EXCHANGE RATES AND TRADE

OBSERVATORY ON EXCHANGE RATES SÃO PAULO SCHOOL OF ECONOMICS

FGV-SP 2013

Prof. Vera Thorstensen, Prof. Emerson Marçal, Prof. Lucas Ferraz

Big Mac Index – 1/2013

IMF Estimates of Exchange Rate Misalignments (6/2012) Pilot External Sector Report

Misalignment from FEER – Cline and Williamson

Exchange rate misalignments 2010 - 2012 (Shin, Johansen, Engle-Granger) FGV

Exchange rate misalignments 2010 - 2012 (Shin, Johansen, Engle-Granger) FGV

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

% em

relaç

ão a

o eq

uilíb

rio

Exchange Rate Misalignment Estimates (2010-2012)

2010

2011

2012

Methodologies:Fundamentals analysis - fundamentalsestimated using 3 methodologies: Shin, Engle & Granger e Johansen .

Exchange Rate Misalignments FGV 2012

Petersen x IMF x FGV (REER)

Brazil: real exchange rate, fundamentals and exchange rate misalignments (annually)

9

Sources: Misalignment estimates – Observatory on Exchange Rate - EESP/FGV (2013)

Real Effecitive Exchange Rate Fundamentals

1970 1975 1980 1985 1990 1995 2000 2005 2010

60

80

100

Real Effecitive Exchange Rate Fundamentals

Exchange Rate Misalignment

1970 1975 1980 1985 1990 1995 2000 2005 2010

-20

-10

0

10

20

30Exchange Rate Misalignment

US: real exchange rate, fundamentals and exchange rate misalignments (annually)

10

Sources: Misalignment estimates – Observatory on Exchange Rate - EESP/FGV (2012)

Real Effective Exchange Rate Estimated Fundamentals

1970 1975 1980 1985 1990 1995 2000 2005 2010

100

120

140

Real Effective Exchange Rate Estimated Fundamentals

Estimated Exchange Rate Misaligment

1970 1975 1980 1985 1990 1995 2000 2005 2010

-0.1

0.0

0.1

0.2

Estimated Exchange Rate Misaligment

China: real exchange rate, fundamentals and exchange rate misalignments (annually)

11

Sources: Misalignment estimates – Observatory on Exchange Rate - EESP/FGV (2013)

China Real Effective Exchange Rate China Fundamentals

1985 1990 1995 2000 2005 2010

100

150

200China Real Effective Exchange Rate China Fundamentals

Exchange Rate Misalignment

1985 1990 1995 2000 2005 2010-50

0

50Exchange Rate Misalignment

European Area: Exchange Rate Misalignments FGV (2009 – 2011)

“Tariffication” of exchange rate misalignments

To exam the impact of exchange rate misalignments on trade, one possibility is to transform a misaligment into a tariff and then to adjust the import tariff of each country, through a “tariffication” exercise.

An overvalued exchange rate has the effect of reducing or nullifying the import tariffs of the overvalued country, creating an incentive to imports from third countries.

An undervalued exchange rate, on the other hand, will give an incentive to exports from the undervalued country. A country’s undervalued currency will have the effect of increasing its import tariffs, sometimes above the bound levels at the WTO.

The equation used to “tarifficate” the effects of exchange rate misalignments is presented in the next slide

Tariffication of Exchange Rates

14

Simulations regarding the effects of exchange rate misalignments on selected Tariff Profiles

Using the “tariffication methodology”, one can represent the effects of exchange rate misalignments on a country Tariff Profile.

The Tariff Profile is comprised of bound tariffs and applied tariffs

Bound tariffs are the tariffs negotiated at the WTO as the maximum permitted level of an import tariff.

Applied tariffs are the import tariffs actually applied by a country and notified to the WTO

After applying the “tariffication methodology” the results are adjusted bound and applied tariffs that represent the actual level of protection of a given country.

In the following slides we present the simulations for Brazil, US and EU Tariff Profiles, considering the effects of the exchange rate misalignments of selected countries.

Impacts of Exchange Rates on China Tariff Profile China devaluation in 2012 (17%)

0,00%

10,00%

20,00%

30,00%

40,00%

50,00%

60,00%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

China Tariffs x Adjusted Tariffs - Effects of China 17% Exchange Rate Devaluation (2012) Simple averages at HS 2 digits - source WTO

Applied Tariffs (simpleaverage)

Adjusted AppliedTariffs: China - 14%

Bound Tariffs (simpleaverage)

Cereals Sugar

Wool

Meat Footwear

Vehicles

Musical instruments

Miscelaneous manufactured articles

Furskins

Clothing

Tobacco

Impacts of Exchange Rates on China Tariff Profile (2012) Ch-Brazil (37%), Ch-Germany (13%), Ch-US (12%) Bilateral Misalignments

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

China Tariffs x Adjusted Tariffs - Effects of Selected Countries Exchange Rate Deviations (2012) Simple averages at HS 2 digits

Adjusted Applied Tariffs -effect of CH + BRdeviations - 37%

Adjusted Applied Tariffs -effect of GER + CHdeviations: 13%

Adjusted Applied Tariffs -effect of CH + USAdeviations: 12%

Bound Tariffs (simpleaverage)

Applied Tariffs (simpleaverage)

Brazilian exporter (2012)

American exporter

German exporter

Impacts of Exchange Rates on US Tariff Profile US devaluation in 2012 (5%)

141%

153%146%

0%

20%

40%

60%

80%

100%

120%

140%

160%

0%

5%

10%

15%

20%

25%

30%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

USA Applied Tariffs x Adjusted Tariffs - Effects of USA Exchange Rate Devaluation Simple averages at HS 2 digits - source WTO (2010)

Applied tariffs

Adjusted appliedtariffs: USA - 5%

Bound tariffs

Dairy

Tobacco

vegetables

LeatherWool

Cotton

Clothing

Footwear

Locomotive

Impacts of Exchange Rates on US Tariff Profile (2012) US-Brazil (25%), US-Spain (9,5%), US-China (12%) Bilateral Misalignments

-20%

-10%

0%

10%

20%

30%

40%

50%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

USA Applied Tariffs x Adjusted Tariffs - Effects of Selected Countries Deviations (Article I)Simple averages at HS 2 digits - Except HS sector 24 (Tabacco)

Adjusted applied tariffs -effect of USA + BR: 25%

Adjusted applied tariffs -effect of USA + SPAIN:9,5%

Bound tariffs

Applied tariffs

Adjusted applied tariffs -effect of USA + CH: 12%

Dairy vegetables

Leather WoolCotton

Clothing Footwear

LocomotiveBrazilianexporter

Spanishexporter

Chineseexporter

Impacts of Exchange Rates on Brazil Tariff Profile Brazil Overvaluation in 2012 (20%)

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

Brazil Tariffs x Adjusted Tariffs - Effects of Brazil Exchange Rate Overvaluation (2012) Simple averages at HS 2 digits

Bound Tariffs (simple averages)

Applied Tariffs

Adjusted Bound Tariffs -Exchange Rate Overvaluation BR + 20%

Adjusted Applied Tariffs -Exchange Rate Overvaluation BR + 20%

DairySugar Beverages

Tobacco

LeatherCotton

Clothing

SteelTools

Vehicles

21

Impacts of Exchange Rates on Brazil Tariff Profile Brazil-China (37%), Brazil-US (25%), Brazil-Germany (24%) Bilateral

Misalignments in 2012

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

Brazilian Market Adjusted for Multiple Exchange Rate Misalignments Simple averages at HS 2 digits

Applied Tariffs

Brazilian Producer

Adjusted Applied Tariffs -effect of BR + GER: 24%

Adjusted Applied Tariffs -effect of BR + USA: 25%

Adjusted Applied Tariffs -effect of BR + CH: 37%

Dairy

Sugar

BeveragesTobacco Leather Cotton

Clothing

SteelTools

Vehicles

22

Impacts of Exchange Rates on EU Tariff Profile Brazil (40%), US (7%), China (14%) Misalignments in 2011 and Brazil

(15%) in 06/2012

-20%

0%

20%

40%

60%

80%

100%

120%

1 - 4 - 7 - 10 - 13 - 16 - 19 - 22 - 25 - 28 - 31 - 34 - 37 - 40 - 43 - 46 - 49 - 52 - 55 - 58 - 61 - 64 - 67 - 70 - 73 - 76 - 79 - 82 - 85 - 88 - 91 - 94 - 97 -

EU Market - Effects of Selected Countries Deviations (Article I) Simple averages at HS 2 digits - Exchange rate misalignments for 2011-12

Adjusted Applied Tariffs -Exchange Rate Overvaluation BR - 40%

Adjusted Applied Tariffs -Exchange Rate Overvaluation BR - 15% (06/2012)

Bound Tariffs

Applied Tariffs

Adjusted Applied Tariffs -Exchange Rate Devaluation USA - 7%

Adjusted Applied Tariffs -Exchange Rate Devaluation China - 14%

Brazilianexporter (2011)

Brazilian exporter (06/2012)

American exporter

Chineseexporter

Conclusions

- Countries with overvalued exchange rates (Brazil) have their negotiated tariffs reduced or nullified. - Countries with undervalued exchange rates (USA, China) grant subsidies to their exports and their applied tariffs surpass the bound levels agreed at the WTO.

- Substantial and persistent exchange rate misalignments significantly affect or nullify most WTO rules: tariffs, antidumping, countervailing measures, safeguards, rules of origin, regional agreements, DSB retaliations…

- Problem: the WTO does not have adequate rules to address the exchange rate issue

23

IMF - manipulation (Article IV)

WTO - frustation (Article XV)

Solutions

General Agreement on Tariffs and Trade (GATT)

Article XV:4

Contracting parties shall not, by exchange action, frustrate* the intent of the provisions of this Agreement, nor, by trade action, the intent of the provisions of the Articles of Agreement of the International Monetary Fund.

* Ad Article XV -Paragraph 4

The word “frustrate” is intended to indicate, for example, that infringements of the letter of any Article of this Agreement by exchange action shall not be regarded as a violation of that Article if, in practice, there is no appreciable departure from the intent of the Article. Thus, a contracting party which, as part of its exchange control operated in accordance with the Articles of Agreement of the International Monetary Fund, requires payment to be received for its exports in its own currency or in the currency of one or more members of the International Monetary Fund will not thereby be deemed to contravene Article XI or Article XIII. Another example would be that of a contracting party which specifies on an import license the country from which the goods may be imported, for the purpose not of introducing any additional element of discrimination in its import licensing system but of enforcing permissible exchange controls.

WTO Rules relating trade and exchange rates

General Agreement on Tariffs and Trade (GATT)

Article II:6

(a) The specific duties and charges included in the Schedules relating to contracting parties members of the International Monetary Fund, and margins of preference in specific duties and charges maintained by such contracting parties, are expressed in the appropriate currency at the par value accepted or provisionally recognized by the Fund at the date of this Agreement. Accordingly, in case this par value is reduced consistently with the Articles of Agreement of the International Monetary Fund by more than twenty per centum, such specific duties and charges and margins of preference may be adjusted to take account of such reduction; provided that the CONTRACTING PARTIES (i.e., the contracting parties acting jointly as provided for in Article XXV) concur that such adjustments will not impair the value of the concessions provided for in the appropriate Schedule or elsewhere in this Agreement, due account being taken of all factors which may influence the need for, or urgency of, such adjustments.

Rules relating between exchange rates and trade

IMF’s Articles of Agreement Article IV: Obligations Regarding Exchange Arrangements

Section 1. General obligations of members

Recognizing that the essential purpose of the international monetary system is to provide a framework that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth, and that a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability, each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. In particular, each member shall:

(i) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances;

(ii) seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions;

(iii) avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members; and

(iv) follow exchange policies compatible with the undertakings under this Section

IMF Rules relating exchange rates and trade

GATT Guideliness to Art II.6(a) (Approved by CP) 15 February 1980 (L/4938)

Assume a World with different exchange rate arrangements

. Allow undervalued countries to renegotiate especific tariffs

. CP ask IMF to calculate size of depretiation

. Undervaluation was more than 20%

. Basket of currencies of 85% of imports

. Period of analysis for size of depreciation:

rate of 6 months preciding the request x 6 months

preceding last bound (weighted avarage)

IMF’s Articles of Agreement Article IV: Obligations Regarding Exchange Arrangements

Section 3. Surveillance over exchange arrangements

(a) The Fund shall oversee the international monetary system in order to ensure its effective operation, and shall oversee the compliance of each member with its obligations under Section 1 of this Article.

(b) In order to fulfill its functions under (a) above, the Fund shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies. Each member shall provide the Fund with the information necessary for such surveillance, and, when requested by the Fund, shall consult with it on the member’s exchange rate policies. The principles adopted by the Fund shall be consistent with cooperative arrangements by which members maintain the value of their currencies in relation to the value of the currency or currencies of other members, as well as with other exchange arrangements of a member’s choice consistent with the purposes of the Fund and Section 1 of this Article. These principles shall respect the domestic social and political policies of members, and in applying these principles the Fund shall pay due regard to the circumstances of members.

IMF Rules relating exchange rates and trade

- Create a world currency - Negotiate a fluctuation band

- Solve the conflict bilaterally

A NEW PROPOSAL

Exchange Rate Misalignment Bands

-4

-3

-2

-1

0

1

2

3

4

Jan-

60Ap

r-61

Jul-6

2Oc

t-63

Jan-

65Ap

r-66

Jul-6

7Oc

t-68

Jan-

70Ap

r-71

Jul-7

2Oc

t-73

Jan-

75Ap

r-76

Jul-7

7Oc

t-78

Jan-

80Ap

r-81

Jul-8

2Oc

t-83

Jan-

85Ap

r-86

Jul-8

7Oc

t-88

Jan-

90Ap

r-91

Jul-9

2Oc

t-93

Jan-

95Ap

r-96

Jul-9

7Oc

t-98

Jan-

00Ap

r-01

Jul-0

2Oc

t-03

Jan-

05Ap

r-06

Jul-0

7Oc

t-08

Jan-

10Ap

r-11

Jul-1

2

Normalized PPP - Trade weight world basket

United States Brazil Australia Austria Belgium Canada

China France Germany India Italy Japan

South Korea Mexico Netherlands Spain Sweden Switzerland

United Kingdom Malaysia +- 2 S.D. +- 1 S.D.

Brazil – Bilateral Misalignments

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

2000 2002 2004 2006 2008 2010 2012

% r

elat

ive

to e

quili

briu

m

Brazilian Bilateral Real Exchange Rate Misalignment

Argentina Australia Austria Belgium Brazil Canada

China Colombia Denmark Finland France Germany

Greece Hong Kong Ireland Italy Japan Korea

Mexico Netherlands New Zealand Norway Portugal Singapore

Spain Sweden Switzerland United Kingdom United States Uruguai

South Africa Indonesia Turquia

US – Bilateral Misalignments

-55%

-45%

-35%

-25%

-15%

-5%

5%

15%

25%

35%

45%

55%

2000 2002 2004 2006 2008 2010 2012

% r

elat

ive

to e

quili

briu

m

United States Bilateral Exchange Rate Misalignment

Argentina Australia Austria Belgium Brazil Canada

Colombia Denmark Finland France Germany Greece

Hong Kong Ireland Italy Japan Korea Mexico

Netherlands New Zealand Norway Portugal Singapore Spain

Sweden Switzerland United Kingdom United States Uruguai South Africa

Indonesia Turquia

Substantial and persistent exchange rate misalignments affect the effectiveness of trade instruments negotiated at the WTO. Therefore, they must be object of WTO regulation

Juridical concept of time x economic concept of time

(time of violation x time for long run equilibrium)

In summary:

The WTO must address the effects of exchange rate misalignments or misaligned exchange rates will turn the WTO into a juridical and economic fiction !!!

34

Conclusions