Approaches to Assessing Currency Misalignment Menzie D. Chinn UW-Madison & NBER Presentation at Office of International Affairs Department of the Treasury October 26, 2006

Outline Caveats Methodologies Example: China New Approaches Conclusion

Key Point: There Are Many Equilibrium Exch. Rates There is no way to get the equilibrium rate and hence misalignment The appropriate measure depends upon the conditions of the economy you’re examining Different models will be relevant And different models will be consistent with different time horizons.

Methodologies Relative PPP Absolute PPP/Deviations from Absolute PPP Productivity based models BEERs/Fair Value Models Macroeconomic Balance/FEERs/External or Basic Balance

Relative PPP Assumes that relative price levels (measured by deflators, CPIs, or PPIs) adjusted by nominal exchange rates must be revert to some average level. Other deflators possible -- ULCs More flexible interpretations allow for reversion to trends. A long run – goods arbitrage perspective

Example: US Dollar (in real terms) Source: DB, Exchange Rate Perspectives, October 2006.

Example: US Dollar (nom. terms)

Example: Korean Won (nom. terms) Source: Chinn, EMR (2000)

Problems The relative PPP level must occur in the sample period. Only if the real exchange rate is stationary is the conditional mean invariant with respect to the sample. Related to the issue of whether the real rate is I(0), or price indices and the exchange rate are cointegrated with (1 -1 1) coefficients.

Absolute PPP Absolute PPP requires the prices of bundles of goods are equalized in common currency terms. MacParity is a special case of absolute PPP. But Absolute PPP doesn’t hold across countries of dissimilar incomes

The Failure of Absolute PPP Note: Log “price level” & log income/capita in 2000$. Source: Cheung, et al. (2006); WDI.

“Penn Effect” and MacParity Source: Pakko and Pollard, FRB SL Review (2003).

Productivity Based Models Balassa-Samuelson is the most prominent Higher productivity levels in tradable sector induces a stronger currency in real terms. Assumes PPP for traded goods. Perfect factor mobility w/in countries. Isn’t the only relevant model; in two good models, higher productivity may lead to a weaker real currency. Also a long run/long horizon model.

Example: China Source: Cheung, et al., FRB SF conference paper (2005).

BEER/DEER or “Kitchen Sink” Combination of Balassa-Samuelson, real interest differential (UIP with sticky prices), nontradables, and portfolio balance motivations (see Cheung, et al. (2005)). Source: F. Yilmaz and S. Jen, Morgan Stanley (2001). Where does NFA come from? CA equals inverse of negative returns times NFA. See Lane and Milesi-Ferretti (2002).

Macro Balance and Related Approaches Determine a “normal” level of current account balance or “basic balance” “Basic balance” is current account plus financial account (sometimes FDI flows). Using price elasticities, back out the equilibrium exchange rate. If an econometric approach is used to determine “normal” level of CA, then IMF’s “Macroeconomic Balance” approach.

In-Sample Fit for CA “ norms ” : Korea & Emerging Asia Source: Chinn and Ito (2006)

In-Sample Fit: China Source: Chinn and Ito (2006)

Complications Large prediction intervals for CA norms. What are the relevant trade elasticities? What are the conditioning variables (e.g., does one take budget deficits as given?) Details? See Isard, Faruqee, Kincaid, Fetherston (2001). FEER uses a normative assessment of equilibrium current account/basic balance. Looking at reserve accumulation is a variation on this approach.

Many Equil’m Rates: China GAO (August 2005)

Relative PPP (I)

Relative PPP (II)

Absolute PPP and Uncertainty Source: Cheung et al. (2006)

Recent Developments The role of net foreign assets, gross assets Measurement of the effective exchange rate

Assets and Adjustment: Gourinchas-Rey Propose a framework for NFA-ex rate movements Builds upon reversion to trend in NFA And an intertemporal budget constraint So a deficit can be closed by either the traditional trade channel (net exports), or Closed by revaluation effects NB: depreciation works in same direction

Normalized net exports/net assets Nxa is normalized so export weight is unity This means it’s measured in same units as exports. Interpretation: nxa is (approx.) the %age increase in exports necessary to restore ext. balance

Econometrics First part: component that f’casts future ret. Second: component that f’casts nx growth Estimate using VAR

Exchange Rate Adjustment Gourinchas and Rey, “International Financial Adjustment” (2005)

Approximating G-R (in-sample) Source: author’s calculations

Measurement: Divisia vs. geometric? Source: Thomas and Marquez (2006)

References Cheung, Yin-Wong, Menzie Chinn and Eiji Fujii, 2006, “The Overvaluation of Renminbi Undervaluation,” paper presented at the conference on “Financial and Commercial Integration,” SCCIE-JIMF conference, Santa Cruz (Sept.). Cheung, Yin-Wong, Menzie Chinn and Antonio Garcia Pascual, 2005 “Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?” Journal of International Money and Finance 24: Chinn, Menzie, 2000, “Before the Fall: Were East Asian Currencies Overvalued?” Emerging Markets Review 1(2) (August 2000): GAO, 2005, “International Trade: Treasury Assessments Have Not Found Currency Manipulation, but Concerns about Exchange Rates Continue,” Report GAO (April).

Gourinchas, Pierre-Olivier and Helene Rey, 2005, “International Financial Adjustment.” NBER Working Paper No (February). Isard, Peter, Hamid Faruqee, G. Russell Kincaid, Martin Fetherston, 2001, Methodology for Current Account and Exchange Rate Assessments, IMF Occasional Paper No Lane, Philip and Gian Maria Milesi-Ferretti, 2002, “External Wealth, the Trade Balance, and the Real Exchange Rate,” European Economic Review 46: Pakko, Michael R. and Patricia S. Pollard, 2003, “Burgernomics: A Big Mac™ Guide to Purchasing Power Parity,” Review 85(6) Nov.: