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

TL;DR

This paper investigates how capital flow volatility impacts exchange rate stability worldwide and identifies macroeconomic fundamentals that can mitigate this effect, proposing a new FX resilience measure.

Contribution

It introduces a novel FX resilience measure and analyzes how macroeconomic fundamentals moderate the impact of capital flow volatility on exchange rates.

Findings

Capital flow volatility worsens FX volatility regardless of controls.

Certain macroeconomic fundamentals significantly reduce this adverse effect.

A threshold effect exists where fundamentals can neutralize the impact.

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.