Chapter 5 Forex - pisani-ferry.typepad.comLucia, St Vincent and the Grenadines. Currency board...

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pisani-ferry november 20111

Chapter 5International financial integration

and foreign-exchange policy

Introduction

• Regime choice rather than policy decisions• Major choice

– Currency convertibility (China)– Taxation of capital inflows (Brazil)– Fixed or floating exchange rates (CEECs)– Devaluation (Latvia)– Joining/leaving monetary union (EU countries)

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Outline3.1 Issues

• The balance of payments and the savings-investment balance• Currency convertibility and exchange rate regimes• Stocks and flows• A brief history of international monetary arrangements• Exchange rates concepts and measurements3.2 Theories

• Equilibrium exchange rates 1: price equalisation• Equilibrium exchange rates 2: external flow equilibrium• Equilibrium exchange rates 3: portfolio balance• Long term equilibrium and the current exchange rate• Currency crises3.3 Policies

• Financial openness• Choosing an exchange rate regime• Managing floating exchange rate


3.1 Issues





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The balance of payments

• Note that the balance of payments records flows between residents and non-residents

A) Merchandises (X, M)

X - M = TB (trade balance)

B) Services and factors income balance

• Services (tourism, transport, royalties...) • Income (interest, expatriates’ wages)

TB + Services and factors balance = balance on goods and services = GSB

C) Unilateral transfers s (U)

• Grants, financing of international organisations

GSB + U = B (current account balance)

• Note that the sum of foreign income and transfers corresponds to the difference between GDP and GNP


The capital account and the financialaccount

A) The capital account (balance BK)

• Capital transfers (e.g. debt foregiveness)

B) The financial account (balance BΦ)

BΦ = credits (capital inflows) – debits (outflows)

• FDI (threshold for control is a share above 10%) • Portfolio investments (no control)• Trade credits and financial credits• Operations on derivatives• Change in FX reserves (∆R)

Important accounting identity: B + BK + BΦΦΦΦ = 0


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US and euro area balances of payment, 2008


UNITED STATES EURO AREAEURO AREA

$Bn % GDP €Bn % GDP

Current account and transfers -673.3 -4.7% -67.3 0.7%

Goods and services -681.1 47.0

Factor income 127.6 -22.0

Transfers -119.7 --92.3

Capital account -2.6 -0.0% 13.7 0.1%

Financial account* 546.6 3.8% 212.6 2.3%

Direct investments 7.4 409.2

Portfolio investments 154.4 235.7

Financial derivatives -373,9 -12.3

Other investments 342.2 102.1

Foreign exchange reserves 416,5 -4.9

Statistical discrepancies 129.3 0.9% -151.1 -1.6%

Source: European Central Bank and US Bureau of Economic Analysis

Internal and external equilibrium

• There is an accounting link between the current account balance (external equilibrium) and the savings-investment balance (internalequilirium). To see why start from goods market equilibrium

Y + M = C + I + G + XWhere Y is GDP

• The national income or GNP is:R = Y + U + i*F –iO* = [C + I + G] + [X - M + U + i*F – i O*]

Where:• U are unilateral transfers received• F is the foreign currency wealth of the residents• O* is the domestic currency wealth of the non-residents

The first term on the right-hand side is domestic absorptionThe second term is the current account balance

• Hence the current account balance is the difference betweenincome and domestic absorption


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The current account and the savings-investment balance

• Now start again from:

Y + U + i*F –iO* = [C + I + G] + [X - M + U + i*F – i O*]

• The equation can be rewritten:

[(Y + U + i*F - iO* - T - C) - IP] + [T – G - IG] = B

Where T represents taxes, IP private investment and IG government investment.

• The first term on the left-hand side is the difference between private savingand private investment, the second the difference between governmentsaving and government investment. Hence,

B = SP + SG – I

Where Sp is private saving and SG government saving.• The current account balance equals the difference between domestic saving

and domestic investment.

• In an open economy, investment can be financed by foreign saving – and this implies a current account deficit


The US case


-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

19

70

-I

19

71

-II

19

72

-III

19

73

-IV

19

75

-I

19

76

-II

19

77

-III

19

78

-IV

19

80

-I

19

81

-II

19

82

-III

19

83

-IV

19

85

-I

19

86

-II

19

87

-III

19

88

-IV

19

90

-I

19

91

-II

19

92

-III

19

93

-IV

19

95

-I

19

96

-II

19

97

-III

19

98

-IV

20

00

-I

20

01

-II

20

02

-III

20

03

-IV

20

05

-I

20

06

-II

20

07

-III

20

08

-IV

Pe

rce

nta

ge

of

GD

P

Gross Saving in Investment in the US, 1970-2009

Household saving Corporate saving Government saving

Investment (inverted) Statistical adjustment Net foreign lending

Source: NIPA

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Convertibility and exchange rate regimes

• Convertibility – Current-account convertibility– Financial-account convertibility

• Exchange-rate regimes– Floating– Fixed– (in reality a whole range of regimes)


De jure financial openness, 1970-2007


Source: Chinn and Ito (2008)

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The balance of payments and exchange-rate regimes


Net financial inflows

∆Fin - ∆out > 0

Financial outflows

∆Fout

Financial inflows ∆F

in

Exports X

Imports M

Current account balance B = X-M < 0

Fall in foreign exchange reserve

∆R < 0

Exports X

Financial inflows ∆F

in

Decrease in foreign exchange reserves

∆R < 0

Imports M

Financial outflows ∆F

out

B + net financial

inflows (∆Fin - ∆Fout) < 0

Floating exchange rate system

Fixed exchange rate system

A variety of exchange-rate regimes


Highflexibility

‘Dollarization’,‘euroization’

Monetaryunion

Soft peg with fluctuationband

Fixed exchangerate

Currencyboard

Crawlingpeg

Managedfloat

Free floatLowflexibility

Intermediate regimesHard pegs

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Official exchange-rate regimes, 2008


Exchange rate regime

Number of countries Countries

No separate legal tender 41

27 US dollarization Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama.

13 euroization Montenegro, San Marino, Timor-Leste.

1 Australian dollarization Kiribati

Monetary union 35

15 Euro area

Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain. Floating exchange rate against the rest of the world.

8 WAEMUa Benin, Burkina-Faso, Côte d’Ivoire, Guinea Bissau, Mali, Niger,

Senegal, Togo. Fixed exchange rate against the euro.

6 CAEMCb Cameroun, Central African Rep., Chad, Rep. of Congo, Equatorial

Guinea, Gabon, Fixed exchange rate against the euro.

6 ECCUc Antigua and Barbuda, Dominica, Grenada, St Kitts and Nevis, St

Lucia, St Vincent and the Grenadines. Currency board against the US dollar.

Currency board: 7

4 against the euro Bosnia and Herzegovina, Bulgaria, Estonia, Lithuania

2 against the US dollar Djibouti, Hong Kong S.A.R.

1 against the Singapore dollar Brunei Darussalam

Conventional fixed pegs: 54

6 against the euro Cape Verde, Comoros, Croatia, Denmark, Latvia, FYR of Macedonia

36 against the US dollar Angola, Argentina, Aruba, Bahamas, Bahrain, Bangladesh, Barbados, Belarus, Belize, Eritrea, Guyana, Honduras, Jordan, Kazakhstan, Lebanon, Malawi, Maldives, Mongolia, Netherlands Antilles, Oman, Qatar, Rwanda, Saudi Arabia, Seychelles, Solomon Is., Sri Lanka, Suriname, Syria, Tajikistan, Trinidad and Tobago, Turkmenistan, United Arab Emirates, Venezuela, Vietnam, Yemen, Zimbabwe

3 against the South African rand

Lesotho, Namibia, Swaziland

2 against the Indian rupee

Bhutan, Nepal

7 against a basket Libya, Fiji, Kuwait, Morocco, Russian Fed., Samoa, Tunisia

Pegged rates with a horizontal band: 6

1 against the euro , Slovak Republic

2 against the US dollar Syria, Tonga

Crawling pegs: 5

7 against the US dollar Bolivia, China, Costa Rica, Ethiopia, Iraq, Nicaragua, Uzbekistan

3 against a basket Azerbaijan, Botswana, Iran

Managed floating: 44

8 Against the US dollar Cambodia, Kyrgyz Rep., Lao P.D.R., Liberia, Mauritania, Mauritius, Myanmar, Ukraine

3 against a basket Algeria, Singapore, Vanuatu

33 undefined

Independently floating: 26

Albania, Australia, Brazil, Canada, Chile, Dem. Rep. of Congo, Czech Rep., Euro area, Hungary, Iceland, Israel, Japan, Rep. of Korea, Mexico, New Zealand, Norway, Philippines, Poland, South Africa, Somalia, Sweden, Switzerland, Turkey, United Kingdom, United States, Zambia

Source: IMF

De facto exchange rate regimes: fear of floating?


Source: Ilzetzki, Reinhart and Rogoff (2008) based on IMF data

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Stocks and flows

Financial convertibility results in accumulation of financial stocks• BOP records flows• But stocks (foreign assets and liabilities) matter too • Net stocks depend on net flows, i.e. current account

balances (stock/flow dynamics) • Gross stocks depend on gross flows (capital inflows and

outflows)

Why they matter:

• Net stock: Net Foreign Asset position is the external wealth/debt of a nation Generates income if positive (rentier behaviour), involves cost if negative. Sustainability issue

• Gross stock: exposure to market risk (currency risk; interest rate risk)


Net flows 1996-2010


In the 2000s net flows have mostly been South-North

-3

-2

-1

0

1

2

3

4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Global Imbalances(percent of world GDP)

US JPN Eur surplus CHN EMA OIL ROW Eur deficit Discrepancy

Source: Blanchard and Milesi-Ferretti (2010)

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Net stocks: NFA positions, 1970-2008


Source: Lane and Milesi-Ferretti (2006) from 1970 to 1996, and IMF, World Economic Outlook, October 2008, from 1997 to 2008.

Assets and liabilities are measured at estimated market value

Gross flows 1998-2008


In the 2000s the rise in gross flows mainly involved advanced countries

Source: Milesi-Ferretti (2009)

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Gross stocks are mainly held by advanced countries


World distribution of external assets and

liabilities, 2007

G7

Other advanced

non-G7 G20

Others

Source: Authors calculations with Lane and Milesi-Ferretti data

Wealth dynamics

• Net Foreign Assets (NFA) = External Assets minus Liabilities

W = F – O*

• Value changes because of:– Current account surpluses / deficits– Valuation changes:

• Market valuations• Exchange rates

• If they were no valuation changes, one could writeW - W-1 = B

• If PB is the primary balance, PB = B - i*F – iO*= X – M

• Then:W - W-1 = B = BP + i*F - iO*


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Valuation matters

Assets Liabilities Balance

Total 10 12.5 - 2.5

… dollar-denominated 3.5 11.9 - 8.4

…other currencies and gold 6.5 0.6 +5.9

Effects of a 10% dollar

exchange rate decline+0.65 +0.06 +0.59


Example: US end 2004 (dollar trillions)

Source: adapted from Tille (2005)

Exchange rate concepts and measurements

• Nominal exchange rate E• Real exchange rate Q = EP/P*

– where P = Π(Pi)αi, P* = Π(P*i)α*i, Σαi= Σα*i=1

• Effective exchange rate – Average of exchange rates, generally weighted by trade shares

– There are nominal and real effective exchange rates

– Many alternatives measures of effective exchange rates


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Nominal and real effective exchange rates of the euro


Source: ECB

80

85

90

95

100

105

110

115

120

125Ja

n-9

5

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

Jan

-11

Ind

ex

(Ja

n 1

99

9=

10

0)

Nominal

Real

There is more than one effective real exchange rate


E ffec tive E x c hang e R ates of the € (1999Q1=100)

80

85

90

95

100

105

110

115

120

1999

Q1

1999

Q3

2000

Q1

2000

Q3

2001

Q1

2001

Q3

2002

Q1

2002

Q3

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

2007

Q1

2007

Q3

NEER

REER C PI

REER GDP Deflator

REER Produc er Pric es

REER UL C

Manufac turing

REER UL C Total

Ec onomy

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Real exchange rate within a monetary union may diverge


R eal E ffec tive E xc hang e R ates in E urope (2000=100)

80

90

100

110

120

130

140

A us tria

Belg ium

Denmark

F inland

Franc e

G ermany

G reec e

Ireland

Italy

L uxemburg

Netherlands

Portugal

S pain

S w eden

UK

EA 12

EU 15

3.1 Issues





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Equilibrium exchange rates 1: Price equalisation

• Purchasing Power Parity (PPP) introduced by Cassel in the 1920s

• Two versions– Absolute Q = 1– Relative Q = cste

• PPP amounts to saying that the internal and external purchasing power of a currency are the same (or evolve in tandem)

• ‘The international neutrality of money’• PPP only holds (a) in the long run or (b) in situations of

high inflation• Even so many deviations from PPP



PPP: short term and long term

Source : Taylor and Taylor 2004

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The PPP and hyperinflation


External and internal value of the Brazilian real, 1991-94


The PPP performs poorly in situations of moderate inflation

Taux de change nominal et réel du dollar contre

grandes monnaies, 1973-2004

50

60

70

80

90

100

110

120

130

140

150

1973

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1997

1999

2001

2003

source : Fed de New-York

Nominal

Réel

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Development levels and deviations from PPP


PPP GDP per capita and real exchange rates in 2006


euro area price level = 1

0.00.10.20.30.40.50.60.70.80.91.01.11.21.31.41.5

eu15

euro IE

F

I LU

F

R

NL

DE

A

T

BE

IT

E

S

GR

P

T

DK

S

E

UK

CY

M

T

SI

HU

E

E

CZ

S

K

PL

LV

LT

HR

T

K

RO

B

G

1995

2005

Price dispersion: also in Europe

Source B. Egert (2006)

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The Balassa-Samuelson effect

• Applies to developing economies• 1 factor (labour), mobile across sectors, and 2 sectors

– Tradables sector T (weight α) : industry• PPP for tradables : EPT = PT* • Productivity much lower than in advanced countries πT

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But B-S does not seem to apply to China

Source: Cheung, Chinn and Fujii 2007


The use of PPP for measurementpurposes

PIB Revenu par tête

en dollars

courants

en dollars de

PPA

en dollars

courants

en dollars de PPA

USA 12168 11693 41440 39820

Japon 4734 3809 37050 29810

Allemagne 2532 2324 30690 28170

Royaume-Uni 2013 1882 33630 31430

Chine 1938 7634 1500 5890

France 1884 1779 30370 29460

Inde 673 3369 440 1970

Brésil 551 1460 3000 7940

Russie 488 1392 3400 9680

Source : Banque mondiale

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Equilbrium exchange rate 2:External flow equilibrium

• Under Bretton Woods the IMF developed techniques to assessexchange rate policies and diagnose exchange rate misalignments

• Under floating John Williamson (1983) revives thesetechniques and proposes to define a FundamentalEquilibrium Exchange Rate (FEER)

• The basic idea is that the equilibrium exchange rate corresponds to a situation where the country achieves bothinternal and external balance

• It is therefore a normative, general equilibrium concept


FEERs in a nutshell

• Macroeconomicapproach: – Internal and external

equilibrium– Internal: equilibrium

unemployment (NAIRU)– External : net structural

capital outflow (inflow)• This determines the

Fundamental EquilibriumExchange rate Qe

GDP

Q

Internal balance

External

balance

Qe

Ye

Inflation + deficit

Unemployment + deficit

Unemployment

+ surplus

Inflation + surplus

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Internal equilibrium

• Elementary– Vertical supply curve

• A little more subtle– The internal balance depends on the exchange rate since:

– For a given purchasing power of wages W/Pc, the real wage is a decreasing function of the real exchange rate

– Hence a depreciation reduces aggregate supply

ω

ω

ω

−

−

=

==

QP

W

P

W

E

PPP

P

P

P

W

P

W

c

cc

c

*où 1


External equilibrium

+ + + -Since M = M(Y, Q) et X = X(Y*, Q),

- + -TB = TB(Y, Y*, Q)

where TB is the trade balance

• The trade balance writes:

B = B (Y, Y*, Q)

• Given exogenous structural capital flows (ex FDI) this imples

• Macroeconomic policy is supposed to take care of the internalequilibrium, hence :

FAB =

FAQYYBFEER =)*,,(

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FEER-based estimates of RMB undervaluation

Période d’étude Cibles de compte courant chinois (en % du PIB)

Sous-évaluation vis-à-vis du dollar US

Coudert et Couharde (2005)

2002/2003 -1,5% -54%

Coudert et Couharde (2005)

2002/2003 -2,8% -44%

Goldstein (2004) 2003 -1% de -15 à -30%

Jeong et Mazier (2003) 2000 -1,5% -60%


Volumes, values and the J curve

• Whereas trade and current account balances at constant prices respond positively to exchange rate depreciation, the response of current price balances is ambiguous

• Constant prices trade balance:TB = X(Y*, Q) - M(Y, Q)

• Current prices trade balance:TBV = PX - P*M/ETBV = P(X - M/Q)

• It can be shown (see Appendix) that the current pricesbalance only responds positively if the sum of price elasticitiesof exports and imports exceeds one

• This is true only in the medium term, hence the ‘J-curve’response of the trade/current account balance

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Empirical alternatives to the FEER

• Unlike PPP, the FEER approach encompasses the macroeconomicequilibrium

• But it is normative in essence (not adequate for positive purposes, e.g. forecasting)

• And it rests on disputable assumptions– Especially ad-hoc current account norms

• Clark and MacDonald (1998) build on the FEER but introducemore degrees of freedom

• They rely on equilibrium exchange rate theories to choose the long-run determinants of the exchange rate, without setting norms

• Result: BEER (Behavioural Equilibrium Exchange Rate) • Stein (1994) also defines the NatREx (Natural Real Exchange Rate

which is a variante of the BEER


The BEER• Start from estimation of:

qt = βHt + τTt + εt

• Where q is the (log of the) exchange, rate H represents itslong-term determinants (Net Foreign Asset Position, relative productivity) and T temporary factors (e.g. interestrate differentials)

• Eliminating transitory factors gives the equilibriumexchange rate :

st = βHt

• Unlike for the FEER approach there is no predeterminednorm

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Example: Clark-MacDonald 1998

Estimated equilibrium

exchange rate

Market exchange rate

Overvaluation at t


Equilibrium exchange rates 3: Portfolio model

• Assumptions behind uncovered interest rate parity:– Asset allocation is entirely determined by relative returns– Investors are indifferent between euro and dollar assets, if

they expect the same return on both• Realistic?

– Is accumulation of dollar-denominated assets somethinginvestors are indifferent to?

– For a euro area resident, is can the exchange rate riskinvolved in holding dollar-denominated assets beneglected?

– Are assets so perfectly substitutable?• Leads to portfolio choice model

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Investors’ behaviour

• Investors typically distribute investments across:– instruments (cash, bonds, stocks..)– risk classes (from AAA to junk assets)– maturities– currencies

• Expected returns differ across instruments, risk classes, etc..

• The higher the return, the more the investor is willing to take risk (Tobin, 1958)

• The share of risky assets (e.g. stocks) in the portfolio therefore depends on relative returns


Example: benchmark allocations

Source: The Economist

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Risk and return (for US assets, 1926-1994)

Average return

(%)

Standard

deviation (%)

Stocks small companies 12.2 34.6

Stocks large companies 10.2 20.3

Corporate bonds 5.4 8.4

Government bonds 3.7 3.3

Source : Burton Malkiel


Basic ideas

• Allocation decisions are made for stocks :– An household’s total financial wealth– A companies’s total debt– An institutional investor’s total portfolio

• The investor allocates its portfolio by asset classes and then individual classes:– Portfolio diversification in search of risk/return combination

• Flows (e.g. net purchase of govt bonds) are derivedfrom stock allocation.– Difference between current stock and desired stock for t + 1

This is the portfolio choice model

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Example: bond yields, maturitiesand risk

Aaa

/AA

A

Aa1

/AA

+

Aa2

/AA

Aa3

/AA

-

A1

/A+

A2

/A

A3

/A-

Baa1

/BB

B+

Baa2

/BB

B

Baa

3/B

BB

-

Ba1

/BB

+

Ba2

/BB

Ba3

/BB

-

B1

/B+

B2

/B

B3

/B-

Caa/

CC

C1 an

3 ans5 ans

10 ans 30 ans

0

200

400

600

800

1000

Spreads corporate, 1/03/04

1 an

3 ans

5 ans

10 ans

30 ans


Risk and decision

• How to represent behaviour in riskyenviromnent

Hypotheses:• Utility increases with income but decreasingmarginal utility of income– U’(Y) > 0, U’’(Y) < 0

• Agent can either– Play and gain x with probability p [p = ½] and ywith probability (1 – p)

– Do not play and receive (x + y) / 2• Will she play? • Depends on attitude towards risk

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Utility and income

• If the agent does not playher utility is: U[½(x + y)] - point A

• If she plays it is : ½[U(x) + U(y)] - point B

• U(A) > U(B), so it ispreferable not to play

• This is risk aversion • Agent will prefer lower, but

more certain income• Would be the opposite with

convex utility (e.g. profit) Income

Utility

A

B

x y

U(y)

U(x)

(x+y)/2


Measuring risk aversion

• Reason for risk aversion: utility is concave, i.e. U’’(W) < 0– Intuitively, risk aversion grows with concavity of utility function i.e.

with |U’’(W)|– But U’’ is not invariant to changes in measure of utility.

• Normalised measurement:• Absolute aversion:

• Relative aversion

)('

)('' )(

WU

WUW −=Φ

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29


A basic two-assets portfolio

• Initial wealth W0, two assets yielding i, i*• Assets characterised by variance (σi, σi*) and covariance • If x is the share of the (*) asset in the portfolio,

W= W0 [(1-x) (1 + i) + x (1 +i*)]

E[W] = W0 (1 + (1 - x) E[i] + x E[i*])

σ2W =W02[(1 - x)2σi2 + x2 σi*2 +2x(1 - x) σii*]

• Assume utility depends on expected wealth, variance

U = U[E(W), σ2W/2]


A basic two-assets portfolio (2)

Maximising U yields:

[ ] ( )[ ]

*

2

*

22

2

*

2

2

0

*

2

*

2

*

22

00

2

2 avec )(*)(

'

'~

:*asset of share optimal giveswhich

0)2(')(*)('

0''

iiiiiiiW

iiiiiiiW

W

SSS

iEiE

UW

Ux

xWUiEiEWUdx

dU

dx

dU

dx

dWU

dx

dU

σσσσσ

σσσσσ

σ

σ

σ

σ

−+=−

+−

−=

=+−−++−=

=+=

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30

A basic two-assets portfolio (3)

• Equivalently:

• ψ measures risk aversion• Portfolio has two components:

– Minimum variance portfolio xM (independent from returns)– Spéculative component xS (depends on returns)

• Optimal equalises marginal utility of return and marginal cost of risk

• If the first asset is risk-free, minimum variance portfolio does not include the otherone

• There is therefore a risk premium for holding the risky asset. It increases with the share of this asset in the total porfolio.


'

'- where W

'

'W- with

)*( ~

00

22

*

2

WW

iii

U

U

U

U

S

iiE

Sx

σσ ψψθ

θ

σσ

===

−+

−=

xSiiE ~*)(2θ+=

What are equilibrium exchange rates for?


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31

Long-term equilibrium and the current

exchange rate

• Simple uncovered interest parity condition under strict hypotheses

– Perfect mobility

– Asset substitutability

– No risk aversion

• UIP widely used for simplicity (in spite of shortcomings) in theoretical and empirical models, but does not fit facts well

• Implication in floating rate context (s = se + i – i*) : exchange rate ‘jumps’ in response to news about future policies:

pisani-ferry octobre 2011 61

eS

iSi

*)1()1(

+=+ esii &−= *

( )∑

−

=

+++ −+=1

0

*T

e

tt

e

Ttt iissτ

ττ

implies

Exchange rate adjustment when prices are sticky: the Dornbusch overshooting model

• Influential model of 1976• Combination of long-run monetary model with money neutrality

and flexible prices and short-run keynesian model with sticky prices

• Results in overreaction of exchange rate to changes in money supply (overshooting)

• Explains high exchange rate volatility


29/11/2011

32

Key dynamics


time

Exchange rate

Interest rate

Price level

Money supply

Overshooting


0 (7)

* )6(

* )5(

)]()( (4)

)( )3(

* )2(

)1(

yy

p-peq

ppe

ppqqp

eee

eii

iypm

a

a

=

+=

−=

−+−=

−=

=−

−=−

µγ

θ

βα

&

&

&

The model

Log-linearised

stands for the long term value of XX

29/11/2011

33


Solving the model

• Start from long-term stationary equilibrium

(Where )

• Consider permanent shock to money supply and examine:– New long term equilibrium

– Dynamics

• p is a state variable that moves continuously.

• The exchange rate can ‘jump’ (no rigidity on asset pricemarkets)

0== ep &&


0 )'7(

0 )'6(),'5(

0* )'2(

)'1(

yy

q

ii

iypm

=

=

=−

−=− βα

Long term solution

• Assume , the model simplifies:

• A monetary shock translates into a proportionate increase in the price level

• Money is neutral in the long run

xx =

0==

−=

=

qdyd

mded

mdpd

29/11/2011

34


Dynamics

• The model can be rewritten in difference with the steadystate solution. (1), (2), (3), (7) lead to:

• Substraction from (1’) gives

• This equation represents the money market equilibrium

• Similarly equations (4) and (7) result in the price stabilitycondition

)(* )8( 0 eeiypm −+−=− βθβα

)( )( eeppAA −=− βθ

-p)p(PP )(e)-e( )( µγγ +−=


Graphical solution

AA

AA’

PP

PP’

E’’

E’

e

p

p

'p

'e''e e

E

overshooting

29/11/2011

35


The Dornbusch model: off-equilibrium

aspects

• The only stable trajectory isthe saddle path AA

• The other trajectories are divergent

PP

p

e

p

AA


Lessons from the Dornbusch model

• The model combines

– Instant adjustment of asset prices

– Goods market price rigidity

• This leads to overshooting

• Exchange rate volatility is no accident, it comes from thiscombination of internal rigidity and flexibility

• Model still includes considerable simplifications and is of limited empirical values, but captures an important link

29/11/2011

36

Currency crises

pisani-ferry november 201171

Source IMF

Crises since 1970

Currency crises: Asia 1997-98


40

50

60

70

80

90

100

110

Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99

Ind

ex

(Ja

n 1

99

6 =

10

0)

Thai baht

Malaysian ringitt

Korean won

Indonesian rupee

29/11/2011

37


A basket case: Argentina, 8 January 2002

Taux de change du peso argentin en dollar, 2001-2003

0

0.2

0.4

0.6

0.8

1

1.2

01/0

1/20

01

01/0

3/20

01

01/0

5/20

01

01/0

7/20

01

01/0

9/20

01

01/1

1/20

01

01/0

1/20

02

01/0

3/20

02

01/0

5/20

02

01/0

7/20

02

01/0

9/20

02

01/1

1/20

02

01/0

1/20

03

Exchange rates and reserves


A balance-of-payments crisis: Pakistan 2008

29/11/2011

38


Questions

• Questions :– Why does the crisis occur (deep causes or marketirrationality)?

– When does the crisis occur? At random or at a determined moment?

– Do speculators coordinate among themeselves (and how)?

– Can / should policymakers resist speculation?

• Not a single theory, but several ‘generations’ of currency crises models– Each generation of models aims at explaining new crisischaracteristics

– Different responses to the above questions


A generic model

• 2 speculators, 1 central bank• Each speculator can borrow up to 6 units of the national

currency at cost 1

• The central bank holds R units of reserves. Consider 3 cases:

• R = 20• R = 6• R = 10

• Fixed exchange rate E = 1. If the central bank has to giveup the fixed parity, E = 0.5 after devaluation

• If R =20 the central bank wins, if R =6 it loses, if R =10 two equilibria depending on whether the speculatorscoordinate or not.

• The $1tr question: why and how do speculators coordinate?

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39


1st generation (Krugman, 1979) : Unsustainable policies

• Motivation: • Understand the ‘runs’ on reserves

• Hypothesis: • Crisis has a ‘fundamental’ origin, i.e. there policy is inconsistent with

participation in the fixed exchange rate regime. For example:• Persistent current-account deficits• Inflation • Public debt accumulation

• Prediction• Crisis occurs before reserves are exhausted, at determined moment:

when the post-crisis floating exchange rate equals the pre-crisis fixedexchange rate.

• Insight: speculateurs• The crisis is a rational response to policy incoherence

• Speculators do not act upon observing that there is incoherence but they do not wait until reserves are exhausted either


How the model works

• Reserves declinegradually untilthe crisis

• Shadowexchange rate evolves smoothly

• The crisis occurswhen the gain from speculationis nil

Forex reserves

Exchange rate

time

Underlying shadow exchange rate

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40


Implications and limits

• Applies to all unsustainable policies• Policy implications:

– As markets are rational, governments should• Avoid trying to keep defend exchange rate if there is underlyinginconsistency

• Resist the crisis if fundamentals are ‘good’

– Post crisis, case for IMF programmes (conditional financialassistance)

• Limits: model does not explain

− Attacks on currencies with ‘strong’ fundamentals

− Contagion

• Representation of government behaviour is simplistic (thoughsometimes correct)


Applications

• Crises of fixed-exchange rate regimes:– Italy / Spain 1992 (but not France)– Thailand 1997 (but not Korea)– Argentina 2002 – Latvia 2008

• Debt crises involve similar mechanisms– Greece 2010

29/11/2011

41


2° generation (Obstfeld, 1994) : The ‘new fundamentals’

• Motivation : Why attacks on strong currencies whosetraditional ‘fundamentals’ are strong (e.g. FF 92-93)

• Hypothesis : the government declares it wants to keepthe exchange rate fixed, but in fact it may prefer to devalue

• Principle : • Authorities have several objectives. Exchange-rate stability is one

among others;• Markets know that devaluation may be optimal under certain

conditions.

• Prediction : • The cost of keeping fixed exchange rates increases if

markets anticipate devaluation.• The currency crisis takes place at a determined moment,

before authorities decide to devalue.


ExampleHypotheses: • Unemployment follows

with 0 < ρ < 1 • Authorities’ loss function L = U2 + cZ

where Z = 1 if there is devaluation, Z = 0 otherwise• Inflation:

– Zero if exchange rate is fixed and credible– Equal to d after a devaluation.

• Model resolution starts from minimisation of loss function:• Three cases:

– Exchange-rate should be kept fixed if unemployment is low;– Exchange-rate should be devalued if unemployment is high;– In intermediate cases there are two equilibria : there should

be devaluation if expected by market.

εαρ +−−= − )ˆˆ(1a

tt ppUU

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42


Insights

• In 1992, French authorities did not understandwhy the currency was under attack in spite of low external deficit and low inflation

• Second-generation models introduce « new fundamentals » (unemployment) : there canbe rational attacks against strong currencies

• ‘Psychoanalytic’ theory of the crisis(speculation reveals the policymakers’ hiddendesires).


Implications and limits

• The model applies to all cases when keeping fixed exchange rates can be suboptimal (for example, when an excessive public debt ratio could be reduced through inflation)

• Policy implications: – Exit clauses are costly because their used is being pricedin by speculators;

– Policy tightening can paradoxically precipitate the crisisif perceived as unsustainable by speculators.

• Limits : the crisis is still a rational crisis

• Cases: UK 1992 (Norman Lamont, the chancellor of the Excheker, said afterwards that he ‘sang in his bath’)

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43


• Example: A government is coerced into devaluation (or debt default)

• Principle: Because of multiple equilibria, the behaviourof speculators plays determinant role.

• Prediction: There can be purely self-fulfilling attacks, even in the absence of any fundamental factor

• Insight: There can be multiple equilibria, contagion.

Self-fulfilling speculative attacks(Obstfeld, 1996)


Self-fulfilling speculative attacks(cont’d)

• Policy implications : – Avoid exchange-rate regimes that are prone to speculative

attacks, especially intermediate regimes e.g. soft pegs; – If exchange regime is vulnerable, need for strong defense

mechanisms of capital controls ;– Standard IMF programmes are not adequate. Need for

anti-contagion instruments.

• Limits : (a) What is the trigger for speculation? How do speculators

coordinate? (b) Assumes speculation is validated ex-post by policy

change.

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44


Conclusions

• Theoretical insights:– Crises are not random events– There is more than one type of fundamentals– There are good and bad crises

• Policy insights: – Policy responses need to be tailored to the type of crisis

• Problem: Many different models

3.1 Issues


• Equilibrium exchange rates 1: price equalisation• Equilibrium exchange rates 2: external flow equilibrium• Equilibrium exchange rates 3: portfolio balance• Currency crises3.3 Policies• Financial openness• Choosing an exchange rate regime• Managing floating exchange rate


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45

A brief history of international monetary arrangements


Period Trade regime Capital

flows

Monetary arrangements

Pre-1879 Increasingly free following

repeal of corn laws 1846

and F/UK agreement 1860

Mostly free Variety of national arrangements (gold

standard, silver standard, bimetallism,

inconvertibility)

1879-

1914

Liberal Free capital

movements

Gold standard

Interwar Increasingly protectionist No stable arrangement

1944-

1973

Increasingly liberal Capital

controls

Gold exchange standard, fixed-but-adjustable

exchange rates (Bretton Woods)

1973-

2011

Mostly liberal Gradual lifting

of capital

controls

Floating exchange rates among major

currencies, with:

• Frequent pegs to one of major currencies• Regional arrangements

Source: based on Eichengreen (1996) and Mc Kinnon (1993)

De facto international financial integration, 1870-2009


Average of absolute values of current accounts to GDP ratios for major countries.

Source: Taylor (1996), updated by Bénassy-Quéré et al. (2010)

0

1

2

3

4

5

6

18

70

-74

18

75

-79

18

80

-84

18

85

-89

18

90

-94

18

95

-99

19

00

-04

19

05

-09

19

10

-14

19

15

-19

19

20

-24

19

25

-29

19

30

-34

19

35

-39

19

40

-44

19

45

-49

19

50

-54

19

55

-59

19

60

-64

19

65

-69

19

70

-74

19

75

-79

19

80

-84

19

85

-89

19

90

-94

19

95

-99

20

00

-04

20

05

-09

Ca

pit

al

mo

bil

ity

in

de

x

Significant integration

pre-WW1

Low integration post-

WW2

Rising integration

since the 1990s

29/11/2011

46

Financial openness

Arguments for financial integration:Micro

• Intertemporal exchange– Better allocation of savings– Relaxation of financial constraint

• Technology transfer

Macro

• Shock absorption

Political economy

• Institutions• Policy discipline


a) Trade across borders and over time


US

RoW

Aircrafts TV sets

US

Row

Future savings Current savings

29/11/2011

47

Global allocation of saving: Theory

• Developed countries:– High capital stock, low return– Ageing population, high savings

• Developing countries– Low capital stock, high return– Younger population, low savings (hence constraints to capital

accumulation and growth, e.g. in Solow model)

� Mutual integration gains� Capital (mostly equity investment) to flow ‘downhill’


Intertemporal substitution in a two-period model

• Financial openness allowsdissociating consumption and investment behaviour

• Instead of production possibilities schedule AA, budget constraint DD with

• Optimal consumption is E• Intertemporal exchange is

formally equivalent to international trade


C1

C2

EB

D

Dr

YY

r

CC

++=

++

11

21

21

A

A

A

29/11/2011

48

However no evidence of correlation of NFA with development level


Worse: capital has been flowing uphill


Source Prasad et al.

Average income of capital-exporting and capital-importing countries, 1970-2005

Source: Prasad et al.

29/11/2011

49

b) Shock absorption

• Benefits from openness– Risk diversification through capital outflows– Consumption smoothing in case of temporary incomeshocks

• Important for small, specialised economies (e.g. commodityexporters)

• Illustrated by US regions (Asdrubali, Sorensen and Yosha1996). Channels of absorption of shocks to primary income:– Portfolio diversification: 39% of shock– Credit………………………….. 23%– Federal transfers…………. 13%– Total……………………….…… 75%

• Suggests major benefits from financial openness


Shock absorption or shock propagation?


0

100

200

300

400

500

600

700

800

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

US

do

lla

r b

illi

on

s

Source: IMF, WEO database

Net private capital flows to developing

countries

Other private financial

flows, net

Private portfolio flows, net

Direct investment, net

29/11/2011

50

Financial opening, institutions and corruption

pisani-ferry november 2011 99Source Kose Prasad Rogoff et Wei 2006

The political economy approach to financial openness


Source Kose Prasad Rogoff et Wei 2006

A

29/11/2011

51

Summing up: The post-Asian crisis view on financial openness

pisani-ferry november 2011 101Source Kose Prasad Rogoff et Wei 2006


Choosing an exchange rate regime

• “No single exchange rate regime is right for all countries or at all times” (Jeff Frankel)

• Considerable variation of choices across countries..

– euro area / UK– Asia/ Latin America

• ..and over time

– Succession of ‘fads’: soft pegs in the 1970s, hard pegs in the 1990s; intermediate regimes in the 1980s, corner solutions in the 2000s

• Why? Choice of a regimes depends on:

– Micro criteria– Macro criteria– Political economy criteria– International coordination criteria

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52


Micro criteria

• Several monies =– Transaction costs (« tax ») – Exchange rate uncertainty– Both imply blurred relative price signals

« Money is a convenience and this restrictsrestricts the optimum number of currencies”

(Mundell, 1961)


How large the micro costs/benefits?

• No time-series evidence of costs of exchange rate volatility

• Cross-country evidence highlights ‘border effects’, however currency effects hard to disintangle from other effects– Frankel-Rose: monetary union would multiply tradeby a factor 3 in the long run

– Baldwin : so far effects of the euro have been + 5 to +15%

– Mayer and Ottaviano 2009: no significant effects on extensive margin

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Macro criteria

• Poole (1970): the good monetary regime is the one that best provides stabilisation

• Assume:– Yi= ΣaikXk+ εi model– L = L(Y1,… Yn) macro loss function

• Criterion is to choose exogenous variables Xk in order to minimise E(L) conditionally to shocks εi

• Hence good monetary regime depends on distribution of shocks

• Same approach can be used for exchange rate regime


The Poole approach

• If real demandshocks (IS shifts) dominate, bettercontrol money supply -> floatingexchange rates

• If money demandshocks dominate (LM shifts), the opposite holds

Y0Y’LMY’II

ISIS’

II

LM

IS’

29/11/2011

54


Exchange rate regime and economic performance

Taux de croissance moyen du PIB et des prix selon le régime de change dans 10 pays émergents d’Asie

Régime de change Croissance du PIB

Inflation

Ancrage fixe 6% 4,8%

Ancrage glissant 6,5% 7,4%

Flottement administré 6% 7,5%

Flottement libre 8,4% 9,2%

Episodes de dévaluation 2,2% 8,4%

Source : Coudert et Dubert (2004)


Implications

• The right exchange rate regime dependson the characteristics of the economy:– Nature and origin of shocks– Internal flexibility

• Examples– Highly specialised countries need flexible exchange rate

– Transition countries were right to choose fixedexchange rates initially

• However exchange rate policy choicesoften exhibit (damageable) inertia

29/11/2011

55


Credibility

• Major motive during the high inflation period. In the 1980s and the 1990s exchange rate policyoften served as an instrument to fosterdisinflation:– European ERM countries– Latin America– CEECs

• Reason was often low internal credibility• Fixed exchange rate served to « import » credibility

Example: Argentina


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56


A simple model

θ

γ

βθω

ββ

θω

β

βθω

ββ

θ

γ

θγω

β

≥++

+−

−+

=++

+−=

=>

++−+=

=−+= −

2

2

222

1

]ˆ)1[(

:ifn devaluatio be willereHowever th

inflation reduce thereforerates exchange Fixed

)1(~ˆ nsexpectatio rationalunder and

]ˆ)1[(~ˆ

n,devaluatioWithout

regime rate exchange fixedunder inflation ofcost higher therepresents

ndevaluatio ofcost political therepresents

ndevaluatio if 1 Z1, k where

ˆZ)-(1Z)(ˆ

)ˆ(ˆ avec )ˆˆ(

a

a

tt

aa

pyk

ykppyk

p

pykypL

pEpppyy


Implications

• Fixed exchange rates a solution if:– Incentives to inflation are strong (k large)– The central bank is not credible (ω small)– Inflation expectations are high

• However escape clause leaves door to devaluation open

• This may trigger crisis

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Coordination

• Floating exchange rates involve risks of non-cooperative policies– Competitive depreciation if adverse demand shock– Competitive appreciation if adverse supply shock

• Fixed exchange rate = institutionalisedcoordination

But• Fixed echange rate favourable if shocks are symmetric, not if shocks are asymmetric


Conclusions

Résumé des coûts et bénéfices des régimes de change

Changes fixes Changes flottants

Micro-économie + -

Stabilisation-- si écarts d’inflation

- si chocs réels+ si chocs monétaires

- si chocs monétaires+ si chocs réels

Coordination + -

Crédibilité + en principe, maisrisque de crise

neutre

29/11/2011

58


Monetary union

• Robert Mundell (1961): what is the right geography of money?

• Example : USA - Canada / East – West

• Depends on:– symmetry / asymmetry of schocks

– adjustment mechanisms

• The geography of money does not necessarilycoincides with political geography– supranational currency

– regional currency?


Monetary borders in North America

Ea

ste

rn D

olla

r

We

ste

rn D

olla

r

Canadian Dollar

U.S. Dollar

Forestry Car-making

Canada

United States

29/11/2011

59


Flexible exchange rates or monetaryunion between two ‘regions’?

Costs, benefits

Integration

Benefits

Costs

Flexible exchange rates Monetary union

Asymmetries

Adjustments


Measuring shocks asymmetry• Descriptive methods

• Variance of real exchange rate across regions

• Correlations of GDP or employment

• These methods do not distinguish between shocks and responses toshocks

• Econometric methods• Panel regressions

• Same criticism applies

• VAR (Bayoumi-Eichengreen) addresses identificationproblem

i

t

i

t

i

t tiyy εβα ++=− − )()(1

=

−

−∑

∞

=s

t

t

t

iii

ii

i

t

t

aa

aaL

pL

yL

ε

ε

0 2221

1211

)1(

)1(

29/11/2011

60

Evidence on the euro area


Share of country-specific shocks in explaining output fluctuations

Source: Giannone and Reichlin (2006)


Adjustment mechanisms: US/Europe

Importance EU

Evolution US EU

Labour mobility strong very weak +

(but slow)

Capital mobility strong med ++

Relative price

flexibility

weak med ?

National budget nil med ?

Federal budget med nil ?

29/11/2011

61


Taking stock: Europe compared to the US benchmark

– Shocks of roughly similar magnitude– Less powerful adjustment mechanisms

Evolution– Schocks : vicious cercle (Krugman) or virtuouscricle (Frankel - Rose) ?

– Ajustement : slow improvement or perverse evolution?

Managing exchange rates

• Longstanding controversy on the effectiveness of foreign exchange intervention

• Mixed evidence depending on:– Capital mobility– Timing of interventions – Goals of interventions


29/11/2011

62

Chinese interventions


Japanese interventions


0

200

400

600

800

1000

1200

1400

01-ja

nv-0

3

14-ja

nv-0

3

27-ja

nv-0

3

7-Fe

b-03

20-F

eb-0

3

05-m

ars-

03

18-m

ars-03

31-m

ars-03

11-A

pr-0

3

24-A

pr-0

3

7-M

ay-0

3

20-M

ay-0

3

02-ju

in-0

3

13-ju

in-0

3

26-ju

in-0

3

09-ju

il-03

22-ju

il-03

4-A

ug-0

3

15-A

ug-0

3

28-A

ug-0

3

10-s

ept-0

3

23-s

ept-0

3

06-o

ct-0

3

17-o

ct-0

3

30-o

ct-0

3

12-n

ov-0

3

25-n

ov-0

3

8-D

ec-0

3

19-D

ec-0

3

105

110

115

120

Achats de dollars et d'euros (milliards de yens, échelle de gauche)

Dollar/yen (échelle de droite)

y = 0,0007%x - 0,2481%

-2,00%

-1,50%

-1,00%

-0,50%

0,00%

0,50%

1,00%

1,50%

2,00%

0 200 400 600 800 1000 1200 1400

Interventions quotidiennes (milliards de yens)

Bais

se (

+)

ou

ha

uss

e (-

) d

u y

en

29/11/2011

63

Appendices



Appendix 1: The Marshall-Lerner condition

• Nous avons vu que la réponse du solde extérieur en valeur à une variation du taux de change est a priori ambigue

• Pour lever l’indétermination il faut expliciter les élasticités-prix du commerce extérieur

• Équations standard :

• µ et ν sont les élasticités-revenu• ε et η sont les élasticités-prixdu commerce extérieur

ην

εµ

QYM

QYX

=

= −*

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64


La condition de Marshall-Lerner

• Dévaluation : en faisant initialement Q = 1 et en supposant que M = X,

• où ω est le taux d’ouverture X/Y• Pour que la dévaluation améliore le solde extérieur, il faut que

ε + η ≥ 1 : condition de Marshall-Lerner, dite théorème des élasticités critiques

• Si le solde extérieur est déficitaire, la condition doit être plus stricte

[ ]Q

dQ

PY

dBV

Qd

X

M

M

dM

QX

dX

PY

PX

PY

dBV

QPMddM

Q

PPdXdBV

1

)1

(1

)1

(

−+−=

−−=

−−=

ηεω


Marshall-Lerner in practice

Source : Coudert et Couharde 2005

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65


La courbe en J

• En réalité imports et exports ne répondent que progressivement à la variation du change

• Le profil du solde extérieur après une dévaluation est donc une « courbe en J »

• La dynamique peut être enrichie en prenant en compte les effets sur la croissance et l’inflation internes

t

BV

dévaluation

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