1 currency wars: global money in 2011 jeffrey frankel harpel professor of capital formation &...

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Currency Wars:Currency Wars:Global Money in 2011Global Money in 2011

Jeffrey FrankelJeffrey FrankelHarpel Professor of Capital Formation & Growth,Harpel Professor of Capital Formation & Growth,

Harvard University Harvard University

MAS Sponsored Public Lecture, Singapore, March 2011MAS Sponsored Public Lecture, Singapore, March 2011

22

What What areare the currency wars? the currency wars? • Review of the last 6 months.Review of the last 6 months.

• Is the currency war metaphor appropriate?Is the currency war metaphor appropriate?

Which emerging markets are intervening the most Which emerging markets are intervening the most to dampen the appreciation of their currencies?to dampen the appreciation of their currencies?• What is the right way to measure it?What is the right way to measure it?• What What shouldshould they be doing? Lessons from recent crises. they be doing? Lessons from recent crises.

The 3 big currenciesThe 3 big currencies• $$

• RMBRMB

• €€

33

Who is doing how much?Who is doing how much?• It is not enough to look at increases in FX reserves.It is not enough to look at increases in FX reserves.• The question: The question:

for a given increase in Exchange Market Pressure for a given increase in Exchange Market Pressure (EMP), how much does the central bank absorb as an (EMP), how much does the central bank absorb as an rise in the value of its currency (exchange rate) versus rise in the value of its currency (exchange rate) versus how much as an increase in the how much as an increase in the quantityquantity (reserves). (reserves).

How much How much shouldshould it intervene, vs. appreciate? it intervene, vs. appreciate?• What can we learn from recent crises?What can we learn from recent crises?

44

Currency Wars chronology, 2010Currency Wars chronology, 2010

June June China announces more flexibility in RMB,China announces more flexibility in RMB,

• after postponement of Treasury report on after postponement of Treasury report on undervaluation, thereby saving face; undervaluation, thereby saving face;

• but little appreciation follows. but little appreciation follows. (Repeat of 2005.)(Repeat of 2005.)

September 15September 15Japan buys $20 b for ¥, Japan buys $20 b for ¥, • after 6-year absence from FX markets;after 6-year absence from FX markets;• thereby joining Switzerland, the other floater to thereby joining Switzerland, the other floater to

have appreciated in 2008-09 GFC and to have have appreciated in 2008-09 GFC and to have fought it by FX intervention.fought it by FX intervention.

55

September 27 September 27 warning from Brazil’s Finance warning from Brazil’s Finance Minister Guido Mantega:Minister Guido Mantega:

““We’re in the midst of We’re in the midst of an international currency war, an international currency war, a general weakening of currency. a general weakening of currency. This threatens us because it takes away our This threatens us because it takes away our competitiveness.”competitiveness.”

I.e., countries everywhere are trying I.e., countries everywhere are trying to push down the value of their currencies, to push down the value of their currencies, to gain exports and employment,to gain exports and employment,• a goal that is not globally consistent.a goal that is not globally consistent.

Currency Wars chronology, Currency Wars chronology, continuedcontinued

66

Some consider FRB policy another instance.Some consider FRB policy another instance.

Renewed flows to emerging markets Renewed flows to emerging markets have met with interventionhave met with intervention• e.g., by Korea, host of November G20 summit.e.g., by Korea, host of November G20 summit.• Brazil, Thailand, India & others must decide how to manage inflows:Brazil, Thailand, India & others must decide how to manage inflows:

Capital controls?Capital controls? Appreciation?Appreciation? Buying $ to prevent appreciationBuying $ to prevent appreciation

China’s RMB remains the dominant issue.China’s RMB remains the dominant issue.

77

Currency Wars chronology,Currency Wars chronology, Nov.2010Nov.2010

As European sovereign debt crisis resurfaces As European sovereign debt crisis resurfaces in Ireland, in Ireland, (1.3 $/€(1.3 $/€ Nov.17Nov.17).).

Chinese government, Chinese government, responding to 4.4% inflation responding to 4.4% inflation in Octoberin October • raises raises ii, , • reserve requirements, reserve requirements, • & price controls.& price controls.

US core inflation falls to 0.6% for year, US core inflation falls to 0.6% for year, • the lowest since 1957.the lowest since 1957.

88

and climbed back up to 4.9% as of Feb.2011

Source: WSJ

Chinese inflation reached 8% in 2008

99

US core inflation is the lowest in 50 yearsUS core inflation is the lowest in 50 years

Jan 2011

1010

Currency Wars chronology, Currency Wars chronology, Nov.2010Nov.2010

G20 Summit in Korea is first G20 Summit in Korea is first chaired by a non-G8 countrychaired by a non-G8 country

1111

Currency Wars chronology, Currency Wars chronology, Nov.2010Nov.2010

Nov. 12: G-20 Summit in Seoul Nov. 12: G-20 Summit in Seoul judged a failure, at least for Obama:judged a failure, at least for Obama:• Rebuff of US proposal for cap on Current Rebuff of US proposal for cap on Current

Account surpluses at 4% of GDP.Account surpluses at 4% of GDP.• No pledge to refrain from “competitive No pledge to refrain from “competitive

undervaluation” undervaluation” • A suggestion to countries with widely used A suggestion to countries with widely used

currencies like the $ to “be vigilant against currencies like the $ to “be vigilant against excess volatility,” a warning against loose excess volatility,” a warning against loose monetary policy. monetary policy.

1212

Currency Wars chronology, Nov. 2010Currency Wars chronology, Nov. 2010

Nov.21: Fed announces QE2 decision --Nov.21: Fed announces QE2 decision --• Will purchase $600b in bonds.Will purchase $600b in bonds.• Short-term market reaction -- $ depreciates.Short-term market reaction -- $ depreciates.• Critiques -- Critiques --

Sarah Palin & John Taylor: Sarah Palin & John Taylor: “US is debauching its currency.”“US is debauching its currency.”

Germany, China & Brazil: Germany, China & Brazil: “$“$ depreciationdepreciation == deliberatedeliberate salvo salvo in in currencycurrency

wars.”wars.”

1313

Jan.14, 2011: Jan.14, 2011: Geithner notes that Geithner notes that ---- including China’s higher including China’s higher inflation inflation -- -- RMB is appreciating at 10% RMB is appreciating at 10% per yearper year..

That suggests (appropriately) lower USG priority That suggests (appropriately) lower USG priority on the currency issueon the currency issue• than on IPR, North Korea than on IPR, North Korea

& other issues& other issues in Jan.19 in Jan.19

Obama-Hu summit.Obama-Hu summit.

Currency Wars chronology, Currency Wars chronology, Jan.Jan. 20112011

1414

Data sources: The Economist, BLS, CEIC, Thomson Reuters

5% nominal appreciation per annum 5% nominal appreciation per annum + 5% inflation differential + 5% inflation differential

≈ 10% real appreciation per annum≈ 10% real appreciation per annum over last half-yearover last half-year

Global Macro Monitor

1515

Currency Wars chronology, 2011Currency Wars chronology, 2011

Feb. 4, 2011Feb. 4, 2011• In biannual report to Congress, U.S.Treasury In biannual report to Congress, U.S.Treasury

calls RMB "substantially undervalued." calls RMB "substantially undervalued." • But it once again refrains from naming China But it once again refrains from naming China

a currency manipulator.a currency manipulator.• and points out real appreciation is at 10%.and points out real appreciation is at 10%.

1616

Feb. 15, 2011:Feb. 15, 2011:US Treasury US Treasury Secretary Geithner Secretary Geithner fails to convince fails to convince Brazil to jointly Brazil to jointly pressure China.pressure China.

Mantega responds:Mantega responds:“the $ is as much a “the $ is as much a problem as the RMB.”problem as the RMB.”

Financial Times Feb. 16, 2011

Currency Wars chronologyCurrency Wars chronology

1717

Feb. 18-19, 2011: Feb. 18-19, 2011:

First meeting of G20 ministers First meeting of G20 ministers in France’s year as host.in France’s year as host.

Sarkozy no longer talking Sarkozy no longer talking of “a new Bretton Woods.”of “a new Bretton Woods.”

But G20 goes ahead with But G20 goes ahead with a system of indicators, a system of indicators, • including probably currency reserves, including probably currency reserves,

exchange rates, current account balances, exchange rates, current account balances, budget deficits and sovereign debt levels. budget deficits and sovereign debt levels.

1818

Fear of non-cooperative “competitive devaluation” Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange ratesis an argument for fixed exchange rates• rooted in the 1930s.rooted in the 1930s.• That is why the architects of That is why the architects of

the post-war monetary order the post-war monetary order chose fixed exchange rates chose fixed exchange rates at Bretton Woods, NH, in 1944.at Bretton Woods, NH, in 1944.

But it is now used to argue that China But it is now used to argue that China should move should move from fixingfrom fixing to to floatingfloating..• US Congressmen don’t US Congressmen don’t

care about regimes;care about regimes;• they just want a stronger RMB vs. $.they just want a stronger RMB vs. $.

Is the currency war metaphor applicable?Is the currency war metaphor applicable?

1919

Intervention in emerging markets Intervention in emerging markets to fight currency appreciationto fight currency appreciation




2020

Meanwhile, fear of “competitive devaluation” Meanwhile, fear of “competitive devaluation” is also used as an argument against is also used as an argument against US monetary expansion.US monetary expansion.

But But monetary expansion is notmonetary expansion is nota “beggar-thy-neighbor” policya “beggar-thy-neighbor” policy::• Although in theory it should depreciate $,Although in theory it should depreciate $,• at the same time it boosts US growth & so imports.at the same time it boosts US growth & so imports.• The net of the two effects on trade balance The net of the two effects on trade balance

is ambiguous in theory and ≈ 0 in practice.is ambiguous in theory and ≈ 0 in practice.• Do other countries want a U.S. “double dip” ?Do other countries want a U.S. “double dip” ?

Is the currency war metaphor applicable?Is the currency war metaphor applicable?

2121

Economic historians have decided Economic historians have decided competitive devaluation under 1930s competitive devaluation under 1930s conditions was not a problem after all.conditions was not a problem after all.

True, countries couldn’t all devalue True, countries couldn’t all devalue against each other,against each other,

But they could and did all devalue against goldBut they could and did all devalue against gold• which worked to ease global monetary policy, which worked to ease global monetary policy,

just what was needed.just what was needed.

The same was needed in 2008-09The same was needed in 2008-09

Is the currency war metaphor applicable?Is the currency war metaphor applicable? continuedcontinued

2222

The currency war talk – especially the criticism of US The currency war talk – especially the criticism of US monetary policy -- seems to forget the point of floating monetary policy -- seems to forget the point of floating rates:rates:• Different countries will always have different needs Different countries will always have different needs

at any point in time at any point in time e.g., high unemployment in US & European periphery, e.g., high unemployment in US & European periphery, while China & Brazil & India are overheating. while China & Brazil & India are overheating.

• The point of a floating rate system is that US can choose its The point of a floating rate system is that US can choose its easy monetary policy and Brazil its tight monetary system,easy monetary policy and Brazil its tight monetary system, with with appreciation of $ vs. real accommodating the divergence. appreciation of $ vs. real accommodating the divergence.

Multilateral cooperation is not necessary for this.Multilateral cooperation is not necessary for this.


2323

But other kinds of international cooperation But other kinds of international cooperation areare needed; needed;• the currency war & 1930s metaphors are not totally misplaced:the currency war & 1930s metaphors are not totally misplaced:

Currency war could turn into trade warCurrency war could turn into trade war

• if Congress follows through on legislation to impose if Congress follows through on legislation to impose (WTO-illegal)(WTO-illegal) tariffs on China as punishment for non-appreciation.tariffs on China as punishment for non-appreciation.

• Until now, the US & G20 have held the line on protectionism Until now, the US & G20 have held the line on protectionism compared to the milder recessions of 1991 & 2001,compared to the milder recessions of 1991 & 2001, let alone the Smoot Hawley tariff of 1930.let alone the Smoot Hawley tariff of 1930.


2424

China would take some responsibilityChina would take some responsibility• to reallocate its economy away from to reallocate its economy away from

exclusive reliance on exports & manufacturingexclusive reliance on exports & manufacturing toward domestic consumption & services,toward domestic consumption & services,

• health, education, housing, environment, insurance & other services.health, education, housing, environment, insurance & other services.

• How? By allowing the RMB to appreciate,How? By allowing the RMB to appreciate,• but also by increasing domestic demand.but also by increasing domestic demand.

Meanwhile, the US would ideally also take responsibility.Meanwhile, the US would ideally also take responsibility.• Even while prolonging expansionary policy this year,Even while prolonging expansionary policy this year,

including fiscal expansion designed with high bang-for-the-buck,including fiscal expansion designed with high bang-for-the-buck,

• the US should take steps today to lock the US should take steps today to lock in a future return to fiscal responsibility,in a future return to fiscal responsibility,

e.g., by putting Social Security on a firm footing.e.g., by putting Social Security on a firm footing.

Ideally the US & China would reach agreement Ideally the US & China would reach agreement on how to address current account imbalances:on how to address current account imbalances:

2525

Intervention in emerging markets Intervention in emerging markets to fight currency appreciationto fight currency appreciation




2626

Capital flows to emerging markets, especially Asia, Capital flows to emerging markets, especially Asia, recovered quickly from the 2009 recession.recovered quickly from the 2009 recession.

These countries again show big balance of payments surplusesThese countries again show big balance of payments surpluses

Goldman Sachs

2727

China gets the most attention, China gets the most attention, partly because it is so large in trade andpartly because it is so large in trade and

partly because it absorbs most of its Exchange Market partly because it absorbs most of its Exchange Market Pressure as FX intervention, rather than appreciationPressure as FX intervention, rather than appreciation

%

2828

Korea (& Singapore & Taiwan) are also Korea (& Singapore & Taiwan) are also adding heavily to reserves.adding heavily to reserves.

GS Global ECS Research

2929

But that’s partly because Singapore But that’s partly because Singapore & Korea faced the greatest total & Korea faced the greatest total

Exchange Market Pressure in 2010Exchange Market Pressure in 2010

Goldman Sachs Global Economics Weekly 11/07 Feb. 16, 2011

3030

Since 2008, India, followed by Indonesia, have had Since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; the greatest tendency to float, given EMP;

Hong Kong & Singapore the least, followed by Malaysia & China.Hong Kong & Singapore the least, followed by Malaysia & China.


3131

Korea’s intervention to dampen won appreciation Korea’s intervention to dampen won appreciation has been largely on the forward markethas been largely on the forward market


3232

India & Malaysia in 2010 took the inflows India & Malaysia in 2010 took the inflows in the form of currency appreciation, in the form of currency appreciation,

more than reserve accumulation.more than reserve accumulation.


less-managed floating (“more appreciation-friendly”)

more-managed floating

3333

In Latin America, renewed inflowsIn Latin America, renewed inflows

less-managed floating (“more appreciation-friendly”)

more-managed floating


but as appreciation in Chile & Colombiabut as appreciation in Chile & Colombia. . are reflected mostly as reserve accumulation in Peru,are reflected mostly as reserve accumulation in Peru,

3434

If a country faces an increase in If a country faces an increase in exchange market pressure, should exchange market pressure, should

it appreciate? Or intervene?it appreciate? Or intervene?

It is the old debate over floating It is the old debate over floating versus fixed exchange rate.versus fixed exchange rate.

What can we learn about the answer What can we learn about the answer from recent crises?from recent crises?

3535

Two lessons from the 1990s emerging Two lessons from the 1990s emerging market currency crisesmarket currency crises

Advantages of floating:Advantages of floating:• Speculators don’t have a target to shoot at;Speculators don’t have a target to shoot at;• Accommodate shocks;Accommodate shocks;• Discourage unhedged $ liabilities.Discourage unhedged $ liabilities.

Advantages of holding forex reservesAdvantages of holding forex reserves• Reduces danger of crisis.Reduces danger of crisis.

How did these lessons fare in the crises How did these lessons fare in the crises of 2008-09?of 2008-09?

3636

EWIs: EWIs: The variables that show up as the strongest The variables that show up as the strongest predictors of country crises in 83 studies are: predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation(i) 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

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)

Source: Frankel & Saravelos (2010)

3737

Best and Worst Performing Countries Best and Worst Performing Countries -- F&S (2010), -- F&S (2010), Appendix 4Appendix 4

-25% -20% -15% -10% -5% 0% 5% 10%

China

India

Morocco

Egypt, Arab Rep.

Indonesia

Jordan

Sri Lanka

Argentina

Poland

Australia

Turkey

Finland

Mexico

Georgia

Russian Federation

Macao, China

Estonia

Ukraine

Latvia

Lithuania

GDP Change, Q2 2008 to Q2 2009

Top 10

Bottom 10

64 countries in sample

3838

Table Appendix 6

Coefficients of Bivariate Regressions of Crisis Indicators on Each Independent Variable* (t-stat in parentheses)bolded number indicates statistical signficance at 10% level or lower, darker color shading equivalent to higher statistical significance

Currency Market

Equity Market

Recourse to IMF

Industrial Production

GDPSignificant and

Consistent Sign?^

Independent Variable

Reserves (% GDP)0.082 (2.52)

0.850 (1.6)

-1.020 (-1.92)

0.155 (2.22)

0.008 (0.27)

Yes

Reserves (% external debt)-0.000 (-1.42)

0.000 (2.11)

-0.010 (-3.42)

0.000 (3.62)

0.000 (3.07)

Yes

Reserves (in months of imports)0.002 (1.58)

0.103 (4.71)

-0.089 (-3.31)

0.006 (1.48)

0.001 (0.75)

Yes

M2 to Reserves0.000 (0.14)

-0.026 (-3.81)

-0.067 (-1)

-0.001 (-2.46)

0.000 (1.44)

Yes

Short-term Debt (% of reserves)-0.000 (-2.6)

-0.007 (-4.45)

0.000 (1.18)

-0.000 (-1.7)

-0.000 (-2.93)

Yes

REER (5-yr % rise)-0.293 (-5.4)

-0.303 (-0.32)

0.889 (0.99)

-0.000 (-0.01)

-0.029 (-0.85)

REER (Dev. from 10-yr av)-0.292 (-2.93)

-0.920 (-0.81)

0.671 (0.58)

-0.000 (-0.01)

-0.041 (-0.91)

GDP growth (2007, %)0.003 (1.7)

0.078 (1.58)

0.039 (1.63)

0.010 (2.59)

-0.002 (-1.21)

Yes

GDP Growth (last 5 yrs)0.002 (1.08)

0.118 (2.14)

0.052 (1.68)

0.009 (2.14)

-0.003 (-1.21)


0.087 (1.06)

0.042 (1.2)

0.016 (2.63)

-0.004 (-0.76)

GDP per capita (2007, constant 2000$)-0.003 (-0.7)

-0.296 (-4.69)

-0.221 (-3.23)

-0.027 (-2.48)

-0.010 (-1.74)

Change in Credit (5-yr rise, % GDP)-0.029 (-0.83)

-1.979 (-5.42)

0.139 (0.37)

-0.092 (-1.67)

-0.065 (-2.34)

Yes


-0.904 (-3.9)

-0.011 (-0.08)

-0.046 (-1.58)

-0.019 (-1.13)

Yes

Credit Depth of Information Index (higher=more)-0.005 (-1.34)

-0.115 (-1.72)

0.009 (0.19)

0.006 (0.57)

-0.003 (-0.47)

Bank liquid reserves to bank assets ratio (%)0.000 (1.52)

0.022 (1.51)

-0.000 (-13.97)

0.002 (2.34)

0.001 (2.58)

Yes

Current Account (% GDP)0.001 (1.57)

0.032 (2.18)

-0.032 (-3.46)

0.000 (0.42)

0.000 (0.78)

Yes

Current Account, 5-yr Average (% GDP)0.001 (1.31)

0.030 (1.66)

-0.032 (-2.76)

0.000 (0.53)

0.000 (0.42)


0.034 (1.46)

-0.038 (-2.63)

0.000 (0.15)

0.001 (1.59)

Net National Savings (% GNI)0.000 (0.9)

0.048 (4.5)

-0.020 (-1.88)

0.003 (2.42)

0.002 (2.92)

Yes

Gross National Savings (% GDP)0.000 (0.76)

0.047 (3.9)

-0.028 (-2.51)

0.003 (1.99)

0.002 (2.52)

Yes

Change in M3 (5-yr rise, % GDP)0.000 (0.16)

-0.018 (-1.41)

-0.001 (-0.14)

-0.002 (-1.49)

-0.001 (-1.05)


-0.023 (-1.5)

0.007 (0.63)

-0.002 (-1.14)

-0.001 (-0.91)

Trade Balance (% GDP)0.000 (0.44)

0.013 (1.2)

-0.018 (-2.38)

-0.000 (-0.78)

0.000 (0.01)

Exports (% GDP)0.000 (0.2)

-0.004 (-1.42)

-0.004 (-1.08)

-0.000 (-1.21)

-0.000 (-1.42)

Imports (% GDP)-0.000 (-0.04)

-0.007 (-1.67)

0.003 (1.01)

-0.000 (-1.18)

-0.000 (-1.46)

Inflation (average, last 5 yrs)0.000 (0.36)

0.080 (3.33)

-0.000 (-2.91)

0.003 (1)

-0.000 (-0.23)

Yes

Inflation (average, last 10 yrs)-0.000 (-1.25)

0.038 (1.81)

-0.000 (-0.92)

0.000 (0.03)

0.000 (0.31)

Stock Market (5 yr % change)-0.004 (-1.05)

0.022 (0.99)

0.046 (1.04)

0.001 (0.37)

-0.000 (-0.14)

Stock Market (5 yr return/st. dev.)-0.012 (-0.59)

-0.166 (-0.74)

0.436 (1.47)

-0.005 (-0.22)

-0.004 (-0.2)

Real Interest Rate-0.000 (-0.46)

0.036 (3.18)

0.006 (0.36)

0.001 (0.87)

0.004 (2.07)

Yes

Deposit Interest Rate-0.005 (-2.08)

0.107 (2.84)

0.001 (0.18)

0.002 (0.99)

-0.000 (-0.49)

Short-term Debt (% of exports)-0.000 (-0.88)

-0.023 (-3.66)

0.000 (0.09)

-0.000 (-2.03)

-0.001 (-3.99)

Yes

Short-term Debt (% of external debt)-0.001 (-1.41)

-0.014 (-0.64)

0.001 (0.18)

-0.000 (-0.2)

-0.000 (-0.26)

Public Debt Service (% of exports)0.001 (3.3)

0.022 (0.85)

-0.004 (-0.44)

-0.001 (-0.76)

0.003 (1.41)

Public Debt Service (% GNI)0.001 (3.02)

-0.010 (-0.33)

-0.031 (-0.83)

-0.005 (-0.68)

0.008 (1.1)

Multilateral Debt Service (% Public Debt Service)0.000 (1.41)

-0.001 (-0.2)

0.004 (1)

0.000 (0.97)

0.000 (0.65)

Aid (% of GNI)0.000 (2.67)

-0.019 (-0.93)

0.001 (0.18)

0.002 (1.09)

-0.001 (-0.09)

Financing via Int. Cap. Markets (gross, % GDP)0.000 (0.79)

-0.026 (-1.1)

-0.003 (-0.45)

0.001 (0.39)

-0.008 (-2.61)

Legal Rights Index (higher=more rights)-0.009 (-2.71)

-0.125 (-2.58)

-0.040 (-0.91)

-0.006 (-1.45)

-0.005 (-1.8)

Yes

Business Extent of Disclosure Index (higher=more disclosure)

-0.005 (-1.61)

-0.009 (-0.18)

-0.023 (-0.62)

0.006 (1.38)

0.002 (1.15)

Portfolio Flows (% GDP)-0.499 (-2.92)

0.344 (0.11)

1.433 (0.55)

0.726 (1.38)

-0.474 (-0.57)

FDI net inflows (% GDP)-0.000 (-0.67)

-0.003 (-3.73)

0.000 (0.2)

-0.000 (-15.13)

-0.000 (-1.52)

Yes

FDI net outflows (% GDP)0.000 (0.24)

0.002 (5.59)

0.001 (0.61)

0.000 (13.09)

0.000 (1.31)

Yes

Net FDI (% GDP)-0.000 (-0.05)

0.004 (0.97)

0.004 (0.43)

0.001 (7.06)

-0.000 (-0.05)

External Debt Service (% GNI)0.000 (0.76)

-0.058 (-2.39)

-0.007 (-0.65)

-0.001 (-0.74)

-0.005 (-6.32)

Yes

Present Value of External Debt (% exports)0.000 (0.31)

-0.007 (-3.99)

-0.000 (-0.08)

-0.000 (-1.67)

-0.000 (-2.77)

Yes

Present Value of External Debt (% GNI)0.000 (0.11)

-0.014 (-3.7)

-0.000 (-0.61)

-0.000 (-1.29)

-0.000 (-4.77)

Yes

Peg (1 = peg)0.057 (3.41)

-0.577 (-2.47)

-0.363 (-1.48)

-0.053 (-2.17)

-0.021 (-1.55)

Financial Openness (0=open)0.023 (1.34)

0.899 (4.56)

0.230 (1.03)

0.085 (1.6)

0.020 (0.63)

M3 (% GDP)0.000 (4.76)

-0.001 (-0.57)

-0.020 (-4.06)

0.000 (0.81)

0.000 (1.52)

Yes

M2 (% GDP)0.000 (4.21)

-0.001 (-0.59)

-0.019 (-3.88)

0.000 (0.63)

0.000 (1.43)

Yes

Domestic Credit (% GDP)0.012 (0.84)

-0.626 (-4.24)

-0.881 (-4.2)

-0.016 (-0.86)

0.004 (0.45)

Domestic Credit Provided by Banks (% GDP)0.000 (1.09)

-0.005 (-3.59)

-0.009 (-4.44)

-0.000 (-1.14)

0.000 (0.51)

Domestic Credit to Priv. Sector (% GDP)0.000 (0.58)

-0.006 (-4.92)

-0.014 (-4.19)

-0.000 (-1.03)

-0.000 (-0.32)

Market Cap of Listed Companies (% GDP)0.000 (1.86)

0.000 (0.28)

-0.010 (-1.91)

0.000 (0.45)

0.000 (1.66)

Yes

Euro Area-0.009 (-1.06)

-0.901 (-4.9)

--0.055 (-2.29)

-0.006 (-0.68)

Yes

Low Income Country0.021 (1.16)

0.729 (2.45)

0.376 (1.54)

- -

Middle Income-0.025 (-1.58)

0.821 (3.7)

0.398 (1.85)

0.067 (3.19)

0.017 (1.17)

Upper Income0.013 (0.86)

-0.982 (-4.83)

-1.079 (-3.27)

-0.067 (-3.19)

-0.017 (-1.17)

OECD-0.042 (-2.29)

-0.709 (-3.69)

-0.478 (-1.27)

-0.051 (-2.39)

-0.005 (-0.47)

Yes

South Asia0.063 (3.63)

0.799 (2.71)

0.185 (0.4)

0.195 (17.65)

0.015 (0.37)

Yes

Europe & Central Asia-0.078 (-4.9)

-1.038 (-5.13)

0.306 (1.34)

-0.071 (-3.45)

-0.052 (-4.29)

Yes

Middle East & North Africa0.074 (4.18)

0.092 (0.31)

-0.673 (-1.39)

0.058 (2.03)

0.074 (5.63)

Yes

East Asia & Pacific0.017 (0.8)

0.494 (1.75)

-0.953 (-2.12)

0.056 (1.55)

0.038 (2.64)

Yes

Sub-Saharan Africa-0.049 (-2.12)

0.549 (2.79)

0.513 (2.17)

0.068 (5.93)

0.017 (2.47)

Latin America & Carribean0.024 (0.94)

-0.634 (-1.53)

-0.320 (-0.81)

-0.018 (-0.73)

-0.046 (-1.82)

North America0.016 (0.26)

-1.003 (-5.2)

--0.027 (-2.25)

0.006 (0.91)

Yes

*OLS with heteroscedaticity robust standard errors performed for four continuous variables; probit for IMF recourse variable^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

CAPITAL

FLOWS

EXT DEBT

INCOME

REGI

ON

FINANCIAL MKT

DEVELOPMENT

RESERVES

REER

GDP

CURRENT

ACCOUNT

TRADE

INFL.

DEBT COMPOSITI

ON

INT

RATE

CREDIT

STOCK

MKT

MONEY

F & Saravelos (2010): Bivariate

3939

Exchange Market

Pressure

Currency % Changes

(H208-H109

Recourse to IMF

(SBA only)

Equity %Chng (Sep08-Mar09)

Equity % Chng

(H208-H109)

Significant and

Consistent Sign?^

Independent Variable

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 Reserves0.000 (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)


0.001 (0.43)

0.064 (1.66)

-0.012 (-0.67)

-0.020 (-1.12)


-0.035 (-0.98)

0.552 (1.02)

-0.274 (-2.97)

-0.248 (-4.13)

Yes


-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


0.001 (1.82)

-0.025 (-1.72)

0.007 (2.4)

0.006 (2.74)

Yes


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)

Yes

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


-0.000 (-0.16)

-0.000 (-0.08)

-0.004 (-1.08)

-0.004 (-2.79)


-0.000 (-0.29)

0.006 (0.51)

-0.005 (-1.25)

-0.006 (-2.86)

Trade Balance (% GDP)0.001 (1.73)

0.001 (1.78)

-0.014 (-1.51)

0.006 (2.72)

0.003 (1.97)

Yes

Exports (% GDP)0.000 (0.93)

0.000 (1.97)

-0.002 (-0.53)

0.000 (0.02)

-0.000 (-0.83)

Imports (% GDP)-0.000 (-0.15)

0.000 (0.57)

0.002 (0.79)

-0.000 (-0.73)

-0.000 (-1.36)


-0.001 (-0.75)

0.094 (3.4)

0.000 (0.01)

0.002 (0.26)

Yes


-0.001 (-1.54)

0.017 (2.04)

-0.000 (-0.16)

0.000 (0.18)

Yes

Stock Market (5 yr % change)-0.006 (-0.86)

-0.006 (-1.34)

0.035 (0.74)

-0.016 (-3.72)

-0.018 (-5.59)

Yes

Stock Market (5 yr return/st.dev.)0.010 (0.31)

-0.024 (-1.02)

-0.394 (-1.17)

-0.097 (-1.92)

-0.042 (-0.93)

Real Interest Rate-0.001 (-0.79)

-0.000 (-0.42)

-0.022 (-1.05)

0.005 (1.81)

0.004 (1.85)

Yes

Deposit Interest Rate-0.014 (-4.43)

-0.003 (-1.72)

0.058 (1.78)

0.019 (3.33)

0.009 (1.39)

Short-term Debt (% of exports)-0.000 (-0.04)

-0.000 (-1.43)

0.000 (0.36)

-0.004 (-3.28)

-0.003 (-2.82)

Yes

Short-term Debt (% of external debt)-0.001 (-1.41)

-0.001 (-2.1)

0.009 (1.17)

-0.001 (-0.34)

-0.000 (-0.03)

Public Debt Service (% of exports)0.002 (3.04)

0.000 (1.18)

-0.036 (-1.14)

0.008 (1.22)

0.005 (0.98)

Public Debt Service (% GNI)0.001 (2.37)

0.000 (0.97)

-0.050 (-0.71)

0.003 (0.33)

0.002 (0.3)

Multilateral Debt Service (% Public Debt Service)0.001 (1.77)

0.000 (0.52)

0.001 (0.17)

-0.001 (-1.05)

0.000 (0.01)

Aid (% of GNI)0.002 (2.81)

0.000 (1.22)

-0.141 (-3.23)

-0.007 (-0.77)

-0.001 (-0.15)

Yes

Financing via Int. Cap. Markets (gross, % GDP)-0.000

(0)-0.000 (-0.48)

-0.011 (-0.57)

-0.012 (-2.14)

-0.005 (-1)

Legal Rights Index (higher=more rights)-0.009 (-1.49)

-0.006 (-1.46)

0.008 (0.15)

-0.017 (-1.52)

-0.015 (-1.78)

Business Extent of Disclosure Index (higher=more disclosure)

-0.002 (-0.39)

-0.001 (-0.32)

-0.024 (-0.52)

-0.001 (-0.13)

-0.000 (-0.1)

Portfolio Flows (% GDP)-0.616 (-2.88)

-0.435 (-3.33)

2.090 (0.74)

-0.979 (-0.77)

-0.889 (-0.77)

Yes

FDI net inflows (% GDP)-0.000 (-2.05)

-0.000 (-0.87)

-0.000 (-0.04)

-0.000 (-2.57)

-0.000 (-2.05)

Yes

FDI net outflows (% GDP)0.000 (1.8)

0.000 (0.81)

-0.000 (-0.45)

0.000 (3.38)

0.000 (2.84)

Yes

Net FDI (% GDP)0.001 (1.15)

0.000 (0.44)

-0.002 (-0.27)

-0.000 (-0.13)

-0.000 (-0.27)

External Debt Service (% GNI)0.000 (0.91)

0.000 (0.05)

-0.000 (-0.04)

-0.016 (-5.11)

-0.013 (-4.87)

Yes

Present Value of External Debt (% exports)0.000 (0.08)

-0.000 (-0.38)

-0.000 (-0.06)

-0.001 (-3.55)

-0.001 (-3.92)

Yes

Present Value of External Debt (% GNI)0.000 (0.16)

-0.000 (-0.82)

0.000 (0.38)

-0.003 (-4.39)

-0.002 (-3.8)

Yes

Peg (1 = peg)0.100 (3.89)

0.055 (3.34)

-0.577 (-1.89)

-0.075 (-1.67)

-0.041 (-1.04)

Yes

Financial Openness (0=open)0.083 (2.76)

0.023 (1.16)

-0.587 (-1.72)

0.059 (0.68)

0.003 (0.05)

Yes

M3 (% GDP)0.001 (4.12)

0.000 (4.47)

-0.020 (-3.45)

0.000 (0.31)

-0.000 (-0.22)

Yes

M2 (% GDP)0.001 (4.24)

0.000 (4.78)

-0.022 (-3.43)

0.000 (0.4)

-0.000 (-0.03)

Yes

Domestic Credit (% GDP)0.040 (1.53)

0.009 (0.61)

-0.593 (-2.66)

-0.010 (-0.22)

-0.027 (-0.62)

Domestic Credit Provided by Banks (% GDP)0.000 (1.81)

0.000 (1.52)

-0.006 (-3.17)

-0.000 (-0.21)

-0.000 (-0.55)

Yes

Domestic Credit to Priv. Sector (% GDP)0.000 (1.87)

0.000 (1.51)

-0.012 (-3.13)

-0.000 (-0.5)

-0.000 (-0.87)

Yes

Market Cap of Listed Companies (% GDP)0.000 (1.65)

0.000 (2.01)

-0.006 (-1.41)

0.000 (1.35)

0.000 (1.47)

South Asia0.045 (0.81)

0.045 (2.12)

0.476 (0.99)

0.158 (1.81)

0.033 (0.54)

Yes

Europe & Central Asia-0.150 (-4.43)

-0.095 (-5.61)

0.636 (2.09)

-0.202 (-4.43)

-0.167 (-4.64)

Yes

Middle East & North Africa0.080 (2.7)

0.061 (2.86)

-0.003 (0.05)

0.049 (0.84)

Yes

East Asia & Pacific0.071 (2.71)

0.034 (1.58)

-0.629 (-1.34)

0.135 (2.63)

0.054 (1.08)

Yes

Sub-Saharan Africa-0.006 (-0.14)

-0.024 (-0.83)

-0.424 (-0.98)

-0.068 (-0.89)

0.047 (0.72)

Latin America & Carribean-0.014 (-0.23)

-0.013 (-0.39)

0.205 (0.47)

-0.049 (-0.84)

-0.048 (-0.93)

North America0.061 (0.92)

0.041 (0.91)

-0.030 (1.1)

0.024 (0.95)

*OLS with heteroscedasticity robust standard errors performed for four continuous variables; probit for IMF recourse variable^At least two statistically signficant coefficients, of which all must have consistent sign (consistent = same sign, with exception of coefficient on IMF recourse variable, which should have opposite sign)

RESERVES

REER

GDP

CURRENT

ACCOUNT

CREDIT

MONEY

STOCK

MKT

TRADE

INFL.

DEBT COMPOSITI

ON

INT

RATE

CAPITAL

FLOWS

EXT DEBT

REGI

ON

FINANCIAL MKT

DEVELOPMENT

F & Saravelos (2010): Multivariate

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

4040

ReservesReserves

Even though many developing & emerging market Even though many developing & emerging market countries described themselves as floating,countries described themselves as floating,

most took advantage of the boom of 2003-2008 most took advantage of the boom of 2003-2008 to build up reserves to unheard of heights, to build up reserves to unheard of heights, • in the aftermath of the crises of 1994-2001.in the aftermath of the crises of 1994-2001.

in contrast to past capital booms (1975-81, 1990-97).in contrast to past capital booms (1975-81, 1990-97).

4141

When the 2008-09 global financial crisis hit,When the 2008-09 global financial crisis hit,• those countries that had taken advantage of those countries that had taken advantage of

the 2003-08 boom to build up reserves did better.the 2003-08 boom to build up reserves did better. E.g., Obstfeld, Shambaugh & Taylor E.g., Obstfeld, Shambaugh & Taylor (2009)(2009) Frankel & Saravelos Frankel & Saravelos (2010),(2010),

This had also been the most common finding This had also been the most common finding in the many studies of Early Warning Indicators in the many studies of Early Warning Indicators in past emerging market crises.in past emerging market crises.

4242

Poland,Poland, the the only continental EU member with a floating only continental EU member with a floating exchange rate, was also the only one to escape exchange rate, was also the only one to escape negative growth in the global recession of 2009negative growth in the global recession of 2009

2006 2007 2008 2009 2010 Exchange Rate

Poland6.2 6.8 5.1 1.7 3.5f

Floating

Lithuania7.8 9.8 2.9 -14.7 -0.6f

Fixed

Latvia12.2 10.0 -4.2 -18.0 -3.5f

Fixed

Estonia10.6 6.9 -5.1 -13.9 0.9f

Fixed

Slovakia8.5 10.6 6.2 -4.7 2.7f

Euro

Czech Republic6.8 6.1 2.5 -4.1 1.6f

Flexible

Hungary3.6 0.8 0.8 -6.7 0.0f

Flexible

Source: Cezary Wójcik, 2010

(de facto)

% change in GDP

4343

DepreciationDepreciation boostedboosted netnet exports; contribution to GDPexports; contribution to GDP growth growth > > 100%100%

3,2

3,5

3,7

4,0

4,2

4,5

4,7

I III V VII IX XI I III V VII IX XI I III V VII IX

2008 2009 2010

8,0

13,0

18,0

23,0

28,0

Contribution of Net X to GDP:

2009: 2,5 3,4 3,2 3,4

GDP growth rate: 1,7

Source: Cezary Wójcik

kroon / $Estonia

Latvialats / $

zlotys / $

The Polish exchange rate increased by 35%. The Polish exchange rate increased by 35%.

4545

Appendices: The 3 big currenciesAppendices: The 3 big currencies

Appendix I: The end of $ hegemony?

Appendix II: Is RMB appreciation in China’s own interest?

Appendix III: Predictions – Sovereign debt troubles & the €

Appendix IV: More on the trend to a multiple reserve system

4646

Appendix 1: Appendix 1: The end of dollar hegemony ?The end of dollar hegemony ?

Some argue the US current account Some argue the US current account deficit is sustainable indefinitely.deficit is sustainable indefinitely.• They believe that the US will continue to enjoy They believe that the US will continue to enjoy

its unique “exorbitant privilege,” its unique “exorbitant privilege,” able to borrow unlimited amounts in its own currencyable to borrow unlimited amounts in its own currency because it is the dominant international reserve asset.because it is the dominant international reserve asset.

4747

““Bretton Woods II”Bretton Woods II”

Dooley, Folkerts-Landau, & Garber Dooley, Folkerts-Landau, & Garber (2003) (2003) ::

• today’s system is a new Bretton Woods,today’s system is a new Bretton Woods, with Asia playing the role that Europe played with Asia playing the role that Europe played

in the 1960s—buying up $ to prevent in the 1960s—buying up $ to prevent their own currencies from appreciating.their own currencies from appreciating.

• More provocatively: More provocatively: China is piling up dollars China is piling up dollars not because of myopic mercantilism, not because of myopic mercantilism, but as part of an export-led development strategy but as part of an export-led development strategy that is rational given China’s need to import workable that is rational given China’s need to import workable systems of finance & corporate governance.systems of finance & corporate governance.

4848

My own view on Bretton Woods II:My own view on Bretton Woods II:

• The 1960s analogy is indeed apt, The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or 1958. but we are closer to 1971 than to 1944 or 1958.

• Why did the BW system collapse in 1971?Why did the BW system collapse in 1971?

The Triffin dilemma could have taken decades The Triffin dilemma could have taken decades to work itself out.to work itself out.

But the Johnson & Nixon But the Johnson & Nixon administrations accelerated administrations accelerated the processthe process by fiscal & monetary expansion by fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively).(driven by the Vietnam War & Arthur Burns, respectively).

These policies produced: declining external balances, These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods$ devaluation, & the end of Bretton Woods. .

4949

There is no reason to expect better today:There is no reason to expect better today:

1)1) Capital mobilityCapital mobilityis much higher now than in the 1960s.is much higher now than in the 1960s.

2)2) The US can no longer rely The US can no longer rely on support of foreign central banks:on support of foreign central banks:

neither on economic groundsneither on economic grounds

(they are not now, as they were then, (they are not now, as they were then, organized into a cooperative framework where organized into a cooperative framework where each agrees explicitly to hold $ if the others do), each agrees explicitly to hold $ if the others do),

nor on political groundsnor on political grounds

(these creditors are not the staunch allies (these creditors are not the staunch allies the US had in the 1960s). the US had in the 1960s).

5050

The financial crisis caused a flight to quality The financial crisis caused a flight to quality which evidently still means a flight to US $.which evidently still means a flight to US $.

US Treasury bills in 2008-09 were more in demand US Treasury bills in 2008-09 were more in demand than ever, as reflected in very low interest rates.than ever, as reflected in very low interest rates.

The $ The $ appreciatedappreciated, rather than depreciating as the “hard landing” , rather than depreciating as the “hard landing” scenario had predicted.scenario had predicted.

=> The day of reckoning had not yet arrived.=> The day of reckoning had not yet arrived.

Chinese warnings Chinese warnings (2009)(2009) may be turning point: may be turning point:• Premier Wen worried US T bills will lose value.Premier Wen worried US T bills will lose value.

• PBoC Gov. Zhou proposed PBoC Gov. Zhou proposed replacing $ as international replacing $ as international currency.currency.

5151

Multiple international Multiple international reserve asset systemreserve asset system

The € now exists as a rival to the $.The € now exists as a rival to the $.

The ¥ & SF are also safe havens.The ¥ & SF are also safe havens.

The SDR came back The SDR came back from the dead in 2009.from the dead in 2009.

Gold made a comeback as Gold made a comeback as an international reserve too.an international reserve too.

Someday the RMB will join the rosterSomeday the RMB will join the rosterthough it is just beginning now.though it is just beginning now.

= a multiple international reserve currency system.= a multiple international reserve currency system.

5252

Countries should have the right to fix Countries should have the right to fix their exchange rate if they want to.their exchange rate if they want to.

True, the IMF Articles of Agreement True, the IMF Articles of Agreement and the US Omnibus Trade Act of 1988 and the US Omnibus Trade Act of 1988 call for action in the event that a country call for action in the event that a country is “unfairly manipulating its currency”.is “unfairly manipulating its currency”.

ButBut• Few countries have been forced to appreciate.Few countries have been forced to appreciate.• Pressure on surplus countries to appreciate will inevitablyPressure on surplus countries to appreciate will inevitablybe less than pressure on deficit countries to depreciate.be less than pressure on deficit countries to depreciate.• I support ending the language of “manipulation.”I support ending the language of “manipulation.”

Usually, it is hard to say when a currency is undervalued.Usually, it is hard to say when a currency is undervalued. Don’t cheapen the language that is appropriate to WTO rules.Don’t cheapen the language that is appropriate to WTO rules.

China should do what is in its own long-term interest.China should do what is in its own long-term interest.

Appendix II: What is in China’s interest?Appendix II: What is in China’s interest?

5353

Five reasons why China should let Five reasons why China should let the RMB appreciate, in its own interestthe RMB appreciate, in its own interest

1.1. Overheating of economyOverheating of economy

2.2. Reserves are excessive. Reserves are excessive. • It gets harder to sterilize the inflow over time.It gets harder to sterilize the inflow over time.

3.3. Attaining internal and external balance.Attaining internal and external balance.• To attain both, need 2 policy instruments. To attain both, need 2 policy instruments. • In a large country like China, In a large country like China,

expenditure-switching policy should be the exchange rate.expenditure-switching policy should be the exchange rate.

4.4. Avoiding future crashes.Avoiding future crashes.

5.5. RMB undervalued, judged by RMB undervalued, judged by Balassa-Samuelson relationship.Balassa-Samuelson relationship.

5454

1. Overheating of economy:1. Overheating of economy: Bottlenecks. Pace of economic growth is outrunning:Bottlenecks. Pace of economic growth is outrunning:

• raw material supplies, andraw material supplies, and• labor supply in coastal provinceslabor supply in coastal provinces• Also:Also:

• physical infrastructurephysical infrastructure• environmental capacityenvironmental capacity• level of sophistication of financial system.level of sophistication of financial system.

Asset bubbles.Asset bubbles.• Shanghai stock market bubble in 2007.Shanghai stock market bubble in 2007.

Inflation 6-7% in 2007 Inflation 6-7% in 2007 => price controls=> price controls shortages & social unrest.shortages & social unrest.

All of the above was suspended in late 2008,All of the above was suspended in late 2008,• due to global recession.due to global recession.• But it is back again now; skyrocketing real estate prices.But it is back again now; skyrocketing real estate prices.

5555

Attempts at “sterilization,” to insulate Attempts at “sterilization,” to insulate domestic economy from the inflowsdomestic economy from the inflows

Sterilization is defined as offsettingSterilization is defined as offsettingof international reserve inflows,of international reserve inflows,so as to prevent them from showing upso as to prevent them from showing updomestically as excessive money growth & inflation.domestically as excessive money growth & inflation.

For awhile PBoC successfully sterilized…For awhile PBoC successfully sterilized…• until 2007-08.until 2007-08.• The usual limitations finally showed up:The usual limitations finally showed up:

Prolongation of capital inflows Prolongation of capital inflows <= self-equilibrating mechanism shut off.<= self-equilibrating mechanism shut off. Quasi-fiscal deficit: Quasi-fiscal deficit: gap between domestic interest rates & US T bill rategap between domestic interest rates & US T bill rate Failure to sterilize: Failure to sterilize: money supply rising faster than incomemoney supply rising faster than income Rising inflation Rising inflation (admittedly due not only to rising money supply)(admittedly due not only to rising money supply)

5656

2. Foreign Exchange Reserves2. Foreign Exchange Reserves

Excessive:Excessive:• Though a useful shield against currency crises, Though a useful shield against currency crises, • China has enough reserves: $2 ½ China has enough reserves: $2 ½ trilliontrillion by by April 2010;April 2010;

• & US treasury securities do not pay high returns.& US treasury securities do not pay high returns.

Harder to sterilize Harder to sterilize the inflow over time.the inflow over time.

5757

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

The Balance of Payments≡ rate of change of foreign exchange reserves (largely $),

rose rapidly in China over past decade,due to all 3 components:

trade balance, Foreign Direct Investment, and portfolio inflows

5858

While reserves (NFA) rose rapidly, the growth of the monetary basewas kept to the growth of the real economy – even reduced in 2005-06.

Successful sterilization in China: 2005-06Attempts to sterilize reserve inflow:Attempts to sterilize reserve inflow:

were remarkably successful in 2005-06.were remarkably successful in 2005-06.

High reserve growth

offset by cuts indomestic credit

=> steady money

5959

In 2007-08 China began to have more In 2007-08 China began to have more trouble sterilizing the reserve inflowtrouble sterilizing the reserve inflow

PBoC began to pay higher interest rate PBoC began to pay higher interest rate domestically, & receive lower domestically, & receive lower interest rate on US T bills interest rate on US T bills => quasi-fiscal deficit.=> quasi-fiscal deficit.

Inflation became a serious problem.Inflation became a serious problem.• True, global increases in food & energy pricesTrue, global increases in food & energy prices

were much of the explanation.were much of the explanation.• ButBut

China’s overly rapid growth itself contributed.China’s overly rapid growth itself contributed. Appreciation is a good way to put immediate downward Appreciation is a good way to put immediate downward

pressure on local prices of farm & energy commodities.pressure on local prices of farm & energy commodities. Price controls are inefficient and ultimately ineffective.Price controls are inefficient and ultimately ineffective.

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Sterilization faltered in 2007 & 2008Sterilization faltered in 2007 & 2008

Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

Monetary baseaccelerated

Growth of China’smonetary base,

& its components

6161

New York Times Jan 12, 2011

Foreign exchange reserves held by

the People’s Bank

of China are approaching

$3 trillion in 2011.

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New York Times Jan 12, 2011

The Chinese money supply has almost doubled in the last

3 years, contributing to a rapid growth

aggregate demandas reflected in nominal GDP.

No wonder inflation is rising again.

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3. Need a flexible exchange rate to 3. Need a flexible exchange rate to attain internal & externalattain internal & external balancebalance

Internal balance ≡ Internal balance ≡ demand neither too low (recession) nor too high demand neither too low (recession) nor too high (overheating).(overheating).

External balance ≡ appropriate balance of payments.External balance ≡ appropriate balance of payments.

General principle: to attain both policy targets, General principle: to attain both policy targets, a country needs to use 2 policy instruments.a country needs to use 2 policy instruments.

For a country as large as China, one of those policy For a country as large as China, one of those policy instruments should be the exchange rate.instruments should be the exchange rate.

To reduce BoP surplus without causing higher unemployment, To reduce BoP surplus without causing higher unemployment, China needs bothChina needs both• currency appreciation, currency appreciation, and and • expansion of domestic demandexpansion of domestic demand

gradually replacing foreign demand,gradually replacing foreign demand, developing neglected sectors: developing neglected sectors:

health, education, environment, housing, finance, & services.health, education, environment, housing, finance, & services.

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4. Avoiding future crashes4. Avoiding future crashes

Experience of other emerging markets Experience of other emerging markets suggests it is better to exit from a peg in suggests it is better to exit from a peg in good times, when the BoP is strong, than good times, when the BoP is strong, than to wait until the currency is under attack.to wait until the currency is under attack.

Introducing some flexibility now, even though not ready for free floating.

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5. Longer-run perspective:5. Longer-run perspective:Balassa-Samuelson relationshipBalassa-Samuelson relationship

Prices of goods & services in China are lowPrices of goods & services in China are low• compared at the nominal exchange rate.compared at the nominal exchange rate.• Of course they are a fraction of those in the U.S.: < ¼ .Of course they are a fraction of those in the U.S.: < ¼ .• This is to be expected, This is to be expected,

explained by the Balassa-Samuelson effectexplained by the Balassa-Samuelson effect which says that low-income countries have lower price levels.which says that low-income countries have lower price levels. As countries’ real income grows, their currencies experience real As countries’ real income grows, their currencies experience real

appreciation: approx. .3% for every 1 % in income per capita.appreciation: approx. .3% for every 1 % in income per capita.

• But China is one of those countries that is cheap or But China is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.undervalued even taking into account Balassa-Samuelson.

6666

-1-.

50

.51

Lo

g o

f P

rice L

evel

-3 -2 -1 0 1 2Log of Real Per capita GDP (PPP)

coef = .23367193, (robust) se = .01978263, t = 11.81

Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluationand Policy Implications,” PB10-08, Peterson Institute for International Economics

Undervaluation of RMB in the regression estimated above = 26%.Estimated undervaluation averaging across four such estimates = 31%.

Compare to Frankel (2005) estimate for 2000 = 36%.

The Balassa-Samuelson Relationship2005

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Appendix III: Debt PredictionsAppendix III: Debt Predictions

Greece will needGreece will needto re-structure its debt.to re-structure its debt.

The euro will survive.The euro will survive.• There is no legal provision There is no legal provision

for members to leave the euro zone.for members to leave the euro zone.

Prices of government bonds in Prices of government bonds in advanced countries in general will fall.advanced countries in general will fall.

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The euro project is lookingThe euro project is lookingfar less successful than just a few years agofar less successful than just a few years ago

Many predictions of euro skeptics have come true:Many predictions of euro skeptics have come true:• Periphery countries and core countries have had trouble Periphery countries and core countries have had trouble

reconciling asymmetric monetary needs.reconciling asymmetric monetary needs.• Euro members have not had enough labor mobility Euro members have not had enough labor mobility

or flexibility to make up for it.or flexibility to make up for it.

• Efforts to prevent excessive debt & bailouts have failed:Efforts to prevent excessive debt & bailouts have failed: The Stability & Growth Pact failed The Stability & Growth Pact failed with members big & small.with members big & small. The “No bailout clause” has failed with Greece.The “No bailout clause” has failed with Greece.

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Frankfurt & Brussels Frankfurt & Brussels made 4 mistakes regarding Greecemade 4 mistakes regarding Greece

2001: They let Greece into the euro2001: They let Greece into the euro

2002-09: ECB accepted Greek debt as collateral2002-09: ECB accepted Greek debt as collateral• despite consistent violation of SGP.despite consistent violation of SGP.• => Did not allow interest rate spreads to open up.=> Did not allow interest rate spreads to open up.

Winter 2010: Did not tell Greece to go to the IMF. Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally.”Preferred instead to “handle it internally.”

Still today: No “Plan B” to restructure Greek debt Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).(and save the bailout fund for more deserving banks & PIIGs).

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Judging from spreads, 2001-07, Judging from spreads, 2001-07, investors put zero odds on a default by Greece investors put zero odds on a default by Greece

or other Mediterranean countriesor other Mediterranean countries

Council on Foreign Relations

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Suddenly, in 2010, the Greek sovereign spread Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. shot up, exceeding 800% by June.

Even when the Greek crisis erupted, Even when the Greek crisis erupted, leaders in Brussels & Frankfurt leaders in Brussels & Frankfurt seemed to view it as a black swan, seemed to view it as a black swan, • instead of recognizing it as a close cousin instead of recognizing it as a close cousin

of the Argentine crisis of ten years earlier, of the Argentine crisis of ten years earlier, and many others in history,and many others in history,

• including among European countries.including among European countries.

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Sovereign debt worriesSovereign debt worries ......

• The next big asset market to fall• after the stock market in 2000• the housing market in 2006• and banking in 2008

• will likely be sovereign debt• among the advanced economies.

• The major emerging market countries are in much better shape,

• in an amazing & historic role reversal.

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Sovereign spreads for 5 euro countries shot up in the 1st half of 2010

Creditworthiness: Some advanced economics Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.have fallen, as emerging markets have risen.

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A remarkable role-reversal:

• Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets;

• and rising rapidly.

• By 2014 (at ≈ 120%), it could be triple.

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Even judged by ratings of credit Even judged by ratings of credit agencies, emerging markets are now agencies, emerging markets are now intermingled with advanced countriesintermingled with advanced countries

• Singapore’s credit rating is now above Belgium’sSingapore’s credit rating is now above Belgium’s• China’s rating rose above Japan’s in JanuaryChina’s rating rose above Japan’s in January• Taiwan is above Italy Taiwan is above Italy • Chile is above Israel Chile is above Israel • Korea is above Portugal Korea is above Portugal • Malaysia is above IrelandMalaysia is above Ireland• South Africa is above IcelandSouth Africa is above Iceland• India is above Greece. India is above Greece.

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Ratings for “Emerging Economies”Ratings for “Advanced Economies”

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When does the “privilege” become “exorbitant?”When does the “privilege” become “exorbitant?”

if it accrues solely because of size and history, without if it accrues solely because of size and history, without the US having done anything to earn the US having done anything to earn the benefit by virtuous policies such as budget the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. discipline, price stability & a stable exchange rate.

Since 1973, the US has racked up $10 trillion Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in debt and the $ has experienced a 30% loss in value compared to other major currencies.in value compared to other major currencies.

It seems unlikely that macroeconomic policy discipline It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !is what has earned the US its privilege !

Appendix IV: More on the trend from $ hegemony to a multiple reserve system

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Some argue that the privilege to incur $ Some argue that the privilege to incur $ liabilities has been earned in a different way:liabilities has been earned in a different way:

Global savings glutGlobal savings glut (Bernanke)(Bernanke)

The US appropriately exploits its comparative advantage The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the worldin supplying high-quality assets to the rest of the world ..

• ““Intermediation rents…pay for the trade deficits.” Intermediation rents…pay for the trade deficits.” -- Caballero, Farhi & Gourinchas-- Caballero, Farhi & Gourinchas (2008)(2008)

• In one version, the US has been operating as the World’s In one version, the US has been operating as the World’s Venture Capitalist, accepting short-term liquid deposits and Venture Capitalist, accepting short-term liquid deposits and making long-term or risky investmentsmaking long-term or risky investments -- Gourinchas & Rey-- Gourinchas & Rey (2008)(2008)..

• US supplies high-quality assets:US supplies high-quality assets:Cooper Cooper (2005);(2005); Forbes Forbes (2008);(2008); Ju & Wei (2008);Ju & Wei (2008); Hausmann & Sturzenegger Hausmann & Sturzenegger (2006a, b);(2006a, b); Mendoza, Quadrini Mendoza, Quadrini & & Rios-RullRios-Rull (2007a, b)…(2007a, b)…

7979

The argument that the US offers assets of superior The argument that the US offers assets of superior quality, and so has earned the right to finance its quality, and so has earned the right to finance its deficits, was undermined by the dysfunctionality deficits, was undermined by the dysfunctionality revealed in the financial crisis of 2007-08. revealed in the financial crisis of 2007-08.

American financial institutions suffered a severe American financial institutions suffered a severe loss of credibility loss of credibility (corporate governance, accounting (corporate governance, accounting standards, rating agencies, derivatives, etc.), standards, rating agencies, derivatives, etc.),

How could sub-prime mortgages be How could sub-prime mortgages be the superior type of assets that uniquely the superior type of assets that uniquely merit the respect of the world’s investors?merit the respect of the world’s investors?

8080

But the events of 2008-09 also But the events of 2008-09 also undermined the opposing interpretation, undermined the opposing interpretation, the unsustainability position: the unsustainability position:

Why no hard landing for the $, as long feared? Why no hard landing for the $, as long feared? The $ appreciated after Lehman Brothers’ The $ appreciated after Lehman Brothers’

bankruptcy, & US T bill interest rates fell. bankruptcy, & US T bill interest rates fell.

Clearly in 2008 the world still viewed Clearly in 2008 the world still viewed • the US Treasury market as a safe haven and the US Treasury market as a safe haven and

• the US $ as the premier international currencythe US $ as the premier international currency..

8181

Is the $’s unique role Is the $’s unique role an eternal god-given constant? an eternal god-given constant?

Or will a sufficiently long record of deficits & Or will a sufficiently long record of deficits & depreciation induce investors to turn elsewheredepreciation induce investors to turn elsewhere??

Though arguments about the unique high quality of US private assets have been tarnished, the idea of America as World Banker is still alive: the $ is the world’s reserve currency, by virtue of US size & history.

8282

Historical precedent: £Historical precedent: £ ’s loss of premier ’s loss of premier international currency status in 20international currency status in 20thth century century

By 1919, US had passed UKBy 1919, US had passed UK in in

1.1. output (1872)output (1872)

2.2. trade (1914)trade (1914)

3.3. net international creditor position (1914-19)net international creditor position (1914-19)

Subsequently, Subsequently, $ passed £ as #1 reserve currency $ passed £ as #1 reserve currency (1940-45).(1940-45).

8383

From the literatureFrom the literatureon reserve currencieson reserve currencies

Determinant: Determinant:

1.1. SizeSize

2.2. Depth of Fin.mkt.Depth of Fin.mkt.

3. Rate of return3. Rate of return

Proxy:Proxy:

GDPGDP

FX turnoverFX turnover

inflation,inflation,LR depreciation,LR depreciation,Exch. rate varianceExch. rate variance

8484

From the literature, From the literature, continuedcontinued

Network externalities Network externalities

=> Tipping => Tipping captured by:captured by:

1)1) InertiaInertia lagslags

2)2) NonlinearityNonlinearity logistic functional formlogistic functional form

in determinantsin determinants oror

dummy for leader GDPdummy for leader GDP

8585

0.0

0.2

0.4

0.6

0.8

1.0

75 80 85 90 95 00 05 10 15 20 25 30 35 40

USD

DEM

EUR

Chinn & Frankel Chinn & Frankel (2005)(2005)

Projection of $ vs € Projection of $ vs € as shares of central banks’ foreign exchange reserves: as shares of central banks’ foreign exchange reserves:

a function of country size, financial market depth, & rate of return, a function of country size, financial market depth, & rate of return, with parameters estimated on 1973-98 datawith parameters estimated on 1973-98 data..Simulation assumes $ depreciation continues at 2001-04 rate.Simulation assumes $ depreciation continues at 2001-04 rate.

birthof €€

This scenario showed € This scenario showed € overtaking $ as top international overtaking $ as top international

reserve currency in 2022.reserve currency in 2022.

8686

International Currency RolesInternational Currency RolesTable B

Adapted from Kenen Function of money:

Governments Private actors

Store of value

International reserve holdings

Currency substitution (private dollarization)

Medium of exchange

Vehicle currency for foreign exchange intervention

Invoicing trade and financial transactions

Unit of account

Anchor for pegging local currency

Denominating trade and financial transactions

More on a multiple-asset international reserve system

8787

A multiple reserve currency system is inefficient, A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: in the same sense that barter is inefficient: money was invented in the first place to cut down money was invented in the first place to cut down on the transactions costs of exchange. on the transactions costs of exchange.

Nevertheless, if sound macro policies Nevertheless, if sound macro policies in the leader country cannot be presumed, in the leader country cannot be presumed, the existence of competitor currencies gives the existence of competitor currencies gives the rest of the world protection against the leader the rest of the world protection against the leader exploiting its position by running up too much exploiting its position by running up too much debt and then inflating/depreciating it away.debt and then inflating/depreciating it away.

8888

GoldGold

Gold was seen as an anachronism Gold was seen as an anachronism just a few years ago:just a few years ago:• the world’s central banks were selling off their stocks.the world’s central banks were selling off their stocks.

Gold re-joined the world monetary system in 2009:Gold re-joined the world monetary system in 2009:• The PBoC, RBI, & other Asian central banks The PBoC, RBI, & other Asian central banks

bought gold, to diversify their reserves.bought gold, to diversify their reserves.• Even in advanced countries, central banks Even in advanced countries, central banks

appear to have stopped selling.appear to have stopped selling.

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Special Drawing RightsSpecial Drawing Rights

The SDR has made a surprising comeback as a potential The SDR has made a surprising comeback as a potential international money, from near-oblivion. international money, from near-oblivion.

The G20 in 2009 decided to create new SDRs ($250b). The G20 in 2009 decided to create new SDRs ($250b). Shortly later, PBoC Gov. Zhou proposed replacing Shortly later, PBoC Gov. Zhou proposed replacing

the $ as lead international currency with the SDR. the $ as lead international currency with the SDR. The IMF is now borrowing in SDRs. The IMF is now borrowing in SDRs. The proposal has been revived for an international The proposal has been revived for an international

substitution account at the IMF, to extinguish an unwanted substitution account at the IMF, to extinguish an unwanted $ overhang in exchange for SDRs. $ overhang in exchange for SDRs.

The SDR has little chance of standing up as a competitor The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $. to the € or ¥, let alone to the $.

Still, it is back in the world monetary system.Still, it is back in the world monetary system.

9090http://ksghome.harvard.edu/~jfrankel/index.htm

1 currency wars: global money in 2011 jeffrey frankel harpel professor of capital formation &...

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