Master PPD M1 2008 / 2009 LECTURE 7 Exchange rate policies in developing economies Marc Raffinot, LEDa Université Paris Dauphine
Where do we stand? Lecture 3 did already provide: Exchange rate and RER Exchange rate regime and macroeconomic policies Choice of exchange rate regime We will focus in lecture 7 on the level of the RER
Outline of the lecture Exchange rate and the current account Exchange rate, financial flows and NFAs Exchange rate and growth Crises A very special case: the franc Zone
Balance of payments: example Uses Resources Imports 150 Exports 80 Borrowing (drawings) 50 Amortization (capital repayment) 30 Change in reserves 50
Balance of payments: example Uses Resources Imports 150 Exports 80 Borrowing (drawings) 50 Amortization (capital repayment) 30 Change in official reserves ( NFA) 50
Exports and Imports depend on the RER (REER) Exports volume depend on the income of the partners countries (rest of the world)(+) and on the RER (-) Imports volume depend on the income of the country (+) and on the RER (+) Net exports (NX = exports less imports) depend on incomes of both countries, and on the exchange rate. NX is a part of global demand
Net exports and the RER An increase in the RER is a loss of competitiveness, a decrease ( devaluation in the case of Fixed Xrate) a gain. In the case of a decrease of the RER, the Trade Balance in local currency usually improves. But from a theoretical point of view this is not always the case (Marshall Lerner condition), because of conflicting impacts of: Increased volume of exports, increased prices of exports Cut in volume of imports, But: increased prices of imports Moreover, in real life, there is a case for pricing to market behaviour
The J curve Net Exports Depreciation time 0 A B
Macro impact of changes in the RER Changes of the RER have an impact on exports, imports, but also on output Example in the Mundell/Fleming framework
Demand ZZ 45 Net exports Y 0 Output, Y Y cb
Demand G ZZ ZZ 45 Net exports Y 0 Y 1 Output, Y Y cb
NX or Y* Demand NX ZZ ZZ 45 Net exports Y 0 Y 1 Output, Y Y cb NX
Some further considerations According to this, devaluation should have a positive impact on growth (depending on price elasticities of export and imports) Is there a case for contractionary impacts of devaluation in the short run? This issue is controversial. Alleged rationale : increase in prices (namely capital goods), benefits to the well-off results in an increase in the share of savings. Inflation has an adverse impact on poverty.
Case study: Argentina after the crisis (Roberto Villambrosa November, 2004) Peg to the dollar Crisis Floating since beginning 2002 (1 dollar 3 pesos)
RECOVERY OF THE ECONOMIC ACTIVITY Multilateral real exchange rate and bilateral real exchange rate with Brazil and U.S. 185 165 145 125 105 85 Mulilateral Brazil USA 2001=100 The stability of the nominal exchange rate and domestic prices, after the apreciation of the dollar, determined that the real exchange rate stabilizes in levels higher than the ones registered before the devaluation Competitivty with the U.S. is falling since the first moths of 2003, due to the apreciation of the euro. Source: FMI, Worl bank, Federal Reserve of Saint Louis, Fundacion Julio Varga.
EXTERNAL TRADE External Trade (millions of US$) 36.000 Balance Exports Imports 31.000 26.000 21.000 16.000 11.000 6.000 1.000-4.000 1999 2000 2001 2002 2003 en-sep 04 Source: IDEC On september 2004, exports have experinced an increase of 25.3% with respect to the same month on 2003, while imports increased a 57.2% during the same period. The balance acumulated during the firts nine months of 2004 raises to 9.541 millions of dollars.
CURRENT ACCOUNT Exports and imports of goods, balance of goods and current account balance (million of US$) 10.000 8.000 Exports Imports Balance of goods Current Account 6.000 4.000 2.000 0-2.000-4.000 I 00 II 00 III 00 IV 00 I 01 II 01 III 01 IV 01 I 02 II 02 III 02 IV 02 I 03 II 03 III 03 IV 03 I 04 II 04 Source: Secretaria de Politica Economica, Ministerio de Economia.
ACTIVITY Imports of capital goods influenced by investment recovery. Import of goods: level and composition (in million of dollars CIF) Imports of capital goods in percent of total imports 10000,00 8000,00 Other Consumer goods and vehicles Capital goods 26% 24% 22% 6000,00 20% 18% 4000,00 16% 2000,00 14% 12% 0,00 I 00 II 00 III 00 IV 00 I 01 II 01 III 01 IV 01 I 02 II 02 III 02 IV 02 I 03 II 03 III 03 IV 03 I 04 II 04 III 04 10% I 00 II 00 III 00 IV 00 I 01 II 01 III 01 IV 01 I 02 II 02 III 02 IV 02 I 03 II 03 III 03 IV 03 I 04 II 04 III 04
ACTIVITY Activity level and current account 300000 290000 280000 Devaluation 5000 4000 3000 Million of $ (1993) 270000 260000 250000 240000 230000 2000 1000 0-1000 Million of US$ 220000-2000 210000 GDP Current Account -3000 200000 I 00 II 00 III 00 IV 00 I 01 II 01 III 01 IV 01 I 02 II 02 III 02 IV 02 I 03 II 03 III 03 IV 03 I 04 II 04-4000 Source: Secretaria de Politica Economica, Ministerio de Economia.
A first look at Equilibrium exchange rates The Exchange rate level may be inadequate. This results in a deficit of the CA, increasing indebtedness, loss of reserves, low growth. How can we check the right level of the Xrate? A useful benchmark is provided by PPP Misalignment may be the case even with a flexible Exchange rate, because of, say a sudden big inflow of capital (not likely to last)
PPP basis: law of one price: Example: The Economist Burgernomics A Big Mac (July 08) Price in Yuans Price in Dollars Implied PPP Actual exchange rate Underval uation of the Yuan China 12.5 1.83 3.50 6.83-49% USA 3.57 But there are several goods and services in an economy
REER in developing countries Special features to be taken into account: Asymmetry of the external trade Commodities (prices set on international markets, volatility, commodities as financial assets)
RER and the BS effect We use the RER (absolute vs relative) as a benchmark But one has to take into account the Balassa-Samuelson effect In developing economies (low productivity): In the tradable sector, low productivity is compensated by low wages It results in low wages and low(er) prices also in the non-tradable sector The RER increases with the GDP pc
Source: Bénassy-Quéré et alii, Politique économique, de Boeck, 2005
Low competitiveness Competitiveness may be measured by the share of exports of a country in the world market (or share of imports relative to the domestic market) In open economies, competitiveness means either: Specialising in sectors where the world demand is high Producing cheaper goods and services Producing goods and services of better quality at an afordable price Producing goods and services that nobody else produces (provided there is some demand) (countries at the technical frontier)
Outline of the lecture Exchange rate and the current account Exchange rate, financial flows and NFAs Exchange rate and growth Crises A very special case: the franc Zone
Balance of payments: example Uses Resources Imports 150 Exports 80 Borrowing (drawings) 50 Amortization (capital repayment) 30 Change in official reserves ( NFA) 50
Determinants of capital flows (financial operations) Theoretical point of view: interest rates Real life: FDI, Concessional flows (LICs) Problem: a target for NFAs? (IMF practice in month of imports)
A closer look at the Equilibrium X- rate Are the NFA increasing or decreasing? Is this sustainable in the Long Run? What are the determinants of this Long run equilibrium? Benchmark: Covered X-rate parity
Where should we invest our money? Europe of South Africa? (covered interest rates parity) Today 1 Current interest rate 3 % Next year 1.03 Rand: 13.14 zar 7% 14.06 zar Expected Xrate 13.65
Capital flows and Covered interest parity is forward looking If goods and services markets and financial market do not clear at the same speed, there is a case for overshooting (Dornbush)
A closer look at Equilibrium X-rate Having prices in line with international prices does not guarantee the equilibrium of the CA (it depends also on specialisation, savings rates, etc.) What is our target (preferred) CA (in the long run, taking into consideration the dynamics of external debt)? What is our target level of reserves (adjustment vs opportunity costs)? (IMF; Three months, Rodrik(2006): cost of excess reserves amounts to 1 % of developing countries GDP
Equilibrium X-rates (EER) Fondamental EER (Williamson, 1983). The FEER is the X-rate that is consistent with both internal and external balance simultaneously REER Internal equilibrium REER* External equilibrium Y e
Equilibrium X-rates (EER) (contd) FEER with a target for the CA : Desired EER = DEER Other approaches: Disentangling long term and short term (interest rates) determinants of the Xrate : Behavioural EER or BEER (Clark and MacDonald 1998) NATREX (Natural RER): X-rate that would prevail if speculative and cyclical factors were removed while unemployment was at its natural rate (Stein 1994) Practice: find out the econometric relationship of the ER with income per capita, fiscal balance, output gap, etc. problem: diverging estimates
Outline of the lecture Exchange rate and the current account Exchange rate, financial flows and NFAs Exchange rate and growth Crises A very special case: the franc Zone
Equilibrium and/or growth For developing countries, the main focus should be on LT growth. Is Equilibrium RER relevant from this point of view? Observation: many successful emerging countries have under-valuated currencies Rodrik tries to show that some undervaluation is good for growth (2007): a case for voluntary under-valuation? Emerging countries need to invest (= import), but undervaluation could result in high inflation.
An example: China (Bouveret, Mestiri, Sterdyniak 2006) Peg to the dollar (1994-2005) : 1$ = 8,28 Yuan Target: «aggressive» competitiveness (but not during the 97 crisis) Problem: 100 million unemployed in 2003 + underemployment Specificities of China: low cost manpower, flexibility, very high savings rate (45 % of GDP in 2007). Slow increase in domestic demand
Results High growth rate of exports, very high growth Inflation under control (high demand, higher supply) Reserves accumulation (selfinsurance against external shocks, capital outflows) because of: surplus of the CA, FDI, Portfolio investment.
Foreign Reserves (Economist.com), Jan 8th 2009 $bn, Latest China 1,906 Hong Kong India Taiwan South Korea Singapore Brazil Russia 166 239 292 201 174 189 442
X-rate of the Yuan appreciated (slowly) since 2005 reform 21 July 2005 : the peg is no more to the dollar, but to a basket. Each day, the change margin +/- 0,3% to the dollar, +/- 1,5% to other currencies in the basket. 23 September 2005, the fluctuation margin to other currencies widens to +/- 3% As a result, the Yuan appreciation was 8.87 % (July 9th 2007)
Estimations of the over-valuation of the Yuan
Taking into consideration the importance of external demand for Chinese growth, the exchange rate of the Yuan seems rather over-valuated today
Other examples: Ghana, Mali
Example 1: Ghana
Exemple : Mali
Exemple : Mali
Example 2: Mali (FMI 2006)
Example 2: Mali (FMI issues 2006)
Outline of the lecture Exchange rate and the current account Exchange rate, financial flows and NFAs Exchange rate and growth Crises A very special case: the franc Zone
Crises First generation: 1982 debt crisis, Mexico 1994 (Krugman 1979): The crisis occurs because of a decrease of NFAs. But before reserves have completely run out (benchmark: the exchange rate that would prevail with a flexible exchange rate regime, without reserves.)
Second generation (Obstfeld 94): 1992-93 crises in Europe (peg to the ECU- DM) The main determinant of the crisis is an outflow of capital. To avoid a crisis, the standard recipe is to increase the interest rates. It is very dangerous. Is it likely to last? There is a case for self-fullfilling prophecies, even if the fundamentals are right.
Third generation Asian crisis 97, Brazil, Russia 98 (Krugman 99) Interactions between BoP and banking crises. In case of a crisis, the Central Bank will lend to banks (and so IMF), increasing the Money stock (lender of last resort), so leading to a depreciation of the X-rate If banks are indebted in hard currency, this results in twin crises Ex-post explanations? Determinants of the crises have been overlooked in the previous analyses (Krugman)
Outline of the lecture Exchange rate and the current account Exchange rate, financial flows and NFA Exchange rate and growth Crises A very special case: the franc Zone
A very special arrangement The Cfa francs are pegged to the euro (no market, no market rate). Only one devaluation in 1994 since 1948 The convertibility of the Cfa franc is guaranteed by the French Treasury (main difference with East Caribbean $) Pooling of reserves (BCEAO, BEAC, Comoros). Ministers of Finance set the monetary policy.
Franc Zone (contd) A part of the reserves has to be hold in the compte d opération CO (special banking account of the reserves banks in the books of the French Treasury). The CO may be overdrawn The Net Credit to the Government was limited. It should be zero Since 1994, a concern about convergence (UEMOA or WAMU, CEMAC or CAMU)
Trade-offs? Inflation is generally low (except 2008), TCER under control (See next slide) Central Banks buy credibility Financing of the Gov is not easy (creation of regional financial markets) What about growth?
Source: Banque de France, Rapport sur la zone franc, 2007