Interesting article from the IMF on exchange rates......
Fixed or Flexible?
Getting the Exchange Rate Right
Economic Issues No. 13 -- Fixed or Flexible?--Getting the Exchange Rate Right in the 1990s
Adjusting to Capital Inflows
"In many fast-growing emerging market economies, upward pressure on the exchange rate in recent years has stemmed largely from vastly increased private capital inflows.
When capital inflows accelerate, if the exchange rate is prevented from rising, inflationary pressures build up and the real exchange rate will appreciate through higher domestic inflation. To avoid such consequences, central banks have usually attempted to "sterilize" the inflows–by using offsetting open market operations to try and "mop up" the inflowing liquidity.
Such operations tend to work at best only in the short term for several reasons. First, sterilization prevents domestic interest rates from falling in response to the inflows and, hence, typically results in the attraction of even greater capital inflows. Second, given the relatively small size of the domestic financial market compared with international capital flows, sterilization tends to become less effective over time. Finally, fiscal losses from intervention, arising from the differential between the interest earned on foreign reserves and that paid on debt denominated in domestic currency, will mount, so sterilization has a cost.
As capital inflows increase, tension will likely develop between the authorities’ desire, on the one hand, to contain inflation and, on the other, to maintain a stable (and competitive) exchange rate. As signs of overheating appear, and investors become increasingly aware of the tension between the two policy goals, a turnaround in market sentiment may occur, triggering a sudden reversal in capital flows.
Since open market operations have only a limited impact in offsetting the monetary consequences of large capital inflows, many countries have adopted a variety of supplementary measures. In some countries the authorities have raised the amount of reserves that banks are required to maintain against deposits. In others, public sector deposits have been shifted from commercial banks into the central bank–to reduce banks’ reserves. A number of countries have used prudential regulations, such as placing limits on the banking sector’s foreign exchange currency exposure. Some central banks have used forward exchange swaps to create offsetting capital outflows–although there appear to be limits on how long such a policy can be used, given the likelihood, as with open market operations, that it can cause fiscal losses. In other cases the authorities have responded by widening the exchange rate bands for their currencies, thus allowing some appreciation. And a few have introduced selective capital controls.
While such instruments and policies can for a time relieve some upward pressure on a currency and ease inflationary pressure, none appears to have been able to prevent an appreciation of the real exchange rate completely.
Can exchange rate flexibility help manage the impact of volatile capital flows? As mentioned earlier, if interest rates and monetary policy are "locked in" by an exchange rate anchor, the burden of adjustment falls largely on fiscal policy–that is, government spending and tax policies. But often taxes cannot be raised or spending reduced in short order, nor can needed infrastructure investments be postponed indefinitely. (Clearly, policymakers who cannot adjust fiscal policy in the short run should not adopt a rigidly fixed exchange rate regime.)
Allowing the exchange rate to appreciate gradually to accommodate upward pressures would appear to be a safer way of maintaining long-run economic stability. Furthermore, by allowing the exchange rate to adjust in response to capital inflows, policymakers can influence market expectations. In particular, policymakers can make market participants more aware that they face a "two-way" bet–exchange rate appreciations can be followed by depreciations. This heightened awareness of exchange rate risks should discourage some of the more speculative short-term capital flows, thereby reducing the need for sharp corrections."