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1 TRADE CURRENCIES AND FINANCE

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3 TRADE CURRENCIES AND FINANCE Morris Goldstein Peterson Institute for International Economics, USA World Scientific NEW JERSEY LONDON SINGAPORE BEIJING SHANGHAI HONG KONG TAIPEI CHENNAI TOKYO

4 Published by World Scientific Publishing Co. Pte. Ltd. 5 Toh Tuck Link, Singapore USA office: 27 Warren Street, Suite , Hackensack, NJ UK office: 57 Shelton Street, Covent Garden, London WC2H 9HE Library of Congress Cataloging-in-Publication Data Names: Goldstein, Morris, 1944 author. Title: Trade, currencies and finance / Morris Goldstein, Peterson Institute for International Economics, USA. Description: New Jersey : World Scientific Publishing, [2017] Identifiers: LCCN ISBN (hard cover) Subjects: LCSH: International trade. Foreign exchange. Banks and banking, International--Law and legislation. Classification: LCC HF1379.G DDC 332/.042--dc23 LC record available at British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. Copyright 2017 by World Scientific Publishing Co. Pte. Ltd. All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the publisher. For photocopying of material in this volume, please pay a copying fee through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA. In this case permission to photocopy is not required from the publisher. Desk Editor: Tay Yu Shan Typeset by Stallion Press enquiries@stallionpress.com Printed in Singapore

5 About the Author Photo Credit: Jeremey Tripp Morris Goldstein, non-resident Senior Fellow at the Peterson Institute for International Economics, has held several senior staff positions at the International Monetary Fund, including Deputy Director of Research from 1987 to From 1994 to 2010, he held the Dennis Weatherstone Senior Fellow position at the Peterson Institute. He has written extensively on international economic policy. He is the author of Banking s Final Exam: Stress Testing and Bank-Capital Reform (2017, forthcoming), Managed Floating Plus (2002), The Asian Financial Crisis: Causes, Cures, and Systemic Implications (1998), The Case for an International Banking Standard (1997), The Exchange Rate System and the IMF: A Modest Agenda (1995), co-editor of Debating China s Exchange Rate Policy (2008), Private Capital Flows to Emerging Markets after the Mexican Crisis (1996), co-author of The Future of China s Exchange Rate Policy (2009) with Nicholas R. Lardy, co-author of Controlling Currency Mismatches v

6 vi About the Author in Emerging Markets (2004) with Philip Turner, co-author of Assessing Financial Vulnerability: An Early Warning System for Emerging Markets with Graciela Kaminsky and Carmen Reinhart (2000), and project director of Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture (1999) for the Council on Foreign Relations Task Force on the Future of the International Financial Architecture.

7 About the Author Introduction By Morris Goldstein Contents Part I: Foreign Trade 1 1. Income and Price Effects in Foreign Trade 3 By Morris Goldstein and Mohsin S. Khan Morris Goldstein and Mohsin S. Khan, Income and Price Effects in Foreign Trade, Reprinted from Ronald W. Jones and Peter Kenen (editors), Handbook of International Economics, Vol 2, pp , Copyright (1985) with permission from Elsevier. v xiii 2. The Supply and Demand for Exports: A Simultaneous Approach 83 By Morris Goldstein and Mohsin S. Khan Morris Goldstein and Mohsin S. Khan, The Supply and Demand for Exports: A Simultaneous Approach, The Review of Economics and Statistics, 60:2 (April, 1978), vii

8 viii Contents pp by the President and Fellows of Harvard College. Used with permission of the publisher. 3. Prices of Tradable and Nontradable Goods in the Demand for Total Imports 105 By Morris Goldstein, Mohsin S. Khan, and Lawrence H. Officer Morris Goldstein, Mohsin S. Khan, and Lawrence H. Officer, Prices of Tradable and Nontradable Goods in the Demand for Total Imports, The Review of Economics and Statistics, 62:2 (May, 1980), pp by the President and Fellows of Harvard College. Used with permission of the publisher. Part II: Currency Regimes, Exchange Rate Policy and International Policy Coordination Market-Based Fiscal Discipline in Monetary Unions: Evidence from the US Municipal Bond Market 127 By Morris Goldstein and Geoffrey Woglom Morris Goldstein and Geoffrey Woglom, Market-Based Fiscal Discipline in Monetary Unions: Evidence from the U.S. Municipal Bond Market, in Mathew Canzoneri, Vittorio Grilli, and Paul Masson, (editors), Establishing a Central Bank: Issues in Europe and Lessons from the US, Cambridge University Press, A Guide to Target Zones 165 By Jacob A. Frenkel and Morris Goldstein A Guide to Target Zones by Jacob A. Frenkel and Morris Goldstein. Reprinted from Vol. 33, No. 4 (December 1986) International Monetary Fund Staff Papers. Copyright 1986 by the International Monetary Fund. Used with permission of the publisher.

9 Contents ix 6. Managed Floating Plus 207 By Morris Goldstein Managed Floating Plus from Managed Floating Plus, by Morris Goldstein, pp (2002). Peterson Institute for International Economics. Used with permission of the publisher. 7. The Rationale for, and Effects of, International Economic Policy Coordination 241 By Jacob A. Frenkel, Morris Goldstein, and Paul R. Masson Jacob A. Frenkel, Morris Goldstein, and Paul R. Masson, The Rationale for, and Effects of International Economic Policy Coordination, in William Branson, Jacob A. Frenkel, and Morris Goldstein (editors), International Policy Coordination and Exchange Rate Fluctuations, pp (1990). University of Chicago Press and NBER. Used with permission of the publishers. Part III: Banking, Financial Crises and Financial Regulation Banking Crises in Emerging Economies: Origins and Policy Options 301 By Morris Goldstein and Philip Turner Banking Crises in Emerging Economies: Origins and Policy Options, by Morris Goldstein and Philip Turner. Copyright 1996 by Bank for International Settlements. Used with permission of the publisher. 9. An International Banking Standard: The Time is Ripe 365 By Morris Goldstein Morris Goldstein, An International Banking Standard: The Time is Ripe, in George C. Kaufman (editor), Research in Financial Services: Private and Public Policy, Volume 9, pp Copyright 1997 by JAI Press Inc., Emerald Group Publishing Limited. Used with permission of the publisher.

10 x Contents 10. Origins of the Crisis 375 By Morris Goldstein Origins of the Crisis from The Asian Financial Crisis: Causes, Cures, and Systemic Implications by Morris Goldstein, pp (1998). Peterson Institute for International Economics. Used with permission of the publisher. 11. Methodology and Empirical Results 397 By Morris Goldstein, Graciela Kaminsky and Carmen Reinhart Methodology and Empirical Results from Assessing Financial Vulnerability by Morris Goldstein, Graciela L. Kaminsky and Carmen M. Reinhart, pp (2000). Peterson Institute for International Economics. Used with permission of the publisher. 12. Measuring Currency Mismatch and Aggregate Effective Currency Mismatch 437 By Morris Goldstein and Philip Turner Measuring Currency Mismatch: Beyond Original Sin and Aggregate Effective Currency Mismatch from Controlling Currency Mismatches in Emerging Markets by Morris Goldstein and PhilipTurner, pp (2004). Peterson Institute for International Economics. Used with permission of the publisher. 13. The Case for an Orderly Resolution Regime for Systemically-Important Financial Institutions 483 By Rodgin Cohen and Morris Goldstein The Case for an Orderly Resolution Regime for Systemically- Important Financial Institutions by Rodgin Cohen and Morris Goldstein. Copyright 2009 by The Pew Charitable Trusts. Used with permission of the publisher.

11 Contents xi 14. The 2014 EU-Wide Bank Stress Test Lacks Credibility 503 By Morris Goldstein The 2014 EU-wide bank stress test lacks credibility by Morris Goldstein. Copyright 2014 by VOX, CEPR s Policy Portal. Used with permission of the publisher. Part IV: IMF Policies Evaluating Fund Stabilization Programs with MultiCountry Data: Some Methodological Pitfalls 511 By Morris Goldstein and Peter Montiel Evaluating Fund Stabilization Programs with Multicountry Data by Morris Goldstein and Peter Montiel. Reprinted from Vol. 33 No. 2 (June 1986) International Monetary Fund Staff Papers. Copyright 1986 by International Monetary Fund. Used with permission of the publisher. 16. IMF Structural Programs 553 By Morris Goldstein Morris Goldstein, IMF Structural Programs, in Martin Feldstein (editor), Economic and Financial Crises in Emerging Market Economies, pp (2003). University of Chicago Press and NBER. Used with permission of the publishers. 17. The Fund Appears to be Sleeping at the Wheel 639 By Morris Goldstein and Michael Mussa The Fund appears to be sleeping at the wheel by Morris Goldstein and Michael Mussa. Originally published in the Financial Times, October 2, 2005.

12 xii Contents 18. Currency Manipulation and Enforcing the Rules of the International Monetary System 643 By Morris Goldstein Currency Manipulation and Enforcing the Rules of the International Monetary System by Morris Goldstein from Reforming the IMF for the 21 st Century, Edwin M.Truman, editor, pp (April 2006). Peterson Institute for International Economics. Used with permission of the publisher. Part V: China s Exchange Rate Policies Two-Stage Currency Reform for China 663 By Morris Goldstein and Nicolas Lardy Two-Stage Currency reform for China by Morris Goldstein and Nicholas Lardy. Originally published in the Wall Street Journal, September 12, China s Exchange Rate Policy Dilemma 667 By Morris Goldstein and Nicholas Lardy Morris Goldstein and Nicholas Lardy, China s Exchange Rate Policy Dilemma, American Economic Review, Vol 96, No. 2, pp , Used with permission of the publisher. 21. Challenges Facing the Chinese Authorities Under the Existing Currency Regime 677 By Morris Goldstein and Nicholas Lardy Morris Goldstein and Nicholas Lardy, Challenges Facing the Chinese Authorities Under the Existing Currency Regime, in Morris Goldstein and Nicholas Lardy, The Future of China s Exchange Rate Policy, pp (2009). Peterson Institute for International Economics. Used with permission of the publisher.

13 Introduction to Trade, Currencies, and Finance Morris Goldstein The 21 papers collected in this volume were written between 1978 and About three-quarters of the papers were collaborations with a wonderful and talented group of co-authors, many of which remain good friends today. By choice, the included papers encompass the different outlets for my writings from very short editorials (op-eds) on economic controversies of the day (published in financial newspapers), to technical empirical papers based on more formal hypothesis testing (published in leading economic journals), to much longer analyses of macroeconomic policy questions (published in conference volumes or my own books). Taken as a group, the collected papers shine a light on many of the important research and policy issues in international economics over the past 40 years or so. I believe that those issues remain highly relevant today. In this Introduction, I identify several key questions that are addressed in each of the 21 papers. The papers are divided up into five subject areas: (i) foreign trade; (ii) currency regimes, exchange rate policy, and international policy coordination; (iii) banking, financial crises, and financial regulation; (iv) IMF policies; and (v) China s exchange rate policies. xiii

14 xiv M. Goldstein PART I: FOREIGN TRADE Chapter 1: Goldstein and Khan on Income and Price Effects in Foreign Trade How should the time-series behavior of imports and exports be modeled? How should the model for manufactured goods (imperfect substitutes) differ from the model for primary commodities (perfect substitutes)? Is the sum of long-run price elasticities of demand for imports and exports in advanced economies large enough to allow an exchange rate depreciation to improve the trade balance (is the Marshall-Lerner condition usually satisfied)? Are short-run price elasticities of demand for imports and exports much smaller than long-run ones; what about differences is short-run versus long-run income elasticities of demand for imports and exports? What are representative estimates of the effect of import price changes on aggregate domestic price indices? Chapter 2: Goldstein and Khan on The Supply and Demand for Exports Is it reasonable to assume an infinite export price-elasticity of supply for an individual country? How should an export supply equation best be specified, and can export supply and demand be integrated in a simultaneous approach? What are representative estimates of the export elasticity of supply for advanced economies? Chapter 3: Goldstein, Khan, and Officer on Prices of Tradable and Nontradable Goods in the Demand for Imports Is it justifiable in specifying the demand for imports to include only one relative price, namely, that between imports and domestic tradable goods, and to ignore the prices of nontradable goods If one did want to drop this assumption of separability and test for the influence of nontradable goods prices on import demand, how would one construct an index of nontradable goods prices?

15 Introduction to Trade, Currencies, and Finance xv Do empirical import-demand equations for advanced economies justify leaving out the price of nontradable goods? PART II: CURRENCY REGIMES, EXCHANGE RATE POLICY, AND INTERNATIONAL POLICY COORDINATION Chapter 4: Goldstein and Woglom on Market-Based Fiscal Discipline in Monetary Unions What constraints should be placed on national fiscal polices in a currency union? Can market-based fiscal discipline (a rising default premium on the debt of the member-country running excessive fiscal deficits) be expected to rein-in fiscal policy excesses? What insights into this market-discipline issue can be gleaned from estimating the relationship between the cost of borrowing and the measures of default risk in the US municipal bond market? Chapter 5: Frenkel and Goldstein on A Guide to Target Zones What is meant by a target-zone approach to exchange rate management? What are the perceived deficiencies in the other exchange rate systems that have motivated a call for the adoption of target zones? How would target zones (allegedly) remedy these deficiencies? What factors are behind the skepticism over and opposition to target zones? Chapter 6: Goldstein on Managed Floating Plus What are the key characteristics of a managed floating plus exchange rate regime for emerging-market economies with high capital mobility? Why are all three components of this regime (that is, managed floating, inflation targeting, and measures to discourage currency mismatching) necessary to make it function effectively? What advantages for emerging economies does a managed floating plus currency regime possess over the competition (adjustable pegs, crawling bands, currency boards, and dollarization)?

16 xvi M. Goldstein Chapter 7: Frenkel, Goldstein, and Masson on The Rationale for, and Effects of, International Policy Coordination Why is international policy coordination beneficial? What are the main barriers to effective international policy coordination? What is the appropriate range and depth of economic policies to be coordinated? What are the leading alternatives mechanisms for coordination and what are their pros and cons? Judging from simulations with multi-country models (e.g., the IMF s MULTIMOD model) what are the effects of international policy coordination? PART III: BANKING, FINANCIAL CRISES, AND FINANCIAL REGULATION Chapter 8: Goldstein and Turner on Banking Crises in Emerging Economies Why do banking crises in developing countries merit particular attention? What are the leading factors contributing to the high incidence of banking crises in developing countries? What are the policy options for strengthening banking systems in these countries? Chapter 9: Goldstein on An International Banking Standard Why is an international banking standard needed? What guidelines should be included in such a standard? Who would set the standard? How would compliance with the standard be monitored and encouraged? Chapter 10: Goldstein on The Origins of the (Asian Financial) Crisis Which countries were at the eye of the Asian financial crisis of ? What were the multiple origins of this crisis?

17 Introduction to Trade, Currencies, and Finance xvii Chapter 11: Goldstein, Kaminsky, and Reinhart on Methodology and Empirical Results (for an early warning system for emerging economies) What guidelines should influence the design of an early-system for forecasting currency and banking crises in emerging economies? Why is the signals approach the preferred methodology for forecasting currency and banking crises in our sample of 25 emerging economies over the period (with 1996 and 1997 reserved for out-of-sample exercises)? What should the 15 early-warning indicators tested in this early-warning exercise be? How should the optimal thresholds for each indicator be estimated? Which early-warning indicators proved to be the best ones based on their in-sample and out-of-sample forecasts? Chapter 12: Goldstein and Turner on Measuring Currency Mismatch How should currency mismatch be defined? Why is original sin a poor measure of currency mismatch? Why is our new measure of aggregate effective currency mismatch an advance over earlier measures of currency mismatch? Are large negative currency mismatches either leading or contemporaneous with currency and banking crises in emerging economies over the period? Chapter 13: Cohen and Goldstein on The Case for an Orderly Resolution Regime for Systemically-Important Financial institutions Why is a new Orderly Resolution Regime (ORR) for Systemically- Important Financial Institutions (SIFIs) needed? Will a New ORR be over-used and will it increase moral hazard going forward? How should an ORR for SIFIs be designed?

18 xviii M. Goldstein Chapter 14: Goldstein on Why the 2014 EU-Wide Bank Stress Test Lacks Credibility What were the four key findings of the 2014 EU-wide stress test and accompanying Asset Quality Review (AQR)? Why were these findings not credible? Why was this test a missed opportunity for the ECB to gain credibility as the Single Supervisor for Europe s largest banks? PART IV: IMF POLICIES Chapter 15: Goldstein and Montiel on Evaluating Fund Stabilization Programs with MultiCountry Data: Some Methodological Pitfalls How have the effects of Fund (IMF) stabilization programs been estimated in the past? Why do the before-after approach and the control group approach yield estimates of program effects that differ from true program effects? How can a modified control-group approach remove sample-selectivity bias and produce a non-biased estimate of program effects when the selection of program countries is non-random? What operational issues need to be confronted when using the modified control group approach? Chapter 16: Goldstein on IMF Structural Programs What are structural policies? Why has there been active debate on the scope and intrusiveness of IMF policy conditionality over structural policies since the Asian financial crisis? What would alternative mandates for the Fund imply about the intrusiveness of structural policy conditionality? What has the structural content of Fund policy conditionality and its effectiveness been? Have the product of the number of Fund structural policy conditions and the effectiveness of those conditions been roughly equal to a constant?

19 Introduction to Trade, Currencies, and Finance xix What are the alternative approaches to streamlining Fund structural policy conditionality? Chapter 17: Goldstein and Mussa on the Fund Sleeping at the Wheel Has the Fund been asleep at the wheel on its most fundamental responsibility, namely, firm surveillance over its members exchange rate policies? Why was large-scale, prolonged, one-way intervention in exchange markets by several Asian economies (and particularly by China) to resist meaningful appreciation of their currencies in contrary to their responsibilities as members of the IMF? Why should the international community insist that the IMF does its assigned job as the vigorous, competent, unbiased, international umpire for exchange rate policies? Chapter 18: Goldstein on Currency Manipulation and Enforcing the Rules of the International Monetary System Why are international codes of conduct on exchange rate policies needed? Why are several popular arguments denying that currency manipulation took place over the period seriously flawed? What is the evidence that China was engaging in currency manipulation over the period? What can be done to reduce the frequency and scale of currency manipulation? PART V: CHINA S EXCHANGE RATE POLICIES Chapter 19: Goldstein and Lardy on Two-Stage Currency Reform for China How could the circle (in 2003) be squared that seemingly called for three objectives: a near term revaluation of the yuan, greater stability of the yuan in the medium term, and greater flexibility and market determination of the yuan down the road?

20 xx M. Goldstein Imagine (in 2003) a two-step reform of China s currency regime. Step one would consist of a medium-size (15-25%) revaluation of the yuan, a widening of the currency band (to 5-7% from less than 1%), and a switch from a unitary peg to the dollar to a three-currency basket peg. Step two would be adoption of a managed float. Would such a two-step reform process solve China s currency dilemma? Why was this two-step currency reform superior to the alternatives favored (in 2003) by both the Chinese government and the US government? Chapter 20: Goldstein and Lardy on China s Exchange Rate Policy Dilemma Was the currency reform announced by China on July 21, 2005 a meaningful change, and if not, why not? Was the Chinese RMB undervalued (in 2005), and if so, by how much? What problems did the 2005 currency regime pose for China and the global economy? What was constraining China s willingness and ability to deal with the shortcomings of its currency regime and what would be a reasonable compromise solution? Chapter 21: Goldstein and Lardy on Challenges Facing the Chinese Authorities under the Existing (2009) Currency Regime Was the RMB highly undervalued at the end of 2007? How did an increasingly undervalued exchange rate, a rapidly expanding current account surplus, and a concomitant accelerating buildup of foreign exchange reserves pose challenges for the independence of monetary policy, the rebalancing of the sources of economic growth, efforts to reform China s banking system, and China s external adjustment? Would an RMB appreciation have had much effect on China s global current-account adjustment? I have enjoyed very much writing working on this set of papers over the past 40 years. I hope you the reader will enjoy reading them. February 2017