Thorvaldur Gylfason IMF-Middle East Center for Economics and Finance (CEF) Course on Macroeconomic Management in Natural Resource-Rich Countries Kuwait City, Kuwait, 6-17 January 2013

1.Real vs. nominal exchange rates 2.Dutch disease, overvaluation, and volatility 3.Exchange rate regimes To float or not to float To float or not to float How many currencies? How many currencies?

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 number of units of foreign currency needed to purchase one unit of local currency

Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

1.e falls 1. Suppose e falls Then more dinars per dollar, X risesZ falls so X rises, Z falls 2.P falls 2. Suppose P falls X risesZ falls Then X rises, Z falls 3.P* rises 3. Suppose P* rises X risesZ falls Then X rises, Z falls Q falls Capture all three by supposing Q falls X risesZ falls Then X rises, Z falls X = exports Z = imports X = exports Z = imports

 Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness  In 1960s, Netherlands discovered natural resources (gas deposits)  Currency (Dutch guilder) appreciated  Exports of manufactures and services suffered, but not for long  Not unlike natural resource discoveries, aid inflows could trigger the Dutch disease in receiving countries 2 See my “Dutch Disease” in New Palgrave Dictionary of Economics OnlineDutch Disease See my “Dutch Disease” in New Palgrave Dictionary of Economics OnlineDutch Disease

Foreign exchange Real exchange rate Imports Exports without oil Exports with oil A CB Oil discovery leads to appreciation, and reduces nonoil exports Composition of exports matters

Foreign exchange Real exchange rate Imports Exports without oil Exports with oil A CB Imports with immigration D Immigration means more income and imports as well as remittances abroad

 Spending effect  Increased income from booming natural resource sector boosts private and public spending, raising prices and output in non-tradables sector  In non-natural resource tradables sector (“manufacturing”), prices are fixed at world levels, profits are squeezed by rising wages, and increased demand is met out of rising imports  Resource movement effect  Natural resource boom attracts capital and labor away from rest of economy  Output declines in non-resource economy, esp. in tradables, where prices are fixed at world levels

 Both effects result in  Decrease in output share of non-natural resource tradables relative to non-tradables  Appreciation of real exchange rate  So, decline of manufacturing and appreciation of currencies in real terms tend to go hand in hand  Extensive theoretical literature behind this result  What do the data say?  Recent literature survey by Magud and Sosa (2010) “When and Why Worry About Real Exchange Rate Appreciation? The Missing Link between Dutch Disease and Growth,” IMF WP/10/271

Dutch disease shocks Natural resources/capital inflows Source: Magud and Sosa (2010) Number of cases reported

RemittancesForeign aid Number of cases reported Source: Magud and Sosa (2010)

Empirical studiesTheoretical studies Number of cases reported Source: Magud and Sosa (2010)

Currency misalignmentsExchange rate changes Number of cases reported Source: Magud and Sosa (2010) Does overvaluation reduce growth? Does undervaluation?

 Dutch disease does exist  Resource booms make currencies appreciate  When currency appreciates in real terms, factors of production are reallocated and production switches away from manufacturing Exchange rate volatility hampers economic growth (not shown here, will see later)  Misalignment of real exchange rate from its fundamental value also lowers growth Overvaluation is always bad for growth Evidence on the effect of undervaluation on growth is inconclusive

 Foreign exchange earnings are converted into local currency and used to buy domestic goods  Fixed  Fixed exchange rate regime real  Reserve inflow causes expansion of money supply that leads to inflation and appreciation of domestic currency in real terms  Flexible  Flexible exchange rate regime nominal real  Increase in supply of foreign exchange leads to nominal appreciation of currency, so real exchange rate also appreciates M = D + R Q = eP/P* M = Money D = Domestic credit R = Reserves M = Money D = Domestic credit R = Reserves

Foreign exchange Real exchange rate Imports aid Exports without aid aid Exports with aid A CB Foreign aid leads to appreciation, and reduces exports (e.g., Zambia) Trade vs. aid

 Foreign aid has sometimes been compared to natural resource discoveries  Aid and growth are inversely related across countries  Cause or effect?  156 countries, r = r = rank correlation Other people’s money Importance of good governance Leakages

Foreign exchange Real exchange rate Imports inflow Exports without inflow inflow Exports with inflow A CB Capital account liberalization leads to appreciation, and sometimes instability when inflow stops or reverses itself Crises

 Term refers to fears of de-industrialization that gripped the Netherlands following the appreciation of Dutch guilder after the discovery of natural gas deposits in North Sea around 1960  Is it Dutch? Is it a disease? No  Some say No, viewing it simply as matter of one sector’s benefiting at the expense of others, without seeing any macroeconomic or social damage done Yes  Others say Yes, viewing the Dutch disease as an ailment, pointing to the potentially harmful consequences of the resulting reallocation of resources – from high-tech, high-skill intensive service industries to low-tech, low-skill intensive primary production, for example – for economic growth and diversification Double misnomer?

 Volatility of commodity prices leads to volatility in exchange rates, export earnings, output, and employment  Volatility can be detrimental to investment and growth  Hence, natural-resource rich countries may be prone to sluggish investment and slow growth due to export price volatility  Likewise, high and volatile exchange rates tend to slow down investment and growth

Uneven income streamEven income stream

Output volatility and economic growth  Inverse cross-country correlation between per capita growth and GDP volatility  GDP volatility is defined as the standard deviation of per capita growth  163 countries, r = -0.47

always floats  The real exchange rate always floats  Through nominal exchange rate adjustment or price change  Even so, it matters 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 3

 There is a range of options Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate Fixed exchange rate (peg) Crawling peg Managed floating Pure floating

 Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Managed Independent FIXED FLEXIBLE

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

Flexible peg  Fixed but readily adjusted Crawling peg  Complete  Compensate for past inflation  Allow for future inflation  Partial  Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable

Managed floating  Management by sterilized intervention I.e., by buying and selling foreign exchange  Management by interest rate policy, i.e., monetary policy E.g., by using high interest rates to attract capital inflows and thus lift the exchange rate of the currency Pure floating

Governments may try to keep the national currency overvalued To keep foreign exchange cheap To have power to ration scarce foreign exchange To make GDP look larger than it is Other examples of price ceilings Negative real interest rates Rent controls in cities

Inflation can result in an overvaluation of the national currency Q = eP/P* Remember: Q = eP/P* eP Suppose e adjusts to P with a lag Q Then Q is directly proportional to inflation Numerical example

Time Real exchange rate Average Suppose inflation is 10% per year

Time Real exchange rate 110Average real Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag Suppose inflation rises to 20%

 If overvaluation of currency hurts exports, undervaluation must by similar logic help exports  Yet, as we saw, empirical evidence is mixed  Some countries – e.g., China – have kept their currencies undervalued to boost exports and contain imports  Undervaluation as export promotion policy  Undervaluation leads to buildup of foreign exchange reserves  Reserve buildup raises some of the same issues as natural resources booms

 In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force  Consider four categories  Existing monetary unions  De facto monetary unions  Planned monetary unions  Previous – failed! – monetary unions

 CFA franc  14 African countries  CFP franc  3 Pacific island states  East Caribbean dollar  8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note  Euro, more recent  17 EU countries plus 6 others Thus far, at least until recently (Greece), a success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

 Indian rupee  India plus Bhutan  South African rand  South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe  US dollar  US plus Ecuador, El Salvador, Panama, and 6 others  Swiss franc  Switzerland plus Liechtenstein (pop. 30,000)  Australian dollar  Australia plus 3 Pacific island states (small populations)  New Zealand dollar  New Zealand plus 4 Pacific island states (small pop.)

 East African shilling  Burundi, Kenya, Rwanda, Tanzania, and Uganda  Eco  Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)  Common currency for four GCC countries  Bahrain, Kuwait, Qatar, and Saudi-Arabia  Other, more distant plans  Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa  African Union aims to launch the afro in 2029 Time tables have been relaxed

 Danish krone  Denmark and Iceland : 1 IKR = 1 DKR  2009: 2,500 IKR = 1 DKR (due to inflation in Iceland)  Scandinavian monetary union  Denmark, Norway, and Sweden  East African shilling  Kenya, Tanzania, Uganda, and 3 others  Mauritius rupee  Mauritius and Seychelles  Southern African rand  South Africa and Botswana  Many others No significant divergence of prices or currency rates following separation 99.95%

 Centripetaljoin  Centripetal tendency to join monetary unions, thus reducing number of currencies stable exchange rates  To benefit from stable exchange rates at the expense of monetary independence  Centrifugalleave  Centrifugal tendency to leave monetary unions, thus increasing number of currencies monetary independence  To benefit from monetary independence often, but not always, at the expense of exchange rate stability  With globalization, centripetal tendencies appear stronger than centrifugal ones

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Free to choose only two of three options; must sacrifice one of the three

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Capital controls (China) Free to choose only two of three options; must sacrifice one of the three

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Flexibleexchange rate (US, UK, Japan) Flexibleexchange Free to choose only two of three options; must sacrifice one of the three

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Flexibleexchange rate (US, UK, Japan) Flexibleexchange Capital controls (China) Free to choose only two of three options; must sacrifice one of the three

free trade four freedoms  If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … monetary independence flexible exchange rates) vs. fixed rates  … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates  Cannot have both!  Either type of regime has advantages as well as disadvantages  Let’s quickly review main benefits and costs

BenefitsCosts Fixed exchange rates Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

 In 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 inefficiency  If inefficiency and slow growth due to currency overvaluation are the main problem, floating rates can help inflation  If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation  Ones both problems are under control, time may be ripe for monetary union What do countries do? To eliminate high inflation, need fixed exchange rate for a time

 There is no evidence that countries with abundant natural resources are more prone to inflation than other countries  They tend to grow more slowly, yes, but their inflation record is indistinguishable from others  Therefore, as far as inflation is concerned, choice between fixed and floating rates is essentially the same in natural-resource rich countries and elsewhere  Volatility of export earnings in natural-resource rich countries calls for flexibility – if not in exchange rate, then, e.g., in migration

Source: Annual Report on Exchange Arrangements and Exchange Restrictions database. What countries actually do (Number of countries, April 2008) (3) (12) (22) (5)(2)(66) (44)(40) (76) (84) (10)

Exchange rate anchor Monetary aggregate target (29) Inflation targeting framework (32) Other (38) 190 countries US dollar (43) Euro (27) Composite (13) Other (8) No separate legal tender (13) Currency board (12) Conventional peg (43) Stabilized arrangement (16) Crawling peg (3) Crawl-like arrangement (12) Pegged exchange rate within horizontal bands (1) Other managed Arrangement (24) Floating (35) Free floating (31)

No national currency 7% Currency board 6% Conventional fixed rates 31% Intermediate pegs 21% Managed floating 19% Pure floating 16% 100% 35% 65% increased interest in fixed rates There is a gradual tendency towards floating, from 10% of LDCs in 1975 to 35% of all countries today, followed by increased interest in fixed rates in economic and monetary unions The End These slides will be posted on my website: