Fixed Exchange Rates and Currency Unions

Transcription

1 Trade and International Finance SciencesPo Second Year Fall 2018 Fixed Exchange Rates and Currency Unions Lecture 8 Nicolas Coeurdacier nicolas.coeurdacier@sciencespo.fr

2 Fixed exchange rates and currency unions Motivation Many countries belong to regional currency arrangements and/or share a common currency (Denmark, Euro area) Many developing and emerging markets peg to the dollar(china) many central banks intervene to influence exchange rates in floating exchange rate regimes Implications of these policies?

3 Fixed exchange rates and currency unions 1. How do central banks fix the exchange rate? 2. Policies under fixed exchange rates 3. Currency Unions 4. Currency and Sovereign Debt Crisis

4 Fixed exchange rates and currency unions 1. How do central banks fix the exchange rate? 2. Policies under fixed exchange rates 3. Currency Unions 4. Currency and Sovereign Debt Crisis

5 Exchange Rate Regimes Exchange Rate Choice can be considered a continuum, from most rigid to least interventionist (pure free float). Pure Fixed Rate Adjustable Peg Managed Float Pure Flexible Rate

6 Distribution of Exchange Rate Regimes in Emerging Economies (in %)

7 How to fix the exchange rate? Example: Denmark and euro Denmark participates in European Exchange Rate Mechanism II (ERM II) with a central rate of kr per 100 euro. Denmark has narrower fluctuation band of +/-2.25 per cent (krone can only fluctuate between kr per 100 euro and kr per 100 euro). Danmarks Nationalbank stabilizes the krone by buying and selling foreign currency in the market. When sells foreign currency (and buys kroner), the krone tends to strengthen. When buys foreign currency (and sells kroner), the krone tends to weaken.

8 Assets Central banks balance sheets Liabilities Foreign assets: 100 Deposits held by private banks: 200 Domestic assets: 500 Currency in circulation: 400 Central bank sells 10 in foreign assets (official reserves) on exchange market, Buyer pays in currency Foreign assets: 90 Deposits held by private banks: 200 Domestic assets: 500 Currency in circulation: 390 A central bank that sells its reserves, reduces the money supply. A central bank that buys reserves, increases the money supply

9 Interest rates and fixed exchange rates With perfect capital mobility, interest parity condition, fixed Ē exchange rate Dan/ implies: r D -r = (E e E)/E = 0 or r D = r The Danish central bank is obliged to follow the monetary policy of euro zone The Danish central bank effectively looses control of monetary policy

10 Exchange rate E Ē Return on euro assets Return on D assets r D ECB increases interest rate Denmark must do the same Decrease money supply r D r D M D /P D Return L(r D,Y D ) L(r D,Y D ) M D /P D Money supply Real money supply/demand Money market and exchange rate market equilibrium

11 Exchange rate E Ē Return on D assets r D Recession in Denmark: To keep fixed exchange rate need restrictive money supply r D Return L(r D,Y D ) L(r D,Y D ) M D /P D M D /P D Money supply Real money supply/demand Money market and exchange rate market equilibrium

12 Source: Danmarks Nationalbank and ECB

13 Interest rates with non fully credible fixed exchange rates If expected probability(10%) of a devaluation(30%): Expected depreciation rate is 3% so r-r = (E e E)/E = 3% Ifthefixedexchangerateisnotfullycredible:interestrateof countrythatfixesatēmustbehighertocompensateforpossible depreciation e.g. Baltic states in ERM II during financial crisis, in the beginning 90scountrieslikeItalyorFrancehadtohaveveryhighinterest rates to compensate for devaluation risk.

14 Fixed exchange rates and currency unions 1. How do central banks fix the exchange rate? 2. Policies under fixed exchange rates 3. Currency Unions 4. Currency and Financial Crisis

15 Capital mobility, fixed exchange rate and monetary policy autonomy Loss of monetary policy autonomy in a fixed exchange rate with free capital movements Interest parity condition (arbitrage with free capital mobility):r-r*=(e e E)/E=0orr=r* Suppose restrictions on capital movements (taxes on capital inflows and outflows): breaks the interest parity condition. The interest can be lower (with taxes on capital outflows) or higher (with taxes on capital inflows) than foreign interest rate

16 The impossible trinity of Mundell Independent monetary policy China 1990s US/JP/Euro Fixed exchange rate Free capital movements Denmark/Argentina 1990s/within Eurozone

17 Policies under fixed exchange rate Loss of monetary autonomy if capital mobility What about fiscal policy? Fiscal policy becomes more efficient under fixed exchange rates if capital mobility Loose fiscal policy can threaten the peg and leads to speculative attacks and currency crisis

18 E Fiscal policy with fixed exchange rate AA AA DD DD Ē Y Fiscal policy becomes efficient due to accommodative monetary policy

19 Cumulative fiscal multiplier in fixed and flexible exchange rate regimes Source: Ilzetzki, Mendoza, and Vegh (2009).

20 Fixed or Floating exchange rates? The case for fixed exchange rate Discipline on price stabilization Reduces speculation and money market disturbances Promotes international trade and investment But Loss of monetary policy autonomy Exchange rate movements act as an automatic stabilizer Fixedexchangerateregimescanbesubjecttolarge adjustments(currency crisis)

21 Flexible exchange rate regimes as an automatic stabilizer: reaction to a fall of demand in flexible and fixed exchange rates E AA DD DD E AA DD DD AA Ē Y Y

22 Fixed exchange rates and currency unions 1. How do central banks fix the exchange rate? 2. Policies under fixed exchange rates 3. Currency Unions 4. Currency and Sovereign Debt Crisis

23 Monetary policy and currency unions - Loss of monetary policy autonomy in a fixed exchange rate with free capital movements - Link with EMU: if Denmark considers that instability of exchange rate with euro too costly (most of its trade is with euro zone), why have a national currency and no voice in euro monetary policy? - Choice of France: European Monetary System was Germany dominated, better to have a say in common monetary policy.

24 Currency Union: Optimum Currency Area (Mundell) Two regions constitute an optimum currency area if Transaction costs considerations are important There is a lot of trade between the regions There are macroeconomic shock absorbers other than the exchange rate High labor mobility Large fiscal transfers The two regions have a similar production structure, so there is little need for macroeconomic shock absorbers.

25 Mundell s Analysis 2 countries, 2 regions Shocks common across regions Western Canada Manufacturing Eastern Canada Agriculture Agriculture Manufacturing Western US Eastern US

26 Mundell s Analysis Other ways to cushion shock of fall-off in demand for Western goods Western Canada Labor Transfers Eastern Canada Eastern US Western US Transfers Labor

27 Macroeconomic costs of a currency union Loss of monetary instrument and of the nominal exchange rate as a stabilization tool (exchange rate is irremediably fixed) This loss is all the more costly if: Wages and prices are rigid : if not, demand shocks have no real effect and monetary policy is not very useful. Its loss is not costly. Macroeconomic shocks are asymmetric Business cycles are not synchronized across regions Labor force is not very mobile and/or fiscal transfers are difficult

28 An asymmetric negative demand shock in Italy but not Germany E: between It. and G. AA DD DD E AA DD DD AA Ē Y Y Flexible exchange rates or multiple currencies Irremediably fixed exchange rate: single currency

29 Symmetric and Asymmetric shocks Asymmetric negative shock in Italy but not Germany: Euro depreciates(stabilizes) but not as much as Lira would The ECB can react by monetary expansion but not as much as a Italian national central bank would Cost for Italy: not enough depreciation, stabilization and monetary response Cost for Germany: too much depreciation and monetary expansion ; inflation (imported through depreciation and direct through monetary expansion) With symmetric shocks, common monetary policy not costly.

30 Currency Union: tensions in the euro area PIGS (Italy, Spain, Portugal, Greece, Ireland) facing adjustment problems(fiscal and external) post Alike an asymmetric shock. Large current account deficits and negative shocks cannot be offset by an exchange rate depreciation. Cost of fiscal adjustment larger with fixed exchange rates International fiscal transfers and labor mobility are not large

31 Fixed exchange rates and currency unions 1. How do central banks fix the exchange rate? 2. Policies under fixed exchange rates 3. Currency Unions 4. Currency and Sovereign Debt Crisis

32 Currency crises Oftenjustseenasalargedevaluation Speculative attack with sudden loss of confidence in the centralbankpromisetokeeptheexchangeratefixed:runon the central bank foreign reserves: to defend the fixed exchange rate the central bank sells its reserves But not all attacks succeed distinguish between currency crash(large devaluation) and crisis, when authorities defend exchange rate peg - withsharpspikeininterestrates - sharp fall in foreign exchange reserves

33 The dangers of managed exchange rates

34 And 11 years later Iceland ISK/EUR

35 Currency crises are common Most fixed exchange rate regimes eventually come under severe strain (and flexible rates can also suffer sudden depreciation) Currency crises have been frequent in the past and also since the 1990s 1992/1993: European Monetary system 1994:Mexico 1997/1999 : Thailand, South Korea, Malaysia, Indonesia, Brazil, Russia 2000/2001: Turkey, Argentina 2008: Iceland, Pakistan, Hungary, Baltic states

36 Currency crises are costly Currency crisis lead to dramatic declines in GDP. Source: IMF

37 Generations of currency crisis models 1) «Fundamental» balance of payments crises (Krugman, 1979) 2) Crises with self-fulfilling expectations (Obstfeld, 1994, Krugman, 1999)

38 Fundamentals based crises (Krugman, 1979) The fixed exchange rate is fundamentallyinconsistent with macro policy (fiscal and monetary). Monetary policy too expansionary for the peg to be sustainable (CB buys domestic assets) E.g., CB finances budget deficit; buys T-Bills For ER to remain fixed, r = r*, money supply remains fixed. CB must sell reserves at the same rate as it buys TBs. Central bank balance sheet M S = Foreign Reserves + Domestic assets If CB sticks to this policy, will eventually run out of reserves. The fixed exchange rate is not sustainable in the long-term. When does the collapse of the exchange rate occur?

39 Fundamentals based crises (Krugman, 1979) The timing of the currency crisis Rational speculators understand that at some point reserves will be exhausted and fixed ER will be abandoned. Crisis comes before reserves are exhausted due to expectations of future collapse of the currency. Speculative attack = run on CB reserves (all speculators want to sell domestic currency and buy reserves of the CB). SharpfallinreservesandCBmustabandonthepeg. Looks like panic but the result of rational speculators who understand the fundamental inconsistency of the fixed exchange rate regime.

40 Crises with self-fulfilling expectations Fundamental currency crises in Latin America in the eighties. But theory could not well explain crises in the nineties Mexico ( ) Asian crises of Russia ( ) Argentina (2001) Or more recently: Iceland (2008)...

41 Multiple equilibria and self-fulfilling attacks Conditional on speculators not expecting a depreciation, the peg is maintained. Conditional on speculators expecting a depreciation, the government must abandon the peg. multiple equilibria The realized equilibrium does not depend only on fundamentals but also on speculators expectations. The speculative attack is self-fulfilling. bank run: speculation against a fixed ER regime generates the objective conditions that make the crisis possible.

42 Self-fulfilling crisis with balance sheet effects Krugman(1999) Danger of debts (private and public) denominated in foreign currency. Original Sin : to borrow abroad, firms, banks, governments in developing countries cannot borrow in their own currency(long memory of markets of very large depreciations of their currency). More than 80% of their debt denominated in foreign currency(hausmann and Panizza(2010)). Currency mismatch: economic agents (banks, firms, households) borrow in foreign currency but their assets and incomes are in domestic currency. Currency devaluation worsens the balance sheet.

43 Self-fulfilling crisis with balance sheet effects Key mechanisms: consider firms borrowing in foreign currency to invest. If markets expect large depreciation, likely do be insolvent: do notlendtothem. Credit crunch, low output, low demand for currency and depreciated currency. If markets expect a strong currency, low expected foreign debt payments and firms likely to repay. Large supply of credit. High credit, high output, high demand for currency and appreciated currency. Multiple equilibria driven by self-fulfilling expectations.

44 A credit model with balance sheet effect (Krugman 1999) 1 st relation: AA Investment I Demand for domesyc currency interest rate AppreciaYon; AA curve : E appreciates as I 2 nd relation: CC Firms borrow to invest. If currency depreciated in the future, high foreign debt payments and limited ability to borrow. I decreasing with expected depreciation E e I = λ(π e d D E e. d F ) Profit debt in domestic currency debt in foreign currency Borrowing constrained by the expected value of the firm : collateral in case of default

45 E and E e The case of share of private debt in foreign currency is small CC is very steep E appreciates with investment AA The case of a unique equilibrium CC: investment does not depend much on E e I or credit

46 E and E e The case of large share of debt in foreign currency E crash Crash: big depreciation, firms default, credit crunch, sudden stop 3 equilibria crash and boom Multiple equilibria driven by expectations Boom: I high, ER is appreciated CC : investment decreases with expected depreciation E e E appreciates with investment AA Note: If E e > E crash : Firms value <0 (default) and I = 0 I or credit

47 Circular mechanism: the crisis equilibrium Expected crisis and depreciation Credit and investment crisis (sudden stop) Balance sheet effect: value of foreign debt in domesyc currency Ability to borrow/value of collateral of firms, banks, households

48 An application to the crisis in Iceland (2008) Banks lend massively to firms (I) and households (real estate) : assets of three main banks = 10 x Iceland GDP Banks in Iceland borrow massively in foreign currency ( ): collateral of the banks is based on the value of their net assets Expected depreciation (E e ) ; collateral of banks banks cannot borrow on internayonal markets Financial, real estate, credit and currency crisis. Again, circular mechanism

49 Icelandic Banking Sector Increasein leverageand size of the Icelandicbankingsector. Source: Buiter and Sibert (2008)

50 Icelandic Banking Sector 800% Foreign currency liabilities of banks and CB forex reserves september % 600% 750% GDP 500% 400% 300% 200% CB forex reserves: 21% GDP CB swaps and creditlines: 14% GDP 100% 0% Foreign currency liabilities of the banks CB forex liquidity and highly vulnerable to a currency crash

51 Icelandic Crash ISK/EUR Currency Crash

52 Sovereign debt crisis Sovereign debt crisis and sovereign defaults are common over history. What is default? Missing any contractual payment - outright complete default(rare) - repudiation or moratorium - restructuring: renegotiation (with terms less favorable to the lender). Sovereign - no international enforcement of debt contracts (difficult for creditors to seize assets, no collateral, no bankruptcy court)

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54 What is the cost of sovereign default? Gain=wealthtransfer.Donotpaybackdebt. Reputation costs = exclusion from international financial markets. Broader macroeconomic costs Triggers or worsen banking/financial crisis Triggers currency crisis Trade disruption (Rose, 2005): countries in default face severe difficulties to finance simple trade activities; disruption of trade credit. Default costs crucial to understand international sovereign lending.

55 Default and Debt Sustainability Every period the government runs a deficit its debt increases. How can we assess the sustainability of the path of government debt? Difficult question but can examine the conditions under which the government can stabilise the debt burden. A useful tool to calculate the size of fiscal adjustment needed to stabilise debt at a current level. Or a useful tool to calculate the eventual level of debt that will occur if current fiscal deficit is maintained

56 Sustainable Debt: a reminder Debt is sustainable if Debt/GDP not changing (1) Debt/GDP rises because of interest payments r x (Debt/GDP) (2) Debt/GDP falls because of output growth g x (Debt/GDP) (3) Debt increases because of primary deficit (G-T) Putting (1),(2) and (3) together Change Debt/GDP (r-g) Debt/GDP + Primary Deficit/GDP Debt sustainability (Change Debt/GDP = 0), implies: (r-g) Debt/GDP Primary Surplus/GDP

57 Sustainable Debt: a reminder To keep debt levels constant fiscal policy needs to generate primary surplus/gdp =(r-g) Debt/GDP Ifr>ggovernmenthastorunaprimarysurplusinordertocontrol the Debt/GDP ratio If r<g then government can run a deficit (of a certain size) without seeing Debt/GDP ratio increase Shifts in interest rates and growth rates have big impact on government debt dynamics. If r increases with Debt/GDP and higher r leads to lower g then countries can rapidly find their public finances deteriorating.

58 Application: Sovereign debt crisis in Argentina Context: The Convertibility Plan , President Carlos Menem takes office. Monthly inflation > 200%. Output plummeting April 1991, Finance Minister Domingo Cavallo implements the Convertibility Plan, including the policy of a Currency Board: Fixed Exchange Rate of 1 Peso / $1 People free to buy and sell Dollars. Implication: Central Bank no longer controls monetary policy. gradual loss of competitiveness as no longer possible to depreciate the currency and inflation still high

59 (Hyper)Inflation in Argentina Inflation Rate % change per year Stabilization Policy in Argentina in early nineties breaks down hyperinflation.

60 Indicators of Fiscal Sustainability Argentina s crisis caused not by high debt (around 50% GDP) buthighrandfallingg! (source: Perry & Serven)

61 Currency Mismatch and Balance Sheets Effects

62 The Unravelling Recession exacerbated government s fiscal position. Investor fears that currency board would be abandoned. Fear of devaluation and fear of default pushed up interest rates dramatically increasingfiscalburdenfrominterestpayments. Although debt not extraordinarily high, the low growth together with rising interest rates quickly makes the debt burden unsustainable. A lot of debt denominated in dollars. Increases the likelihood of defaultincaseofadevaluationofthepeso. With debt considered unsustainable and expectations of currency devaluation, further interest rates increase/sudden stop in capital flows. Runonthecurrency(runonbanks)andgov tdefault(dec.2001).

63 Run on Banks and Capital Outflows $US billion $US billion IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ 2001 Bank deposits -10 IVQ 2000 IQ 2001 IIQ 2001 IIIQ 2001 IVQ 2001 Non-financial sector private capital inflows (BOP) Source: Argentine Central Bank and Ministry of Economy

64 31/01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ /09/ /01/ /05/ Peso per Dollar Nominal Exchange Rate

65 The euro sovereign debt crisis Investor fear of sovereign debt and default. Confidence/Liquidity crisis = mechanism of self-fulfilling expectations Demand higher interest rates to cover risk of default. High interest rate more difficult to pay if the debt-gdp ratio is high. Evenmoresoifgrowthislow. Defaultcouldbe caused by the belief thatacountry can trepay debt --- validating expectations ex-ante. ECB role = attempt to manage the confidence/liquidity crisis

66 Run on public debt and multiple equilibria The self-fulfilling equilibrium expected default on public debt Rising public debt and default probability Rising borrowing cost: r Higher interest payments on debt: rd

67 The euro sovereign debt crisis Confidence/liquidity crisis Circular causality with self-fulfilling expectations. remedy--- break the expectations = ECB intervention and creation of financial safety nets Solvency crisis: some countries not able to repay (whatever markets reactions, e.g. Greece) remedy--- restructure sovereign debt. When? How much?

68 Summary Countries with fixed exchange rates and free capital mobility loose their monetary policy autonomy. In a currency union, this loss is less costly if (i) business cycles are synchronized,(ii) fiscal transfers across regions are easily implemented,(iii) labor is mobile across regions. Currency crisis are a common phenomenon in countries with pegged exchange rates. They can be due to misaligned policies but also to selffulfilling expectations combined with weak fundamentals. In particular, borrowing in foreign currency and lending in domestic currency makes countries vulnerable to self-fulfilling crashes due to balance sheet effects. Sovereign risk can lead to sovereign debt crisis when public debt becomes unsustainable. Changes in interest rates and growth rates have large impact on debt sustainability. Sovereign debt markets also subject to selffulfilling liquidity crisis.