external sector policies thorvaldur gylfason singapore, february 2008
DESCRIPTION
Real vs. nominal exchange rates 1 Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Increase in Q means real appreciation e e refers to foreign currency content of domestic currencyTRANSCRIPT
External External Sector Sector PoliciesPolicies
Thorvaldur GylfasonThorvaldur GylfasonSingapore, February 2008Singapore, February 2008
OutlineOutline1)1)Real vs. nominal exchange ratesReal vs. nominal exchange rates2)2)Exchange rate policy and Exchange rate policy and
welfarewelfare3)3)The scourge of overvaluationThe scourge of overvaluation4)4)From exchange and trade From exchange and trade
policies to economic growthpolicies to economic growth5)5)Capital flowsCapital flows6)6)Exchange rate regimesExchange rate regimes
To float or not to floatTo float or not to float
Real vs. nominal Real vs. nominal exchange ratesexchange rates11
*PePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Increase in Q means real appreciation
ee refers to foreign currency content of domestic currency
Real Real vs. nominal vs. nominal exchange ratesexchange rates
*PePQ
Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad
Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged
Three thought Three thought experimentsexperiments
*PePQ
1.1. Suppose e fallse fallsThen more baht per dollar, so X risesX rises, Z fallsZ falls
2.2. Suppose P fallsP fallsThen X risesX rises, Z fallsZ falls
3.3. Suppose P* risesP* risesThen X risesX rises, Z fallsZ falls
Summarize all three by supposing Q fallsQ falls Then X risesX rises, Z fallsZ falls
Foreign exchangeForeign exchange
Real
exc
hang
e ra
teRe
al e
xcha
nge
rate
Imports
Exports
Exchange rate policy Exchange rate policy and welfareand welfare22
Earnings from exports of goods, services, and capital
Payments for imports of goods, services, and capital
Equilibrium
Equilibrium between demand and supply in foreign exchange market establishes• Equilibrium real exchange rate• Equilibrium in the balance of
paymentsBOP = X + Fx – Z – Fz
= X – Z + F = current account + capital
account = 0
Exchange rate policy Exchange rate policy and welfareand welfare
Foreign exchangeForeign exchange
Real
exc
hang
e ra
teRe
al e
xcha
nge
rate
Imports
Exports
Exchange rate policy Exchange rate policy and welfareand welfare
OvervaluationDeficit
RR R moves when e is fixed
Foreign exchangeForeign exchange
Price
of f
orei
gn e
xcha
nge
Price
of f
orei
gn e
xcha
nge
Supply (exports)
Demand (imports)
Exchange rate policy Exchange rate policy and welfareand welfare
Overvaluation
Deficit
Overvaluation works like a price ceiling
The scourge of The scourge of overvaluationovervaluationGovernments may try to keep the
national currency overvalued• To keep foreign exchange cheap• To have power to ration scarce
foreign exchange• To make GNP look larger than it is
Other examples of price ceilings• Negative real interest rates• Rent controls
33
Inflation and Inflation and overvaluationovervaluationInflation can result in an
overvaluation of the national currency• Remember: Q = eP/P*Q = eP/P*
Suppose e adjusts to P with a lagThen Q is directly proportional to
inflationNumerical example
InflationInflation and and overvaluationovervaluation
Time
Real exchange rate
100
110105 Average
Suppose inflation is 10 percent per year
Inflation and Inflation and overvaluationovervaluation
Time
100
120
Real exchange rate
110 Average
Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag
Suppose inflation rises to 20 percent per year
How to correct How to correct overvaluationovervaluationUnder a floating exchange rate
regimeAdjustment is automatic: e moves
Under a fixed exchange rate regimeDevaluation will lower e and thereby
also Q – provided inflation is kept under control
Does devaluation improve the current account?The Marshall-Lerner condition
The Marshall-Lerner The Marshall-Lerner condition: Theorycondition: TheoryB = eeX – Z = eX(e) – Z(e)Not obvious that a lower e helps
TLet’s do the arithmeticBottom line is:Devaluation strengthens the
current account as long as1ba
Suppose prices are fixed, so that e = Q
a = elasticity of exportsb = elasticity of imports
ValuatioValuation effect n effect arises arises from the from the ability ability to affect to affect foreign foreign pricesprices
TheThe Marshall-Lerner Marshall-Lerner conditioncondition
ZeXB )()( eZeeXB
dedZ
dedXeX
dedB
eZ
Ze
dedZ
eX
Xe
dedXeX
dedB
1 1
-a b
- +
Export elasticityExport elasticity ImportImportelasticityelasticity
TheThe Marshall-Lerner Marshall-Lerner conditioncondition
eZ
Ze
dedZ
eX
Xe
dedXeX
dedB
XbabXaXXdedB
1
0dedB 1baif
X
Assume X = Z/e initially
Appreciation weakens current
account
The Marshall-Lerner The Marshall-Lerner condition: condition: EvidenceEvidenceEconometric studies indicate that
the Marshall-Lerner condition is almost invariably satisfied
Industrial countries: a = 1, b = 1Developing countries: a = 1, b =
1.5Hence,
1ba Devaluation strengthens the current account
Empirical evidence Empirical evidence from developing from developing countriescountries Elasticity of Elasticity of
exports importsArgentina 0.6 0.9Brazil 0.4 1.7India 0.5 2.2Kenya 1.0 0.8Korea 2.5 0.8Morocco 0.7 1.0Pakistan 1.8 0.8Philippines 0.9 2.7Turkey 1.4 2.7Average 1.1 1.5
The small country The small country case case Small countries are price takers
abroad• Devaluation has no effect on the
foreign currency price of exports and imports
So, the valuation effect does not arise
Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged
Hence, if a > 0 or b > 0, devaluation strengthens the current account
The importance of The importance of appropriate side appropriate side measuresmeasuresRemember:
It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation
To work, nominal devaluation must result in real devaluation
*PePQ
From exchange and From exchange and trade policies to trade policies to growthgrowthGovernments may try to keep the
national currency overvaluedOr inflation may result in
overvaluationIn either case, overvaluation
creates inefficiency, and hurts growth
Therefore, exchange rate policy matters for growth
Need real exchange rates near equilibrium
44
From exchange and From exchange and trade policies to trade policies to growthgrowthHow do we ensure that exchange
rates do not stray too far from equilibrium?
Either by floating …Then equilibrium follows by itself
… or by strict monetary and fiscal discipline under a fixed exchange rate
The real exchange rate always floatsThrough nominal exchange rate
adjustment or price change, but this may take time
Why inflation is Why inflation is detrimental to growthdetrimental to growthWe saw before that inflation leads
to overvaluation which hurts exports
So, here is one additional reason why inflation hurts economic growthExports and imports are good for
growthSeveral other reasons
Inflation distorts production and impedes financial development, and scares foreign investors away
How How tradetrade increases increases efficiency and growthefficiency and growthTrade with other nations
increases efficiency by allowing1. Specialization through
comparative advantage2. Exploitation of economies of scale3. Promotion of free competition
Not only trade in goods and services, but also in capital and labor“Four freedoms”
How trade increases How trade increases efficiency and growthefficiency and growthTrade also encourages international
exchange of • Ideas• Information• Know-how• Technology
Trade is tantamount to technological progress
Trade isis educationWhich is also good for growth!
EfficiencyEfficiency is crucial is crucial for economic growthfor economic growthNeed economic policies that help
increase efficiency• Produce more output from given
inputs • Takes fewer inputs to produce given
output• More efficiency, better technology
are two ways of increasing output per unit of input
• So is more and better educationTrade increases efficiency and
thereby also economic growth
ExportsExports and economic and economic growth 1960-2000growth 1960-2000
-8
-6
-4
-2
0
2
4
6
0 40 80 120 160 200
Exports (% of GDP)Per
cap
ita g
row
th a
djus
ted
for i
nitia
l inc
ome
(%)
163 countriesr = 0.26
Asia: Exports Asia: Exports (% of GDP)(% of GDP)
FDIFDI and economic and economic growth 1960-2000growth 1960-2000
152 countriesr = 0.21
-8
-6
-4
-2
0
2
4
6
8
0 2 4 6 8 10 12 14
Foreign direct investment (% of GDP)Per
cap
ita g
row
th a
djus
ted
for i
nitia
l inc
ome
(%)
Asia: FDI net inflowsAsia: FDI net inflows(% of GDP)(% of GDP)
Evolution of capital Evolution of capital flowsflows
Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.
A stylized view of capital mobility 1860-2000
Cap
ital
mob
ility
First era of international
financial integration
Capital controls
Return toward financial
integration
55
Source: WEO
-90
-70
-50
-30
-10
10
30
50
70
90
110
130
150
170
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Bill
ions
of U
SD ($
)
Direct investment, net (left axis) Other private, net (left axis) Official capital flows, net (left axis)
Asia: Net capital flows and external Asia: Net capital flows and external debt indicators, 1980-2006debt indicators, 1980-2006
Push vs. pull factorsPush vs. pull factorsExternal factors “pushed” capital from
industrial countries to LDCs Cyclical conditions in industrial
countriesRecessions in the early 1990sDecline in world interest rates
Structural changes in industrial countriesFinancial structure developmentsDemographic changes
Push vs. pull factorsPush vs. pull factorsInternal factors “pulled” capital into
LDCs from industrial countries Macroeconomic fundamentals Reduction in barriers to capital
flows Private risk-return characteristics
CreditworthinessProductivity
Large capital flows to Asia Large capital flows to Asia have resumed in recent have resumed in recent yearsyears
Improved allocation of global savings (allows capital to seek highest returns)
Greater efficiency of investment More rapid economic growthReduced macroeconomic volatility
through risk diversification (which dampens business cycles) Income smoothing Consumption smoothing
Potential benefits Potential benefits of capital flowsof capital flows
Open capital accounts may make receiving countries vulnerable to foreign shocks Magnify domestic shocks and lead to
contagion Limit effectiveness of domestic macro policy
instrumentsCountries with open capital accounts are
vulnerable to Shifts in market sentiment Reversals of capital inflows
May lead to macroeconomic crisis Sudden reserve loss, exchange rate pressure Excessive BOP and macro adjustment Financial crisis
Potential risks Potential risks of capital flowsof capital flows
Overheating of the economy Excessive expansion of aggregate demand with
inflationary pressures, real exchange rate appreciation, widening current account deficit
Increase in consumption and investment relative to GDP
Quality of investment suffersConstruction booms
Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime
Potential risks Potential risks of capital flowsof capital flows
-3 -2 -1 0 1 2 3 4 5 6 70
100
200
300
400
500
600
-200
0
200
400
600
800
1,000
1,200
1,400
1,600
Real stock prices during inflow Real stock prices during inflow periods, selected countriesperiods, selected countries
Year with respect to start of Inflow periodNote: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the
1980s and 1990s and for Venezuela is shown on the right.Source: World Bank (1997)
Sweden
Venezuela
Chile 1978-81
Mexico
Chile 1989-94
Finland
Stock prices in Thailand 1987-Stock prices in Thailand 1987-20002000
Thailand: Stock Market Index, 1987-2001
0
50
100
150
200
250
300
12/87 12/88 12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/000
50
100
150
200
250
300
Bank index
Total SET
April 2, 1993 = 100
Large deficits Current account deficits Government budget deficits
Poor bank regulation Government guarantees (implicit or explicit),
moral hazardStock and composition of foreign debt
Ratio of short-term liabilities to foreign reservesMismatches
Maturity mismatches (borrowing short, lending long)
Currency mismatches (borrowing in foreign currency, lending in domestic currency)
Early warning signsEarly warning signs
Asia: Ratio of short-term Asia: Ratio of short-term liabilities to foreign reserves in liabilities to foreign reserves in 19971997
Large reversalsLarge reversals
Source: Finance and Development, September 1999.
Mexico, '93-95Korea, '96-97
Mexico, '81-83Thailand, '96-97
Venezuela, '87-90Turkey, '93-94
Venezuela, '92-94Argentina, '88-89Malaysia, '86-89
Indonesia, '84-85Argentina, '82-83
0 10 20 30 40 50 60Billion dollars
10% of GDP
12% of GDP
9% of GDP
18% of GDP
15% of GDP
11% of GDP
6% of GDP
10% of GDP
7% of GDP
5% of GDP
4% of GDP
Country experiences with Country experiences with capital account liberalizationcapital account liberalization External or financial crisis followed capital
account liberalization E.g., Mexico, Sweden, Turkey, Korea, Paraguay
Response Rekindled support for capital controls Focus on sequencing of reforms
Sequencing makes a difference Strengthen financial sector and prudential
framework before removing capital account restrictions
Remove restrictions on FDI inflows early Liberalize outflows after macroeconomic
imbalances have been addressed
Some types of capital flows are Some types of capital flows are riskier than othersriskier than others
Transitory
High degree of risk sharing
Permanent
No risk sharing
Foreign direct
investment
Long term debt
(bonds)
Portfolio equity
Short term debt
Sequencing Capital Sequencing Capital Account LiberalizationAccount LiberalizationPre-conditions for liberalizationSound macroeconomic policiesStrong domestic financial systemStrong and autonomous central bankTimely, accurate, and
comprehensive data disclosure
Exchange rate regimesExchange rate regimesThe real exchange rate always
floats• Through nominal exchange rate
adjustment or price changeEven so, it makes a difference how
countries set their nominal exchange rates because floating takes time
There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates
66
Exchange rate regimesExchange rate regimesThere is a range of options
Monetary union or dollarizationMeans giving up your national
currency or sharing it with others (e.g., EMU, CFA, EAC)
Currency boardLegal commitment to exchange
domestic for foreign currency at a fixed rate
Fixed exchange rate (peg)Crawling pegManaged floatingPure floating
Currency union or dollarization Currency board Peg
Fixed Horizontal bands
Crawling peg Without bands With bands
Floating Managed Independent
FIXEDFIXED
FLEXIBLFLEXIBLEE
Exchange rate regimesExchange rate regimes
Dollarization Use another country’s currency as sole legal tender
Currency union Share same currency with other union members
Currency board Legally commit to exchange domestic
currency for specified Foreign currency at fixed rate
Conventional (fixed) peg Single currency peg Currency basket peg
Basically fixedBasically fixed
Flexible peg Fixed but readily adjusted
Crawling peg Complete
Compensate for past inflationAllow for future inflation
PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment
Fixed but adjustable
IntermediateIntermediate
Managed floating Management by sterilized intervention Management by interest rate policy, i.e.,
monetary policyPure floating
Basically floatingBasically floating
Benefits and costsBenefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Floating Floating exchange exchange ratesrates
Benefits and costsBenefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
Floating Floating exchange exchange ratesrates
Benefits and costsBenefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
Benefits and costsBenefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiencyBOP BOP equilibriumequilibrium
Benefits and costsBenefits and costsBenefitsBenefits CostsCosts
Fixed Fixed exchange exchange ratesrates
Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation
InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence
Floating Floating exchange exchange ratesrates
EfficiencyEfficiencyBOP BOP equilibriumequilibrium
Instability of Instability of trade and trade and investmentinvestmentInflationInflation
Exchange rate regimesExchange rate regimesIn view of benefits and costs, no
single exchange rate regime is right for all countries at all times
The regime of choice depends on time and circumstance• If inefficiencyinefficiency and slow growth are
the main problem, floating rates can help
• If high inflationinflation is the main problem, fixed exchange rates can help
What countries What countries actually do (2004, 193 actually do (2004, 193 countries)countries)No national currency 17%Other types of fixed rates 23Dollarization 5Currency board 4Crawling pegs 3Bilateral fixed rates 3Managed floating 26Pure floating 19 100
51%
49%
There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today
Bottom lineBottom line
The EndThe End
These slides will be posted on my website: www.hi.is/~gylfason
External sector policies are important because external trade is important
Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debtMust avoid overvaluation!
Need to adopt exchange rate regime that is conducive to moderate inflation and rapid economic growth