Transcript Exchange Rates and Competitiveness

Thorvaldur Gylfason
IMF Institute/Center for Excellence in Finance, Slovenia
Course on Macroeconomic Management and Financial Sector Issues
Ljubljana, Slovenia
September 21–29, 2011
1. Real exchange rates versus
nominal exchange rates
2. Exchange rate policy and welfare
3. Capital flows
4. Exchange rate regimes
 To float or not to float
5. Why we have fewer currencies
than countries
eP
Q
P*
Increase in Q
means real
appreciation
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
eP
Q
P*
Q = real exchange rate
e = nominal exchange rate
P = price level at home
P* = price level abroad
1. Suppose e falls
eP
Q
P*
Then more rubles per dollar,
so X rises, Z falls
2. Suppose P falls
Then X rises, Z falls
3. Suppose P* rises
Then X rises, Z falls
Capture all three by supposing Q falls
Then X rises, Z falls
Remember:
eP
Q
P*
Devaluation needs to be
accompanied by fiscal and
monetary restraint to prevent
prices from rising and thus eating
up the benefits of devaluation
To work, nominal devaluation must
result in real devaluation
Real exchange rate
Imports
Exports
Foreign exchange
Equilibrium between demand and
supply in foreign exchange
market establishes
Equilibrium real exchange rate
Equilibrium in balance of payments
BOP = X + Fx – Z – Fz
=X–Z+F
= current account + capital account = 0
Real exchange rate
R
Deficit
Imports
Overvaluation
Exports
Foreign exchange
Price of foreign exchange
Overvaluation works
like a price ceiling
Supply (exports)
Overvaluation
Deficit
Demand (imports)
Foreign exchange
Price
A
B
C
Consumer
surplus
E
Producer
surplus
Supply
Total welfare gain associated
with market equilibrium equals
producer surplus (= ABE) plus
consumer surplus (= BCE)
Demand
Quantity
Consumer surplus = AFGH
Price
A
J
Welfare
loss
F
B
H
C
E
G
Producer surplus = CGH
Total surplus = AFGC
Supply
Price ceiling imposes a
welfare loss equivalent
to the triangle EFG
Price ceiling
Demand
Quantity
Price
A
J
Welfare
loss
F
B
H
C
Price ceiling imposes a
welfare loss that results
from shortage (e.g., deficit)
E
G
Shortage
Supply
Price ceiling
K
Demand
Quantity
 Appreciation
of currency in real terms,
either through inflation or nominal
appreciation, leads to a loss of export
competitiveness
 In 1960s, Netherlands discovered natural
resources (gas deposits)


Currency appreciated
Exports of manufactures and services suffered,
but not for long
 Not
unlike natural resource discoveries, aid
inflows could trigger the Dutch disease in
receiving countries
Real exchange rate
C
B
A
Imports
Exports with oil
Exports without oil
Foreign exchange
Real exchange rate
C
B
A
Imports
Exports with aid
Exports without aid
Foreign exchange
Governments may try to keep the
national currency overvalued
To keep foreign exchange cheap
To have power to ration scarce
foreign exchange
To make GNP look larger than it is
Other examples of price ceilings
Negative real interest rates
Rent controls in cities
Inflation can result in an
overvaluation of the national
currency
Remember: Q = eP/P*
Suppose e adjusts to P with a lag
Then Q is directly proportional to
inflation
Numerical example
Real exchange rate
Suppose inflation is
10 percent per year
110
105
100
Average
Time
Real exchange rate
Suppose inflation rises
to 20 percent per year
120
110
Average
100
Time
Under floating
Depreciation is automatic: e moves
But depreciation may take time
Under a fixed exchange rate regime
Devaluation will lower e and thereby
also Q – provided inflation is kept
under control
Does devaluation improve the current
account?
The Marshall-Lerner condition
B = eX – Z
= eX(e) – Z(e)
Valuation
effect
arises
from the
ability to
affect
foreign
prices
Not clear that a lower e helps B because
decrease in e lowers eX if X stays put
Let’s do the arithmetic
Bottom line is:
Devaluation strengthens current
account as long as
a  b 1
-
+
B  eX  Z B  eX (e)  Z (e)
dB
 dX  dZ
 X  e

de
 de  de
-a
dB
 dX
 X  e
de
 de
b
 e  X   dZ   e  Z 
    
   
 X  e   de   Z  e 
1
1
-a
b
dB
 dX  e  X   dZ   e  Z 
 X  e
    
   
de
 de  X  e   de   Z  e 
dB
 X  aX  bX  1  a  b X
de
dB
0
de
if
a  b 1
X
Econometric studies indicate that
the Marshall-Lerner condition is
almost invariably satisfied
Industrial countries: a = 1, b = 1
Developing countries: a = 1, b = 1.5
Hence,
a  b 1
Argentina
Brazil
India
Kenya
Korea
Morocco
Pakistan
Philippines
Turkey
Average
Elasticity of Elasticity of
exports
imports
0.6
0.9
0.4
1.7
0.5
2.2
1.0
0.8
2.5
0.8
0.7
1.0
1.8
0.8
0.9
2.7
1.4
2.7
1.1
1.5
Small countries are price takers abroad
 Devaluation has no effect on the foreign
currency price of exports and imports
So, the valuation effect does not arise
Devaluation will, at worst, if exports and
imports are insensitive to exchange
rates (a = b = 0), leave the current
account unchanged
Hence, if a > 0 or b > 0, devaluation
strengthens the current account
For an emerging country with …
Initial trade balance
Export-to-GDP ratio of 40%
… nominal depreciation by 10%
permanently improves trade balance
by 1½% to 2% of GDP in medium term
Effect depends on class of exporter
Oil, non-oil, manufactures
Most of the effect is through imports
and is felt within 3 to 5 years
Capital mobility
A stylized view of capital mobility 1860-2000
First era of
international
financial
integration
Return toward
financial
integration
Capital
controls
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
Real interest rate
Emerging countries
save a little
Saving
Investment
Loanable funds
Real interest rate
Industrial countries
save a lot
Saving
Investment
Loanable funds
Emerging countries
Industrial countries
Saving
Borrowing
Investment
Loanable funds
Real interest rate
Real interest rate
Financial globalization encourages investment in
emerging countries and saving in industrial countries
Lending
Saving
Investment
Loanable funds
3
3
2
1
1
0
-1
-1
-2
Direct investment, net (left axis)
Other private, net (left axis)
Official capital flows, net (left axis)
Direct investment/GDP (right axis)
Other private/GDP (right axis)
Official capital/GDP (right axis)
09
20
08
07
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
99
20
98
19
97
19
96
19
19
95
19
94
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
Source: IMF WEO
19
19
19
19
81
-2
In Percent of GDP (%)
2
80
Billions of USD ($)
700
650
600
550
500
450
400
350
300
250
200
150
100
50
0
-50
-100
-150
-200
-250
-300
-350
-400
External
factors “pushed” capital
from industrial countries to LDCs
Cyclical conditions in industrial
countries
Recessions in the early 1990s
Decline in world interest rates
Structural
changes in industrial
countries
Financial structure developments
Demographic changes
Internal
factors “pulled” capital
into LDCs from industrial countries
Macroeconomic fundamentals
Reduction in barriers to capital
flows
Private risk-return characteristics
Creditworthiness
Productivity
Improved
 Allows
allocation of global savings
capital to seek highest returns
Greater
efficiency of investment
More rapid economic growth
Reduced macroeconomic volatility
through risk diversification (which
dampens business cycles)
 Income smoothing
 Consumption smoothing
 Open
capital accounts may make receiving
countries vulnerable to foreign shocks
 Magnify domestic shocks and lead to contagion
 Limit effectiveness of domestic macro policy
instruments
 Countries
with open capital accounts are
vulnerable to
 Shifts in market sentiment
 Reversals of capital inflows
 May
lead to macroeconomic crisis
 Sudden reserve loss, exchange rate pressure
 Excessive BOP and macro adjustment
 Financial crisis
 Overheating


of the economy
Excessive expansion of aggregate demand with
inflationary pressures, real exchange rate
appreciation, widening current account deficit
Increase in consumption and investment
relative to GDP
 Quality of investment suffers
 Construction booms
Monetary consequences of capital inflows
and accumulation of foreign exchange
reserves depend crucially on exchange
regime
Real stock prices during inflow periods,
6
0
0
selected countries
Chile 1978-81
1
,
6
0
0
1
,
4
0
0
5
0
0
1
,
2
0
0
Mexico
4
0
0
1
,
0
0
0
Venezuela
Chile 1989-94
8
0
0
3
0
0
6
0
0
2
0
0
4
0
0
Sweden
Finland
2
0
0
1
0
0
0
0
3 2 1 0
1
2
3
4
5
6
2
0
0
7
Year with respect to start of Inflow period
Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the
1980s and 1990s and for Venezuela is shown on the right.
Source: World Bank (1997)
 Large
deficits
 Current account deficits
 Government budget deficits
 Poor
bank regulation
 Government guarantees (implicit or explicit),
moral hazard
Stock and composition of foreign debt
 Ratio of short-term liabilities to foreign reserves
 Mismatches
 Maturity mismatches (borrowing short, lending
long)
 Currency mismatches (borrowing in foreign
currency, lending in domestic currency)
Mexico,
Korea,
Mexico,
Thailand,
Venezuela,
Turkey,
Venezuela,
Argentina,
Malaysia,
Indonesia,
Argentina,
'93-95
'96-97
'81-83
'96-97
'87-90
'93-94
'92-94
'88-89
'86-89
'84-85
'82-83
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
10% of GDP
5% of GDP
4% of GDP
0
10
20
30
40
Billion dollars
Source: Finance and Development, September 1999.
50
60
 External
or financial crisis followed capital
account liberalization
 E.g., Mexico, Sweden, Turkey, Korea, Paraguay
 Response
 Rekindled support for capital controls
 Focus on sequencing of reforms
 Sequencing
makes a difference
 Strengthen financial sector and prudential
framework before removing capital account
restrictions
 Remove restrictions on FDI inflows early
 Liberalize outflows after macroeconomic
imbalances have been addressed
High
degree
of risk
sharing
Portfolio
equity
Foreign
direct
investment
Short
term
debt
Long term
debt
(bonds)
No risk
sharing
Transitory
Permanent
Pre-conditions
for liberalization
Sound macroeconomic policies
Strong domestic financial system
Strong and autonomous central bank
Timely, accurate, and comprehensive
data disclosure
The real exchange rate always floats
Through nominal exchange rate
adjustment or price change
Even so, it matters how countries set
their nominal exchange rates
because floating takes time
There is a wide spectrum of options,
from absolutely fixed to
completely flexible exchange rates
There is a range of options
Monetary union or dollarization
Means giving up your national currency or
sharing it with others (e.g., EMU, CFA, EAC)
Currency board
Legal commitment to exchange domestic
for foreign currency at a fixed rate
Fixed exchange rate (peg)
Crawling peg
Managed floating
Pure floating
Fixed
No Independent
Monetary Policy
Flexible
Independent
Monetary Policy
 Currency union or dollarization
 Currency board
 Peg
FIXED
Fixed
Horizontal bands
 Crawling peg
Without bands
With bands
 Floating
FLEXIBLE
Managed
Independent
Dollarization

Use another country’s currency as sole legal tender
Currency union

Share same currency with other union members
Currency board

Legally commit to exchange domestic
currency for specified foreign currency at fixed
rate
Conventional (fixed) peg


Single currency peg
Currency basket peg
Flexible peg
Fixed but readily adjusted
Crawling peg
Complete
Compensate for past inflation
Allow for future inflation
Partial
Aimed at reducing inflation, but real appreciation
results because of the lagged adjustment
Fixed but adjustable
Managed floating
 Management

by sterilized intervention
I.e., by buying and selling foreign
exchange
 Management
by interest rate policy,
i.e., monetary policy

E.g., by using high interest rates to
attract capital inflows and thus lift the
exchange rate of the currency
Pure floating
“Pure”

float
X - Z + F = ΔR = 0, so X – Z = -F
Independent
float
Exchange rate is market-determined
 Market intervention is limited to
moderating the rate of change and
preventing undue fluctuations

Managed

float
Central bank influences exchange rate by
active intervention without specifying, or
committing to, an exchange rate path
FREE CAPITAL
MOVEMENTS
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
FIXED
EXCHANGE
RATE
MONETARY
INDEPENDENCE
FREE CAPITAL
MOVEMENTS
Flexible
exchange
rate (US, UK, Japan)
Monetary
Union (EU)
FIXED
EXCHANGE
RATE
Capital controls
(China)
MONETARY
INDEPENDENCE


Monetary authorities face a
tradeoff between the degree of
exchange rate stability and the
extent to which they can act to
stabilize economic activity and
the domestic price level
International capital mobility
exacerbates the tradeoff
Outside Europe



Floating exchange rates
Monetary policy used to pursue domestic
stabilization objectives
Removal of capital controls
Within much of Europe

Fixed exchange rates



Common currency floating against outside world
Monetary policies highly coordinated and
pooled in the European Central Bank
Removal of capital controls
 If
capital controls are ruled out in view of
the proven benefits of free trade in goods,
services, labor, and also capital (four
freedoms), …
 … then long-run choice boils down to one
between monetary independence (i.e.,
flexible exchange rates) vs. fixed rates

Cannot have both!
 Either
type of regime has advantages as well
as disadvantages
 Let’s quickly review main benefits and costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Stability of trade
and investment
Low inflation
Costs
Benefits
Fixed
exchange
rates
Floating
exchange
rates
Costs
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Benefits
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Benefits
Costs
Fixed
exchange
rates
Stability of trade Inefficiency
and investment BOP deficits
Low inflation
Sacrifice of
monetary
independence
Floating
exchange
rates
Efficiency
BOP equilibrium
Instability of
trade and
investment
Inflation
 In
view of benefits and costs, no single
exchange rate regime is right for all
countries at all times
 The regime of choice depends on time and
circumstance
 If inefficiency and slow growth due to currency
overvaluation are the main problem, floating
rates can help
 If high inflation is the main problem, fixed
exchange rates can help, at the risk of renewed
overvaluation
 Ones both problems are under control, time may
be ripe for monetary union
What countries actually do (Number of countries, April 2008)
(22)
(84)
(12)
(44)
(40)
(76)
(10)
(66)
(3)
(5)
(2)
Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.
68
No national currency
Currency board
Conventional fixed rates
Intermediate pegs
Managed floating
Pure floating
6%
7%
36%
5%
24%
22%
100%
54%
46%
There is a gradual tendency towards floating, from 10% of LDCs
in 1975 to almost 50% today, followed by increased interest
in fixed rates through economic and monetary unions
In
view of the success of the EU and
the euro, economic and monetary
unions appeal to many other
countries with increasing force
Consider four categories
 Existing
monetary unions
 De facto monetary unions
 Planned monetary unions
 Previous – failed! – monetary unions
 CFA

franc
14 African countries
 CFP

3 Pacific island states
 East

franc
Caribbean dollar
8 Caribbean island states

Picture of Sir W. Arthur Lewis, the great Nobel-prize
winning development economist, adorns the $100 note
 Euro,

more recent
16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old
conflicts among European nation states, cultural
variety, many different languages, etc.

Australian dollar


Indian rupee


South Africa plus Lesotho, Namibia, Swaziland – and
now Zimbabwe
Swiss franc


New Zealand plus 4 Pacific island states
South African rand


India plus Bhutan (plus Nepal)
New Zealand dollar


Australia plus 3 Pacific island states
Switzerland plus Liechtenstein
US dollar

US plus Ecuador, El Salvador, Panama, and 6 others
 East

Burundi, Kenya, Rwanda, Tanzania, and Uganda
 Eco

African shilling (2009, delayed)
(2009, delayed)
Gambia, Ghana, Guinea, Nigeria, and Sierra
Leone (plus, perhaps, Liberia)
 Khaleeji

Bahrain, Kuwait, Qatar, Saudi-Arabia, and United
Arab Emirates
 Other,

(2010, delayed)
more distant plans
Caribbean, Southern Africa, South Asia, South
America, Eastern and Southern Africa, Africa

Danish krone 1886-1939
Denmark and Iceland 1886-1939: 1 IKR = 1 DKR
 2009: 2,500 IKR = 1 DKR (due to inflation in Iceland)


Scandinavian monetary union 1873-1914


East African shilling 1921-69


Mauritius and Seychelles 1870-1914
Southern African rand


Kenya, Tanzania, Uganda, and 3 others
Mauritius rupee


Denmark, Norway, and Sweden
South Africa and Botswana 1966-76
Many others
 Centripetal
tendency to join monetary
unions, thus reducing number of currencies

To benefit from stable exchange rates at the
expense of monetary independence
 Centrifugal
tendency to leave monetary
unions, thus increasing number of currencies

To benefit from monetary independence often,
but not always, at the expense of exchange rate
stability
 With
globalization, centripetal tendencies
appear stronger than centrifugal ones
 External sector policies are important
because external trade is important for
growth
 Need to maintain real exchange rates
at levels that are consistent with BOP
equilibrium, including sustainable debt
Must avoid overvaluation!
 Need to adopt monetary and exchange
rate regimes that are conducive to
moderate inflation and rapid growth
These slides will be posted on my website:
www.hi.is/~gylfason
Monetary
policy and exchange rate
regimes have changed over time
Over the past decade,
 Many
countries have moved to more
flexible exchange rate arrangements,
with more independent monetary policy
 Others aim to form monetary unions
Choice
of exchange rate regime may be
viewed as a means to sound fiscal,
monetary, and financial policies