Emerging countries' counter-currency cycles in the face of crises and dominant currencies

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Emerging countries' counter-currency cycles in the face of crises and dominant currencies

https://doi.org/10.21203/rs.3.rs-5283456/v1

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This article examines how emerging economies use countercyclical monetary policies to manage economic crises and fluctuations in dominant currencies, such as the US dollar and the euro. Global economic cycles are marked by phases of expansion and recession, often exacerbated by major financial crises. These crises, such as those of 1997, 2008 and the disruption caused by the COVID-19 pandemic, have a particular impact on emerging economies due to their heightened vulnerability to foreign capital flows and exports.

Counter-cyclical monetary policies, including interest rate adjustments, foreign exchange interventions and capital controls, are essential to stabilize these economies. These measures aim to mitigate the effects of economic shocks, maintain price stability and promote sustainable growth.

This article presents a theoretical analysis of economic cycles and financial crises, highlighting the role of dominant currencies in global economic stability. Currencies such as the dollar and the euro strongly influence emerging economies, notably through exchange rate variations and international capital movements.

Analysis of the monetary strategies of emerging economies, through case studies of Brazil, India and Nigeria, reveals how these countries use tools such as interest rates, foreign exchange interventions and capital controls to manage the impacts of crises and fluctuations in dominant currencies. The article also highlights the challenges and limitations faced by these countries, including structural and institutional constraints and the reactions of international financial markets.

Finally, an econometric analysis using a Vector AutoRegression (VAR) model illustrates the impact of monetary policies on key economic variables, such as GDP, interest rates, inflation and exchange rates. The results show that emerging economies, although sensitive to external shocks, can adjust their policies to stabilize economic growth in the medium and long term.

Economy

Currency

GDP

Change rate

International

Emerging countries

International Economy

Global economic cycles are characterized by alternating phases of expansion and recession, influenced by a multitude of economic, political and social factors. These cycles are often punctuated by major financial crises, such as the Asian crisis of 1997, the global financial crisis of 2008, and more recently, the economic turbulence induced by the COVID-19 pandemic. These events not only disrupted international financial markets, but also had a profound impact on emerging economies, which are often more vulnerable due to their dependence on foreign capital flows and exports.

In this context, monetary policy plays a crucial role for emerging economies. Central banks in these countries have to navigate a complex environment, marked by volatile global markets and fluctuations in dominant currencies such as the US dollar and the euro. Monetary policy decisions, whether they involve adjusting interest rates, intervening in the foreign exchange market or imposing capital controls, are essential to stabilizing national economies, controlling inflation and promoting sustainable economic growth.

Faced with these challenges, a fundamental question arises: how do emerging countries use counter-cyclical monetary policies to protect themselves from economic crises and mitigate the effects of fluctuations in dominant currencies? Monetary counter-cycling refers to the use of monetary policies to moderate economic fluctuations, by tightening or easing monetary conditions in response to internal or external shocks. This approach is particularly relevant for emerging economies, which are often exposed to violent external shocks, such as sudden changes in global financial conditions or abrupt variations in commodity prices. What's more, as emerging economies are often more fragile, the risks of inflation are high, and these risks are vital to avoid if emerging economies are to develop and achieve economic convergence with more developed economies.

1. Economic cycles and financial crises

Business cycles are recurring fluctuations in global economic activity, characterized by phases of expansion (economic growth) and contraction (recession). These cycles are generally measured by macroeconomic indicators such as gross domestic product (GDP), employment, investment and industrial production. The phases of a typical business cycle include expansion, when GDP rises, employment and incomes improve, and investment is buoyant; peak, the highest point in the business cycle when the economy reaches its highest level before beginning to slow; recession, a period of economic decline characterized by falling GDP, rising unemployment, falling incomes and reduced investment; and finally trough, the lowest point in the business cycle before the economy begins to recover.

These cycles can be influenced by a variety of factors, such as demand and supply shocks, monetary and fiscal policies, and technological change.

Financial crises, on the other hand, are severe disruptions to the financial system, often marked by bank failures, stock market collapses and acute economic contractions. Financial crises can have a variety of origins, including speculative bubbles, shocks to confidence or macroeconomic imbalances.

Notable examples of major financial crises include the Asian crisis of 1997, which began in Thailand with the collapse of the baht and spread rapidly to other Asian economies such as Indonesia, South Korea and Malaysia, leading to massive currency devaluations, severe economic contractions and structural reforms imposed by the International Monetary Fund (IMF); the global financial crisis of 2008, triggered by the collapse of the US real estate market and the bankruptcy of Lehman Brothers, which led to a global recession, affecting emerging countries through falling exports, capital flight and exchange rate volatility; and the European sovereign debt crisis of 2010-2012. Although centered in Europe, this crisis had global repercussions, affecting emerging countries in particular through financial contagion and falling demand for their exports.

2. Role of dominant currencies

Leading currencies, such as the US dollar (USD) and the euro (EUR), play a central role in the global economy due to their extensive use in international transactions, foreign exchange reserves and financial markets. Their importance lies in several key aspects: as a store of value, where the world's central banks hold substantial reserves in USD and EUR to stabilize their own currencies and manage economic crises; as a medium of exchange, as the dollar and euro are widely used for international trade, facilitating exchanges between countries; and as a unit of account, as many financial contracts, including international loans, are denominated in USD or EUR, reinforcing their central role.

Fluctuations in the dominant currencies can have a significant impact on emerging economies, affecting their economic and financial stability. Fluctuations in exchange rates between dominant currencies and local currencies can lead to unpredictable fluctuations in import costs and export revenues. Emerging economies that borrow in USD or EUR may see the cost of their debt rise if their local currency depreciates. In addition, interest rate variations in dominant economies can lead to volatile capital flows, with capital outflows on interest rate rises and inflows on interest rate falls.

3. Concept of monetary counter-cycle

Counter-cyclical policies are strategies implemented by monetary authorities to smooth economic fluctuations and stabilize the economy. These policies aim to smooth economic cycles by reducing the scale of expansions and contractions to maintain stable economic growth, prevent financial crises by using preventive measures to avoid asset bubbles and macroeconomic imbalances, and stabilize prices by keeping inflation low and stable, adjusting interest rates and foreign exchange reserves.

Emerging countries use counter-cyclical policies to protect themselves from external shocks and economic crises. The history of their use reveals a variety of approaches. In the 1990s, following the financial crises of that period, many emerging countries adopted structural reforms and strengthened their monetary policy frameworks to include counter-cyclical measures. For example, the Asian crisis of 1997 prompted several countries to accumulate substantial foreign exchange reserves and adopt flexible exchange rate policies to better absorb external shocks. Similarly, during the global financial crisis of 2008, emerging economies used monetary and fiscal stimulus policies to support domestic demand and stabilize their economies in the face of the global recession, whereas the more developed economies first promoted austerity to stabilize the economic situation before launching large-scale stimulus plans.

1. Monetary strategies adopted by emerging countries

Emerging economies, faced with often volatile economic and financial environments, can implement a variety of monetary strategies to stabilize their economies. These strategies are crucial to managing economic shocks, whether in times of global financial crisis or in the face of significant fluctuations in dominant currencies. The main monetary strategies adopted by these countries include interest rate policies, foreign exchange intervention, capital controls and other measures that can be classified as unconventional.

Interest rate policies.

Interest rate policies are one of the main instruments of monetary policy in emerging economies. Central banks adjust key interest rates to influence the cost of credit and, consequently, consumption and investment in the economy. Lower interest rates tend to stimulate economic activity by making borrowing cheaper, encouraging companies to invest and consumers to spend. Conversely, higher rates are generally aimed at containing inflation by dampening aggregate demand.

In times of crisis or economic slowdown, emerging economies often resort to an accommodating monetary policy, lowering interest rates to support growth. For example, during the 2008 financial crisis, many emerging countries cut interest rates to mitigate the effects of the global recession. However, this approach is not without risks, as interest rates that are too low can lead to an overheating economy or financial instability, particularly if it leads to excessive debt accumulation.

Foreign exchange intervention

Foreign exchange intervention is another key strategy used by central banks in emerging countries to manage their exchange rates. These interventions can take the form of buying or selling foreign currencies to influence the value of the domestic currency. For example, to avoid excessive currency depreciation, central banks may sell foreign currency reserves to buy the local currency, thereby increasing its demand and value.

These interventions are primarily aimed at stabilizing the exchange rate, avoiding excessive volatility and maintaining the competitiveness of exports. In economies where imports of everyday consumer goods are significant, a depreciation of the local currency can quickly translate into imported inflation. Foreign exchange intervention also helps to boost investor and consumer confidence, by mitigating unpredictable exchange rate fluctuations.

However, foreign exchange interventions can be costly, especially if they require the massive use of foreign exchange reserves, which are often lower in emerging countries. What's more, they can sometimes be perceived as currency manipulation by trading partners, which can lead to international tensions and a retraction of international trade for the country linked to the currency instability induced by these possible manipulations.

Capital controls and other unconventional measures

Capital controls and other unconventional measures are instruments often used by emerging countries to manage capital flows and prevent financial crises. Capital controls include restrictions on capital inflows and outflows, which may take the form of taxes, quotas or specific regulations on international financial transactions. These measures are designed to protect the national economy against volatile capital movements, which can destabilize financial markets and the local currency.In particular, during periods of high financial instability or speculative pressure, emerging countries may impose restrictions on capital outflows to avoid massive currency flight, which could weaken their currencies and accentuate economic imbalances. Capital controls can also be used to regulate capital inflows, particularly short-term flows which can create asset bubbles and increase financial vulnerability.

In addition to capital controls, emerging countries may resort to other unconventional measures, such as the use of macroprudential policies to manage systemic risks, or direct interventions in certain segments of the financial market to stabilize monetary conditions. These unconventional measures, while sometimes necessary, can present challenges, particularly in terms of economic costs and effects on investor confidence. Capital restrictions can deter foreign investment and undermine long-term growth. In addition, mismanagement of these policies can distort financial markets, exacerbating existing imbalances.

2. Brazilian, Indian and Nigerian cases

Brazil, as one of the largest emerging economies, has employed various monetary policies to stabilize its economy in the face of crises and fluctuations in dominant currencies.

India has also implemented counter-cyclical monetary policies to stabilize its economy, particularly in times of global financial crisis and dominant currency volatility, in order to become a major South Asian economy.

Nigeria, reputed to be Africa's largest and most promising economy, has employed several monetary strategies to manage the impact of economic crises and dominant currency fluctuations.

Brazil's central bank has often adjusted interest rates to control inflation and stimulate economic growth. For example, after the global financial crisis of 2008, the interest rate was reduced to encourage investment and consumption. This policy was aimed at boosting the Brazilian economy by increasing domestic demand. In addition, the Brazilian Central Bank regularly intervenes on the foreign exchange market to stabilize the Brazilian real. This includes buying foreign currencies to boost reserves and selling currencies to support the domestic currency. These interventions are designed to alleviate pressure on the real and avoid excessive depreciation, which could harm the economy. The country has also imposed capital controls during periods of high volatility. For example, to limit speculative movements and protect the national economy, measures such as taxes on short-term foreign investments have been put in place. These controls aim to prevent capital flight and stabilize domestic financial markets.

The Reserve Bank of India (RBI) regularly adjusts interest rates to manage inflation and support growth. During the global financial crisis of 2008, India lowered interest rates to stimulate the economy. This rate cut was intended to encourage borrowing and investment, in order to boost economic activity. The Reserve Bank of India also intervenes in the foreign exchange market to manage the value of the Indian rupee against dominant currencies such as the US dollar. These interventions are crucial to stabilizing the currency and avoiding depreciations that could exacerbate economic imbalances. In addition, India has imposed various restrictions on capital movements to stabilize its financial market. These include restrictions on foreign direct investment and strict regulations on short-term capital flows. These controls are designed to protect the Indian economy from volatile capital flows that could destabilize financial markets.

The Central Bank of Nigeria adjusts interest rates to control inflation and stimulate growth. For example, in response to falling oil prices in 2015, the central bank raised interest rates to contain inflation. This policy was aimed at stabilizing the Nigerian economy, which is heavily dependent on oil exports. The Central Bank of Nigeria actively intervenes on the foreign exchange market to stabilize the Nigerian naira. In times of strong pressure on the currency, such as major fluctuations in oil prices, the central bank buys or sells foreign currencies to stabilize the exchange rate. These interventions are essential to protect the economy from the adverse effects of currency devaluation. In response to market volatility, Nigeria has also imposed capital controls to limit currency outflows and stabilize the local economy. These measures include restrictions on foreign currency transactions and strict regulations on the transfer of funds abroad. These controls are aimed at preventing capital flight and stabilizing domestic financial markets.

3. Challenges and limitations of countercyclical policies

Structural and institutional constraints

Emerging countries often face structural constraints that reduce their ability to implement effective counter-cyclical policies. These constraints include underdeveloped financial infrastructures, a narrow tax base, and fragile legal or political systems. One example is economies where financial markets are shallow and poorly regulated, and the ability of monetary authorities to influence interest rates and inject liquidity can be considerably reduced. In addition, the absence of efficient public administration and endemic corruption can complicate the implementation of counter-cyclical fiscal policies, limiting the effectiveness of stimulus or austerity measures.

Institutional constraints also play a major role. In many emerging countries, central banks lack independence, which can lead to monetary policy decisions being influenced by short-term political considerations rather than long-term macroeconomic stability objectives. Furthermore, the weakness of domestic financial institutions limits their ability to absorb economic shocks, which can exacerbate crises rather than alleviate them, as in the Thai crisis mentioned above.

Reactions from financial markets and international investors

Counter-cyclical policies in emerging economies can also be limited by the reactions of financial markets and international investors. Foreign investors, in particular, are often sensitive to changes in economic policy in emerging countries. Indeed, expansionary monetary policy aimed at stimulating economic growth can lead to capital flight if investors perceive an increased risk of inflation or currency depreciation. This capital flight can then exacerbate pressure on the domestic currency, forcing the authorities to tighten monetary policy pro-cyclically, i.e. in the opposite direction to what was initially intended. In addition, emerging countries are often vulnerable to fluctuations in global financial conditions, due to their dependence on external financing. Rising interest rates in advanced economies, for example, can make debt servicing more expensive for emerging countries, limiting their ability to pursue counter-cyclical policies. Financial markets can also react negatively to expansionary fiscal policies, especially if they are perceived as unsustainable in the long term, by increasing the risk premiums demanded on sovereign bonds.

To analyze the interactions between the main economic variables in the context of countercyclical policies of emerging countries, we use a Vector AutoRegression (VAR) model introduced by Christopher A.Sims[1]. The VAR model is an econometric tool for capturing dynamic relationships between several economic time series without imposing a strict theoretical structure.

Thus, the main economic variables that will be considered in this model are .

Formulation of a VAR Model

The VAR model consists of a set of equations where each economic variable depends on the past values of all variables in the model, including itself. In the 4-variable VAR model as presented previously the equations will be as follows:

Brazil VAR Analysis

VAR GDP / Interest rate model

The graph illustrates the orthogonal impulse response of GDP to a standard interest rate shock, and will be simulated for each country.

According to this model, a positive interest rate shock initially leads to a fall in GDP. This negative response is in line with economic theory, which states that a rise in interest rates tends to dampen investment and consumption, thus reducing economic activity in the short term. The effect of higher interest rates on GDP seems to persist for several periods before diminishing. This suggests that monetary policy has a lasting impact on economic activity.

However, to analyze the impact of a dominant currency in a country's economy we need to run the same simulation but on the GDP/exchange rate variables.

VAR GDP / Exchange rate model (in USD)

The 1st graph at top left shows the response of GDP (Brazil_GDP) to an exogenous shock in the exchange rate (Brazil_ExchangeRate). Immediately after the shock, we observe a negative response in GDP, suggesting that an initial depreciation in the exchange rate has a negative impact on the Brazilian economy, possibly by increasing the cost of imports, which weighs on domestic production. This negative response continues for several periods before beginning to stabilize. This suggests that the effect of the exchange rate is significant in the short term, but that the economy can slowly adjust.

The 2nd graph at top right shows the direct effect of the exchange rate on itself. This graph shows how the exchange rate reacts to a shock to GDP. The flat line suggests that changes in GDP do not have an immediately perceptible effect on the exchange rate. However, GDP appears to be an important determinant of exchange rate fluctuations in subsequent periods, although the relationship is not linear.

The bottom left and right graphs show the cross-interactions between GDP and exchange rate. The bottom left-hand chart suggests that the effect of an exchange rate shock is gradually absorbed by the economy, allowing for a slight improvement in GDP over the long term. This could materialize through structural adjustments or economic policies that come into play to stabilize the economy.

Thus, the results show that Brazilian GDP seems particularly sensitive to exchange rate shocks, especially in the short term. This demonstrates the importance of maintaining a stable exchange rate policy to avoid significant negative impacts on the economy. In the long term, relative stability suggests that appropriate interventions, such as interest rate adjustments or fiscal policies, can help mitigate the negative impact of the exchange rate on GDP.

India VAR Analysis

VAR GDP / Interest rate model

From the initial shock, we see a slight drop in GDP. This initial negative response suggests that rising interest rates may be reducing domestic demand, possibly by making credit more expensive, thus affecting consumer and investment spending. GDP begins to react positively after the initial decline. This could reflect an adaptation of the Indian economy to the new monetary situation, where companies and consumers adjust their behavior in response to higher interest rates. After the increase, GDP fluctuates, moving above and below the baseline. These oscillations indicate medium-term economic instability, probably due to competing forces - on the one hand, reduced domestic demand, and on the other, a possible improvement in the trade balance thanks to a potentially stronger currency-. The end of the analysis horizon shows that the GDP response converges towards the baseline, indicating that the effect of the interest rate shock diminishes over time, even if a downward propensity remains, pointing to chronic instability.

VAR GDP / Exchange rate model (in USD)

Following a positive shock to the exchange rate, GDP shows an initial negative reaction. This suggests that currency depreciation leads to an increase in the cost of imports, which may reduce domestic consumption and investment in the short term. After the initial negative effect, GDP begins to show signs of recovery after 2-3 periods. This recovery can be attributed to the increased competitiveness of Indian exports due to the weaker currency, stimulating production and incomes in export-oriented sectors.

In the longer term, GDP response tends to stabilize, gradually returning towards the baseline. This indicates that the Indian economy is capable of absorbing exchange rate shocks over an extended period, surely through internal adjustment mechanisms and economic diversification.

A positive shock to GDP leads to an immediate appreciation of the exchange rate. This seems logical, as a growing economy attracts more foreign investment, thus increasing demand for the local currency. The initial exchange rate appreciation is followed by a slight correction, where the exchange rate stabilizes at a level slightly above the baseline. This suggests that the positive effects of economic growth on the value of the currency are long-lasting, but moderated by other macroeconomic factors such as inflation and the trade balance.

A positive shock to GDP leads to an immediate and significant increase in GDP in subsequent periods. This persistence indicates the ripple effect of economic growth, where initial growth stimulates further consumption, investment and production, creating a virtuous cycle of economic growth. This mechanism is recurrent in emerging economies, enabling more or less prolonged phases of uninterrupted growth, particularly in countries with a large production base enabling them to export.

The results indicate that the Indian economy is sensitive to exchange rate fluctuations, with short-term negative effects on GDP in the event of currency depreciation. However, the ability to recover in the medium and long term suggests economic resilience and effective adjustment mechanisms. The recovery of GDP after an exchange rate depreciation shock underlines the importance of exports in the Indian economy. A weaker currency makes Indian products more competitive on the international market, boosting production and employment. However, the results highlight the need to further diversify the Indian economy and strengthen its resilience to external shocks.

Nigeria VAR Analysis

VAR GDP / Interest rate model

The initial shock shows a significant drop in GDP in the first few periods. This movement suggests that the Nigerian economy is relatively dependent on stable and relatively low interest rates. However, periods 4 to 6 show an upturn in GDP, indicating that corrective action by regulatory agencies may be paying off. However, the final periods show a reverse effect, with GDP falling and remaining below the 0 line, indicating risks to the long-term stability of the Nigerian economy if the right macroeconomic decisions are not taken.

VAR GDP / Exchange rate model (in USD)

After an initial positive shock, GDP gradually declines over time, suggesting that initial economic growth may fade as the positive effects of the shock dissipate. This could indicate a difficulty in maintaining sustained growth after an initial growth shock. In addition, an increase in GDP could lead to a slight appreciation of the currency, but this effect is small, suggesting that other external factors or monetary policies play a more decisive role in determining the exchange rate in Nigeria. An initial depreciation of the exchange rate could stimulate economic growth by making Nigerian exports more competitive, thereby increasing demand for domestic goods. However, this relationship could also reflect internal adjustments where a currency depreciation is followed by a gradual economic improvement.

A shock to the exchange rate leads to a continued increase in the exchange rate, although this response is more moderate. This suggests that exchange rate shocks can generate a continuous appreciation dynamic, potentially reinforced by market expectations or restrictive monetary policies in response to inflationary pressures.

The VAR simulation for Nigeria reveals a complex interaction between GDP and the exchange rate. Impulse responses suggest that Nigeria needs to adopt prudent monetary and economic policies to manage internal and external shocks, in order to sustain economic growth while maintaining exchange rate stability.

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[1] Sims, C. A. (1980). Macroeconomics and Reality. Econometrica, 48(1), 1–48. https://doi.org/10.2307/1912017

[2] Currencies studied here:

- Brazil: Real (BRL)

- India: Indian Rupee (INR)

- Nigeria: Naira (NGN)

[3] Here, the exchange rate of each currency will be analyzed against the dollar, the dominant reference currency, but the analysis can also be carried out against the euro.

No competing interests reported.

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Emerging countries' counter-currency cycles in the face of crises and dominant currencies

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Introduction

I. Theoretical and historical context

II. Analysis of monetary counter-cycles

III. Mathematical development of analysis

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