Answer:
The role of the exchange rate in financial crises has been well emphasised in the
literature.3 Past EM crises were typically preceded by large currency mismatches and
overvalued exchange rates, underlining the critical importance of the exchange rate
in the private sector’s decision to borrow in foreign currency. Another aspect of the
exchange rate regime is its interaction with financial development: while a flexible
exchange rate helps the development of hedging and local currency debt markets,
the degree of market development also influences the choice of exchange rate
flexibility.
Explanation: The Deputy Governors broadly agreed that increased exchange rate flexibility
can help to reduce currency mismatches, particularly the extent of foreign currency
borrowing. It was suggested that wrong incentives can be created by too stable an
exchange rate and, in some cases, by FX intervention. Claro and Soto in this volume
provide two main reasons for this observation: first, intervention to restrict
exchange rate flexibility can give a false sense of security for the private sector
regarding financial risks. Second, lower exchange rate volatility leads to higher
speculation about the future value of the currency, encouraging investors to exploit
the interest rate differential more aggressively (the so called “carry trade”). Both
factors create risks for the financial system.
