Carry Trade and Exchange-Rate Regimes

by Laura Alfaro & Fabio Kanczuk

Overview — In emerging countries, carry-trade activity and foreign participation in local-currency bond markets have increased dramatically over the past decade. This study revisits the issue of choosing an exchange-rate regime under the assumption that emerging markets can borrow internationally in local currency. This hypothesis reflects a new trend in international capital flows: carry trade and relevant foreign participation in local-currency bond markets. Results show that, by means of international borrowing in domestic currency, emerging countries can partially offset foreign shocks. The authors argue that as emerging nations develop their local currency markets, a "pseudo-flexible regime," whereby a country accumulates reserves in conjunction with debt, is the best policy alternative under real external shocks. Key concepts include:

This study reflects recent trends in the international flow of funds: the development of local currency bonds in emerging markets and increased foreign participation.
It is well known that the choice of exchange-rate regime depends crucially on the type of shock to an economy. In this new framework, however, a flexible-exchange-rate regime is optimal for domestic shocks and a fixed-exchange-rate regime is optimal for external shocks.
The traditional fixed-exchange-rate regime, albeit ideal in the presence of external shocks, is not sustainable.
A flexible-exchange-rate regime can reduce exchange-rate volatility by issuing local-currency bonds, a policy the authors dub a "pseudo-flexible regime."
Welfare levels are better if a pseudo-flexible regime is implemented in conjunction with reserve accumulation.

Author Abstract

Carry-trade activity and foreign participation in local-currency-bond markets in emerging countries have increased dramatically over the past decade. In light of these trends, we revisit the question of the optimal exchange-rate regime when developing countries can borrow internationally with local-currency-denominated debt. We find that, as local currency bond markets develop, a "pseudo-flexible regime," whereby a country accumulates reserves in conjunction with debt, to be the best policy alternative under real external shocks for emerging nations.