The International Monetary Fund (IMF) has developed a framework to help emerging-market and developing economies determine whether sharp currency movements reflect underlying economic fundamentals or financial shocks that could destabilise markets and deepen economic downturns.
The research, published in an IMF Staff Discussion Note titled Drivers of Exchange Rates in EMDEs: Implications for Foreign Exchange Intervention, examines 15 years of monthly data from 25 emerging-market and developing economies. It focuses on deviations from uncovered interest parity, a measure used to capture currency risk premia and limits to arbitrage in foreign-exchange markets.
The findings suggest that financial shocks account for a relatively modest share of exchange-rate fluctuations but can have significant consequences for economic activity when market frictions amplify the impact of currency movements.
The framework is designed to support the IMF’s Integrated Policy Framework, which helps policymakers assess when foreign-exchange intervention may be appropriate to address disruptions in currency markets.
Financial Shocks Can Intensify Economic Pressure
Applications of the framework to Brazil and Chile found that financial shocks accounted for about one-third of fluctuations in uncovered interest parity premiums. In Chile, the shocks were also associated with approximately half of nominal exchange-rate movements, while explaining less than 10% of variations in output and inflation.
The IMF cautions that these estimates may represent a lower bound because of residual measurement errors and other factors not captured by the model.
Although financial shocks represented only a portion of currency-market movements, their economic effects were more pronounced. In both Brazil and Chile, comparable increases in risk premiums and currency depreciation were followed by short-term declines in output.
The nature of the shock differed between the two countries. Chile experienced an inflationary response, prompting a relatively rapid increase in its policy rate, while Brazil recorded a mildly deflationary response. Chile also experienced wider foreign-exchange bid-ask spreads, an indicator of reduced market liquidity. In Brazil, the strongest reaction appeared in deviations from covered interest parity, pointing to stress in cross-currency funding markets.
Distinguishing Market Disruptions From Fundamentals
The IMF said exchange-rate flexibility generally remains desirable, allowing currencies to adjust to changes in economic conditions. However, financial market frictions can generate destabilising movements even when a country’s economic fundamentals remain relatively sound.
This creates a policy challenge for central banks. Intervening in foreign-exchange markets in response to every sharp depreciation could undermine necessary economic adjustment, while failing to respond to market dysfunction could allow financial stress to spread into the broader economy.
The IMF’s toolkit combines macroeconomic and financial data, model-based sign restrictions and narrative evidence to identify whether exchange-rate movements are primarily driven by fundamental or financial shocks.
The research found that most exchange-rate movements in Brazil and Chile were not attributed to financial shocks and therefore may not require policy intervention. However, episodes involving financial frictions were linked to notable declines in economic activity, indicating that the source of currency pressure matters for policy decisions.
Real-Time Monitoring Could Support Policy Responses
The framework also includes a real-time monitoring component that combines historical macrofinancial information with high-frequency indicators. These include nominal exchange rates, foreign-exchange bid-ask spreads, covered interest parity deviations, funding-market indicators, capital flows, reserve-market behaviour and narrative evidence.
The IMF tested the approach using episodes in Chile. In June 2022, the estimated probability of a positive financial shock initially stood at 0.5 before falling to 0.34 during the first week. As the currency depreciated and bid-ask spreads widened, the probability rose to 0.83, 0.86 and 0.96 over the following weeks.
By contrast, during May 2023, the probability remained close to 0.5, fluctuating between 0.43 and 0.50. The episode was used as a placebo check during a relatively quiet period, illustrating how the toolkit could help distinguish periods of heightened financial stress from ordinary market movements.
The IMF emphasised that conflicting indicators should reduce policymakers’ confidence in a diagnosis rather than trigger an automatic policy response. The framework is intended to inform judgement, not replace it.
Intervention Still Requires Broader Assessment
Evidence of a financial shock may indicate a potential case for foreign-exchange intervention under the IMF’s Integrated Policy Framework. However, the research states that such evidence is neither necessary nor sufficient to justify intervention.
Policymakers must also consider the adequacy of foreign-exchange reserves, the likely effectiveness of intervention, the persistence of the shock and consistency with other economic policies. The potential costs of sterilisation, balance-sheet exposure, market signalling and delaying necessary currency adjustment must also be assessed.
The IMF maintains that exchange-rate flexibility remains an important policy mechanism, even when financial disruptions create pressure for authorities to act.
The study is presented as a proof of concept based on Brazil and Chile. Extending the framework to economies with less-developed foreign-exchange markets and weaker data systems will require further research.
