Transcript On Global Currencies Jeffrey Frankel, Harpel Professor, Harvard

Currency Wars:
The Euro Crisis &
Global Outlook in 2012
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth,
Harvard University
Macquarie Securities
Boston, March 1, 2012
1
Origin of “Currency Wars,” Fall 2010

Warning from Brazil’s Finance
Minister Guido Mantega (9/27/2010):
“We’re in the midst of
an international currency war,
a general weakening of currency. This threatens us
because it takes away our competitiveness.”

I.e., countries everywhere are trying
to push down the value of their currencies,
to gain exports & employment,
• a goal that is not globally consistent.
2
Currency Wars, Fall 2010

Two advanced countries had recently
fought strong appreciations of
their currencies by selling
them in forex intervention:
• Japan
• Switzerland
3
Currency Wars chronology,

continued
Renewed flows to emerging markets in 2010
had met with $ purchases in FX intervention
•
•
•
•
•
Brazil,
Korea,
Thailand,
Peru …
By 2011, even Chile, the cleanest of the floaters,
was intervening to dampen appreciation.
4
Currency Wars,

China had long been intervening
to prevent the RMB from appreciating.


continued
The U.S. tried to enlist help from countries like Brazil
in pressuring China to abandon its undervaluation.
The Brazilian Minister’s response:
The $ is as much a part of the problem as the RMB.
• He was referring to QE2 that fall, which like any other
monetary easing could be expected to depreciate the $.

More attacks on Fed action -• China & Germany: $ depreciation is a deliberate salvo in currency wars
• Sarah Palin, Rick Perry & John Taylor: QE2 “debauches the currency.”
5
Today, in 2012,
Currency Wars look different

As in a real war:
• at first it seems to be about boldness,
clever strategic moves, & strength of will.
• In practice, wars often turn out less uplifting:
 You are shooting yourself in the foot.
6
Who is screwing up its debt crisis worse:
Europe or the US?
It’s a tough call
-- US News & World Report, 11/07/2011

On the one hand,
Europe is much closer to full-fledged crisis.
Debt problems in Mediterranean members:
• are insoluble at current interest rates,
• are pushing Europe back into recession, and
• could well result in one or more countries forced to leave the euro.
By contrast, there is no true fiscal crisis in US yet;
the world’s investors are still buying
lots of US bonds at low interest rates.
7
Who is screwing up its debt crisis worse:
Europe or the US? – continued

On the other hand, mistakes by US politicians are
more gratuitously self-inflicted than across the Atlantic.
• In 2001, all we had to do was continue the 1990s’ fiscal progress:

preserve the budget surplus and move on to address the longer term
problems of social security & Medicare in a deliberate balanced manner.
• Instead we recklessly enacted huge tax cuts and tripled federal spending growth,
in ways guaranteed to generate serious fiscal troubles ten years into the future.
• The debt-ceiling standoff, summer 2011,
was but the latest self-inflicted wound,


new evidence that the American political system was not functioning,
which led to the US credit rating downgrade.
8
Greece & the Euro Crisis:
Seven Mistakes


7 mistakes made by euroland’s leaders
regarding Greece
Slender rays of hope:
• The hour of the technocrats
• Proposals for the future
10
3 mistakes made by euro architects
before the crisis

Admitting Greece to the € in the first place,
• and other countries that were not yet ready -• neither by traditional Optimum Area Currency criteria
incl. cyclical correlation & labor mobility,
• nor by Maastricht criteria,
 esp. fiscal criteria:
 BD < 3% of GDP & Debt < 60% of GDP.


Pretending after 1999 to enforce the fiscal criteria

via the Stability & Growth Pact.


Allowing Mediterranean countries’ bonds spreads ≈ 0,
• helped by investors’ under-perception of risk (2003-07)
• and artificial high credit ratings. But also by
• ECB acceptance of Greek bonds as collateral.
11
The Treaty of Maastricht (1991) surprised many
economists by emphasizing fiscal criteria
as qualifications for membership.
Why did the designers do it?

Theory I: Jason
& the Golden Fleece

Theory II: Theseus
& the stone

Theory III: Odysseus
& the mast.
Frankel, Economic Policy (London) 16, April 1993, 92-97.
12
The motivation for the Maastricht fiscal criteria


was the same as for the No Bailout Clause
and the Stability & Growth Pact (1997):

Skeptical German taxpayers believed that, before
the € was done, they would be asked to bail out
profligate Mediterranean countries.

European elites adopted the fiscal rules to
demonstrate that these fears were groundless.
13
After the euro came into existence

it became clear the German taxpayers had been right
• and the European elites were wrong.

E.g., Greece persistently violated the 3% deficit rule.

The large countries violated the rule too.

SGP targets were “met” by overly optimistic forecasts.

SGP threats of penalty had zero credibility.

Yet each year the ostrich elites stuck
their heads deeper & deeper into the sands.
14
The Greek budget deficit
never got below the 3% of GDP limit,
nor did the debt ever decline toward the 60% limit
15
Yet spreads for Italy, Greece, & other Mediterranean
members of € were near zero, from 2001 until 2008.
16
Market Nighshift Nov. 16, 2011
When PASOK leader George Papandreou
became PM in Oct. 2009,

he announced
• that “foul play” had misstated the fiscal statistics
under the previous government:
• the 2009 budget deficit ≠ 3.7%,
as previously claimed,
but > 12.7 % !
17
Missed opportunity

The EMU elites had to know that someday
a member country would face a debt crisis.

In early 2010 they should have viewed Greece as a good
opportunity to set a precedent for moral hazard:
• The fault egregiously lay with Greece itself.

Unlike Ireland or Spain, which had done much right.
• It is small enough that the damage from debt restructuring could
have been contained at that time.

They should have applied the familiar IMF formula:
serious bailout, but only conditional on serious
policy reforms & Private Sector Involvement.
18

But the ostriches
stuck their heads
ever further down
in the sand.
Mistakes #4 & #5: when the crisis hit,
leaders buried their heads in the sand:
• 2 years ago,
sending Greece to the IMF was “unthinkable.”
• 1 year ago,
restructuring the debt was “unthinkable.”
19
What is wrong with the current debate?



Mistake #6:
6a: Talking as if a “big bazooka” bailout
alone can solve the problem. Or
6b: Talking as if austerity
alone can solve the problem,
• which is related to the belief in some places
that fiscal contraction is expansionary.


Republican politicians say it, but (from their actions) don’t
appear actually to believe it.
UK politicians appear actually to believe it.
• & some other Europeans.
20
Any solution to the euro crisis must include a
way to prevent repeats in the long term.

German taxpayers are no more
supportive of a “transfer union” than ever.

This means finding a way to prevent moral hazard
• as the Maastricht architects knew all along -

preventing individual countries from running big deficits & debts,
expecting to be bailed out in the event of a crisis.
Merkel’s “fiscal compact” is the 7th mistake:
• yet another declaration of determination
to strengthen the SGP,
• incl. via budget limits
in national laws/constitutions.
Perhaps the Fiscal Compact
misunderstands the US system

Yes, despite a common currency,
the 50 states do not have moral hazard:
• the federal government has never bailed one out,

and nobody expects it to do so now.
• But that is not because of the budget rules
that (49 of) the states have.


Their rules are voluntary, varied, and flexible.
Some states do have debt troubles,
• and even default.
How the US avoids moral hazard
in the 50 states

The principle was established in 1840 when the federal government
refused to save 8 states from default.

Government spending at the state level is a far smaller share of
income than at the federal level,
• let alone on the part of European states.
• Is Europe ready for that? No.

When one state begins to run its debt too high,
the private market automatically
imposes an interest rate penalty.
• E.g., California today.
• Gives states the incentives to get back in line.
• This mechanism conspicuously failed from the euro’s 1st day.
• which showed that moral hazard had not been addressed.
Slender rays of hope, #1

Greece, Ireland & Portugal did finally go to the IMF;
Germany & banks did finally agree to write down Greek debt.
• But it has always been much too little, too late.

The only solution for the short-term:
• more money

from ECB & national governments, perhaps via IMF
• conditional on reforms + PSI, country-by-country.
24
Slender rays of hope, #2:
The Hour of the Technocrats

A government of technocrats under Mario Monti
in Italy is a huge improvement
over the disaster of Berlusconi.

Similarly Lucas Papademos in Greece
• But he has been given even less freedom of
action than Monti: his term is very short
and he wasn’t allowed to pick his cabinet.
25
Mario Draghi became
President of the ECB, Nov.1, 2011

He was under intense pressure to expand his predecessor’s purchases
of large quantities of periphery-country bonds.
• The ECB was urged to be the “big bazooka”:

to play the role of “lender of last resort,” an abuse of that term,
• which is supposed to refer to back-stopping banks, not countries.
• If the ECB interpreted its mandate literally,
as no more than keeping inflation low,
then the euro might break up.

On the other hand, as Draghi knew:
• the ECB is legally prohibited from financing governments directly.
• If he had quickly bailed out Italy & the others, he would have:
 facilitated a continuation of Berlusconi-style irresponsibility;
 been immediately written off by Germans as another profligate Italian.
So far, Draghi’s LTRO (Longer-Term Refinancing
Operation) has been a brilliant success.

On Dec. 22, he caught everyone
by surprise by the clever ploy
of doing exactly what he had
previously announced he would do:
• loans to banks for 3 years, at low interest.
 High take-up: € 489 b, 523 banks
• especially in troubled countries.
• No stigma.
• Brought down interbank spreads & country spreads,

while consistent with central bank LoLR mandate.
2nd LTRO, February 29

Some 800 banks took up €530 b of loans
at the 2nd round on Wednesday,
• borrowing at 1% for 3 years

with almost any form of collateral.
• Citigroup: = €316 b of fresh liquidity,
 stripping out renewal of old loans.


Vs. €200 b in extra stimulus at the 1st LTRO
Totalling $1 trillion.
28
My guess

Greece will make it past March 20,
• with usual 3-part formula of bail-out + conditionality + PSI ;

but then will default within a year.
• Greece cannot get back to a sustainable debt path
by austerity, as has been clear for awhile.
• When it succeeds in eliminating its primary budget deficit,
it will have no more incentive to keep servicing debt.

Possibly Portugal as well.
Silver linings of procrastination?

By then, Greece (& Italy et al) may finally have made
some of the structural reforms they need,



such as opening up professions ,
which can only be done under pressure.
Perhaps EU banks, including those that have written CDSs,
will have used the time to provision
• making themselves less vulnerable to default.

Analogy would then be to the international debt crisis of 1982:
International creditor banks used the lost decade to reduce exposure,
• until they were able to mark to market in 1989 (Brady plan).

But I agree with the Macquarie paper on European Banks (Jan. 25)
that a better analogy may be Japan’s lost “decade,” 1990-2003,
when “prolonging the crisis to give banks time to solve the problems
‘inevitably raised the cost of the final resolution [IMF, 2000] ’.”
30
Risk of contagion is high
not just to rest of euro periphery, but to rest of world.
• The outlook
• The U.S. recovery, though weak,
has become more fully established.
• Who is vulnerable?
31
OECD Economic Outlook
Nov.28, 2011
Growth to be sustained by non-OECD
Contribution to annualised quarterly world real GDP growth, percentage points
8
6
World growth
4
2
0
-2
OECD
-4
Non-OECD
-6
-8
2007
2008
2009
2010
2011
2012
2013
Note: Calculated using moving nominal GDP weights, based on national GDP at purchasing power parities.
Source:
Economic
OutlookNov.28,
90 database.
OECDOECD
Economic
Outlook
2011
After 3 years, the U.S. has finally achieved
its pre-recession level of GDP,
13,600
Real GDP
(billions of chain-type (2005) dollars seasonally
adjusted at annual rates)
13,400
Obama
Inauguration
13,200
End of
recession
13,000
12,800
12,600
12,400
12,200
2007
2008
2009
2010
2011
Jan. 2007 – Dec. 2011, monthly, estimated by Macroeconomic Advisers
Source: Macroeconomic Advisers
www.macroadvisers.comMon
Change in Private Sector Employment (2008-2012)
400
End of
recession
Change in Private Sector Employment
(thousands of jobs, by quarter, seasonally adjusted)
200
Obama
Inauguration
Change in private
sector jobs (by
quarter)
0
Average rate of private
sector job creation
during the period of
expansion between the
two Bush recessions
(Nov. 2001-Dec. 2007)
-200
-400
Average rate of
private sector job
creation throughout
Bush's 8 years (Jan
2001-Jan 2009)
-600
-800
-1000
2008 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
thus
far
Data Source: U.S. Bureau of Labor Statistics
U.S. economic news so far in 2012
has been better than 2011

Recent statistics:
• Unemployment has declined to 8.3%
• Growth in Q4 2011 revised up to 3.0%


(2/29/12) from 2.8 %
Blue Chip Economic Indicators survey (February)
consensus forecast for 2012 GDP growth:
Q1 = 2.1 %, Q2 = 2.2 %, Q3 = 2.4 % , Q4 = 2.6 %.
Bernanke’s testimony (2/29/12) was interpreted negatively.
• GDP growth in the next few quarters "at a pace close to or
somewhat above" the 2 ¼ % seen in the 2nd half of 2011.


Estimates by members of the FOMC range from 2.2 to 2.7,
in the new communications strategy for more transparency.
36
Possible risks to the scenario in 2012

Euroland: Worsening of sovereign debt crisis
• and contagion overseas.

US
• new debt ceiling standoff

Emerging markets: hard landing
• particularly in China.

Major oil crisis
• from military confrontation with Iran.
The downside scenario
Intensification of euro-area crisis and excessive US fiscal consolidation
10
10
Downside scenario
Baseline
8
8
Downside
scenario
6
6
4
4
2
2
0
0
-2
-2
-4
-4
2012
2013
United States
2012
2013
Euro area
2012
2013
Japan
Source: OECD calculations.
OECD Economic Outlook
Nov.28, 2011
2012
2013
China
Sovereign debt worries
...
•
• Who is vulnerable?
• The emerging market countries are
in much better shape than past decades,
• in an amazing & historic role reversal.
39
A remarkable role-reversal:
• Debt/GDP of the top 20 rich countries
(> 80%) is already more than twice
that of the top 20 emerging markets;
• and rising rapidly.
• Nor are the EMs necessarily less
“debt tolerant” for a given debt/GDP
• as Reinhart & Rogoff thought not long ago.
40
Country creditworthiness is now inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA
Belgium
AA- Japan
A+
A
Spain
ABBB+ Italy
BBB- Iceland, Ireland
BB+
BB
Portugal
B
CC
Greece
(Formerly) “Developing” countries
Singapore
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia
India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 domestic curren
What Determines Country Vulnerability?

Fundamentally: Quality of institutions.
• This does not mean “tough” rules –
like SGP, debt ceiling or BBA – which lack enforceability.
• Better would be structural budget targets (Swiss)
with forecasts from independent experts (Chile).
• One third of developing countries since 2000 have graduated from
pro-cyclical spending to countercyclical,
• even while US, UK & euro countries have forgotten
how to run countercyclical fiscal policy,

and instead enact fiscal expansion in booms
& contraction after recessions.
Correlations between Govt. Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclical
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
Correlations between Govt. Spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
It’s not so much the level
of debt/GDP that matters

as the risk of getting stuck on an explosive path,
with ever-rising debt/GDP
• because of high primary deficit or interest rates
(or low growth), or risk of a sudden deterioration.

Early Warning indicators:
• composition of capital inflows

Fx-denominated, ST, bank loans vs.
FDI, equity & contracts with automatic adjustment provisions.
• Plus real currency overvaluation, fx reserves (for peggers)…
• Fiscal capacity.
Early Warning Indicators: Reserves

When the 2008-09 global financial crisis hit,
• those countries that had taken advantage of
the 2003-08 boom to build up reserves did better.




Frankel & Saravelos (2010).
Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009)
Vs. Blanchard (2009) and Rose & Spiegel (2009)
This had also been the most common finding
in the many studies of Early Warning Indicators
in past emerging market crises.
46
The variables that show up as the strongest predictors of
country crises in 83 pre-2009 studies:
(i) low reserves and (ii) currency overvaluation
0%
10%
20%
30%
40%
50%
60%
70%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Early Warning Indicators
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
External Debt
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
47
Source: Frankel & Saravelos (2010)
Best and Worst Performing Countries -- F&S (2010), Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bottom 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
48
10%
Table Appendix 7
Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower
F & Saravelos
(2010):
Multivariate
Exchange
Market
Pressure
Currency % Recourse to
Changes
IMF
(H208-H109
(SBA only)
Equity
%Chng
(Sep08Mar09)
Equity %
Chng
(H208H109)
S ignif ic a nt
a nd
C o ns is t e nt
S ign?^
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Reserves (% GDP)
0.164
(3.63)
0.087
(2.98)
-1.069
(-1.66)
0.011
(0.12)
0.010
(0.14)
Yes
Reserves (% external debt)
0.000
(1.06)
0.000
(1.1)
-0.006
(-2.29)
0.000
(1.81)
0.000
(2.65)
Yes
Reserves (in months of imports)
0.004
(2.25)
0.003
(1.95)
-0.119
(-3.01)
0.006
(1.32)
0.009
(2.32)
Yes
M2 to Reserves
0.000
(0.27)
0.000
(0.76)
-0.044
(-0.91)
0.000
(0.02)
-0.000
(-0.09)
Short-term Debt (% of reserves)
-0.000
(-1.97)
-0.000
(-4.22)
0.000
(2.13)
-0.001
(-2.89)
-0.001
(-3.11)
Yes
REER (5-yr % rise)
-0.440
(-5.55)
-0.210
(-3.19)
1.728
(2.15)
-0.182
(-1.24)
-0.185
(-1.61)
Yes
REER (Dev. from 10-yr av)
-0.475
(-3.96)
-0.230
(-2.47)
2.654
(2.56)
-0.316
(-1.71)
-0.316
(-2.1)
Yes
GDP growth (2007, %)
-0.000
(-0.2)
0.001
(0.94)
0.070
(2.58)
-0.001
(-0.1)
-0.007
(-0.71)
GDP Growth (last 5 yrs)
-0.003
(-0.81)
0.000
(0.26)
0.084
(2.4)
-0.003
(-0.26)
-0.014
(-1.15)
GDP Growth (last 10 yrs)
0.000
(0.14)
0.001
(0.43)
0.064
(1.66)
-0.012
(-0.67)
-0.020
(-1.12)
Change in Credit (5-yr rise, % GDP)
-0.021
(-0.36)
-0.035
(-0.98)
0.552
(1.02)
-0.274
(-2.97)
-0.248
(-4.13)
Change in Credit (10-yr rise, % GDP)
-0.017
(-0.93)
-0.011
(-1.05)
0.210
(1.03)
-0.089
(-1.65)
-0.089
(-2.35)
Credit Depth of Information Index (higher=more)
-0.008
(-1.06)
0.000
(0.05)
0.224
(2.4)
-0.006
(-0.37)
-0.018
(-1.33)
Bank liquid reserves to bank assets ratio (%)
0.000
(3.84)
0.000
(0.5)
-0.000
(-11.44)
-0.002
(-0.54)
-0.002
(-0.79)
Yes
Current Account (% GDP)
0.001
(1.48)
0.002
(2.7)
-0.023
(-2.09)
0.009
(3.84)
0.007
(3.95)
Yes
Current Account, 5-yr Average (% GDP)
0.000
(0.48)
0.001
(1.82)
-0.025
(-1.72)
0.007
(2.4)
0.006
(2.74)
Yes
Current Account, 10-yr Average (% GDP)
0.000
(0.14)
0.002
(1.39)
-0.035
(-2.11)
0.008
(2.21)
0.007
(2.44)
Yes
Net National Savings (% GNI)
0.002
(1.6)
0.001
(2.33)
-0.013
(-1.22)
0.006
(2.92)
0.004
(2.28)
Gross National Savings (% GDP)
0.003
(2.01)
0.001
(2.53)
-0.015
(-1.36)
0.008
(3.42)
0.006
(3.03)
Yes
49 Yes
Yes
New lesson regarding exchange rate regimes

Old conventional wisdom: The choice was between
• fixing (changes in reserves; not in exchange rate) vs.
• floating (changes in exchange rate; no reserves).

Now it appears that:
• Intermediate regimes are indeed viable.
• Holding reserves
and floating are both useful.
50
World Bank forecasts


The World Bank has downgraded economic forecasts for
developing countries in its 2012 Global Economic Prospects.
E.g., Brazil’s annual GDP growth, which came to a halt in the 3rd
quarter of 2011, is forecast to reach 3.4% in 2012,
• < half the 7.5% rate in 2010.

Reflecting a sharp slowdown in the second half of the year in
India, South Asia is slowing from a torrid six years,
• which included 9.1% growth in 2010.
• Regional growth is projected to decelerate further, to 5.8%, in 2012.
51
The biblical cycle


Joseph prophesied 7 years of plenty,
with abundant harvests from a full Nile
-- followed by 7 lean years of drought & famine.
The Pharaoh empowered his technocratic official
(Joseph) to save grain in the 7 years of plenty,
• building up sufficient stockpiles to save the Egyptian people
from starvation during the bad years.
• -- a valuable lesson for today’s government officials
in industrialized & developing countries alike.
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Biblical cycle, cont.

For emerging markets, the first phase of 7 years
of plentiful capital flows occurred in 1975-1981,
• recycling petrodollars as loans to developing countries.
• The international debt crisis that began in Mexico in 1982
was the catalyst for the 7 lean years,

known in Latin America as the “lost decade.”
• The turnaround year, 1989, saw the first issue of Brady
bonds, which helped write down the debt overhang

and put a line under the crisis.
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Biblical cycle, cont.

The second cycle of 7 fat years was the period of
record capital flows to emerging markets in 199096.
• Following the 1997 “sudden stop” in East Asia came 7
years of capital drought.

The third cycle of inflows, often identified as a “carry
trade,” came in 2004-2011
• and persisted even through the global financial crisis.

If history repeats itself, it is now time for a third
sudden stop of capital flows to emerging markets.
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Are emerging markets due for a correction,
triggered by a new wave of “risk off” behavior?

China could land hard as its real-estate bubble deflates
and the country’s banks are forced to work off bad loans.

High GDP growth rates in Brazil & Argentina
over the same period could reverse,
• particularly if global commodity prices fall –


Esp. if the Chinese economy begins to falter.
Most worrisome: Europe’s woes
could spread to neighbors such as Turkey.
• Turkey can probably not sustain the rapid economic growth
and very high trade deficits of recent years.
• Vulnerable to world oil price.
• Also, recent domestic politics may put off investors.
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http://ksghome.harvard.edu/~jfrankel/index.htm
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