swiss exchange rate appreciation and domestic economic

Swiss Exchange Rate Appreciation and Domestic Economic Activity

JOHN A. TATOM*

Should the Swiss adopt a new economic policy aimed at lowering the value of the Swiss franc in order to boost domestic competitiveness, employment and real income? Despite the past record of strong gains in the relative income of the Swiss that accompanied successful efforts to pursue price stability or a strong currency, policy critics invariably have responded to each bout of currency appreciation by arguing that it will result in losses in the international competitiveness of domestic industries and to reductions in output and real income, especially in the traded goods sector. Critics have been most outspoken recently because the Swiss exchange rate appreciation from mid-1992 through 1995 was one of the largest and longest recorded since the franc began to float in the early 1970s. Over this 14 quarter period, the franc rose 28.5 percent against the U.S. dollar and 13.2 percent against the German mark, resulting in a 23.8 percent rise on a nominal, export weighted, effective basis and 22.2 percent on a real effective basis. The experience has seemed to give some credibility to the critic's view, as the real economy appeared to grow weakly at best. Opponents of exchange rate appreciations adhere to the conventional wisdom, which suggests that domestic output, employment and real income are jeopardized by currency appreciation. The conventional remedy for these costs is to inflate the currency sufficiently to offset any rise in the external value of the currency. By implication at least, these critics apparently believe that Swiss real income could be boosted further by policy efforts to lower the value of the franc.1

This article examines the link between the value of the Swiss franc and Swiss economic performance. Not only is it concerned with whether the critics' views find support in the Swiss experience, however, it also addresses an alternative hypothesis that points to almost the exact opposite set of outcomes. According to this alternative, supply-side view, currency movements reflect, in part, changes in relative productivity

* The author is indebted to his colleagues, especially BEAT SCHWAB, ALEXANDER KOBLER, THOMAS BIERI

and VENKATRAMEN NAGESWARAN, for help with the data and comments on an earlier draft, and to Professors RODOLFO HELG and GEBHARD KIRCHGÄSSNER for comments at the Swiss Society of Statistics and Economics meetings; the usual disclaimer applies, however.

1. The OECD (1995, pp. 104-6) attributes the weakness of the Swiss recovery in 1994-95 to the strength of the Swiss franc and pins the resumption of a cyclical recovery to its stabilization. Of course, they are not alone. Virtually every major forecasting or interest group in Switzerland has blamed the strong currency for the country's ills.

Swiss Journal of Economics and Statistics 1996, Vol. 132 (3), 473-494

474 JOHN A. TATOM

and output growth, so that an appreciating currency is simply evidence that economic policy or technology changes have improved the outlook for investment, productivity and output.

The article first reviews the two theoretical approaches. Their essential difference is that the conventional view examines the effect of an exchange rate change as an exogenous cause of economic adjustments, while the supply-side view focuses on an exchange rate change as either an endogenous response to changes in fundamental exogenous factors, such as domestic and foreign policy, taste or technology, or an exogenous change that requires accompanying economic policy actions to enforce it. In the latter approach, the relationship between the exchange rate and domestic economic performance is dictated by the relationship of these (domestic or foreign) economic policy changes and exchange rates on the one hand, and these policies and domestic economic performance, on the other. Thus, conventional analyses are quite partial in nature.

Evidence for the United States and Europe in the 1980s is consistent with this supply side view and rejects the conventional view's hypothesis of a negative relationship between currency movements and investment, output or growth.2 Following a discussion of the two competing hypotheses and this evidence, the paper turns to evidence on the link between movements in the nominal or real value of the Swiss franc and various measures of output, including real GDP, industrial production and capacity, and its components in manufacturing and the traded goods sector.

There is perhaps no better country for examining these hypotheses because Swiss economic policymakers have more strongly and successfully pursued price stability than policymakers elsewhere and the result, where competing countries have flexible exchange rates, was expected to be and has been an appreciating franc. This policy, together with fiscal policies that pursue a relatively small and efficient public sector and low taxes is widely believed to have been responsible for lower inflation, faster growth and a higher level of real income than would otherwise have been the case. Indeed, Switzerland is the stereotypical case for such policies and for the view that a strong currency reflects a strong economy. Thus, if the conventional view is correct, this approach is perverse, so that Swiss efforts have been seriously misplaced and even greater success in boosting real income could have been achieved by policies aimed at lowering the franc.

2. See TATOM ( 1987,1988 and 1995), for example. HARRIS and ZABKA ( 1995) provide evidence that positive news on U.S. payroll employment significantly raises the value of the dollar against the German mark, yen, Italian lira, and French franc and raises U.S. and Canadian three month treasury bill rates. They use 111 observations on the release of the employment report from January 1986 to March 1995. They interpret these results as showing that the dollar rises because interest rates do, and the latter occurs, in their view, because a strong employment report indicates a tighter credit market, «particularly if market participants believe that unexpected evidence of economic expansion increases the probability of more restrictive monetary policy». They note that there is a contradictory result suggesting a higher interest rate and lower currency if inflationary expectations worsen due to a strong employment report. They reject this view. Of course, the dollar and interest rate results they find can occur independently of a Fed response according to the argument here.

SWISS EXCHANGE RATE APPRECIATION 475

TWO EXCHANGE RATE HYPOTHESES

While there is a conventional view of the effects of exchange rates on economic activity that emphasizes the inverse relationship between an exchange rate change and output and employment, there is an alternative hypothesis that arrives at precisely the opposite view. This may appear to give credence to critics of economic theory, but it should not, because the two are, strictly speaking, not competing in a theoretical sense. Both can be correct and relevant for understanding economic relationships and for different problems. They are competing in an empirical sense, however, because both bear on the «bottom line» empirical issue of the normal empirically observed correlation between exchange rates and economic performance and the policy implications of this relationship. The conventional view is a partial analysis of an exogenous change in the exchange rate, much like the conventional analysis of the effect of an exogenous price change on consumer demand, while the alternative here focuses on a fuller market analysis that emphasizes that price and quantity in a market are both endogenous and depend on exogenous forces that change quantities supplied or demanded, especially those originating from domestic changes in supply.

The Conventional View: A Rise in the Currency 's Value Lowers Output

The conventional view argues that a rise in the value of a currency raises the price of domestic output measured in foreign currency and lowers the cost of foreign currency and therefore the domestic price of foreign goods. As a result, foreign demand for the nation's exports falls, while domestic demand for imports rise, displacing demand for domestic goods and services that compete with imports. Output, employment and relative prices in the nation's traded goods sector fall. It is not uncommon to generalize this result to the macroeconomy, concluding that a country with a rising currency value will face falling output and employment, and lost competitiveness in the form of lower real wages and lower standard of living.3 Conversely, a fall in the value of domestic currency raises demand for domestic traded goods, raising output, employment and relative prices. The economic policy content of this analysis, to oversimplify, is that a country can boost its traded goods sector and economy by policy actions to lower its currency's value. The problem with this approach is that the monetary or fiscal actions that would reduce the value of a currency do so by reducing incentives to produce domestic output, including tradable goods. It is this broader focus on the endogenous character of the exchange rate that distinguishes the alternative hypothesis explored here.

3. FREEDMAN and SCHWAB ( 1995) argue that the conventional analysis of Swiss franc appreciation ignores the effects of cheaper raw material and capital good import prices on supply and exports, ignores the effects of the terms of trade improvement on consumption demand and ignores the effects of a lower real cost of capital on investment demand.

476 JOHN A. TATOM

Figure 1: Does a Rise in the Exchange Rate Lower Output

Conventional Case or Supply Shock

Export Quantity per period

Exchange Rate (E) rises from E0to E t

Export Quantity per period

An Alternative: A Higher Currency Value is Associated with Higher Output

Policy actions that would boost a currency's value, such as reducing monetary growth to slow inflation, lowering marginal tax rates on capital income or reductions in government spending to raise the return to private investment, all of which increase inflows of foreign capital, also affect supply of goods and services. Similarly, technology shocks that increase supply also tend to raise the return to capital, foreign capital inflows and the exchange rate. The contrast between the two views analyzed here is shown in figure 1, where the price of a domestic product falls as the exchange rate rises, one of the undisputed consequences of an exchange rate change on either view. The conventional view treats the exchange rate as exogenous to the domestic market so domestic output is reduced in the left panel. The alternative view focuses on a domestic supply shift as the source of the decline in the domestic price and rise in the exchange rate. This case is shown on the right panel where domestic output is larger when the exchange rate appreciates. If this alternative case characterizes typical exchange rate changes, then nominal and real exchange rate appreciations reflect policy or other changes that boost domestic output and lower domestic prices and, in the case of monetary policy, inflation. Thus, in the alternative view, the correct reduced form relationship between the exchange rate and various measures of real output is a positive one. The simplest models in which


such results arise are monetary models of the balance of payments, especially those that include real effects of inflation arising through the taxation of capital income.

A simple analogy can perhaps clarify the point of departure here. The economist stock in trade, supply/demand analysis, emphasizes the importance of the law of demand - the negative relation of the quantity demanded of any good to its price. But economists would never argue that quantity is always inversely related to price. For example, when cyclical variations in income, or even permanent changes in income, are the dominant impulse in a market and supply is an increasing function of price, shifts in demand result in a positive relation between price and quantity. For industries most associated with the economic growth process, those where productivity change is lowering relative supply prices, there is an inverse relation between price and quantity, as competition lowers price to induce more buyers to purchase the larger desired supply. The principal factor lowering such a product's price is the greater relative abundance of the good, so it would be absurd to focus on the price decline as a signal to producers to reduce output. Nonetheless, this is precisely the mistake that proponents of the conventional view make; they look at price reductions for domestic traded goods as signs of reduced demand and infer that a stronger currency lowers output and employment in sectors that produce import and export goods.

Earlier Evidence

Consider the effects of slowing monetary growth to slow inflation, for example. Such actions raise the nominal exchange rate by lowering expected inflation, but they also do so, perhaps to a lesser extent, by lowering the cost of capital, raising investment, productivity and domestic output; these real effects arise, in part, to the extent that taxes are a positive function of purely nominal income gains. BARRO (1995) has argued and provided evidence that higher inflation reduces economic growth and presumably a falling value of domestic money relative to foreign goods and services does so equally.4

Monetary or real influences that boost the nominal exchange rate will also raise the real exchange rate to the extent that they boost output, but it does not follow that all real exchange rate shocks will be associated with increased domestic output; for example, a rise in domestic inflation will tend to raise the real exchange rate, especially if domestic policymakers attempt to keep the exchange rate from falling as it otherwise would. Thus the alternative hypothesis is about nominal exchange rate movements and their associated movements in real exchange rates, but not inflation related changes in the measured real exchange rate. For major industrial countries, especially the United States and

4. Since a country's exchange rate is significantly and negatively correlated with its counterpart, inflation, this can be taken as evidence that currency depreciation reduces economic growth. Indeed in one experiment, BARRO uses prior colonial status and for at least two of the six categories that he uses, there is a strong connection for growth to exchange rate systems that produce relatively strong currencies.

478 JOHN A. TATOM

Switzerland, real and nominal exchange rates are strongly and positively correlated so this distinction is not too important.

TATOM (1987,1990, and 1995, for examples) provides evidence for the United States and Europe that currency values are positively related to manufacturing output and real GDP growth. Most notably for the dollar, tax policy changes in 1981 that lowered the tax on capital income raised U.S. investment, productivity, output. Relatively large increases in the value of the dollar anticipated or led the effects of these responses to tax policy and the large rise in the value of dollar continued until tax and monetary reversals actually reversed this pattern beginning in 1985-86. The converse of these movements for European countries were «Eurosclerosis» during the period of dollar appreciation and falling European currencies, but later, following sharp increases in U.S. tax rates on capital income, the dollar fell, and European currencies rose, reflecting increased investment, productivity and output in Europe.

The strong hold that the conventional view has on policy analysts and the business press is actually quite amazing considering the equally strong belief in those same circles that countries that face rapid depreciations typically face other severe economic problems of which devaluation is merely a symptom. Recent cases like the more than 50 percent fall in Mexican peso from 1994 to 1995 and associated surge in inflation from 7 percent to 34.8 percent, and the 6.9 percent decline in real GDP in 1995 should leave little doubt about the negative effects of policies to reduce the value of domestic currency. Italy's float beginning in 1992 has allowed the lira to fall 23.7 percent against the dollar, 34.3 percent against the German mark and 25.1 percent on a real effective basis from 1991 to 1995, but, despite somewhat faster real GDP growth than its major competitors, a 1.3 percent average pace from 1991 to 1995, the dollar return on Italian stocks has been the lowest of G10 countries at -1.4 percent per year over the same period and real wages, especially measured in dollars or any common currency have fallen relative to competitors. For example, in dollar terms, real hourly compensation fell in Italy at a 4.6 percent annual rate from 1991 to 1994, the latest year available, while they rose at a 2.6 percent rate for the European Union countries as a group, rose at a 3.2 percent rate in the United States, 4.6 percent in Switzerland and 13.5 percent in Japan over the same period. When the returns to labor and capital can be so sharply depressed by currency declines, it is difficult to fault a rising currency.

SWISS EXCHANGE RATE MOVEMENTS

The Swiss experience offers an especially useful data set for examining the link between exchange rate movements and real economic performance. The economy has been characterized for decades by a strong and usually successful commitment to low inflation, especially since the early 1970s when floating began and most other industrial nations experienced higher inflation than their earlier experience or than the Swiss.5 Thus the Swiss franc has generally appreciated, including against major currencies including


those of their major trading partners, the dollar and the German mark. Thus the Swiss appreciations offer relatively unique ground to test the relationship between exchange rate movements and economic performance for the appreciating side of the relationship. There also have been a couple of key episodes, however, when policymakers, intentionally or unintentionally allowed Swiss monetary growth to accelerate and inflation subsequently did so as well. These periods were associated with declines in the Swiss franc. Fortunately these episodes were followed by successful policy efforts to reign in inflation. Thus, while the Swiss experience since the early 1970s is one of a generally appreciating exchange rate, there have been major episodes where policy temporarily reversed course, offering observations on the effects of both policies that boost inflation and of resuming anti-inflationary policy, as well. Finally, there have been tax changes that have affected Swiss output and exchange rates, like the 1995 introduction of the value added tax as a substitute for a turnover tax. The latter change was expected to boost Swiss investment and, on the alternative view here, could have been expected to boost productivity, output and the Swiss franc.

Presumably, it also was just such strong franc policies, together with strong security and safety standards, that led to the growth of Swiss banks as international financial intermediaries and capital exporters. Is it possible that the policies that benefit the financial sector also produce a type of financial Dutch disease that damages the rest of the traded goods sector and the Swiss economy? No doubt there are traded goods producers that would argue this viewpoint, at least to the extent that it makes a case for favorable treatment by fiscal authorities, but the evidence below is strongly at odds with this hypothesis, both for the overall economy, for exporters and for several specific industries.

480 JOHN A. TATOM

Chart la: Nominal and Real Swiss Franc Exchange Rate Measures Indexes

180

160

140

120

100

80

60

— Nominal Exchange Rate(Nov.1977=100)

• • • • • Real Exchange Rate (Nov.1977=100) OECD Real Exchange Rate Index (1977=100)

9 I ' M

1 — i 1 1

%J

1 — 1 — 1

s VA-/7

1 Î 1 Y 1 1

^s : ^ v

1 — i 1 —

'' '' ì

i 1 i 1 i 1

r

1 — i

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995

Chart lb: Indexes of Dollar and Mark Prices of Swiss Franc

(1977=100)

£ M -

200 -

17«;

150

125

mn

75 -

50

^ ^ Dollar price of Sfr DM price

—— Real dollar price Real DM price

t

1 1

v^V» 7^^"' i r^

I 1 1

if*'' I A.

J \ \/\j V/ I I ! Y

I 1 — i 1 — i 1 ! 1 — i 1 1

. - a ^ ^

I 1 1 I — I — I

r.. à

I 1 1

^t

i 1 \ 1

1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995


To test the relationship between the exchange rate and economic performance in Switzerland, various exchange rates were selected. The principal series used are nominal and real effective exchange rates measured by the Finance Ministry chain-weighted indices constructed using export shares for the 15 largest importers of Swiss goods. The countries include the European Union countries, with Belgium and Luxembourg combined and excluding Greece, Ireland and Finland, plus Canada, Japan, Norway and the United States. Germany, France and Italy account for about 43 to 52 percent of Swiss exports and the U.S. share is about 12 percent. The real exchange rate is constructed using the respective consumer price index of each country. Because the focus of the exchange rate discussion is almost always on the dollar or German mark, both nominal and real exchange rates for the Swiss franc against these currencies were also included. Chart la shows the nominal and real effective exchange rate for the Swiss franc along with the OECD's measure of a trade-weigh ted real exchange rate for the Swiss franc since 1973. The Swiss and OECD measures of the real exchange rate differ little and the correlation of their first-differences is 0.976. Thus the results below should not be sensitive to using the Swiss measure. Chart lb shows the dollar and German mark prices of the Swiss franc on nominal and real bases. Both panels show the sharp increase in the Swiss franc since mid-1992 except that the initial rise relative to the German mark and especially the dollar was temporary and then resumed from early 1993. Chart la shows that the recent rise in the Swiss franc has been the longest sustained rise and, except for the 26.7 percent rise from 11/1977 to III/1978, the largest since 1973. From the first quarter of 1985 until the first quarter of 1988 the real effective exchange rate rose at a 4.9 percent annual rate, a cumulative 15.5 percent, rivaling the recent 22.2 percent rise at a higher 5.9 percent annual rate for 14 quarters. Before that the longest rise was in the 13 quarters from 1/1973 to 11/1976, when the real exchange rate rose at a 4.9 percent rate, with a cumulative rise of 16.8 percent.

Some Casual Evidence

Table 1 provides some evidence that the latest and previous large Swiss exchange rate increases presaged periods of declining inflation and accelerating output. It shows real GDP and manufacturing output growth rates beginning two to four quarters after the onset of the appreciation and compares these with equally long periods before the acceleration in output. In the 1988 case it shows an equally long period beginning two quarters after the exchange rate peak to show that the peaking presaged a slowdown in output. For the periods of exchange rate appreciation the table also shows that Swiss inflation was lower than that of the export-weighted average inflation abroad. This evidence from the recent experience and the prior one is at least suggestive that the conventional view is incorrect and that the alternative one fits the Swiss experience.

482 JOHN A. TATOM

Table 1: Exchange Rate Appreciations, Output Growth and Inflation

Episode (Length)

11/92 - IV/95 (14Q)

Previous Period of Equal Length

I/85 -1/88 (12Q)

Previous Period of Equal Length

Subsequent Perio of Equal Length

*Exch. Rate

Change

in%

5.9

4.9

i

Real GDP

Lead

4Q

2Q

Period

II/93 - HI/95 ( 9 Q )

1/91 - II/93 ( 9 Q )

HI/85 - IV/88 (13Q)

H/82-III/85

IV/88-I/92

in°/c

1.1

-0.6

2.7

1.8

1.6

Manufacturing

Lead

2Q

2Q

Period

IV/92 - HI/95 (11Q)

1/90 - IV/92 (11Q)

HI/85 - IV/88 (13Q)

H/82-IH/85

IV/88-I/92

in0/«

4.5

-2.5

2.7

1.7

0.4

Inflation in%

Swiss Abroac

1.8

1.4

2.6**

2.5

* Real Exchange Rate Change: AH percent are on compound annua! rates "Period ends 1/1995

Chart 2 provides some evidence that the undisputed effects of exchange rate movements hold. The OECD's data for annual percentage changes in the real value of the Swiss franc is strongly and negatively related to the relative price of Swiss exports (export price deflator relative to GDP deflator) and strongly and positively related to the Swiss terms of trade (export price deflator relative to import price deflator). Thus appreciations are associated with declining prices of both exports and, even more so, import goods. The gain in the terms of trade is one of the principal channels of increase in Swiss living standards arising from the appreciating franc.


Chart 2: Real Exchange Rate, Terms of Trade and Relative Price of Exports

Sourcm: OECD

Chart 3 shows the OECD measure of the real exchange value of the Swiss franc and the shares of real GDP arising from tourism, one area that is typically presumed to be very sensitive to and strongly negatively related to real exchange rate movements, and machinery, electronics and chemical sectors, industries that produce the largest share of Swiss exports. For tourism, there is no obvious relationship. Indeed, tourism shows only a slight trend rate of decline in its share of Swiss output that looks relatively impervious to the swings in the exchange rate. To anticipate later results, there is actually a statistically significant but small relationship between the exchange rate and tourism, but it is actually positive, not negative. Since tourism includes value added in hotels and restaurants, it is dominated by domestic users; only about 35 percent of tourism demand originates abroad. The share of chemicals, electronic and machinery output is more strikingly positively related to the real exchange rate, although the relative stability of the share in 1975-78 when the exchange rate rose sharply is at odds with this later experience. At least at first pass, it is not obvious that key traded goods sectors are inversely related to movements in the Swiss franc.

484 JOHN A. TATOM

Chart 3: Shares of Business Output and the Swiss Franc Value

14T ; ; ; ; ; ; ; ; ; ; ,-180

12

10

./^.i..^-V^

.~r

Machinery, Electronics.Chemicals Tourism Real Value of Swiss Franc Index 1977 = 100 (right scale)

160

140

120

100

75 77 79 81 83 85 87 89 91 93 95

COINTEGRATION TESTS

To more formally examine whether the Swiss franc is negatively or positively related to output and other measures of economic performance, cointegration relationships were tested. These provide information on the existence and the size a of long-run relationship between measures and their related vector error correction models of the relationships provide causality results on the time sequence of significant related movements in the exchange rates and performance measures. The principal question involves the relationship to real GDP, but other measures like manufacturing output could be more closely related to exchange rate movements. In the alternative view, emphasis is on productivity measures, so real GDP per worker and manufacturing output per worker measures are also examined. The same sign difference could be expected from the conventional and alternative views for productivity measures. Other sectoral output measures have been emphasized in popular Swiss discussions, including tourism and exportable products like chemicals, machinery and electronics and metals, so sectoral real value added measures were also examined for these sectors.

Another difference in the two views concerns trade, especially exports in figure 1. Lacking data on the quantity of Swiss exports over a long period, data on nominal exports were used to see if the strong negative relationship to the Swiss franc's value expected on the conventional view is observed. In this view, a rise in the exchange rate reduces both the price and quantity component of nominal exports, so a negative relationship


should be found. Such a negative relationship is also consistent with the alternative view, however, if the effect of an appreciation on price is larger than the rise in quantity. Thus, finding a significant negative relationship is necessary but not sufficient for the conventional view, but no relationship or a positive one is a strong rejection of the conventional view and evidence for the alternative. The Swiss export measures examined here include total exports, chemical exports, machinery and electronics exports, and the total for chemicals, electronics and machinery.

Unit Root Tests

Unit root tests (augmented Dickey-Fuller tests) of the output and export measures were conducted, but are not reported here. All of the output measures were found to be 1(1) series. This includes real GDP, manufacturing output, their productivity counterparts, chemicals, machinery and electronics, metals, tourism, and the total of machinery and electronics and chemicals. While some time trend terms in the level equations had t-statistics larger than two in absolute value (real GDP and real GDP per worker, metals and the total of chemicals, machinery and electronics), no output measure is trend stationary. The export measures, total exports, chemical exports, machinery and electronics and the total of the last three, are all trend stationary, but are not stationary when the trend is not included. Since these measures are likely to be influenced permanently by at least some nonstationary factors, the latter result is followed here and these measures are all considered to be 1(1).

The cointegration test results reported below use five of the exchange rate measures above: the nominal and real effective exchange rate, the dollar and German mark exchange rate and the real German mark exchange rate. The real dollar exchange rate is omitted because this exchange rate is highly correlated, indeed, it is cointegrated with the nominal dollar exchange rate. The nominal and real effective exchange rates are also cointegrated, so that the real exchange rate results are essentially identical as those for the nominal rate, but they are reported anyway. The evidence for cointegration of the real and nominal rates is the stationarity of the relative price measures used to construct the real exchange rates. The evidence for these relationships is found from unit root tests of the log of the relative price measures: the ratio of the Swiss CPI to the U.S.; German and export share weighted foreign CPIs used to compute the respective real exchange rate. None of the three relative price measures has a significant trend in such tests and, without a trend, each has four significant lagged first-differences that remove the autocorrelation in residuals; the lagged level coefficients in the unit root tests have Tau-statistics: of -2.94 for the U.S. case, -2.27 for the German case and -4.33 for the effective measure, while the 5 percent significance level value is -2.89. Thus, for the U.S. and effective measures of relative prices non-stationarity can be rejected, but not for the German case.6 These results imply that the nominal and real effective and dollar

486 JOHN A. TATOM

exchange rate measures are cointegrated but the German mark measures are not. The German relative price ratio is 1(1), however, as its first-difference is stationary. Unit root tests of the exchange rate measures indicate that all except the OECD real effective exchange rate are neither stationary nor trend-stationary, but are 1(1) processes. The OECD real effective exchange rate, while highly correlated with the Swiss measure, is trend-stationary, however, with a Tau-statistic of-3.87, while the Swiss measure is not, because its relevant Tau-statistic is -3.44, slightly below the critical value (5 percent) of -3.46. Other exchange rate measures with what would otherwise be significant trends in the test equations, besides the Swiss and OECD real effective measures, are the dollar and the real German mark exchange rate. As a result some care was taken in the cointegration tests to see if significant trends in the cointegration vectors or in the data would affect the results.

The bivariate relationship of the various output, productivity and export measures to several exchange rate measures was tested on available data since 1973 using the Johansen method of testing cointegration. Four lags of the first-differences of the logs of the variables tested were included in each test to allow for the univariate dynamics of each measure and yet attempt to avoid the loss of valuable degrees of freedom. This arbitrary choice is fairly standard in such tests. Since the unit root tests indicated that some series have statistically significant deterministic time trends, even though the measures are generally neither stationary nor trend stationary, the presence of significant stochastic or deterministic trends was examined and included where significant. Only some deterministic trends affected the reported results, however.

6. ETTLIN ( 1996) implicitly imposes the assumption that the nominal and real German mark exchange rates are cointegrated, but he uses a different sample period that begins in the first quarter of 1979 and ends in 1990.


Table 2: Tests of Cointegration for Exchange Rate and Output Measures

Nominal Effective Exchange Rate Likelihood Ratio Elasticity t-raüo

Real Effective Exchange Rate Likelihood Ratio Elasticity t-ratio

Dollar Price ofSFr Likelihood Ratio Elasticity t-ratio

German mark Price ofSFr Likelihood Ratio Elasticity t-ratio

Real DM Price ofSFr Likelihood Ratio Elasticity t-ratio

Real GDP

Manufacturing Output

Real GDP/ Worker

Manufacturing Productivity

Chemicals

Machinery and Electronics

Machinery, Electronics and Chemicals Metals

Tourism

39.56** 0.597 6.85**

12.63* 0.479

45.20** 35.54** 0.475 7.81**

26.80** 1.310 3.36**

18.48 3.103 0.65

19.84 1.871 1.23

15.20 1.900 1.15

16.04 -1.122 -2.56(+) 49.42**

0.244 2.50*

28.51** 2.562 4.41**

20.38* 1.824 4.00**

48.12** 0.442 4.03**(+)

39.12** 1.875 3.74**(+)

13.26 3.770 1.60

19.42 3.126 4.07

19.42 3.00 4.06

20.26* 3.000 3.90**

22.31** 0.148 6.60**

29.35* 0.108 1.79(+)

21.54* 0.351 7.71**

29.99* 0.072 3.35**(+]

24.77** 0.529 6.13**

11.03 0.637 1.87

19.31 0.693 5.37

22.48* 0.535 7.74**

18.42 0.588 6.77

18.15 0.461 3.92

33.20** 2.047 3.44**

10.41 -1.168 -0.19 21.89** 0.443

1 4.61** 13.41* -0.939

-68.80* 4.38 0.022 0.66 7.55 0.325 6.11

16.16 -1.375 -3.17(+) 14.26 -1.001 -3.39(+) 34.08** 0.612 2.23*

37.86** 1.600 6.76**

17.82 -1.724 -3.44(+) 22.38** 2.329 3.73**

24.40 -2.886 -1.86(+) 29.09* -4.568 -4.18**(+) 14.12 1.671 2.30 9.96 3.979 1.06

11.13 2.011 2.36

37.37** 1.480 8.41**

Estimated using the Johansen technique, with four lags; when significant trends were present in the data, they were included. These estimates are indicated with (+) following the t-ratio. indicates significance at 1% level; indicates significance at 5% level.

488 JOHN A. TATOM

Cointegration Test Results

Table 2 reports the results of the cointegration tests using the five measures of the exchange value of the Swiss franc and the various output and productivity measures. In each case, the top entry is the value of the likelihood ratio test for cointegration and an indication of whether it is significant or not (* or **), the second entry is the long-run elasticity with respect to the exchange rate indicated by the Johansen method*s estimate of the most significant cointegrating vector, and the third entry is the t-ratio for this long-run elasticity and, if there is a significant cointegrating relationship or long-run elasticity, the statistical significance of the elasticity is also indicated, based on large sample significance values. In only two cases is there any evidence of a significant negative effect of the exchange rate on output; that occurs for chemical output using the real German mark exchange rate and the nominal German mark's effect on manufacturing productivity. Generally, the effect of the exchange rate is significantly positive according to the cointegration tests, especially for real GDP and real GDP per worker. For the nominal and real effective exchange rates there is a significant positive long-run relationship with Swiss real GDP, manufacturing output, overall and manufacturing productivity, tourism and, for the real effective measure, metals output. The value of the Swiss franc against the dollar has significant and positive effects on manufacturing output, overall and manufacturing productivity and total output of chemicals, machinery and electronics. The German mark has a significant positive long-run relationship to real GDP, total productivity, and tourism, and the real value of the franc against the German mark has the same positive relationship except for the chemical output result noted above. Even the cases where the long-run relationship is rejected on statistical grounds, the measured relationship is predominantly positive. Thus the alternative view finds strong support in the Swiss output and productivity measures.


Table 3: Test of Cointegration for Exchange Rate and Export Measures

UBS Nominal UBS Real Dollar Price German Real DM Price Exchange Rate Exchange Rate of SFr mark Price Likelihood Likelihood Likelihood Likelihood of SFr Ratio Ratio Ratio Ratio Likelihood Elasticity Elasticity Elasticity Elasticity Ratio t-ratio t-ratio t-ratio t-ratio Elasticity

t-ratio

Nominal Exports

Chemical Exports

Machinery and Electronic Exports Machinery, Electronic and Chemical Exports

23.07** 0.663

24.31** 39.16** -0.204 -4.44**(+) 19.95** 0.436

12.99** 28.20** 0.586

13.25**

31.29** 4.802 3.47**

45.50** -0.698 -7.55**(+) 26.44*

3.395 2.02*

23.23** 0.854 3.11**

20.41* 1.306 3.78**

28.45* -0.091 -2.02*(+) 19.48 0.743 1.20

19.89** 0.712 3.74**

32.17** 0.307 2.30*(+)

34.26** -0.618 -1.97*(+) 16.38** 0.463 8.54**

23.10** 0.644 7.65**

33.83** 0.814 3.13**(+)

33.74** -0.104 -0.60(+) 21.93

1.810 3.03(+)

25.15 0.887 2.72(+)

Estimated using the Johansen technique, with four lags; when significant trends were present in the data, they were included. These estimates are indicated with (+) following the t-ratio. indicates significance at 1% level; indicates significance at 5% level.

Table 3 shows similar tests for nominal export measures. Somewhat surprisingly, the results for exports support the alternative to an even stronger degree, at least as indicated by the existence of significant, positive long-run cointegrating relationships.7 In the exceptional case, the chemical export sector, there is a significant negative relationship to all of the exchange rate measures except the real German mark measure, and even there the insignificant estimated relationship is negative. While this is only a necessary condition for the alternative view's adjustment process, it is the strongest overall result supporting this view. Otherwise, there are significant positive results in every case but the dollar exchange rate/machinery and electronic export case, and the real German mark exchange rate and machinery and electronics and its total with chemicals. Even in these three cases, the effect is positive, though insignificant.

7. BELONGIA and HERMANN (1989) find an insignificant effect of the real effective exchange rate in their cointegrating vector for a measure of real Swiss exports of goods, but a significant negative effect of the real dollar exchange rate in a cointegrating vector with real exports of goods to the United States. Both equations also contain a foreign income measure, but when trade-weighted foreign income is added to the estimates here, the coefficient is not significant and the other results are not affected.

490 JOHN A. TATOM

Problematical Inclusion of Trends in Testing Some Export Measures

In the export tests, significant trends are included in several tests, especially those for chemical exports and for the real German mark measure. This is a problem because all the export measures are trend stationary so that only estimates that do not include the trend will have only non-stationary variables. When the trend is significant and therefore included in the cointegrating vector, at least one component, terms involving the export measure only and the trend, is stationary, according to the unit root tests. Thus, this component cannot, in principle, be cointegrated with exchange rate measures or anything else. The cointegration tests indicate the presence of such a cointegrating relationship, however.8 Moreover, the vector error correction models show significant lagged residuals from the cointegrating vector in the equation for the export measure (and not significant in the exchange rate equation) in every case where significant cointegration is found with the likelihood ratio test, except for exports and the real German mark exchange rate where the lagged residual indicates causality running in both directions. Thus, the equations support the existence of cointegrating relations and, with the one exception, causality running in one direction only, from the exchange rate measure to output. It is difficult to accept that the trend-stationarity result is correct in light of this evidence, but if it is correct, then the principal implication is that the only results that support the conventional view, the negative relationship between the exchange rate measures and chemical exports, is spurious.

Causality and Vector Error Correction Model Results

The interpretation of this «causality» result requires some attention. If exchange markets are efficient, then economic shocks like policy changes that boost productivity (or lower it) are observed before the shock can have a measurable impact on investment and then productivity, so that the exchange rate can be expected to move in anticipation of the productivity or output change. Similarly, in the case of exports, the exchange rate is likely to move before the expected change in prices or quantities occurs. In this case it is reasonable to expect that the time sequence can give rise to a temporal sequence where it appears that causality runs from the exchange rate to productivity, output, or exports.

8. Moreover, in those cases where the trend terms are significant in table 3, omitting the significant trend term results in two significant cointegrating vectors, which suggests that both the exchange rate and export measure are stationary, but neither is, according to the unit root tests. The Granger-Engle two-step method was also used for the export estimates where trends are significant. The results were essentially the same as those reported in table 3 for chemical exports, i.e. every trend and exchange rate term was significantly different from zero and the lagged residual was stationary in the error correction specification, indicating that cointegration could not be rejected. For the German mark values of the Swiss franc and total exports, however, the Granger-Engle test obtains insignificant exchange rate coefficients in the first-stage equation, but there is evidence of cointegration, as found using the Johansen technique.


In the output and productivity tests reported in table 2 the lagged residual in the vector error correction equations also typically indicates causality from the exchange rate to the output measure, although in some cases the causality is bi-directional, so that the residual is significant in both directions. In particular, for the instances of cointegration in table 2, the only cases where causality runs only from the output or productivity measure to the exchange rate are the three significant vectors for manufacturing output and their corresponding productivity measures. The German mark and manufacturing relationship has causality from the exchange rate to productivity; the same unidirectional causality is indicated for real GDP and the nominal effective, dollar and German mark, real GDP per worker and both the nominal and real German mark measures, chemicals and the real German mark measure, and tourism and the nominal and real effective and German mark measures. Bi-directional causality is indicated by the significance of the error correction terms in both equations of the models for real GDP and for the real effective and real German mark rates, respectively; real GDP per worker and the nominal and real effective, and dollar rates; machinery and electronics and chemicals and the dollar rate, metals and the real effective rate and tourism and the real German mark rate. Thus in 18 of 24 cases the exchange rate has a significant effect on a subsequent measure of Swiss output or productivity and in all but two of those cases the long-run relationship is positive. In six instances, all involving manufacturing output or productivity, the long-run relationship is positive, but the evidence suggests that productivity changes prior to its effect on the exchange rate.

CONCLUSION

The analysis of recent Swiss economic performance has been another significant victim of the conventional wisdom that a strong currency presages weak output, employment and income performance as the economy loses its competitiveness. Exchange rates are prices that indicate the relative value of currencies and they are not exogenous forces determining a country's relative performance. Thus, monetary or fiscal policies like those usually pursued by the Swiss that restrain prices and/or boost productivity, also raise the value of the Swiss franc, reflecting the policy-induced gain in relative Swiss productivity and output. This confusion could be ignored if it did not reinforce arguments to pursue inflationary monetary policies or to use fiscal tools to misallocate resources to boost competitiveness. By and large the policies available to governments to boost competitiveness are those that lower the value of the currency by lowering investment, productivity, output, employment and income in the most productive sectors of the economy and in the overall economy.

The results here strongly reject the existence of a negative relationship between various measures of the Swiss franc and overall real GDP and productivity or various other measures of output of traded goods or nominal exports, especially tourism and overall nominal exports. Instead, the evidence strongly supports an alternative view that

492 JOHN A. TATOM

there is a positive long-run relationship between Swiss economic performance and the exchange rate and that the exchange rate generally rises or falls in anticipation of just such positive or negative respective movements in productivity and output. The last time the Swiss exchange rate rose sharply and for a prolonged period, the related favorable economic developments and franc appreciation were brought to a crashing end by an inflationary spike and recession to which the economy is still adjusting to some degree. Whether critics of Swiss policy can bring about a similar reversal remains to be seen, but the evidence is fairly clear that their intended benefits for Swiss resource owners, especially in the traded goods sector, are not only illusory, but that the actual effects on these very sectors are quite negative.

The results here beg the question of why the Swiss economy has shown such slow growth, especially since early 1995, and whether there are not, indeed, «victims» of the recent appreciation. While it is beyond the purpose of this paper to explain cyclical developments, it can be argued that the Swiss economy has not been too weak. At least until mid-1995, the economy showed a cyclical expansion, as the unemployment rate fell from 5.1 percent in the first quarter of 1994 to 4.2 percent in the third quarter of 1995, led by strong growth in business equipment investment. It is true that from 1989 to 1995, output grew at only a 0.4 percent rate per year, but the labor force has fallen at a 0.5 percent rate over the same period, suggesting that on a «per potential worker basis» or high-employment basis, the economy is growing more rapidly than it might otherwise appear. Put differently, even if the unemployment rate in 1995 had returned to its 1989 level of 0.5 percent instead of to 4.2 percent, employment would have been only about 3.9 percent larger, so that output would have been perhaps 2 percent or so larger, raising the 1989-95 growth rate to about a 0.7 percent rate. Thus, part of the reason that the economy looks weak is that it's capacity growth rate has slowed from about 2.5 percent or so to perhaps as little as 1.0 percent or less over the past 6 years. Most of this slowing is due to the 1.8 percent fall in the labor force growth rate from about a 1.3 percent rate over the previous 12 years. In addition there are likely to be cyclical effects of slow monetary base growth and the very tight fiscal policies that are holding back the recovery from the cyclical output loss noted above. The overall fiscal deficit has declined from 4.2 percent of GDP in 1993 to 2.2 percent in 1995, the largest two-year reduction since at least 1960.

Finally, there must be groups that are adversely affected by developments that raised the value of the Swiss franc. Policies that slow inflation, or that switch output from consumption to investment or from public to private output, or boost productivity and economic growth must leave many adversely affected parties. Since these are generally desirable economic outcomes, however, it is difficult to make the case that these unintended consequences should be reversed. It is also not surprising that the beneficiaries of lower real interest rates and inflation, or from higher productivity and real wages, are not as vocal in defending the policies that account for the strong franc as those that have been adversely affected.


REFERENCES

BARRO, R., «Inflation and Economic Growth,» in Bank of England Quarterly Bulletin, May 1995, pp. 166-75.

BELONGIA, M., W. HERMANN, «Swiss Exports and the Real Exchange Rate: an Empirical Analysis, Schweizerische Nationalbank, Geld, Währung and Konjunktur, Quartalsheft No. 4, 1989, pp. 361-9.

ETTLIN, F., «Fundamental Determinants of the Swiss Franc Exchange Rate for the Deutschmark,» Schweizerische Nationalbank working paper presented at the 1996 meetings of the Swiss Society of Statistics and Economics.

FREEDMAN, S., B. SCHWAB, «Starker Franken - schwache Wirtschaft?» Union Bank of Switzerland Economic Focus, June 1995.

HARRIS, E., N. ZABKA, «The Employment Report and the Dollar,» Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 1 no. 8, November 1995.

Organization for Economic Cooperation and Development, Economic Outlook, Winter 1995.

TATOM, J., «Currency Appreciation and Deindustrialization: A European Perspective,» The World Economy, vol. 18 no. 4, July 1995, pp. 519-41.

TATOM, J., «The Link Between the Value of the Dollar, U.S. Trade and Manufacturing Output: Some Recent Evidence,» Federal Reserve Bank of St. Louis Review (November/December 1988), pp. 30-43.

TATOM, J., «Will A Weaker Dollar Mean A Stronger Economy?» Journal of International Money and Finance (December 1987), pp. 433-47.

ZUSAMMENFASSUNG

Die kürzliche Aufwertung des Schweizer Franken hat Gegner auf den Plan gebracht. Ihr Widerstand stützt sich auf die traditionelle Ansicht, wonach eine Währungsaufwertung das Inlandsprodukt und die Beschäftigung reduziert. Eine alternative, sich auf die Angebotsseite beziehende Erklärung geht jedoch davon aus, dass eine höher bewertete Währung ein Beweis dafür ist, dass Veränderungen in der Wirtschaftspolitik zu besseren Aussichten für Investitionen, Produktivität und Gesamtproduktion geführt haben. In diesem Artikel wird zuerst auf die zwei theoretischen Ansätze eingegangen. Danach wird gezeigt, dass die schweizerische Erfahrung gegen die traditionelle Hypothese, wonach ein negativer Zusammenhang zwischen Währungsbewegungen und der Gesamtproduktion eines Landes besteht, spricht. Diese Feststellung basiert auf Tests, welche das Vorhandensein langfristiger Beziehungen (Co-Integration) zwischen dem Wechselkurs und verschiedenen Indikatoren der Gesamtproduktion und der Produktivität sowie der nominellen Exporte prüfen. Solche Zusammenhänge können aufgezeigt werden und unterstützen somit die hier vorgeschlagene alternative Hypothese. Wirtschaftspolitische

494 JOHN A. TATOM

Massnahmen zur Förderung der Investitionstätigkeit und der Produktivität sowie zur Erhöhung des Realeinkommens führen folglich auch zu einer Währungsaufwertung, welche als Zeichen relativen Wohlstands und nicht als Ursache für einen Untergang zu werten ist.

SUMMARY

The recent appreciation of the Swiss franc provoked opposition based on the conventional view that currency appreciations reduce domestic output. An alternative, supply-side view, however, is that an appreciating currency is evidence that policy changes have improved inflation, investment, productivity and output. This article reviews the two views, then shows that the Swiss evidence rejects the conventional hypothesis of a negative relationship between movements in a currency's value and output, based on tests of the existence of cointegrating relationships between measures of the exchange rate and various measures of output and productivity, as well as measures of nominal exports. Statistically significant long-run relationships are found that generally support the alternative view. Policies that boost investment, productivity and real income also raise the currency's value, so the latter rise has been a signal of enhanced prosperity instead of a cause of its demise.

RESUME

La récente appréciation du franc suisse, d'une ampleur et rapidité sans précédent, a provoqué une inquiétude généralisée se basant sur la théorie conventionnelle qui veut que la production nationale, l'emploi et le revenu réel sont compromis par l'appréciation de la monnaie. Selon une autre vision basée sur le point de vue de l'offre, une monnaie qui s'apprécie constitue simplement la preuve que des modifications de la politique économique ou d'ordre technologique ont amélioré les perspectives d'inflation, de production, d'investissement et de productivité. Cet article passe d'abord en revue ces deux approches théoriques, et ensuite montre que l'expérience suisse est en contradiction avec l'hypothèse traditionnelle d'un lien négatif entre les fluctuations de la monnaie et la production nationale. La vision conventionnelle est démentie notamment par des tests montrant des relations à long terme (cointégration) entre diverses mesures de taux de change et diverses variables de production et de productivité, de même que les exportations nominales. Il existe des relations à long terme significatives sur le plan statistique, qui accréditent d'une manière générale l'autre point de vue présenté ici. Une politique économique qui encourage les investissements, la productivité et le revenu réel accroît en même temps la valeur du franc suisse, ce qui est un signe de la prospérité relative du pays, et non pas de son déclin.

swiss exchange rate appreciation and domestic economic

Documents