Are the ‘Swing Consumers’ in Emerging Market Currencies the Cause of Crisis?

The most significant development in currency markets over the last 15 years has been the enormous accumulation of foreign reserves by emerging market economies. The Central Banks of China, India, Malaysia, Korea, Taiwan, Indonesia, the Middle East, Brazil and others have elected to stand in the market and purchase foreign currency in the face of significant capital inflows. Central Banks in the emerging markets have become the “swing consumer” of foreign exchange.

The recent sell-off in the emerging currencies has highlighted an important weakness in this policy. While the Central Banks have been content to buy foreign currency in the open market, they are evidently reluctant to sell back the same foreign currency when capital flows reverse. India, currently in the midst of a vicious speculative attack on the Rupee, has elected to protect their USD 275B of reserves by keeping them firmly under lock and key.

The reluctance to adopt a “swing producer” of foreign exchange policy to support capital outflow while acting as “swing consumer” during periods of capital inflow, is creating a structural imbalance in the foreign exchange market. Historically, Central Banks have tried and failed to successfully intervene in FX markets during periods of speculative attack. Intervention failed primarily because the Central Bank had insufficient reserves to withstand an onslaught of sellers. In the current environment, however, reserve holdings in some cases exceed the supply of local currency in circulation. This means that the balance of power rests with the Central Bank in the face of a speculative sell-off in the local currency.

There is a distinction, therefore, between currency intervention on the one hand (which is likely to fail) and acting as the swing producer in the event of short-term capital repatriation on the other hand. Refusing to fund demand for foreign currency out of existing reserves runs the risk of exacerbating the decline in the value of the domestic currency and precipitating a currency crisis. This may well be the case in India and Indonesia at the present time.