What’s Up with the Exchange Rate? What’s Up with the Exchange Rate? Andrew K. Rose UC Berkeley, NBER and CEPR

Exchange Rates2 The Basic Long-Run Issue  America’s Current Account Deficit –2006: $811.5 billion deficit (!)  6.2% of American GDP  Implies annual Capital Inflows of $2700 per person annually (!) –2007Q1: deficit of $192.6 billion –Almost all Goods (Services in surplus but small)  Small persistent income surplus

Exchange Rates3 Causes  Some Dispute among Economists  Still, Low American Savings chief reason –Personal Savings very low lately, often negative –Public Sector also dis-saving (Federal deficits)  Lack of Investment outside US also possible issue

Exchange Rates4 Current Account: Sustainable?  Size of Deficit unprecedented for America  Also unprecedented for “Anchor” country  US now taking over 75% of all global savings flows  Capital running “uphill” from poor to rich (!)  Growing US external debt

Exchange Rates5 Adjustment must involve Prices  For current account to close, savings must rise (or investment fall, or both)  Symmetrically, exports must rise dramatically, while import growth slows  Exchange Rate one of the key adjustment mechanisms  So long-run depreciation of Dollar is likely

Exchange Rates6 How Much?  Many Different Estimates, Little Consensus  Most expect at least another 15-25%, sometimes more  Exchange Rates often overshoot  Timing: almost impossible

Exchange Rates7 Where will Effects be Felt?  Three Big Currency Zones in World: –Dollar, Asian-zone, Europeans –But exchange rate policy varies across world  Dollar floats freely against Many Currencies –Europeans (including UK, Norway) –Also Canada, NZ, Australia, etc

Exchange Rates8 But Asia is Different  Asians take Exchange Rate Policy Seriously  Almost all East Asians manage currencies, will continue to do so  Part a Legacy of Asian Crisis of ’97-’98  Part a Development Strategy … –Which Leads us to China

Exchange Rates9 How to Think about the Yuan?  Chinese Communist Party Needs Growth to Survive Politically –Growth is Required to Absorb Massive Unemployment in Chinese Countryside  Agricultural Peasants Must Be Transformed Into Manufacturing Workers –Exports Provide Only Possible Outlet

Exchange Rates10 Asian Paradigm for Development  Competitive (Cheap) Unemployed Labor Absorbed into Manufactured Sector –Example of key theory of W.A.Lewis (Nobel Laureate)

Exchange Rates11 Implications for West  China has every incentive to maintain under-valued exchange rate –Under-valuation the key to rapid export growth –Right in theory –Effective in practice (past twenty years!) –Hence rapid accumulation of US$ reserves, as China maintains under-valued peg to US –Reserves act as “collateral”, encourage FDI

Exchange Rates12 Special Role of USA  US is issuer of $, global reserve currency  East Asians fixes against US$  US is largest, most open economy  US willing to handle large, persistent current account deficits

Exchange Rates13 Special Role of USA, contd  American FDI high in Asia –High Returns on Asian Investments help protect against American Protectionism –China Importing Financial Services, since Domestic Financial Sector Weak –US also premier provider of collateral service (hence Asian pegs against $)

Exchange Rates14 Where Does Europe Fit In?  No Direct Role  Still, Large Indirect Role –Euro floats against $ –Europe has powerful central bank with independent monetary policy

Exchange Rates15 Dollar Depreciation Likely to be Mostly against Euro  Some Already Occurred  Dollar depreciated from.8$/euro to 1.4$/euro already  Worse for pound!  More likely to come!

Exchange Rates16 Asia and the Euro  Crisis in Confidence Possible –American Current Account Deficits large  >6% GDP, highly persistent  Dollar Depreciation Resisted by Asians –But Euro Floats Freely!  Euro Likely to Continue to Appreciate Against Dollar over long Term

Exchange Rates17 It isn’t Only China!  Other Asian Economies Waiting in Line behind China –India –Indonesia –Vietnam …

Exchange Rates18 Historical Precedent  European Development in 1950s and 1960s  Export-Lead Growth to transfer under- employed Europeans from countryside to manufacturing  Revival of “Bretton Woods” regime, prevailed before 1971

Exchange Rates19 Conclusion  Dollar Decline likely to continue  Probably Most Dramatically Against Euro  Good argument for foreign diversification!