Chapter 5 Forex - JEAN PISANI-FERRYW -W-1 = B = BP + iF -iO pisani-ferry november 2012 21...

25/11/2012

1

pisani-ferry november 20121

Chapter 5

International 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)

pisani-ferry november 2012 2

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Outline

3.1 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 measurements

3.2 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 crises

3.3 Policies

• Financial openness

• Choosing an exchange rate regime

• Managing floating exchange rate


3.1 Issues






3.2 Theories





• Currency crises

3.3 Policies





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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 financial account

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, EA and Chinese balances of payment, 2010


Internal and external equilibrium

• Accounting link between current-account balance (external equilibrium) and the savings-investment balance (internal equilirium).

• 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 between income 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 saving and privateinvestment, the second the difference between government saving 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 domesticinvestment.

• In an open economy, investment can be financed by foreign saving – and thisimplies 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

1

97

3-I

V

19

75

-I

19

76

-II

19

77

-III

1

97

8-I

V

19

80

-I

19

81

-II

19

82

-III

1

98

3-I

V

19

85

-I

19

86

-II

19

87

-III

1

98

8-I

V

19

90

-I

19

91

-II

19

92

-III

1

99

3-I

V

19

95

-I

19

96

-II

19

97

-III

1

99

8-I

V

20

00

-I

20

01

-II

20

02

-III

2

00

3-I

V

20

05

-I

20

06

-II

20

07

-III

2

00

8-I

V

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, 1970-2009


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The balance of payments and exchange-rate regimes


Net financial inflows ∆Fin - ∆out > 0

Financial outflows

∆Fout

Financial inflows ∆Fin

Exports X

Imports M

Current account balance B = X-M < 0

Fall in foreign exchange reserve ∆R < 0

Exports X

Financial inflows ∆Fin

Decrease in foreign exchange reserves

∆R < 0

Imports M

Financial outflows ∆Fout

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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De facto exchange rate regimes: fear of floating?


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

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)pisani-ferry november 2012 16

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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 DiscrepancySource: Blanchard and Milesi-Ferretti (2010)

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

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Gross flows 1998-2008


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

Source: Milesi-Ferretti (2009)

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

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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 write

W - 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*


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 +5.9Effects of a 10% dollar exchange rate decline

+0.65 +0.06 +0.59


Example: US end 2004 (dollar trillions)

Source: adapted from Tille (2005) (would be good to update, but not trivial)

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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


Nominal and real effective exchange rates of the euro, 1995-2011


Source: ECB

80

85

90

95

100

105

110

115

120

125

Jan

-95

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 (

Jan

19

99

=10

0)

Nominal

Real

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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

1999Q1

1999Q3

2000Q1

2000Q3

2001Q1

2001Q

3

2002Q

1

2002Q

3

2003Q1

2003Q3

2004Q1

2004Q3

2005Q1

2005Q3

2006Q

1

2006Q

3

2007Q

1

2007Q

3

NEER

REER C PI

REER GDP Deflator

REER Produc er Pric es

REER UL C

Manufac turing

REER UL C TotalEc onomy

Real exchange rate within a monetary union may diverge: Spain vs. Germany 1999-2008


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3.1 Issues






3.2 Theories





• Currency crises

3.3 Policies





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


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PPP: short term and long term

Source : Taylor and Taylor 2004

The PPP and hyperinflation


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

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The PPP performs poorly in situations of moderateinflation

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

Development levels and deviations from PPP, 2010


PPP GDP per capita and real exchange rates in 2006

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euro area price level = 1

0.00.10.20.30.40.50.60.70.80.91.01.11.21.31.41.5

eu15

eu

ro IE

FI

LU

FR

N

L D

E

AT

B

E

IT

ES

G

R

PT

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)


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 << πT*

– Nontradables sector N (weight 1 - α) : services• Mobility implies wages is the same as in T : WN = WT

• No technical progress so productivity as in advanced countries πN = πN*

– Perfect competition implies zero profits

• Hence,– Wage is lower in developing country EW << W*

– Service prices are lower EPT << PT*

– PPP does not hold

E[PE αPN

1-α] << [PE* αPN* 1-α]

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Consequences

• Development leadsto real exchange rate appreciation

• True in Central and Eastern Europe

Source: DGTPE/Eurostat



But B-S does not seem to apply to China

Source: Cheung, Chinn and Fujii 2007

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The use of PPP for measurement purposes

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


Equilbrium exchange rate 2:

External flow equilibrium

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

• Under floating John Williamson (1983) revives these techniques and proposes to define a Fundamental Equilibrium Exchange Rate (FEER)

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

• It is therefore a normative, general equilibrium concept

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FEERs in a nutshell

• Macroeconomic approach: – Internal and external

equilibrium

– Internal: equilibriumunemployment (NAIRU)

– External : net structural capital outflow (inflow)

• This determines the Fundamental EquilibriumExchange rate Qe

GDP

Q

Internal balance

Externalbalance

Qe

Ye

Inflation + deficit

Unemployment + deficit

Unemployment

+ surplus

Inflation + surplus


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

ωω

−

−

=

==

QP

W

P

W

E

PPP

P

P

P

W

P

W

c

cc

c

*où 1

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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 =

FAQYYB FEER =)*,,(


FEER-based estimates of RMB undervaluation

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Volumes, values and the J curve

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

• Constant prices trade balance:

TB = X(Y*, Q) - M(Y, Q)

• Current prices trade balance:

TBV = PX - P*M/E

TBV = P(X - M/Q)

• It can be shown (see Appendix) that the current prices balance only respondspositively if the sum of price elasticities of exports and imports exceeds one

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


Empirical alternatives to the FEER

• Unlike PPP, the FEER approach encompasses the macroeconomic equilibrium

• 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 introduce more degrees of freedom

• They rely on equilibrium exchange rate theories to choose the long-rundeterminants 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

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The BEER

• Start from estimation of:

qt = βHt + τTt + εt

• Where q is the (log of the) exchange, rate H represents its long-termdeterminants (Net Foreign Asset Position, relative productivity) and T temporary factors (e.g. interest rate differentials)

• Eliminating transitory factors gives the equilibrium exchange rate :

st = βHt

• Unlike for the FEER approach there is no predetermined norm


Example: Clark-MacDonald 1998

Estimated equilibriumexchange rate

Market exchange rate

Overvaluation at t

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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 expectthe same return on both

• Realistic?

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

– For a euro area resident, is can the exchange rate risk involved in holding dollar-denominated assets be neglected?

– Are assets so perfectly substitutable?

• Leads to portfolio choice model


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 thereforedepends on relative returns

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Example: benchmark allocations

Source: The Economist


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 3.3Source : Burton Malkiel

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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 individualclasses:– Portfolio diversification in search of risk/return combination

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

This is the portfolio choice model


Example: bond yields, maturities and risk

Aaa

/AA

A

Aa

1/A

A+

Aa

2/A

A

Aa

3/A

A-

A1

/A+

A2

/A

A3

/A-

Ba

a1/B

BB

+

Ba

a2/B

BB

Baa

3/B

BB

-

Ba1

/BB

+

Ba

2/B

B

Ba

3/B

B-

B1

/B+

B2

/B

B3

/B-

Ca

a/C

CC

1 an3 ans

5 ans10 ans

30 ans

0

200

400

600

800

1000

Spreads corporate, 1/03/04

1 an

3 ans

5 ans

10 ans

30 ans

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Risk and decision

• How to represent behaviour in risky enviromnentHypotheses:• Utility increases with income but decreasing

marginal utility of income– U’(Y) > 0, U’’(Y) < 0

• Agent can either– Play and gain x with probability p [p = ½] and y with

probability (1 – p)– Do not play and receive (x + y) / 2

• Will she play? • Depends on attitude towards risk


Utility and income

• If the agent does not play her 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 is preferable not to play

• This is risk aversion

• Agent will prefer lower, but more certain income

• Would be the opposite with convexutility (e.g. profit) Income

Utility

A

B

x y

U(y)

U(x)

(x+y)/2

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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


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 =W0

2[(1 - x)2σi2 + x2 σi*

2 +2x(1 - x) σii*]

• Assume utility depends on expected wealth, variance

U = U[E(W), σ2W/2]

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A basic two-assets portfolio (2)

Maximising U yields:

[ ] ( )[ ]

*2*

222

*2

20

*2

*2*

2200

2

2 avec )(*)(

'

'~

:*asset of share optimal giveswhich

0)2(')(*)('

0''

iiiiiiiW

iiiiiiiW

W

SSS

iEiE

UW

Ux

xWUiEiEWUdx

dUdx

dU

dx

dWU

dx

dU

σσσσσ

σσσσσ

σ

σ

σ

σ

−+=−+−−=

=+−−++−=

=+=

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

θσσ

===

−+−=

xSiiE ~*)( 2θ+=

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30

What are equilibrium exchange rates for?


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:


eS

iSi

*)1()1(

+=+ esii &−= *

( )∑−

=+++ −+=

1

0

*T

e

tte

Ttt iissτ

ττ

implies

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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


Key dynamics


time

Exchange rate

Interest rate

Price level

Money supply

Overshooting

25/11/2012

32


0 (7)

* )6(

* )5(

)]()( (4)

)( )3(

* )2(

)1(

yy

p-peq

ppe

ppqqp

eee

eii

iypm

a

a

=+=

−=−+−=

−==−

−=−

µγθ

βα

&

&

&

The model

Log-linearised

stands for the long term value of XX


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 &&

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33


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


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 +−=

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Graphical solution

AA

AA’

PP

PP’

E’’

E’

e

p

p

'p

'e''e e

E

overshooting


The Dornbusch model: off-equilibriumaspects

• The only stable trajectory isthe saddle path AA

• The other trajectories are divergent

PP

p

e

p

AA

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35


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

Currency crises UPDATE

pisani-ferry november 201270

Source IMF

Crises since 1970

25/11/2012

36

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


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

1/200

1

01/0

3/20

01

01/0

5/200

1

01/0

7/200

1

01/0

9/20

01

01/1

1/200

1

01/0

1/200

2

01/0

3/200

2

01/0

5/20

02

01/0

7/20

02

01/0

9/200

2

01/1

1/20

02

01/01

/200

3

25/11/2012

37

Exchange rates and reserves


A balance-of-payments crisis: Pakistan 2008


Questions

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

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

– Do speculators coordinate among themeselves (and how)?

– Can / should policymakers resist speculation?

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

characteristics

– Different responses to the above questions

25/11/2012

38


A generic model

• 2 speculators, 1 central bank

• Each speculator can borrow up to 6 units of the national currency atcost 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 give up the fixed parity, E = 0.5 after devaluation

• If R =20 the central bank wins, if R =6 it loses, if R =10 two equilibriadepending on whether the speculators coordinate or not.

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


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 fixed exchange 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

25/11/2012

39


How the model works

• Reserves declinegradually until the crisis

• Shadow exchange rate evolves smoothly

• The crisis occurswhen the gain fromspeculation is nil

Forex reserves

Exchange rate

time

Underlying shadow exchange rate


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 financial assistance)

• Limits: model does not explain

− Attacks on currencies with ‘strong’ fundamentals

− Contagion

• Representation of government behaviour is simplistic (though sometimescorrect)

25/11/2012

40


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


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

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

• Hypothesis : the government declares it wants to keep the 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, beforeauthorities decide to devalue.

25/11/2012

41


Example

Hypotheses: • 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


Insights

• In 1992, French authorities did not understand why the currency was under attack in spite of low external deficitand low inflation

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

• ‘Psychoanalytic’ theory of the crisis (speculation revealsthe policymakers’ hidden desires).

25/11/2012

42


Implications and limits

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

• Policy implications:

– Exit clauses are costly because their used is being priced in by speculators;

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

• Limits : the crisis is still a rational crisis

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


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

• Principle: Because of multiple equilibria, the behaviour of speculatorsplays 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)

25/11/2012

43


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.


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

25/11/2012

44

3.1 Issues






3.2 Theories




• Currency crises

3.3 Policies





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 capitalmovements

Gold standard

Interwar Increasingly protectionist No stable arrangement

1944-1973

Increasingly liberal Capitalcontrols

Gold exchange standard, fixed-but-adjustableexchange 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)

25/11/2012

45

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

61

87

0-7

4

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

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


25/11/2012

46

a) Trade across borders and over time


US

RoW

Aircrafts TV sets

US

Row

Future savings Current savings

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’


25/11/2012

47

Intertemporal substitution in a two-periodmodel

• Financial openness allowsdissociating consumption and investment behaviour

• Instead of production possibilitiesschedule AA, budget constraint DD with

• Optimal consumption is E

• Intertemporal exchange is formallyequivalent to international trade


C1

C2

EB

D

Dr

YY

r

CC

++=

++

112

12

1

A

A

A

However no evidence of correlation of NFA with development level


25/11/2012

48

Worse: capital flowing uphill


Source Prasad et al.

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

Source: Prasad et al.

b) Shock absorption

• Benefits from openness

– Risk diversification through capital outflows

– Consumption smoothing in case of temporary income shocks

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

• Illustrated by US regions (Asdrubali, Sorensen and Yosha 1996). Channelsof absorption of shocks to primary income:

– Portfolio diversification: 39% of shock

– Credit………………………….. 23%

– Federal transfers…………. 13%

– Total……………………….…… 75%

• Suggests major benefits from financial openness


25/11/2012

49

Shock absorption or shock propagation?


0

100

200

300

400

500

600

700

80019

90

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

US

do

llar

bill

ion

s

Source: IMF, WEO database

Net private capital flows to developing

countries

Other private financial flows, net

Private portfolio flows, net

Direct investment, net

Financial opening, institutions and corruption

pisani-ferry november 2012 98Source Kose Prasad Rogoff et Wei 2006

25/11/2012

50

The political economy approach to financial openness


A

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


25/11/2012

51


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; intermediateregimes 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


Micro criteria

• Several monies =

– Transaction costs (« tax »)

– Exchange rate uncertainty

– Both imply blurred relative price signals

« Money is a convenience and this restricts restricts the

optimum number of currencies”

(Mundell, 1961)

25/11/2012

52


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 othereffects– Frankel-Rose: monetary union would multiply trade by 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


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

25/11/2012

53


The Poole approach

• If real demand shocks (IS shifts) dominate, bettercontrol money supply -> floating exchange rates

• If money demand shocksdominate (LM shifts), the opposite holds

Y0Y’LMY’II

ISIS’

II

LM

IS’


Exchange rate regime and economicperformance

Taux de croissance moyen du PIB et des prix selon l e 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)

25/11/2012

54


Implications

• The right exchange rate regime depends on 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 fixed exchange rates initially

• However exchange rate policy choices often exhibit(damageable) inertia


Credibility

• Major motive during the high inflation period. In the 1980s and the 1990s exchange rate policy often served as an instrument to foster disinflation:– European ERM countries

– Latin America

– CEECs

• Reason was often low internal credibility

• Fixed exchange rate served to « import » credibility

25/11/2012

55

Example: Argentina



A simple model

θγ

βθωββ

θωβ

βθωββ

θγ

θγωβ

≥++

+−

−+

=++

+−=

=>++−+=

=−+= −

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

ttaa

pyk

ykppyk

p

pykypL

pEpppyy

25/11/2012

56


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


Coordination

• Floating exchange rates involve risks of non-cooperativepolicies– Competitive depreciation if adverse demand shock

– Competitive appreciation if adverse supply shock

• Fixed exchange rate = institutionalised coordination

But

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

25/11/2012

57


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


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 necessarily coincideswith political geography

– supranational currency

– regional currency?

25/11/2012

58


Monetary borders in North America

Eastern D

ollar

Wes

tern

Dol

lar

Canadian Dollar

U.S. Dollar

Forestry Car-making

Canada

United States


Flexible exchange rates or monetary union between two ‘regions’?

Costs, benefits

Integration

Benefits

Costs

Flexible exchange rates Monetary union

Asymmetries

Adjustments

25/11/2012

59


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 to shocks

• Econometric methods

• Panel regressions

• Same criticism applies

• VAR (Bayoumi-Eichengreen) addresses identification problem

it

it

it tiyy εβα ++=− − )()(1

=

−−

∑∞

=st

tt

iii

iii

t

t

aa

aaL

pL

yL

εε

0 2221

1211

)1(

)1(

Evidence on the euro area


Share of country-specific shocks in explaining output fluctuations

Source: Giannone and Reichlin (2006)

25/11/2012

60


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 ?


Taking stock: Europe compared to the US benchmark

– Shocks of roughly similar magnitude

– Less powerful adjustment mechanisms

Evolution

– Schocks : vicious cercle (Krugman) or virtuous cricle(Frankel - Rose) ?

– Ajustement : slow improvement or perverse evolution?

25/11/2012

61

Managing exchange rates

• Longstanding controversy on the effectiveness of foreign exchange intervention

• Mixed evidence depending on:– Capital mobility

– Timing of interventions

– Goals of interventions


Chinese interventions


25/11/2012

62

Japanese interventions


0

200

400

600

800

1000

1200

1400

01-ja

nv-03

14-ja

nv-03

27-ja

nv-0

3

7-Feb

-03

20-F

eb-0

3

05-m

ars-0

3

18-m

ars-0

3

31-m

ars-0

3

11-A

pr-03

24-A

pr-0

3

7-M

ay-03

20-M

ay-0

3

02-ju

in-03

13-ju

in-03

26-ju

in-03

09-ju

il -03

22-ju

il-03

4-Aug

-03

15-A

ug-0

3

28-A

ug-0

3

10-se

pt-03

23-se

pt-03

06-oct-

03

17-o

ct-03

30-o

ct-03

12-n

ov-03

25-no

v-03

8-Dec

-03

19-D

ec-03

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)B

aiss

e (+

) ou

hau

sse

(-)

du y

en

Appendices


25/11/2012

63


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-prix

du commerce extérieur

ην

εµ

QYM

QYX

=

= −*


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

25/11/2012

64


Marshall-Lerner in practice

Source : Coudert et Couharde 2005


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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