Reserve option mechanism as a stabilizing policy tool: Evidence from exchange rate expectations

During the recent era, many emerging market economies have implemented unconventional policy measures to mitigate the effect of large swings in short-term capital flows on domestic business cycles. This paper focuses on a novel capital flow management tool, the reserve option mechanism (ROM) introduced by the Central Bank of Turkey, that allows banks to hold a certain fraction of their domestic-currency required reserves in foreign currency. The results suggest that, after the introduction the ROM (i) market expectations leaned towards a significantly lower volatility or skewness in the U.S. dollar/Turkish lira (USD/TL) relative to other emerging market exchange rates; (ii) controlling for a set of domestic and common external factors, the USD/TL expectations have exhibited lower levels of volatility, skewness and kurtosis; (iii) the higher the intensity of ROM (the fraction of ROM-based reserves in total international reserves) the stronger the effect of ROM on exchange rate expectations. Last, we provide evidence that the mechanism acts as an automatic stabilizer of expectations about excessive movements in the exchange rate; the mechanism decreases the sensitivity of expected USD/TL kurtosis to the common external factor (by an estimated decrease of about 85%). In sum, the results provide evidence that the mechanism contains market expectations about excessive fluctuations in the exchange rate, decreasing expected likelihood of an abrupt reversal of capital flows. (C) 2014 Elsevier Inc. All rights reserved.