Money, Banking and the Foreign Exchange Market in Emerging Economies
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Money, Banking and the Foreign Exchange Market in Emerging Economies

Tarron Khemraj

Despite the financial liberalization agenda of the mid-1980s, a system of bank oligopolies has developed in both large and small, open developing economies. Mainstream monetary theory tends to assume a capital markets structure and is therefore not well suited to an analysis of these economies. This book outlines a unique theoretical framework that can be used to examine monetary and exchange rate policies in developing economies or other economies in which banks dominate external finance.
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Chapter 7: Concluding remarks

Tarron Khemraj


The global financial system requires that the central bank hold foreign exchange worth a certain number of months of import cover. It does not matter the nature of the foreign exchange rate regime. This import cover is necessary if the economy is to credibly pay its bills internationally. The central bank buys foreign currencies in the domestic foreign exchange market because it has to pay for the currencies with the money it has the capacity to print and supply. Therefore the long-term growth of foreign currency reserves implies a long-term level of excess non-remunerated reserves will be held in the domestic banking system. The implication here is excessive bank liquidity has more to do with the structure than risks or volatility, which often clusters while excess liquidity stays persistently high, owing to the liquidity preference of banks. As the central bank accumulates foreign exchange reserves, the stock available to commercial banks is diminished. This is the foreign currency constraint in a financial context. The constraint is reflected in a mismatch between the desire of commercial banks to hoard foreign currency assets and the available supply of foreign exchange in the same time period. Therefore to prevent the banks from pressuring the exchange rate downward, the central bank has to institute a compensation mechanism, which involves the sale of interest bearing Treasury bills (or some other government paper) to ‘mop up’ the excess reserves.

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