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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A country with a persistent current account deficit finances it through short-term portfolio inflows. Which risk is most directly implied for its exchange rate?

A sudden stop of capital inflows could trigger sharp depreciation. A deficit financed by short-term portfolio flows depends on investor confidence, so if the flows reverse the currency comes under pressure or reserves are depleted, which makes reserves more important rather than unnecessary.

  1. AA sudden stop of inflows could trigger sharp depreciationCorrect
  2. BInflows guarantee permanent appreciation
  3. CThe deficit will automatically reverse under a fixed peg
  4. DShort-term inflows eliminate the need for reserves

Explanation

Deficits financed by volatile short-term capital depend on investor confidence. If flows reverse, the currency can fall sharply or reserves be depleted. Inflows do not guarantee appreciation, and reserves become more important, not less.

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