1. External Sector Policies Thorvaldur Gylfason Singapore, February 2008

2. Outline 1)Real vs. nominal exchange rates 2)Exchange rate policy and welfare 3)The scourge of overvaluation 4)From exchange and trade policies to economic growth 5)Capital flows 6)Exchange rate regimes  To float or not to float

3. 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 currency

4. Real vs. nominal exchange rates 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

5. Three thought experiments 1.e falls 1. Suppose e falls Then more baht 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 Summarize all three by supposing Q falls X risesZ falls Then X rises, Z falls

6. Foreign exchange Real exchange rate Imports Exports Exchange rate policy and welfare 2 Earnings from exports of goods, services, and capital Payments for imports of goods, services, and capital Equilibrium

7. Equilibrium between demand and supply in foreign exchange market establishes Equilibrium real exchange rate Equilibrium in the balance of payments BOP = X + F x – Z – F z = X – Z + F = current account + capital account = 0 Exchange rate policy and welfare

8. Foreign exchange Real exchange rate Imports Exports Exchange rate policy and welfare Overvaluation Deficit R R moves when e is fixed

9. Foreign exchange Price of foreign exchange Supply (exports) Demand (imports) Exchange rate policy and welfare Overvaluation Deficit Overvaluation works like a price ceiling

10. Market equilibrium and economic welfare Supply Demand E Producersurplus Consumersurplus Quantity Price A B C Total welfare gain associated with market equilibrium equals producer surplus (= ABE) plus consumer surplus (= BCE)  R = 0, so R is fixed when e floats

11. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss equivalent to the triangle EFG A B C Consumer surplus = AFGH H J Market intervention and economic welfare Producer surplus = CGH Total surplus = AFGC

12. Supply Demand Price ceiling E F G Quantity Price Welfareloss Price ceiling imposes a welfare loss welfare loss that results from shortage (e.g., deficit) A B C H J Market intervention and economic welfare Shortage

13. The scourge of overvaluation Governments 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 3

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

15. Inflation and overvaluation Time Real exchange rate 100 110 105 Average Suppose inflation is 10 percent per year

16. Inflation and overvaluation Time 100 120 Real exchange rate 110Average 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

17. How to correct overvaluation Under a floating exchange rate regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation will lower e and thereby also Q – provided inflation is kept under control Does devaluation improve the current account? The Marshall-Lerner condition

18. The Marshall-Lerner condition: Theory e B = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation strengthens the current account as long as Suppose prices are fixed, so that e = Q a = elasticity of exports b = elasticity of imports Valuation effect arises from the ability to affect foreign prices

19. The Marshall-Lerner condition 11 -ab -+ Export elasticity Importelasticity

20. The Marshall-Lerner condition if X Assume X = Z/e initially Appreciation weakens current account

21. The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation strengthens the current account

22. Empirical evidence from developing countries Elasticity of exportsimports Argentina0.60.9 Brazil0.41.7 India0.52.2 Kenya1.00.8 Korea2.50.8 Morocco0.71.0 Pakistan1.80.8 Philippines0.92.7 Turkey1.42.7 Average1.11.5

23. The small country 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

24. The importance of appropriate side measures Remember: 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

25. From exchange and trade policies to growth Governments may try to keep the national currency overvalued Or inflation may result in overvaluation In either case, overvaluation creates inefficiency, and hurts growth Therefore, exchange rate policy matters for growth Need real exchange rates near equilibrium 4

26. From exchange and trade policies to growth How 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 floats Through nominal exchange rate adjustment or price change, but this may take time

27. Why inflation is detrimental to growth We saw before that inflation leads to overvaluation which hurts exports So, here is one additional reason why inflation hurts economic growth Exports and imports are good for growth Several other reasons Inflation distorts production and impedes financial development, and scares foreign investors away

28. How trade increases efficiency and growth Trade with other nations increases efficiency by allowing 1.Specialization through comparative advantage 2.Exploitation of economies of scale 3.Promotion of free competition Not only trade in goods and services, but also in capital and labor “Four freedoms”

29. How trade increases efficiency and growth Trade also encourages international exchange of Ideas Information Know-how Technology Trade is tantamount to technological progress is Trade is education Which is also good for growth!

30. Efficiency is crucial for economic growth Need 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 education Trade increases efficiency and thereby also economic growth

31. Exports and economic growth 1960-2000 163 countries r = 0.26

32. Asia: Exports (% of GDP)

33. FDI and economic growth 1960-2000 152 countries r = 0.21

34. Asia: FDI net inflows (% of GDP)

35. Evolution of capital flows Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846. A stylized view of capital mobility 1860-2000 Capital mobility First era of international financial integration Capital controls Return toward financial integration 5

36. Source: WEO Asia: Net capital flows and external debt indicators, 1980-2006

37. Push vs. pull factors External factors “pushed” capital from industrial countries to LDCs  Cyclical conditions in industrial countries  Recessions in the early 1990s  Decline in world interest rates  Structural changes in industrial countries  Financial structure developments  Demographic changes

38. Push vs. pull factors Internal factors “pulled” capital into LDCs from industrial countries  Macroeconomic fundamentals  Reduction in barriers to capital flows  Private risk-return characteristics  Creditworthiness  Productivity

39. Large capital flows to Asia have resumed in recent years

40. Improved allocation of global savings (allows capital to seek highest returns) Greater efficiency of investment More rapid economic growth Reduced macroeconomic volatility through risk diversification (which dampens business cycles)  Income smoothing  Consumption smoothing Potential benefits of capital flows

41. Open capital accounts may make receiving countries vulnerable to foreign shocks  Magnify domestic shocks and lead to contagion  Limit effectiveness of domestic macro policy instruments Countries 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 of capital flows

42. 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 suffers  Construction booms Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime Potential risks of capital flows

43. Real stock prices during inflow periods, selected countries Year with respect to start of Inflow period Note: 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

44. Stock prices in Thailand 1987-2000

45. Large deficits  Current account deficits  Government budget deficits Poor bank regulation  Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt  Ratio of short-term liabilities to foreign reserves Mismatches  Maturity mismatches (borrowing short, lending long)  Currency mismatches (borrowing in foreign currency, lending in domestic currency) Early warning signs

46. Asia: Ratio of short-term liabilities to foreign reserves in 1997

47. Large reversals

48. Country experiences with capital 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

49. Some types of capital flows are riskier than others Transitory High degree of risk sharing Permanent No risk sharing Foreign direct investment Long term debt (bonds) Portfolio equity Short term debt

50. Sequencing Capital Account Liberalization Pre-conditions for liberalization  Sound macroeconomic policies  Strong domestic financial system  Strong and autonomous central bank  Timely, accurate, and comprehensive data disclosure

51. Exchange rate regimes The real exchange rate always floats Through nominal exchange rate adjustment or price change Even 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 6

52. Exchange rate regimes 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

53.  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Independent FIXED FLEXIBLE Exchange rate regimes

54. 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 fixed

55. 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 Intermediate

56. Managed floating  Management by sterilized intervention  Management by interest rate policy, i.e., monetary policy Pure floating Basically floating

57. Benefits and costs BenefitsCosts Fixed exchange rates Floating exchange rates

58. Benefits and costs BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

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

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

61. Benefits and costs 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

62. Exchange rate regimes 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 are the main problem, floating rates can help inflation If high inflation is the main problem, fixed exchange rates can help

63. FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE MONETARY INDEPENDENCE Monetaryunion (as in EU) Flexibleexchangerate (as in US) Capital controls Impossible trinity

64. What countries actually do (2004, 193 countries) No national currency17% Other types of fixed rates23 Dollarization 5 Currency board 4 Crawling pegs 3 Bilateral fixed rates 3 Managed floating26 Pure floating19 100 51% 49% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

65. Bottom line The End These slides will be posted on my website: www.hi.is/~gylfason 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 debt  Must avoid overvaluation! Need to adopt exchange rate regime that is conducive to moderate inflation and rapid economic growth