Economic Policy #07_08 Foreign-Exchange Policy Foreign-Exchange Policy •History of monetary system •Convertibility and exchange-rate regimes •Currency crisis •Nominal vs. real exchange rate •Theory of optimum currency areas •Balance of payments –pros and cons of capital openness –capital allocation puzzle –global imbalances • EP#07_08: Foreign-exchange policy 2 Brief history of the international monetary system #1 •System of Gold Standard was extended to all major economies in the 1880s and lasted until WWI: value of national currency was determined by a given gold weight => fixed exchange rates between national currencies. •Gold Standard was temporarily restored in the end of 19920s but finally abandoned during 1930s as the countries turned to protectionist measures and competitive devaluations. EP#07_08: Foreign-exchange policy 3 Brief history of the international monetary system #2 •After WWII Bretton Woods Conference established a Gold Exchange Standard, where all currencies were convertible into gold at a fixed rate. This system broke down in 1972. •In 1979 European Monetary System (EMS) was established, whereby all cross exchange rates had to fluctuate within margins of +/- 2.25 % (in some cases +/- 6 %) around a central rate. •In 1999 European monetary union was initiated. • EP#07_08: Foreign-exchange policy 4 Currency convertibility and exchange rate regimes •Governments need to make two crucial decisions: • •on the conditions for exchanging the domestic currency for foreign currencies => currency convertibility •on the extent of exchange rate flexibility => exchange rate regime EP#07_08: Foreign-exchange policy 5 Currency convertibility •Currency is nonconvertible if the government set the value of the exchange-rate and submit foreign-exchange transactions to prior authorization (e.g. Soviet bloc before 1990). • •It is useful to distinguish: •current account convertibility: the currency can be exchanged freely for the purpose of importing good and services, current transfers and factor income •financial account convertibility: direct investments, portfolio investments and bank loans without restriction (=> capital mobility) • • EP#07_08: Foreign-exchange policy 6 Financial openness •While advanced economies have liberalized capital flows in the 1980s, this movement is still incomplete in developing countries. EP#07_08: Foreign-exchange policy 7 Exchange-rate regimes #1 EP#07_08: Foreign-exchange policy 8 Exchange-rate regimes #2 •’Dollarization’, ’euroization’: the currency of another country circulates as the sole legal tender: dollar (e.g. Panama, Ecuador), euro (e.g. Montenegro and San Marino). Another option is that the same legal tender is shared by members of monetary union. •Currency board: explicit legislative commitment to exchange domestic currency at a fixed rate, issuance of domestic currency is backed by foreign assets only. •Fixed exchange rates: the country pegs its currency within margins of +/- 1 % or less vis-à-vis another currency (or basket of currencies) • • EP#07_08: Foreign-exchange policy 9 Exchange-rate regimes #3 •Soft pegs with fluctuation band: the value of the currency is maintained within certain margins of fluctuation of more than +/- 1 % around a fixed central rate •Crawling pegs: the central rate is adjusted periodically, usually in response to changes in selective quantitative indicators (e.g. inflation differentials) •Managed floating: The CB attempts to influence the exchange rate without having a specific exchange rate path or target •Free floating: the exchange rate is fully market-determined • EP#07_08: Foreign-exchange policy 10 Exchange-rate policy in a flexible exchange-rate regime •Who decides? –USA, Japan, UK: Treasury decision, Central bank implementation –Eurozone: ECB’s decision after consulting the Eurogroup •What instruments? –Policy rates –Foreign exchange interventions •Unsterilized: portfolio channel •Sterilized: portfolio/signal/monetary-policy channels –Declarations (ex: G7 statements) –Bilateral meetings (ex. in Beijing) EP#07_08: Foreign-exchange policy 11 Exchange-rate regimes: fear of floating? EP#07_08: Foreign-exchange policy 12 The Exchange Rate Regime Dilemma: the pros and cons of fixed regime •The risk of speculative attacks when the firmness of the commitment is being questioned that can lead to currency crisis. •A country must keep large quantities of foreign currency. •By commiting to a fixed rate a country committs itself not to engage in inflationary policies. •CB must give up independent monetary policy. EP#07_08: Foreign-exchange policy 13 The benefits of pegs: credibility EP#07_08: Foreign-exchange policy 14 The Exchange Rate Regime Dilemma: the pros and cons of floating •Large exchange rate fluctuations are a major source of uncertainty. •Exchange rate fluctuations affect the relative value of assets and liabilities => depreciation raises the value of the external debt. •Monetary independence if the CB is sustained. •Countries are better able to absorb economic shocks. • EP#07_08: Foreign-exchange policy 15 J-curve •What is the effect of currency depreciation? • •In the SR trade volumes tend to react slowly to relative price variations, while the valuation effect is immediate => immediate deterioration in trade balance, then improvement in the LR. EP#07_08: Foreign-exchange policy 16 Convertibility and exchange-rate regime: a joint choice •Mundell’s impossible trinity A country cannot simultaneously enjoy an independent MP, a stable exchange rate and a perfectly mobile capital. EP#07_08: Foreign-exchange policy 17 Regime choice: the optimum currency area theory (OCA) #1 •The OCA theory predicts that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements. EP#07_08: Foreign-exchange policy 18 The optimum currency area theory #2 •Benefits: –saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float –are higher, the higher the degree of economic integration between the joining country and the fixed exchange rate area – EP#07_08: Foreign-exchange policy 19 The optimum currency area theory #3 •Costs: –arise because a country that joins an exchange rate area gives up its ability to use the exchange rate and monetary policy for the purpose of stabilizing output and employment –are lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins • EP#07_08: Foreign-exchange policy 20 Is the euro area an optimal currency area? #1 •An OCA occurs when •Countries have achieved real convergence •They respond in similar ways to external economic shocks or macro policy changes •They have sufficient flexibility in both their product markets and labor markets to deal with these shocks –High mobility of labor –Wage and price flexibility in factor markets •Countries are prepared to use fiscal transfers to even out some of the regional economic imbalances – EP#07_08: Foreign-exchange policy 21 Box. Is the euro area an optimal currency area? #2 •The Euro Zone does not come close to an OCA by most criteria, because •The core group of EU countries are broadly similar (Germany + France + Netherlands + Belgium) but peripheral countries have big structural differences •There are barriers to the mobility of labor •Price and wage flexibility is rather low •The role of fiscal transfers is limited • EP#07_08: Foreign-exchange policy 22 The euro: a counter-cyclical exchange rate? EP#07_08: Foreign-exchange policy 23 Foreign exchange crises •Exchange-rate crisis is sudden move from a fixed to a floating exchange rate under the pressure of market participants. •Such crises have occurred repeatedly in recent history, especially since capital movements are free –1992/1993: European Monetary System (Sweden, UK, Italy ...) –End-1994: Mexico –1997/1999: Emerging market crises (Thailand, Korea, Indonesia, Brazil, Russia...) –2000/2001: Turkey, Argentina –2008: Iceland, Pakistan, Hungary, Latvia (without devaluation) • EP#07_08: Foreign-exchange policy 24 Theoretical explanations of currency crisis •1st generation: –he crisis occurs when foreign exchange reserves are depleted or are expected to be depleted given credit growth –does not apply to ERM crises (current account surpluses, low inflation) – •2nd generation –the crisis occurs when defending the peg becomes too costly (interest rate, unemployment) –does not apply to East Asia (the crisis itself was more costly) – •3rd generation –the crisis occurs when confidence in debtors’ solvency is lost –twin crises (monetary and financial) – – EP#07_08: Foreign-exchange policy 25 Nominal versus real exchange rate •Stylized fact I: When inflation is low, real exchange rate is strongly correlated with the nominal exchange rate. • • EP#07_08: Foreign-exchange policy 26 Nominal versus real exchange rate •Stylized fact II: Real exchange rate tends to constant in the LR, in developing countries it appreciates as the country develops. • • Fig. PPP GDP per capita and real exchange rate in 2006 EP#07_08: Foreign-exchange policy 27 The Balassa-Samuelson effect Consequence: inflation rates should remain dispersed in the euro area => contradiction with Maastricht convergence criteria. EP#07_08: Foreign-exchange policy 28 Balance of payments (BP) •It is a double entry system of record of all economic transactions between the residents of the country and the rest of the world carried out in a specific period of time. • •It takes into account the export and import of both visible and invisible items. EP#07_08: Foreign-exchange policy 29 Structure of balance of payment •BP consists of three accounts: •Current account: all payments from/to the rest of the world deriving from exports of goods and services, labor and capital income •Capital account: capital transfers without a counterpart •Financial account (formerly capital account): all sales of domestic assets to the rest of the world (capital inflows) and all purchases of foreign assets (capital outflows). EP#07_08: Foreign-exchange policy 30 The US and euro area BP in 2008 EP#07_08: Foreign-exchange policy 31 Adjustment under fixed and floating exchange rates EP#07_08: Foreign-exchange policy 32 The pros and cons of capital openness #1 •Theoretical advantages: –enables the capital to flow to the most efficient places – helping both investors as well as all stakeholders –enable emerging economies to diversify narrow production base while simultaneously benefiting from technological spillover –capital flows from capital rich to capital poor countries as they should have higher returns •reduce cost of capital •enable investments •increase growth • • EP#07_08: Foreign-exchange policy 33 The pros and cons of capital openness #2 •Potential problems: –fear of appreciation of domestic currency and making domestic manufacturers less competitive in global markets –fear of hot money; sudden injection of funds into small markets can cause initial dislocation and strains associated with sudden withdrawal –fear of large capital inflows, that can cause dislocations in the financial system and fuel asset price bubbles –fear of loss of monetary autonomy; see impossible trinity • • EP#07_08: Foreign-exchange policy 34 The capital allocation puzzle #1 •Some countries are structural capital exporters, due to: –an undervalued exchange rate, or –a high domestic saving rate (in ageing countries, or in countries where social security is underdeveloped ) –limited investment needs due to a already high stock of capital •Some are structural capital importers, due to: –a high investment needs in the catch-up process –a low domestic saving rate – •=> One would expect long-term capital to flow from North to South • • • EP#07_08: Foreign-exchange policy 35 The capital allocation puzzle #2 •In the real world, however, –Gross capital flows have been mostly North- North although increasingly South-South •Net capital flows have been South-North •No correlation between incoming investment and the marginal return of capital (the allocation puzzle) • EP#07_08: Foreign-exchange policy 36 Global imbalances: the policy discussions • •Current account surpluses have piled up in Asian countries in the 2000s. • •Meanwhile, the US deficit has grown from 2 % GDP in 1997 to more than 6 %. • •The Eurozone suffers from internal imbalances. EP#07_08: Foreign-exchange policy 37 The imbalanced eurozone •Countries with current account deficits are those where productivity grows fast (e.g. some new member states) •Other possible explanations: –Excess demand due to insufficient supply- side reform (excess development of non- tradable sectors, e.g. Greece, France?) –Speculative capital inflows due to asset price bubble (e.g. housing market in Spain), themselves related to single currency (negative real interest rates) EP#07_08: Foreign-exchange policy 38 Current account balance (% of GDP) EP#07_08: Foreign-exchange policy 39 Global imbalances: four explanations EP#07_08: Foreign-exchange policy 40