According to the IMF, the last decade has seen a number of countries actively managing their exchange rates (see Habermeier et al. 2009, IMF 2012). Brazil, Chile, Colombia, Turkey, and other emerging markets with announced inflation-targeting regimes have engaged in considerable intervention of their exchange rates and have accumulated substantial reserves as the flow of foreign capital into these countries has increased (see Aizenman and Hutchison 2010; Céspedes, Chang and Velasco 2012). Are these policies a good way for emerging countries to protect themselves from the large swings of international markets?

Large external debts

Some of the countries accumulating substantial reserves hold large external debts despite the interest rate differential (see Figure 1). For example, the Brazilian government’s net asset position has increasingly been dominated by the accumulation of close to $352 billion in reserves, as of December of 2011, against an external debt of $298 billion. Can the accumulation of reserves in conjunction with external debt be justified? Would it not be better to cancel out the one with the other?

Figure 1. External debt and reserve holdings of emerging countries in 2010 (% GDP)


Source: World Bank, World Development Indicators. For Czech Republic and Korea: gross debt; for others: external debt.

Capital flows into emerging markets have also been characterised by a dramatic increase in carry-trade activity and foreign participation in local-currency-bond markets. As data from the Bank for International Settlements (BIS) shows, this practice became quantitatively relevant only in the last decade. On the whole, the share of domestic bonds in emerging markets increased between 2000 and 2010 (see Table 1). And as documented by Burger, Warnock and Warnock (2012), participation by foreign residents in the emerging markets’ domestic-bond markets has increased. Are these carry-trade activities necessarily harmful to the recipient emerging countries or can emerging markets take advantage of this development of an international market for local-currency-denominated debt – a kind of redemption from the original sin?

Table 1. Outstanding stocks of domestic government debt securities (billions of US dollars)


Notes: In the BIS securities statistics, domestic debt securities are defined as issues by residents in the local market in local currency; some foreign currency issues are included in these data, but they are small. Central bank issues are excluded. Source: BIS, 2012 (BIS securities statistics; JPMorgan Chase; national data).

New research

In Alfaro and Kanczuk (2013), we revisited these questions related to the optimal exchange-rate regime and its implications in light of the new reality of capital flows to emerging markets. More than a decade ago, Calvo and Reinhart (2002) coined the term ‘fear of floating’ for the authorities’ reluctance to allow free fluctuations in the nominal (or real) exchange rate. But the debate over the optimal exchange-rate regime keeps coming back in new forms in response to new conditions. Indeed, the conclusions reached by the literature on optimal exchange-rate regimes vary with their hypotheses (for contrasting examples, see Helpman 1981; Céspedes, Chang and Velasco 2004).

To account for current conditions, we construct and calibrate a dynamic equilibrium model of a small open economy in which the government issues foreign debt in both domestic and international currencies.Domestic and international interest rates may differ and we explicitly model the risks attendant on those differences. Under this framework, we investigate the optimality conditions of different exchange-rate regimes under domestic and international shocks.

  • The traditional fixed-exchange-rate regime, although ideal in the presence of external shocks, is not sustainable.

A sequence of bad shocks, for example, would eventually force the emerging country to abandon the regime and let its currency float.

  • However, we next find that, as an emerging nation develops its local-currency markets, it can implement a ‘pseudo-flexible regime’ whereby it accumulates reserves in conjunction with domestic debt.

This policy results in low exchange-rate volatility, in this way partially emulating the fixed-exchange-rate regime, but without the need for constant intervention in the market. Regardless of the type of international shock, local debt serves to stabilise consumption. When an international shock is favourable, debt services increase and consumption decreases. When an international shock is unfavourable, debt services decrease and consumption increases. This policy does the best job of stabilising fluctuations under external shocks, which in turn implies in higher levels of welfare.

The economics of this result – that, in a stochastic environment, government liability should include state-contingent securities in order to achieve consumption (or tax) smoothing – are well known (Bohn 1990, Alfaro and Kanczuk 2010). In the present case, debt denomination is a useful means of smoothing consumption because debt services are negatively correlated with the endowment shock. Perhaps less recognised is that the potential gains of contingent services are greater than those of contingent debt (Grossman and Han 1999). That is, a constant amount of local-currency debt engenders more smoothing than would be achieved by varying the amount international-currency debt or reserves.


Our analysis thus suggests an additional rationale for reserve accumulation in conjunction with debt. Although it is optimal for a sovereign to issue as much debt as possible to smooth consumption, there is a sustainability limit to the outstanding debt. Having reserves or internationally denominated assets that bear the (risk-free) international rate enables a sovereign to maintain the same amount of net debt and increase the stabilising effect of its domestically denominated debt. An important feature of the proposed construction is that the level of reserves remains high during unfavourable periods. That is, in our analysis – contrary to the usual argument in policy circles – countries do not engage in large reserve accumulation in order to deplete them in ‘bad’ times. Instead, the permanent large reserves act as a hedge against negative external shocks by increasing the stabilising effect of domestically denominated debt.

According to the Mundell-Fleming model, in an economy hit by foreign real shocks, flexible exchange rates dominate fixed rates. The intuition is that nominal rigidities make it both faster and less costly to adjust the nominal exchange rate in response to a shock that requires a fall of the real exchange rate. But what if it were possible to offset or at least mitigate the foreign shock?

Our work suggests that, by means of international borrowing in domestic currency, emerging countries can partially offset foreign shocks. In conjunction with reserve accumulation, they can implement a less-flexible exchange regime, which we term pseudo-flexible, that is sustainable and yields higher welfare than alternative regimes.

This article first appeared in

Authors: Laura Alfaro, Professor, Harvard Business School. Fabio Kanczuk Professor at the University of Sao Paulo.

Image: A woman changes the exchange rate at a Brazilian foreign exchange office REUTERS/Sergio Moraes.