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David F. DeRosa DeRosa Research and Trading, Inc. Central Banking and Monetary Policy in Emerging- Markets Nations Statement of Purpose The Research Foundation of CFA Institute is a not-for-profit organization established to promote the development and dissemination of relevant research for investment practitioners worldwide. Neither the Research Foundation, CFA Institute, nor the publication’s editorial staff is responsible for facts and opinions presented in this publication. This publication reflects the views of the author(s) and does not represent the official views of the Research Foundation or CFA Institute. The Research Foundation of CFA Institute and the Research Foundation logo are trademarks owned by The Research Foundation of CFA Institute. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for the Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. ©2009 The Research Foundation of CFA Institute All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. ISBN 978-1-934667-23-1 19 March 2009 Editorial Staff Maryann Dupes Book Editor Cathy Gentry Cindy Maisannes Assistant Editor Publishing Technology Specialist Lois Carrier Production Specialist Biography David DeRosa is the president and founder of DeRosa Research and Trading, Inc., a firm that does consulting and research on international capital markets. Previously, he worked at a variety of New York financial institutions in the capacity of portfolio manager, foreign exchange trader, and hedge fund manager. Dr. DeRosa is on the boards of several major hedge fund groups. He has taught graduate level courses in international capital markets, derivatives, and corporate finance at the Yale School of Management (since 1996). He has also taught at the University of Chicago and Columbia University. He received his PhD in finance and economics from the Graduate School of Business of the University of Chicago and his AB in economics from the College of the University of Chicago. Contents Foreword . v Preface . viii Chapter 1. Emerging Markets and Their Central Banks . 1 Chapter 2. Money Basics. 15 Chapter 3. Emerging Markets as Open Economies . 39 Chapter 4. Foreign Exchange . 57 Chapter 5. Foreign Exchange Regimes . 68 Chapter 6. The Paradox of International Capital . 97 Chapter 7. Intervention, Sterilization, and Capital Controls. 123 Chapter 8. The Minimalist Emerging-Markets Central Bank . 149 Appendix A. IMF Definitions of Country Groups in the World Economic Outlook Database. 151 References . 154 CONTINUING EDUCATION This publication qualifies for 5 CE credits under the guidelines of the CFA Institute Continuing Education Program. Foreword “If you don’t believe in central banking, you should move to the moon,” joked one of my professors, the distinguished University of Chicago economist Robert Aliber, 30 years ago. As a student, I had come under the influence of radical free-marketers who thought that the market, not the government, should determine what money is. If the market thought that cowrie shells were money, then they were money, likewise with bank notes, gold coins, or anything else that people agreed to accept as a medium of exchange and store of value. And I had challenged Professor Aliber to explain why, in his view, governments, rather than private individuals, should make this determination. He did so, of course, with the panache and wit for which he was then, and still is, well known. In the present volume, one of Aliber’s students, David DeRosa, who received his PhD from the University of Chicago and is now an adjunct professor at the Yale School of Management as well as the proprietor of a firm that does research on currencies and global financial markets, builds exuberantly on this theme. Although all countries need sound central banking and an effective monetary policy, DeRosa sensibly argues that it is in emerging-markets nations that this problem is most sharply brought into focus. Emerging-markets nations have suffered the most from periodic financial crises, hyperinflations, and sharp currency devaluations and thus need the most help. But recent events have shown that developed countries are not immune to these diseases. DeRosa defines emerging markets as countries that are less productive economically than developed countries but that are nonetheless on the path to significant and sustainable growth. They are also “investable,” meaning they have open capital markets to a greater or lesser extent. He argues that, to achieve their economic ambitions, they need to learn how to properly operate a central bank. This book is DeRosa’s primer on central banks and monetary policy, with special emphasis on the emerging-markets nations. The book begins with a review of monetary theory and modern monetary policy regimes, including inflation targeting and the Taylor rule. Next, DeRosa describes emerging markets as natural “open” economies, ones upon which trade and capital flows have a profound influence. Here, he introduces Robert Mundell’s concepts of perfect capital mobility and the much heralded impossible trinity theorem. He then turns to a practical description of the workings of the foreign exchange market and its odd practices and terminology. (Having worked as a bank foreign exchange trader, DeRosa knows this market closely.) ©2009 The Research Foundation of CFA Institute v Central Banking and Monetary Policy in Emerging-Markets Nations The core of the book addresses the interdependence of foreign exchange regimes and monetary policy. These topics occupy three successive chapters. The first in this group describes foreign exchange regimes and the many expedients—managed floats, crawling pegs, target zones, and so forth—used by countries to avoid the perceived disadvantages of either freely floating or completely fixed exchange rates; DeRosa notes that these expedients have mostly disappeared. Arguably, the most innovative chapter is the one titled “The Paradox of International Capital.” Interna- tional flows of capital are of constant concern to central banks. Some economists regard capital flows as an essential ingredient for economic development, whereas others regard them as dangerous nuisances. Using his neoclassical framework to analyze capital flows, DeRosa argues that they are economically motivated and as such are neither capricious nor undesirable. Furthermore, he believes that concerns about the danger of global imbalances are exaggerated. The subsequent chapter is a review of the fundamental central banking functions, including topics of foreign exchange intervention, sterilization, and capital controls. DeRosa concludes with a policy recommendation, namely, that emerging- markets nations seek a “minimalist” central bank: They should not be afraid of floating exchange rates, and they should be circumspect in their monetary policy initiatives. One way to conduct monetary policy is to use inflation targeting; another is to apply the Taylor rule. As for exchange rates, DeRosa argues that they are prices and, like other prices, should not be fettered without serious thought to the potential consequences. Although this is primarily a book about the economics of central banking, DeRosa has embedded his neoclassical conviction that markets generally “work”—that is, they arrive at close to optimal outcomes. And when markets appear not to work, the solution is not necessarily to regulate or impede markets but, instead, to ask what factors caused a given market to fail and to mitigate those factors. An inquiry into optimal central banking and monetary arrangements is poignantly timely. Since DeRosa finished writing this book, a financial crisis of almost unprecedented proportions has threatened to send the world into recession or depression. In response, the United States has, for the first time in its history, adopted what amounts to a zero interest rate monetary policy in an attempt to increase the availability of credit, motivate investors to take risk, and stimulate the real economy. Its central bank, the Federal Reserve System, has also radically expanded its balance sheet by buying—with “good funds,” that is, federal funds that are acceptable to everyone—privately held assets of questionable value. In conver- sations since the book was written, DeRosa has said he believes that preventing a domino-style collapse of the banking system was a highly desirable measure. But he thinks that is as far as the initiative should go. He questions whether massive, taxpayer-funded bailouts of economically distressed industries make sense. vi ©2009 The Research Foundation of CFA Institute Foreword Although the parallels between emerging-market and rich-country financial crises are not exact, this book will stimulate the reader to think about why the central bank’s actions in the United States and other developed countries were undertaken and

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