30 September 2021

Essays in Exchange Rate Regimes

In this interview, Shekhar Hari Kumar speaks about the chapters composing his PhD thesis, three of which analyse aspects of exchange rate arrangements while the fourth focuses on the importance of US dollar and euro funding markets and spillovers from them to emerging markets.

What aroused your interest in macroeconomics and exchange rates?

My interest was sparked in the aftermath of the global financial crisis of 2008 when I was a master’s student in India. Emerging market (EM) economies were affected by the global financial crisis in spite of them being relatively insulated from financial globalisation. This prompted a serious discussion on how EMs manage their policy mix of exchange rate regime, capital account liberalisation and monetary policy (trilemma configuration) given unanticipated spillovers from advanced economy financial markets. This debate centred around two questions: the hegemony of the US dollar as a global reserve currency and the optimal policy mix EMs could adopt to limit adverse spillovers. At the same time, Chinese policymakers started promoting the renminbi as an alternate reserve currency to the dollar. The “taper tantrum” in May 2013 and the renminbi devaluation episode in August 2015 were two other global events that reinforced my decision to explore the dynamics of exchange rate regime choice.

Can you describe the research questions that run through the four papers of your thesis and the methodology you use to approach those questions?

Across the four papers, I study how countries peg their own currencies to global reserve currencies along with the factors that might influence that policy choice. My secondary focus is on how the choice of an exchange rate regime shapes both exposure and policy response to financial spillovers from advanced economies. Structural break econometrics forms the backbone of my thesis. Across my empirical research, I make technical contributions on how to detect and date structural breaks in the exchange rate basket of currencies. I also develop a new factor model for EM exchange rates that accounts for common deviations from their pre-existing basket composition. In my theoretical research, I study the dynamics of exchange rates in target zones like the Exchange Rate Mechanism-II (ERM-II) used by eurozone periphery countries to join the euro. The innovation here is to explicitly model the presence of time-varying investor sentiment in determining the behaviour of the exchange rate and consequently central bank policy response to maintain the target zone.

What are your major findings?

My job market paper, “Who Cares about the Renminbi?”, coauthored with Vimal Balasubramaniam, Ila Patnaik and Ajay Shah, studies the role of the renminbi as a global reserve currency. We find that over 70 currencies show a significant co-movement with the renminbi, which can be seen as a precursor to adopting it as a reserve currency. However, these co-movements are on average short-lived and asymmetric (greater when the renminbi depreciates). Moreover, the share of the renminbi in the explained variation of a currency is less than 2% on average. The co-movements with the renminbi are strongest for commodity exporting countries in Africa and Asia-Pacific. We additionally find that the strength of the co-movement versus the renminbi is explained by export linkages, political affinity and Belt and Road ties with China. These findings imply that the dollar and the euro remain the dominant global anchor currencies, with the renminbi not being used as a nominal anchor by any country as of yet. The trajectory of the renminbi as a reserve asset would depend critically on future Chinese financial account liberalisation. 

My second chapter, “A Fistful of dollarsDollars: Transmission of Global Funding Shocks to EMs”, coauthored with Aakriti Mathur, shows that local money market rates in EMs are a good measure of international monetary transmission. We find that international monetary spillovers to EMs depends on domestic wholesale funding reliance and share of foreign banks, but can be dampened with the use of reserve requirements. These findings have two main implications. First, they provide additional evidence on the international banking channel of monetary policy. Second, they show that domestic macro-prudential tools can provide some relief to EM central banks when faced with a global liquidity shock.

The third chapter, “Can One Hear the Shape of a Target Zone?”, co-authored with Jean-Louis Arcand, Max-Olivier Hongler and Daniele Rinaldo, studies the dynamics of an exchange rate in a target zone like ERM-II under conditions of global risk aversion shocks. We show that the feasibility of the target zone and the type of intervention used by the central bank is affected by the level of global risk, the size of the target zone band and the terminal time chosen to exit the target zone to a new currency. For a particular (target) band size and exposure to global risk we are able to analytically find the minimum time an exchange rate needs to spend in a target zone before exiting to a new currency. This work has major implications for modern day target zones like the ERM-II or ECOWAS. We argue that enhanced risk-sharing between the local central bank and the target currency central bank by using swap lines, as seen during the Covid-19 pandemic, may also be useful in smoothing shocks arising from the global financial cycle while maintaining a target zone.

In my final chapter, titled “Survival of the Fittest? Idiosyncratic Emerging Market Exchange Rate Movements during Risk-off Episodes”, I evaluate whether emerging markets with relatively “worse” fundamentals suffered a higher exchange rate depreciation for five EM stress periods between 2008 and 2018. My key innovation is to measure the residual change in the EM exchange rate calculated using a factor-augmented currency basket model instead of using unconditional returns versus the US dollar as my outcome variable. Using my preferred measure of exchange rate change, I find differentiation on the basis of relative fundamentals for the Federal Reserve tightening-related stress episodes in my sample, but not for the other episodes. For Federal Reserve tightening episodes, EMs with worse fundamentals suffer a greater idiosyncratic depreciation. These results suggest a unique role for US monetary policy stance in mediating global risk appetite and generating investor differentiation within EMs on the basis of their fundamentals. This explains the current pre-emptive tightening of monetary policies in EMs as they expect the Federal Reserve to tighten monetary policy in light of a stronger than expected recovery in the US. 

What do you plan to do in your post-PhD life?

I will be joining Exante Data as a strategist with a view to acquiring some international markets experience before considering a career in academia or policy institutions.  

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Shekhar Hari Kumar defended his PhD thesis in International Economics in June 2021. Professor Cédric Tille presided over the committee, which included Professor Ugo Panizza, thesis supervisor, and Professor Joshua Aizenman, Faculty of Economics and International Relations, University of Southern California, USA.
His PhD essays are available on his website.

Full citation of the PhD thesis:
Hari Kumar, Shekhar. “Essays in Exchange Rate Regimes.” PhD thesis, Graduate Institute of International and Development Studies, Geneva, 2021.

Banner picture: excerpt from an image by William Potter/
Interview by Nathalie Tanner, Research Office.