Currency mismatches have been at the origin of many banking crises in emerging economies. Nonetheless, their financial systems’ resilience to exchange rate fluctuations toward late 2008 and early 2009 showed that lessons were learned, and effects on banks’ balance-sheets, that would have translated an external recession into a far-reaching financial crisis, were avoided. Of course there were exceptions, particularly in emerging Europe, where fragilities arose precisely because of the rigidity of their exchange rate systems and currency mismatches of their banks. Another reason of the importance of having a well-functioning financial market is the distortions caused by exchange rate volatility on resource allocation. In order to minimize such effects it is prudent to develop an exchange rate hedging market allowing producers in the tradable sector to hedge against exchange rate fluctuations at least at one year’s term. In fact, evidence shows that hedging markets are more developed in economies with more flexible exchange rates, because it is that flexibility that creates incentives for these hedging mechanisms to develop (De Gregorio and Tokman, 2005; Kamil and Sutton, 2008). If, on the contrary, the monetary authority attempts to provide stability, the market will have no incentives to develop hedging instruments. However, a floating exchange rate and an inflation targeting regime may be insufficient for stabilizing large amounts of capital inflows. The appreciation that results from massive capital inflows and a credit boom cycle may require other instruments to stabilize the economy and ensure the smooth functioning of the financial system.

From a historical perspective, capital flows today are currently not so abundant and no imbalances of income and expenditure are seen that might reveal substantial misalignments. After the recessive period of 2009, slack remains in our economies, and tensions in the near future cannot be ruled out. It is therefore advisable to begin exploring the proper policy responses. In such circumstances, the first line of defense must be an active monetary and fiscal management, within a context of exchange rate flexibility and stable inflationary perspectives. This combination proved very favorable to maintain macroeconomic and financial stability in 2008-2009, and has the necessary elements to also succeed in dealing with a potential period of strong capital inflows and appreciating exchange rate pressures. Additional measures, such as a foreign exchange intervention or controls on capital inflows, cannot be a priori ruled out, and will depend on each economy’s specific circumstances and characteristics. However, in implementing them it is essential that they do not become the cause of macroeconomic imbalances by encouraging massive capital inflows. In fact, distortions often do not originate in excessive appetite by foreigners for domestic assets, but in disturbances resulting from the application of inconsistent policies. On the one hand, exceptional measures cannot be used as a substitute for, say, a more austere fiscal policy or a strengthening of prudential regulation and supervision of banking and non-banking entities.