1 FX Resilience around the World Fighting Volatile Cross -Border Capital Flows Louisa Chena Estelle Xue Liub and Zijun Liuc

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FX Resilience around the World: Fighting Volatile Cross-Border Capital Flows

Louisa Chen,a* Estelle Xue Liub and Zijun Liuc

a* Department of Accounting and Finance, University of Sussex Business School, University of

Sussex, Brighton, United Kingdom. Tel: +44 (0)1273 877807. Email: l.x.chen@sussex.ac.uk;

b European Department, International Monetary Fund, Washington, D.C. 2043. Email:

ELiu@imf.org

c Hong Kong Monetary Authority, Two International Finance Centre, 8 Finance Street, Hong

Kong. Email: zliu@hkma.gov.hk

FX Resilience around the World: Fighting Volatile Cross-Border Capital Flows

Abstract

We show that capital flow (CF) volatility exerts an adverse effect on exchange rate (FX) volatility,

regardless of whether capital controls have been put in place. However, this effect can be

significantly moderated by certain macroeconomic fundamentals that reflect trade openness,

foreign assets holdings, monetary policy easing, fiscal sustainability, and financial development.

Passing the threshold levels of these macroeconomic fundamentals, the adverse effect of CF

volatility may be negligible. We further construct an intuitive FX resilience measure, which

provides an assessment of the strength of a country’s exchange rates.

Keywords: Capital flow volatility; exchange rate volatility; cluster analysis; threshold analysis;

exchange rate resilience measure

JEL classification: F3; F31; G15

1. Introduction

Is cross-border capital flows volatility a major contributor to exchange rate volatility? How can

countries subdue the effects of capital flow volatility on exchange rate volatility, while preserving

the benefits that capital flows offer in terms of access to global financial resources? This is what

we attempt to find out in this paper.

Cross-border capital flows have increased dramatically since 2000. While capital flows could

support economic growth, the growth in capital flows was also accompanied by an increase in the

volatility of these capital flows (Forbes, 2012). Extreme movements in capital flows – whether in

the form of sharp increases or decreases – can lead to excessive exchange rate volatility and hence

undermine economic growth and financial stability.

As reviewed in the next session, existing theoretical literature generate testable implications on

FX volatility determination. We explore the link between macroeconomic fundamentals and

exchange rates volatility in search of moderators that can alleviate capital flow shocks passing on

to exchange rate volatility. We focus on portfolio investment fund flows as they are the main

contributory factor to short- and medium-term FX movement, rather than other types of capital

flows such as FDI or bank flows

. Using a sample of 20 emerging market economies and

advanced economics in the period from 2002:Q1 to 2020:Q3,

we proceed with this study in two

steps. In Step 1, we conduct a cluster analysis on the impulse response of FX volatility to structural

CF volatility shocks between two clusters countries in the short-term (in weeks), where countries

See, for example, Obstfeld and Rogoff (1998) and Gabaix and Maggiori (2015).

See, for example, Brooks et al. (2004), Caporale et al. (2017), Rafi and Ramachandran (2018) and Cesa-

Bianchi et al. (2019a,b).

In the rest of the paper, capital flows refer to portfolio investment flows (equities and debts).

We exclude Eurozone countries, because the fund flows data of Eurozone countries involves intra-

Eurozone fund flows, making them unsuitable to our research objective.

are categorized by using the K-means clustering algorithm. We test the hypothesis that structural

CF volatility shocks cause a smaller increase in FX volatility in the short-term for countries with

stronger macroeconomic fundamentals, regardless of FX regimes.

In Step 2, we carry out a threshold analysis using panel data regressions to assess how certain

macroeconomic factors could help to moderate the reaction of FX volatility to capital flow

volatility in the medium-term (in quarters). We first identify economic variables that have the

moderating effect, then estimate the threshold of the moderating factors

above which the adverse

effect of CF volatility may be negligible. We further construct an FX resilience measure using the

first principal component of the moderating factors.

We have three main findings: Firstly, we find that FX volatility responds to structural CF

volatility shocks at a smaller scale for countries with strong macroeconomic fundamentals in the

short-term, regardless of FX regimes. FX regimes only affect the components of the FX volatility

response: global, rather than country-specific, capital flow shocks dominate the FX response for

countries with less-strong fundamentals (mostly EMEs) under the floating FX regimes, but the is

the other way round under the managed FX regimes. Secondly, by removing highly correlated

economic factors

, we identify six economic factors that can significantly dampen the adverse

effect of CF volatility on FX volatility in the medium-term horizons. These moderating factors

include trade openness, FX reserves, total foreign investment (the sum of net FDI, net foreign

equities and net foreign bonds), (low) short-term interest rate, fiscal sustainability and financial

In the rest of the paper, moderating factor refers to the economic factor that can moderate (aggravate) the

adverse effect of CF volatility on FX volatility with a higher (lower) level of such a factor.

This refers to credit to private sector, which is highly correlated with financial development, because credit

to private sector reflects financial market depth, and financial market depth is one element of the financial

development index as calculated in Svirydzenka (2016).

market development. Passing certain threshold level of these moderating factors, the adverse

effect of CF volatility may be negligible.

Finally, we find that the FX resilience measure is intuitive, in the sense that countries having

high ranking of the estimated FX resilience measure coincide with those cluster countries that

have smaller FX volatility reaction to the CF volatility shocks. The major contributors to the FX

resilience measure are short-term interest rate, fiscal sustainability and financial market

development.

The remaining part of the paper is organized as follows: Section 2 reviews the related literature.

Section 3 describes the sample data and summary statistics. Sections 4 and 5 present the cluster

analysis and the threshold analysis respectively. Section 6 introduces the FX resilience measure.

Section 7 briefly concludes our findings and offers policy implications.

2. Literature review

Our paper relates to the literature on the determination of exchange rate volatility, with an emphasis

on capital flow volatility.

2.1 Theory insights on exchange rate volatility determinants

Our study is related to three strands of theory on FX volatility in the structural model framework.

The first strand is the optimum currency area theory (OCA) originated in the seminar paper of

Mundell (1961) and its later variants, who argue that shock absorption within a heterogeneous

group of countries is easier if monetary and exchange rate policies remain independent, especially

for countries with rigid labour markets and low international labour mobility. Variables suggested

by the OCA theory, including trade interdependence and the degree of commonality in economic

shocks, have considerable explanatory power for patterns of FX volatility and interventions across

countries.

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1FXResiliencearoundtheWorld:FightingVolatileCross-BorderCapitalFlowsLouisaChen,a*EstelleXueLiubandZijunLiuca*DepartmentofAccountingandFinance,UniversityofSussexBusinessSchool,UniversityofSussex,Brighton,UnitedKingdom.Tel:+44(0)1273877807.Email:l.x.chen@sussex.ac.uk;bEuropeanDepartment,InternationalM...

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1 FX Resilience around the World Fighting Volatile Cross -Border Capital Flows Louisa Chena Estelle Xue Liub and Zijun Liuc

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