18

Emerging Markets and the

Transition to Stability: Role of
Flexibility of Exchange Rates
JOSÉ DE GREGORIO
José De Gregorio, nonresident senior fellow at the Peterson Institute for
International Economics, is dean of the School of Economics and Business at the
University of Chile. He was governor of the Central Bank of Chile from 2007 until
2011.

Implementation of flexible exchange rate regimes in emerging-

market economies (EMEs) occurred long after the dissolution of the
Bretton Woods system, following numerous unsuccessful attempts to
combat inflation through fixed exchange rates and severe fear of
floating. Until the late 1990s, most crises in EMEs were linked to
inflexible exchange rate regimes, as evident in the Latin America
debt crisis in the 1980s, the Mexican crisis in 1994, the Asian
financial crisis in 1997–98, and the Russian default with contagion to
Brazil in 1998. These episodes were characterized by a combination
of fragile financial systems and rigid exchange rate frameworks.
EMEs gradually transitioned toward greater exchange rate
flexibility, leading to the emergence of new questions. In an
environment where a significant portion of international trade is
conducted and priced in US dollars (Gopinath et al. 2020), are
exchange rates still effective in facilitating external adjustment? Do
EMEs experience wealth losses when their currencies depreciate?
How much does depreciation affect local borrowers, including the
government?
This chapter examines the transition toward more flexible
exchange rate regimes in EMEs, a phenomenon that coincided with a
decline in global inflation and the adoption of inflation targeting
frameworks. It analyzes the capacity of exchange rates to foster
external adjustment, taking into account recent research in
international pricing that casts doubt on their effectiveness. It also
looks at currency mismatches and the implications for the net
international investment position of EMEs and the effects of
exchange rate fluctuations.

Inflation, Monetary Policy, and the Exchange Rate Regime

EMEs have been the prime example of fear of floating (Calvo and
Reinhart 2002). Fear of floating arises for two reasons. The first is
concerns about the inflationary effects of currency depreciation
associated with the lack of credibility that leads to high exchange
rate pass-through (ERPT). The second is the fear that currency
depreciations may lead to financial disruptions, even to self-fulfilling
equilibria. In this section I focus on inflation in EMEs and the
monetary policy regime.
In the late 1990s, three main developments took place:

• Inflation declined. Even in Latin American economies

characterized by high inflation, rates fell to single digits for the
first time in decades (figure 18.1).
• Many countries adopted flexible inflation targeting regimes,
characterized mainly by commitment to a specific value or range
for the inflation rate, to be achieved in the medium term, with
or without specifying a policy horizon (figure 18.2). Several
countries announced that the target would be achieved within
two years; others just mentioned the medium term.1
 • Most EMEs abandoned pegged exchange rate regimes, moving
to some type of intermediate regime, ranging from narrow
bands to managed floating (figure 18.3).2 It is difficult to find
fully floating regimes, as most countries that adopt flexibility
retain the possibility of intervention in some special
circumstances; others follow some rules to provide some
stability in the short run. Some countries that declare that they
have narrow bands are just floating with frequent stabilizing
interventions, without a specific numerical target for the
exchange rate. Having a target for the value of the currency is
the central characteristic of rigid regimes and the loss of
monetary autonomy, which becomes dominated by that
numerical target, which could be an explicit narrow band.
Figure 18.1
Median inflation in Latin America, South America, and the world, 1980–
2022

Note: Latin America comprises South American countries plus Costa Rica, El
Salvador, Guatemala, Haiti, Honduras, Nicaragua, and Panama. Data for Argentina
between 1980 and 1997 are from the World Economic Outlook Database, October
2014. In all subsequent editions of the World Economic Outlook, no inflation data
are reported for Argentina between 1980 and 1997. For 1998 onward, data are
from the World Economic Outlook, April 2023.
Source: IMF, World Economic Outlook Database, April 2023.

There has been a clear policy trend toward flexibility in the

exchange rate and inflation targets in the monetary policy regime.
But these policy changes did not cause the decline in inflation.
Indeed, inflation targeting is not a disinflation strategy but a regime
for conducting monetary policy efficiently. Controlling inflation
requires the elimination of its deep roots, mainly fiscal imbalances
and central banks subject to political control, rendering lack of
credibility to control inflation. In the 1990s, there was progress in
both areas (Rogoff 2004). On the fiscal front, there was progress not
only in high-income countries but also in places like Africa and Latin
America. In addition, many countries granted independence to their
central banks. There were also specific factors that contributed to
the decline in inflation, such as increased competition through
globalization and higher productivity as a result of advances in
information technologies.
Figure 18.2
Number of countries operating under inflation targeting regimes, 1990–
2017

Note: Figure does not include euro area countries.

Sources: Roger (2010), Hammond (2011), and IMF’s Annual Report on Exchange
Arrangements and Exchange Restrictions (AREAER).

Figure 18.3
Exchange rate regimes in inflation targeting emerging-market
economies,1960–2019

Note: Data exclude two regimes, “freely falling” and “dual market in which parallel
market data is missing.” Data are as of December of each year.
Source: Ilzetzki, Reinhart, and Rogoff (2022).

One big achievement in macroeconomic policies was allowing

currencies to fluctuate. The last significant currency crisis in EMEs
was the Asian crisis; no similar crises have occurred since then,
despite very challenging world developments, including the global
financial crisis of 2007–09 and the COVID-19 pandemic. Moreover,
exchange rate fluctuations have not caused financial crises, as they
often did in the past.
Apprehension surrounding the adoption of flexible exchange
rates stemmed primarily from concerns about potential volatility in
inflation caused by fluctuations in the exchange rate. Those fears did
not materialize, particularly after inflation control was achieved.
There is evidence of a significant decline in the ERPT in EMEs in the
last 20 years, which fell to the levels of advanced economies.
Although it is not easy to separate its causes, they reflect several
factors, including the decline in inflation (Jasova, Moessner, and
Takats 2019); the increased credibility of monetary policy (Cuitiño,
Medina, and Zacheo 2022; Carrière-Swallow et al. 2021); and the
adoption of inflation targets (Cabezas and Edwards 2022) or
exchange rate flexibility (Borenzstein and Queijo von Heideken
2016). The enhancement in macroeconomic policies has mitigated
the influence of exchange rate fluctuations on inflation dynamics,
addressing one of the principal concerns associated with the fear of
transitioning to flexible exchange rate regimes.

Exchange Rates and International Pricing

Exchange rates are relative prices that facilitate external adjustment.
When there are exchange rate rigidities, because of fear of floating,
external adjustment becomes limited. In such cases, changes in
competitiveness occur through changes in the relative price of goods
in their own currencies rather than through the relative price of
currencies (the nominal exchange rate). Relying on relative price
changes through movements of domestic prices is much more
difficult, especially when a deflation is needed to regain
competitiveness, than relying on changes in the value of the
currency. Facilitating adjustment is one of the primary reasons for
opting for a flexible exchange rate regime. However, doubts have
emerged in recent years regarding the effectiveness of exchange
rates in promoting adjustment.
The observation that ERPTs are small has led many researchers
to argue that export prices are determined in the currency of the
importer, a phenomenon known as local currency pricing (LCP). In
this context, a depreciation of the bilateral exchange rate between
the exporter and importer does not significantly affect the demand
for exports, because relative prices remain unchanged. Extensive
research has been conducted to investigate international pricing and
its implications for external adjustment.
As a substantial portion of international invoicing is conducted in
US dollars, Gopinath et al. (2020) have proposed the dominant
currency paradigm (DCP), which suggests that international prices
are set and fixed in US dollars. A depreciation of the bilateral
exchange rate between the exporter and importer does not have a
substantial impact on the demand for exports or imports, limiting
external adjustment. When, however, the importer’s currency
depreciates against the US dollar, domestic relative prices rise and
demand falls. Therefore, the exchange rate has more limited effects
than those traditionally envisioned in the Mundell-Fleming model
that assumes pricing in the producer’s currency (PCP). In this case,
for example, a depreciation of the currency reduces prices at
destination and, hence, increases demand for exports.
The response of prices and quantities to exchange rate
movements, both bilaterally and with respect to the US dollar, is an
empirical matter. De Gregorio et al. (2023) explore this issue for
Chilean exports of single exported products (at the 8-digit
Harmonized System code) from 2010 to 2019. Their dataset includes
exporting firms, destination countries, and the invoicing currency.
The findings suggest that in the short run, prices are fixed in dollars,
the currency used in around 90 percent of invoicing, resulting in an
ERPT from the dollar exchange rate to local prices of 0.9 (figure
18.4). However, local importers’ prices do not immediately react to
bilateral depreciation, indicating that prices in the short run are fixed
in dollars, the invoicing currency. Over time, the ERPT of the dollar
declines to below 0.4 after eight quarters. In contrast, after a
bilateral depreciation of the local currency against the exporter’s
currency, local importers’ prices gradually increase, reaching an
ERPT of 0.8 after eight quarters. In the short run, DCP prevails, as
prices are fixed in dollars and respond only to changes in the dollar
exchange rate of the importing country. This effect diminishes over
time, and the traditional PCP mechanism comes into play. In the long
run, exporters prefer to set prices in their own currency (home
country bias).3
The impact of exchange rates on quantities is consistent with the
findings for prices. In the short run, quantities are not affected.
However, over time, as local prices begin to rise following a bilateral
depreciation, export volumes decline as expected, thanks to a
decrease in local demand.
The subdued reaction of export volumes to a depreciation of the
local currency relative to the dollar—which exhibits an ERPT of
approximately one in the short run—requires further analysis. It is
likely the result of frictions in the transmission from increased prices
at the dock to retail prices, as De Gregorio et al. (2023) argue.
Distribution margins absorb these exchange rate fluctuations.
Figure 18.4
Exchange rate pass-through to prices and quantities

a. Price

b. Quantity
Note: The dark gray (light gray) line represents the proportional effects of a
depreciation of the local importers’ currency against the Chilean peso (US dollar)
on the local price and volume of Chilean exports. Dashed lines represent 95
percent confidence interval. The horizontal axes show quarters, and the vertical
axes show proportion.
Source: De Gregorio et al. (2023).

The evidence suggests that even in a world in which a dominant

currency is used for most international transactions, exchange rates
against the trading partner and the dollar still play a crucial role in
facilitating external adjustment.

Exchange Rates and the Net International Investment

Position
Fear of floating exchange rates is driven partly by the potential
financial problems it may engender. EMEs have historically relied on
borrowing in foreign currencies, particularly the US dollar, on
international capital markets. The Latin American debt crisis in the
early 1980s, characterized by inflexible exchange rates, significant
currency mismatches, and weak financial systems, resulted in a lost
decade for the region. The adoption of fixed exchange rates and the
availability of international bank financing led to a substantial
accumulation of external debt. When US interest rates sharply
increased, a severe crisis unfolded. The Mexican crisis of 1994 and
the Asian crisis in the late 1990s were also associated with exchange
rate inflexibility and its subsequent impact on the financial system.
The pattern is simple: Countries experience a period of exchange
rate stability, occasionally facing appreciation, and corporations and
governments heavily borrow from highly liquid global financial
markets. When an economic shock exerts pressure on the currency,
fear of floating emerges, leading countries to adopt various
measures, including raising interest rates, depleting reserves, and
implementing capital controls, to safeguard their currencies.
These defensive measures often prove unsustainable, resulting in
a sharp depreciation and a financial crisis stemming from currency
mismatches at the corporate, financial, or governmental level.
A more nuanced scenario arises when the corporate sector
borrows in foreign currency and regulations are lenient. Assuming
the private sector will not incur currency risk ignores the moral
hazard issues stemming from the chosen exchange rate regime.
More recently, in contrast, and as a result of a costly crisis, many
EMEs have built more resilient financial systems, enabling them to
withstand crises such as the global financial crisis and the pandemic
without major disruptions.
Another important discussion relating exchange rate and
mismatches is “original sin” (Eichengreen, Hausmann, and Panizza
2007)—the inability of sovereigns to borrow in their own currencies,
reducing the ability to share risk. Most sovereign borrowing is in US
dollars. When EMEs’ currencies depreciate, wealth transfers occur
from them to foreign creditors, leading to serious fiscal problems. In
contrast, the United States benefits from a depreciation of its
currency thanks to its short position in dollars. Therefore, in the
United States, a depreciation of the dollar contributes to external
adjustment not only through trade effects but also via wealth
effects. In contrast, in EMEs, these wealth effects could potentially
hinder the effectiveness of a depreciation in fostering external
adjustment.
 Research by Gourinchas and Rey (2022) and Atkeson, Heathcote,
and Perri (2022) sheds light on the role of the United States as a
provider of insurance during the global financial crisis and the
pandemic, which resulted in a transfer of wealth to the rest of the
world. Hale and Juvenal (2023) find that EMEs did not experience
significant losses in their net international investment positions
during the pandemic.
Assessing empirically the extent to which EMEs are better
protected against currency depreciations on their balance sheets
requires examining their net international investment positions and
the direction of valuation effects. Valuation effects can arise from
exchange rate movements of different currency denominations on
the asset and liability sides, as well as by price effects stemming
from divergent performance of stock markets across countries.
De Gregorio and Peña (2023) provide evidence on this issue from
Chile and a sample of 20 EMEs from 1999 to 2021. Figure 18.5
illustrates the evolution of Chile’s net international investment
position (NIIP) and the accumulated current account (also known as
the hypothetical net international investment position—the net
position a country would have in the absence of valuation effects).
The difference between the two reflects movements in the real
exchange rate and the relative stock market performance of Chile
and the United States.
Chile began September 2019, just a month before serious social
unrest, with an NIIP equivalent to approximately –20 percent of
GDP. Between September 2019 and December 2021, its currency
depreciated by 17 percent, the S&P index increased by 60 percent,
and the Chilean stock market declined by 15 percent. Remarkably,
during the same period, the NIIP improved from –20 percent to –5
percent of GDP, and the accumulated current account reached –6
percent of GDP. Consequently, Chile benefited from a favorable
valuation effect of approximately 21 percent of GDP, signifying a
substantial transfer of wealth from the rest of the world to Chile.4
Figure 18.5
Net international investment position, accumulated current account, and
real exchange rate in Chile, December 2012–July 2022

Source: Central Bank of Chile.

This analysis of risk-sharing is extended to a sample of 20 EMEs.

It shows that currency depreciation and weaker domestic stock
market performance relative to the United States have a positive
impact on the NIIP. However, the influence of price effects depends
on the degree of financial openness. The relevant explanatory
variables encompass changes in prices (exchange rates and stock
price) interacted with gross asset and liability positions. Although
original sin is still a problem in some EMEs, particularly smaller ones
(Eichengreen and Tsuda 2023), it diminishes substantially in the
sample of De Gregorio and Peña (2023). These valuation effects
have been statistically significant since 2008, when financial
openness stabilized.
Over the past decades, advancements have been made in
mitigating the pessimistic outlook regarding the impact of exchange
rate depreciation on financial stability. Financial systems have
become more resilient, and widespread mismatches do not appear
to be prevalent. On average, EMEs exhibit short positions in their
domestic currency and benefit from risk-sharing with the rest of the
world. These developments signify progress in enhancing financial
stability within EMEs, offering insights into their improved ability to
cope with external shocks via exchange rate flexibility.
Concluding Remarks
The approach adopted by EMEs toward exchange rate flexibility has
been characterized by pragmatism. Most EMEs intervene in the
foreign exchange market; some do so on a permanent basis to
ensure stability; others intervene only under specific circumstances.
The traditional notion of setting numerical medium-term objectives
for the exchange rate has gradually been discarded. The increased
financial integration experienced by these economies highlights the
limitations of tightly managing the exchange rate, which hampers
the effectiveness of monetary policy. Attempts to resist exchange
rate movements have often resulted in excessive volatility in capital
flows. Actively combating depreciation, for example, often triggers
significant capital outflows, undermining the efforts to prevent such
a depreciation.
There have been only a few cases of large financial or macro
collapses since the early 2000s. Indeed, no group of EMEs has
undergone a crisis such as the debt crisis in Latin America or the
Asian crisis. EMEs weathered both the global financial crisis and the
COVID-19 pandemic. Even in the recent fight with inflation,
monetary policy was tightened in EMEs before it was in advanced
economies.
The evidence overwhelmingly establishes the positive outcomes
associated with adoption of inflation targeting regimes and the
establishment of policy credibility in EMEs. The greater flexibility
embedded in their exchange rate regimes has proven to be a crucial
factor in their overall success.

References
Atkeson, Andrew, Jonathan Heathcote, and Fabrizio Perri. 2022. The End of
Privilege: A Reexamination of the Net Foreign Asset Position of the United
States. NBER Working Paper 29771. Cambridge, MA: National Bureau of
Economic Research.
Borenzstein, Eduardo, and Virginia Queijo von Heideken. 2016. Exchange Rate
Pass-Through in South America: An Overview. IDB Working Paper IDB-WP-710.
Washington: Inter-American Development Bank.
Cabezas, Luis, and Sebastian Edwards. 2022. Exchange Rate Pass-Through,
Monetary Policy, and Real Exchange Rates: Iceland and the 2008 Crisis. Open