Does Inflation Targeting in Asia Reduce Exchange Rate Volatility?

ABSTRACT

Inflation targeting has become a popular option among many developing economies, including those in Asia. Despite a gradual move towards inflation targeting, many Asian economies remain concerned about exchange rate variability. Motivated by this, this paper is interested in the impact of inflation targeting on real exchange rate volatility in the Asian economies. In particular, using a panel of developing countries that includes many from Asia for the period 2007–2012, the paper explores the impact of inflation targeting on real exchange rate volatility as well as in terms of its two component parts, i.e. relative tradable prices across countries (external prices) and the sectoral prices of tradables and non-tradables within countries (internal prices). The paper also compares the inflation and growth effects of inflation targeting regimes with non-inflation targeters.

KEY WORDS:

• Asia
• foreign exchange intervention
• hard peg
• inflation targeting
• real exchange rate
• volatility

JEL CLASSIFICATION:

• E58
• F33

Acknowledgment

Financial support from the Program for Innovation Research in the Central University of Finance and Economics and comments by participants at the Centre on Asia and Globalisation (CAG) at the Lee Kuan Yew School of Public Policy, National University of Singapore are greatly acknowledged. The usual disclaimer applies.

Notes

1 Sourced from the IMF's Annual Report on Exchange Arrangements and Exchange Restriction. See IMF (2014, p. 14).

2 For discussions of the performance of inflation targeting regimes in these economies, see Inoue, Toyoshima, and Hamori (2012).

3 While the general literature on the impact of exchange rate volatility on growth has found rather small negative effects, there is more recent evidence that suggests that the negative impacts are of particular concern at low levels of financial development (Nicolas & Héricourt, 2010).

4 In response to the concerns about allowing benign neglect of the exchange rate, there has been a literature on how exchange rates might be incorporated explicitly in an inflation targeting framework. This is referred to as the ‘flexible inflation targeting’, which most economies in Asia seem to favour. See Cavoli and Rajan (2006, 2007); Nordstrom et al. (2009); Ostry, Ghosh, and Chamon (2012); and Volz (2015).

5 The seven countries are Australia, Canada, Finland, Spain, Sweden, the UK and New Zealand.

6 Countries are Australia, New Zealand, Korea, Indonesia, Thailand, Philippines, Singapore, China, India, Malaysia, Hong Kong, Japan,

7 In Figure 1, inflation targeting countries include Korea, Indonesia, Philippines and Thailand. Non-inflation targeting countries include Brunei, Cambodia, China, Laos, Myanmar, Singapore (East Asia); Bangladesh, Bhutan, India, Nepal, Pakistan, Sri Lanka (South Asia).

8 The authors studied 19 countries in total: six Asian inflation targeting countries, seven non-Asian inflation targeting countries, six Asian non-inflation targeting countries.

9 There are other slight differences in the dataset. For instance, Gagnon treats the smaller euro area countries as a separate group (six countries).

10 See Rose (2007) and Gagnon (2013). Durability in turn has positive effects on the macro-economy, especially inflation (Mihov & Rose, 2007).

11 Other studies have suggested that, other things being equal, inflation targeting regimes foster greater fiscal discipline (Minea & Tapsoba, 2014) and reduce risk premia (Fouejieu & Roger, 2013).

12 Two related works are worth noting. Gonçalves and Carvalho (2009) consider the reverse causality and find that the volatility of the RER is not a statistically significant determinant of the probability of inflation targeting adoption. Using a quarterly panel of 16 emerging economies for the period 1989–2004, Aizenman, Hutchison, and Noy (2010) find that countries with inflation targeting regimes tend to respond less strongly to RER changes, unless they are exporters of basic commodities.

13 This section draws on Ouyang and Rajan (2015).

14 Three high income Asian countries are also included, i.e. Hong Kong, South Korea and Singapore.

15 Based on these restrictions, India and Pakistan are dropped because they fail the first criteria, while Cyprus, Estonia, Latvia, Macedonia, Slovenia, and Trinidad and Tobago are dropped because they fail the second criteria.

16 Since we only have annual data for exports and imports we apply the same trade weights for the 12 months within a year.

17 For instance, Vredin (2015) and Woodford (2012). Also see Filardo and Genberg (2009) and Volz (2015).

18 See ‘India Adopts Flexible Inflation Targeting’ http://www.business-standard.com/article/economy-policy/india-adopts-flexible-inflation-targeting-115030201251_1.html. Also see the goals of monetary policy from the Reserve Bank of India https://www.rbi.org.in/scripts/FS_Overview.aspx?fn=2752. For early discussion of the possibility of India adopting an inflation targeting framework, see Cavoli and Rajan (2007, 2008).

19 National Bank of Kazakhstan, ‘Joint Statement of the Government of the Republic of Kazakhstan and the National Bank of the Republic of Kazakhstan on transition to a new economic policy: to reforms in the real economy and new monetary policy regime’, 26 August 2015. http://www.nationalbank.kz/?docid=949&switch=english

20 Information is derived from ‘Sri Lanka for Flexible Inflation Targeting’, Economynext, 27 July 2015. http://www.economynext.com/Sri_Lanka_for_flexible_inflation_targeting-3-2472.html. For an earlier examination of the impact and implication of Sri Lanka moving to an inflation targeting-based framework, see Anand, Ding, and Peiris (2011).