Foreign Exchange Intervention, Capital Flows, and Liability Dollarization

This paper investigates the importance of foreign exchange intervention in dealing with shocks to global capital flows in emerging economies. We show in a VAR analysis that a shock to global capital flows has a sizable effect on economic activity, and this effect is amplified in emerging economies with liability dollarization. However, countries that systematically rely on sterilized foreign exchange intervention in response to movements in global capital flows, display lower output and real exchange rate volatility. Motivated by the empirical evidence, we develop a small open economy model with liability dollarization and balance sheets effects calibrated to an emerging economy. Our quantitative results show that liability dollarization amplifies the effects of fluctuations in capital flows and that foreign exchange intervention can reduce macroeconomic volatility and improve welfare. These results point to the importance of foreign exchange reserves in insulating emerging economies from the global financial cycle.