EM countries used to be afraid of letting their currencies float. Capital inflows may have triggered an appreciation of the currency and led to a loss of competitiveness. This is the reason why many EM countries have adopted pegged or semi-pegged currency regimes and accumulated a huge amount of Forex reserves over the last decade.
As the Fed tapering is raising concerns about evaporating global liquidity, it is worth studying how EM countries manage their reserves in periods of financial stress.
The lesson to be drawn from 2008 is that many EM countries are "afraid of losing." It might come as a surprise, since FX reserves are accumulated as a costly self-insurance against external shocks (sudden stops of foreign capital flows, for instance). But they are also a signal sent to foreign investors on their potential resilience to foreign outflows.
As such, many EM countries abstain from using their accumulated reserves in full force when a crisis occurs. Many empirical studies show that even countries with a high level of reserves have been reluctant to use them during the financial crisis of 2008. The rationale for this behavior is that dwindling FX reserves below a (unfortunately unknown ex ante) threshold might accentuate, not alleviate, speculative outflows.
Lacking any counterfactual evidence, we could also think that some countries did not deplete their reserves because their level was sufficiently high to deter any speculative attack. Also, several countries resorted to swap lines with the Fed to meet their foreign currency requirements (Brazil, Korea, Mexico, and Singapore).
Yet, in light of the "signal" theory, the use of swap lines can also be explained as a means to convey a high level of international reserves. In addition, there is a big difference between reserves and swaps, as reserves forge the credibility of the domestic central bank whereas swap lines depend on the credibility of the CB that provides liquidity (FED, ECB…). They are no substitute, but a complement like the flexible credit line of the IMF.
During the last crisis, countries have chosen to adjust through sharp currency depreciation, in a tentative search to export the crisis, a strategy that was rapidly coined "currency war." In addition, once the pressure eased, many countries decided to restore capital control to limit the inflow of foreign capital and hence limit the growth of FX reserves.
In light of this analysis we can conclude:
- The fear of having many EM countries selling their holdings of U.S. Treasuries to defend their currency is exaggerated. There is no risk of a sell-fulfilling rise in UST 10-year yields as a result of fire sales by EM central banks;
- As the recent Indian and Brazilian cases show, countries harmed by the crisis will let their currency depreciate, trying to control the speed, but not the trend of the move; and
- External vulnerability has not disappeared. Countries with high foreign liabilities as a share of GDP remain the most vulnerable to external market pressure.