While there are certainly grounds for limiting exchange rate fluctuations to prevent temporary misalignments, targeting exchange rates is likely to be counterproductive in the long-run. Doing so requires policymakers to choose a level of the exchange rate to stabilize around. This can be very difficult to implement in practice, not least because the target would change over time as fundamentals evolve. Importantly, there is little that monetary policy can do to influence real exchange rates in the long run. Past attempts to give the exchange rate more weight in monetary policy decisions tended to generate more interest rate volatility, with little lasting effect on the real exchange rate. Here, I should note that emerging markets are generally better placed than in past cycles to withstand capital flow volatility. Key areas where progress has been made include: more flexible exchange rates, clearer monetary policy frameworks, larger foreign reserve cushions, generally moderate external debt levels, improved fiscal discipline, and better capitalized banking systems, supported by stronger supervisory and regulatory frameworks. Moreover, the general shift away from debt-based finance towards equity and foreign direct investment, which together now account for two-thirds of emerging market financing, is significant from a stability perspective. Nevertheless, I want to stress that there is an enormous amount of heterogeneity among emerging market economies. The underlying strengths and weaknesses in terms of institutions and economic capabilities of Thailand and Brazil, for example, are very different. The destinies of emerging markets are not tightly bounded to each other like General Cao Cao’s battleships.

The need and benefits of living on reclaimed land have been accepted and the focus is on strengthening the infrastructure to sustain this. Similarly, financial integration is a choice. Countries decide to become financially integrated because the perceived benefits of doing so outweigh the costs. Moving forward sustainably requires going beyond coping with capital flows to living with them. This involves developing and leveraging on fundamental economic strengths to enhance countries’ resilience to external shocks. A diversified export base focused on high value-added products and services translates into higher margins and pricing power, and hence less sensitivity to swings in the exchange rate. At the same time, developing a firm domestic consumer base will solidify economies’ internal strength and lessen the dependence on external demand. Much can also be done on the financial side. Deep and liquid markets would help to absorb swings in capital flows without overly large price movements. The availability and widespread usage of risk management instruments, particularly foreign currency hedging, would mitigate the negative repercussions from asset price volatility. Outward capital flows by domestic investors can enhance stability as international asset holdings can provide an important buffer during periods of volatility. Last, but not least, limiting leverage in the banking system can go a long way in cushioning the economy from external shocks. In most cases, exchange rate flexibility will be an indispensible part of living with capital flows.