –8.285** (4.092) 1.430 (2.436) 0.981 (3.099) –10.110** (3.960) –0.327 (4.001) –19.021 (11.045) –11.842 (6.102) Observations 56 52 56 52 56 58 59 64 59 46 59 R 2 0.510 0.492 0.515 0.510 0.621 0.430 0.327 0.494 0.336 0.644 0.454 GDP = gross domestic product, GFC = global financial center. Notes: Exchange rate regime = 1 (omitted) is preannounced peg, currency board arrangement and de facto peg. Exchange rate regime = 2 is preannounced crawling peg/band, de facto crawling peg/band. Robust standard errors in parentheses. *** p<0.01 ** p<0.05. Source: Authors’ calculations. Financial Shocks and Exchange Market Pressure | 17 V. ROBUSTNESS CHECKS We test to check whether our results are robust to the different variables used to indicate exchange rate regimes, alternative metrics of exchange market pressure, and whether the determinants of exchange market pressure differ while assessing an event of appreciation shock, such as QE-1. A. Alternative Measures of Exchange Rate Regimes We use the exchange rate stability index in Aizenman, Chinn, and Ito (2010) to assess whether our results are robust to alternative measures of exchange rate regime. The results in Table 5 show that the results in the following section are robust to other measures of an exchange rate regime. Table 5: Alternative Measures of Exchange Rate Regimes Robust Coefficients Dependent Variable: Exchange Market Pressure May–August 2013 Variables m5_8_emp m5_8_emp m5_8_emp m5_8_emp Interest rate dif f erential –0.267 (0.180) –0.185 (0.166) –0.201 (0.178) –0.051 (0.182) Fiscal deficit (% of GDP), 2012 –0.384 (0.304) –0.201 (0.337) Current account balance (% of GDP), 2012 0.173 (0.120) 0.154 (0.136) Domestic credit / GDP (% growth), 2012 –0.121 (0.077) –0.168** (0.084) Inflation rate, 2010–2012 0.112 (0.231) 0.325 (0.272) Exchange rate regime = 2 5.918*** (2.210) 6.953*** (2.650) Exchange rate stability index –7.891** (3.386) –7.813*** (2.896) De facto capital account openness –0.243*** (0.049) –0.230*** (0.049) Log total portfolio liability, 2012 0.543 (0.426) 0.369 (0.396) GFC dummy 5.482* (3.004) 5.988* (3.468) MSCI dummy 11.007*** (3.821) 10.432*** (3.826) Constant –8.285** (4.092) 5.178** (2.534) –11.842* (6.102) 5.010 (4.131) Observations 56 55 59 58 R 2 0.621 0.587 0.454 0.399 GDP = gross domestic product, GFC = global financial center. Notes: Robust standard errors in parentheses. Anchor currencies and exchange rate arrangements for 194 countries from 1946 to 2016 are defined in Ilzetzki, Ethan, Carmen M. Reinhart, and Kenneth S. Rogoff. 2017. “Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?” NBER Working Paper No. 23134. Cambridge, MA: National Bureau of Economic Research. Their methodology to classify exchange rate regimes involves measuring exchange rate movements against the anchor currency for a specific window of time. A new measure of exchange rate stability is defined in Aizenman, Joshua, Menzie D. Chinn, and Hiro Ito. 2010. “The Emerging Global Financial Architecture: Tracing and Evaluating the New Patterns of the Trilemma’s Configurations.” Journal of International Money and Finance 29 (4): 615–41. The new measure is part of their trilemma indices, where higher index values imply greater stability of the exchange rate against an identified base country. *** p<0.01 ** p<0.05 * p<0.1. Source: Authors’ calculations. 18 | ADB Economics Working Paper Series No. 581 B. Determinants of Exchange Market Pressure during Appreciation Pressures We include the same variables and specifications in Table 4 for the year 2007 to assess whether economies respond differently to depreciation and appreciation pressures. The dependent variable is the exchange market pressure from March to June 2009. The results in Table 6 show that, contrary to those in Table 4, gross public debt had a significant impact on exchange market pressure experienced after the announcement of QE-1. Economies with high gross public debt as a percentage of GDP experienced weaker appreciation pressures than those with low gross public debt (higher public debt can indicate instability in the political economy). Trade openness and total external private financing, however, did not have a significant impact and MSCI Emerging Markets Index economies experienced significantly stronger appreciation pressure than other emerging and developing economies. We also find evidence for de facto capital account openness having a significant appreciation effect, similar to the results in Table 4. In stark contrast to Table 4, the stock of total portfolio liabilities and total equity portfolio liabilities had a significant and negative impact. Economies with a larger stock of portfolio liabilities experienced stronger appreciation pressures, potentially because they are a signal for investors that such economies have lesser inflow restrictions, capacity, and the institutional wherewithal to absorb larger portfolio inflows. C. Alternative Exchange Market Pressure Measures To check the robustness of our results for determinants of exchange market pressure during the taper tantrum, we do the analysis with the exchange market pressure metric in Aizenman and Hutchison (2012), with the components of the metric weighted by their respective standard deviations. We take an average of the metric from May to August 2013 (Table 7). Similar to our results in Table 2, we find that an increase in de facto capital account openness is associated with appreciation pressures on the domestic currency, and trade openness has a significant depreciation effect. We also see similar impacts of financial variables and exchange rate regime. Appendix | 25 Economies MSCI Classification GFC Dummy Russian Federation 1 1 Turkey 1 1 Ukraine 0 0 Latin America Argentina 0 1 Bolivia 0 0 Brazil 1 1 Belize 0 0 Colombia 1 0 Costa Rica 0 0 Dominican Republic 0 0 Guatemala 0 0 Guyana 0 0 Honduras 0 0 Haiti 0 0 Jamaica 0 0 Mexico 1 1 Peru 1 0 Suriname 0 0 El Salvador 0 0 Venezuela 0 0 Pacific Fiji 0 0 Solomon Islands 0 0 Tonga 0 0 Vanuatu 0 0 Samoa 0 0 GFC = global financial crisis, Lao PDR = Lao People’s Democratic Republic. Sources: China Development Institute. 2018. The Global Financial Centres Index 23. Shenzhen; and MSCI Country Classification Standard. REFERENCES Ahmed, Shaghil, Brahima Coulibaly, and Andrei Zlate. 2017. “International Financial Spillovers to Emerging Market Economies: How Important Are Economic Fundamentals?” Journal of International Money and Finance 76: 133–52. 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ASIAN DEVELOPMENT BANK 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org Financial Shocks and Exchange Market Pressure After a long period of low interest rates in the United States, tapering quantitative easing in May 2013 led to sizable inflow reversals and currency depreciation in emerging and developing economies. This paper provides evidence for the importance of capital account openness in buffering depreciation pressures during the taper tantrum episode and shows that exposure to external private financing and having a more flexible exchange rate regime led to higher depreciation pressures. Macroeconomic fundamentals, however, did not matter for exchange market pressure. About the Asian Development Bank ADB is committed to achieving a prosperous, inclusive, resilient, and sustainable Asia and the Pacific, while sustaining its efforts to eradicate extreme poverty. Established in 1966, it is owned by 68 members— 49 from the region. 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