Exchange Rate Regimes andGlobal Imbalances

Kuala Lumpur, 28 March 2006

An Overview

Andrew Sheng

Tun Ismail Ali Chair in Monetary and Financial Economics,

University of Malaya

Global Prices, Flows and Balance Sheet Effects

• The Exchange Rate is both a price and policy tool. In theory, the exchange rate balances the trade and capital account flows between a country and the rest of the world. The balance sheet changes because of exchange rate as asset price (valuation changes) and flows.

• Four types of global flows:-– World trade in goods and services is already US$11 trn in 2004. – FDI flows of US$648 bn in 2004– FPI flows of US$4,213 bn in 2004 (CPIS data for top 10)– Gross daily turnover of FX of US$1.9 trn in 2004, derivatives

trading of US$5.7 trn (BIS Triennial Survey 2004)

• Central Bank holdings of FX reserves in 2003 reached US$3 trn. Global gross external assets amounted to US$37.9 trn, of which EMC accounted for 4.9%), up 12 times gross external asset of US$3.1 trn in 1980 (of which EMC 3.7%)

Globalization is accelerating, but imbalances have also grown in size

Source: IMF WEO

Exchange Rate Regimes: Classification

Source: Ghosh, Gulde & Wolf

Can be subject to attacks

Limits volatilityMixes market with limits

Bands

Also target for speculative attacks

Combines stability with flexibility

Rule-based system

Crawling peg

Provides target for speculative attack

Basket reduces volatility

Single or basket peg

Traditional Peg

Asymmetric shock on members

Reduces exchange ratevolatility

Safety in numbers

Monetary Union

Tough to maintain

Impose fiscal & productivity discipline

Fixed exchange regime

Currency Board

ERR not tool against shocks

Borrowed currency credibility

Foreign legal tender

Dollarization

ConsProsFeaturesRegime

Real vs.. Nominal Exchange Rates

Real Exchange Rate =

Price of Tradable Goods_________________________Price of nontradable goods

RER is a proxy for degree of competitiveness. Decline in RER implies real exchange rate appreciation or deterioration in competitiveness.

Source:Sebastian Edwards: Exchange Rate Misalignment in Developing Countries, World Bank 1988

Samuelson-Balassa Effect

The Samuelson-Balassa hypothesis states that the real exchange rate tends to appreciate in countries experiencing rapid growth. This is because productivity improvement is more rapid in countries with higher growth rates than those with lower ones.

In faster growing countries, technological progress is biased toward the tradable sector, leading to a rise in the economy-wide real wage. This creates an an increase in the price of nontradables relative to tradables.

The result is that real exchange rate rises for fast growing economies.

The Washington View • ﾒ .... the choice of appropriate exchange rate

regime, which, for economies with access to international capital markets, increasingly means a move away from the middle ground of pegged but adjustable fixed exchange rates towards the two corner regimes of either flexible exchange rates or a fixed exchange rate supported, if necessary, by a commitment to give up altogether an independent monetary policy. ﾓ Lawrence H. Summers (2000), p. 8.

• for countries open to international capital flows: (i) pegs are not sustainable unless they are very hard indeed; but (ii) that a wide variety of flexible rate arrangements are possible; and (iii) that it is to be expected that policy in most countries will not be indifferent to exchange rate movements. Stan Fischer (2001)

The Fischer View 1. In the last decade, share of both hard pegs and floating gaining at the

expense of soft pegs. 2. Main reason is that soft pegs are crisis-prone and not viable over long periods.

This is primarily due to the logic of the impossible trinity. 3. Polarization is towards currency boards, dollarization, or currency unions on

one side, and towards a variety of floating rate arrangements, including managed floating, on the other.

4. As exchange rate flexibility increases, a country needs to determine the basis for its monetary policy. The record of inflation targeting has been a good one in this regard.

5. The choice between a hard peg and floating depends in part on the characteristics of the economy, and in part on its inflationary history. The choice of a hard peg makes sense for countries with a long history of monetary instability, and/or for a country closely integrated in both its capital and current account transactions with another or a group of other economies.

6. An exchange rate peg can and has been successfully used to disinflate from high inflation, without a crisis, but it is important to exit from the peg during the process. That is most easily done under pressure to appreciate.

7. When misalignments among big three currencies become extremely large, the authorities tend to intervene to try to move exchange rates in the direction of equilibrium. This is loose and informal system, with no commitments to

numerical ranges, as there would be in a formal target zone system.

Global Imbalances: AVERAGE CURRENT ACCOUNT BALANCES IN US$Bn

SOURCE: IMF

-16NA-6-5+5-101970-1979

-64NA-13-21+11-12-301980-1984

-73-5+8-7+73+68-1341985-1989

-102+50-62+97+36-821990-1994

-52+20+35-50+102+167-1691995-1999

-137+30+96+126+104+167-4032000-2001

MEMO: WORLD

OF WHICH CHINA

DEV. ASIA

LDCSOF WHICH JAPAN

OTHER HDCS

USPERIOD

Global Imbalances - Four Historical Episodes -

• 19th Century classic gold standard, adjustment through gold flows, no role for monetary policy.

• Interwar years: failed gold standard as surplus countries (US, France) imposed burden of adjustment on UK and Germany, so burden of deflation and recession.

• Bretton Woods I: adjustment between surplus and deficit countries through IMF assistance under fixed rate system. Broke down when US abandoned gold link and became inflationary 1965-71

• Managed Floating: abandonment of exchange controls, and adjustments have been a combination of exchange rate, relative prices and domestic expenditure

Conclusion: Past collapse was due to fundamental flaws and pursuit of inappropriate policies by major countries. No need for policy coordination and reinvent Bretton Woods

Michael Bordo (May 2005)

Regional Features Compared: Asia is still smaller than NAFTA & EU

Germany accounts for 22% of regional GDP and 19% of total financial assets

25 +

US$11.7 trn

4 mn sq. km

460 mn

EU

Japan accounts for 57% of regional GDP and 65% of total financial assets

US accounts for 87% of the regional GDP

Concentration

153No. of members

US$7 trnUS$12.9 trnGDP

15 mn sq. km.21 mn sq. kmArea

2 billion430mnPopulation

East Asia(ASEAN+3)

NAFTARegional Features

Structural Imbalances persist despite high volatility of exchange rates

1. US imbalances growing while Japanese surplus remains strong

2. EU trade balance with US has remained stable at roughly US$100 bn despite wide FX swings

3. Asians fear sharp swings in exchange rates would be destabilizing.

4. Pre-crisis, developing Asia in deficit, strong surplus post-crisis to build up reserves against future crisis.

5. China’s surplus is growing, but much of exports are from US, EU, Japan, Korea and other companies operating out of China

6. Do you blame imbalances on host country or home countries in terms of ownership of exporters?

Current Account Balances 2004 - Deficits are largely in Anglo-sphere

Anglo Sphere (a) Asia

Total US Euro Japan China Other area East Asia

% of GDP -4.7 -5.7 0.5 3.7 4.2 6.3

US$ billion -734 -668 47 172 69 118

(a) Australia, Canada, New Zealand, United Kingdom, United States

Source : IMF, MacFarlane, Reserve Bank of Australia

US External Position - from world banker to venture capitalist

• US went from net creditor position (10% of GDP in 1952) to net debt position (-26% of GDP) by 2003

• End 2004, US net external debt (with FDI at market value) was US$2.5 trillion or 22% of US GDP. Foreign assets of US$10 trn (85% of GDP), liabilities of US$12.5 trn (107%)

• 70% of US foreign assets are in FX, but all liabilities in US$. 10% US$ depreciation transfers 5.9% of US GDP to US.

• Over period 1952-2003, average real rate of return on asset (5.72%) higher than average real rate of return on liabilities (3.61%), averaged 2.11%.

• Since 1973, average asset return increased to 6.82%, liability cost was 3.5%, leading to increased excess return of 3.32%.

• 2% excess return allows US to accumulate debt exceeding assets by 30% and still have excess income.

• But leverage (liabilities greater than assets) reaching 1.34 in 2004 may be reaching tipping point.

Source: Gourinchas and Rey, Sept 2005

US External Position - from world banker to venture capitalist

• US went from net creditor position (10% of GDP in 1952) to net debt position (-26% of GDP) by 2003

• End 2004, US net external debt (with FDI at market value) was US$2.5 trillion or 22% of US GDP. Foreign assets of US$10 trn (85% of GDP), liabilities of US$12.5 trn (107%)

• 70% of US foreign assets are in FX, but all liabilities in US$. 10% US$ depreciation transfers 5.9% of US GDP to US.

• Over period 1952-2003, average real rate of return on asset (5.72%) higher than average real rate of return on liabilities (3.61%), averaged 2.11%.

• Since 1973, average asset return increased to 6.82%, liability cost was 3.5%, leading to increased excess return of 3.32%.

• 2% excess return allows US to accumulate debt exceeding assets by 30% and still have excess income.

• But leverage (liabilities greater than assets) reaching 1.34 in 2004 may be reaching tipping point.

Source: Gourinchas and Rey, Sept 2005

Is US External Position unsustainable? US Congress research

• As long as US assets yield higher risk-adjusted return than foreign assets, foreigners will buy US assets.

• EU area holds 53% of wealth in home assets and 10% in US assets, whereas Japan hold 63% in home assets and 4% in US assets.

• Trade alone won’t solve deficit. Truman estimates that if current account reaches 6% of GDP, net income payments will be 4.5% of GDP, so trade deficit accounts for 1.5% GDP

• 2000-2004, US earned 9.6% on foreign assets, and paid 0.9% of foreign liabilities.

• Obstfeld + Rogoff (2004)- US$ need to depreciate 14.7%-33.6% for elimination of CA deficit.

• Blanchard, Giavazzi + Spa (2005) - depreciation of 56% for CA deficit to go to 0.75% of GDP.

• Edwards (2005), US net debt would reach 60% of GDP by 2010, CA deficit would peak at 7.5% of GDP in four years. Real value of US$ need to decline by 21% in first three years.

Source: Labonte, Congress Research Service, Dec 2005

Some Chinese Views on Global Imbalances

Four factors why RMB revaluation will not help reduce US-China trade deficit

• 55% of Chinese exports are in processed trade, with imports from Japan, South Korea and Taiwan (revaluation will make imports cheaper)

• Export-tax rebate, now account for US$24 bn or one quarter of China’s trade surplus with US. Removing this would be equivalent to revaluation

• Large labour surplus would still ensure export competitiveness.

• FDI inflows make Chinese exporters consistently more productive and competitive

Domestic considerations:-• Internal financial markets and banking system still

undergoing restructuring - risks not small• China being large economy, changes to internal structure

would have to take place before further liberalization

Li-Gang Liu (March 2005)

Impediments to Asia adjusting its

structural imbalances • High Asian savings are a demographic story of a young

educated work force accumulating savings during its high growth stage. But parts of Asia is also aging.

• Two reasons why domestic expenditure cannot rise faster:-– After Asian crisis, huge cut back in fiscal

expenditure, especially social infrastructure which are badly needed. Emphasis was on FX-earning exports to build up reserves against future crisis

– Asian financial systems are not as developed as EU/US, being too fragmented, lacking breadth and depth in skills, liquidity and institutional strength (property rights infrastructure)

Raguram (IMF) October 2005• US running current account deficit of 6.25% of GDP

and over 1.5% of world GDP, requiring financing equivalent to 70% of global capital flows.

• In OECD countries, government savings have dropped (esp. US Japan), while householder savings disappeared with housing boom.

• Emerging markets running current account surpluses, so world needs two kinds of transition: – Consumption needs to move to higher investments, especially

in EMC, oil producers and low-income countries– Demand from deficit countries need to move to surplus

countries

• Two greatest worries - – US will slow abruptly– Financing of US deficit will change. US current account deficit

is financed by foreign private investors, while US private investments abroad are financed by foreign central banks.

Global Imbalances - Five Views• Deutsche Bank's "Bretton Woods Two": No need to change

fiscal balances, current account balances or exchange rates.• Ron McKinnon: the US fiscal deficit is the problem but the

Chinese/Asian currencies do not need to move.• Fed's views: the US current account deficit derives from a "

global savings glut" rather than a lack of US savings. US fiscal deficits may be a problem but their reduction may not shrink a US current account deficit whose source is foreign, not domestic. Global savings glut will continue due to the high growth and returns of the US.

• Richard Cooper's View: the current account is sustainable as foreign investors love to invest into safe US assets; also a Chinese currency move is inappropriate as it would seriously hurt China's growth.

• Roubini and Setser (and consensus view): global rebalancing requires both US fiscal adjustment (and private savings increase) and a Chinese/Asian currency appreciation.

Source: Nouriel Roubini, May 2005

Global Assets Under Management (US$ trillion end 2003)

International Banking Assets (BIS data) 23.6International debt securities

14.6Insurance companies

13.5Pension Funds

15.0Investment Companies

14.0Hedge Funds

0.8Other Institutional Investors

3.4Total: 84.9

Memo: OTC Derivative Contracts (notional) 270.1

Source: BIS, IMF

International Monetary Fund, total quota (capital) of SDR213 bn (USD306 bn), 184 members (2005 data)

World Bank (International Bank for Reconstruction and Development), capital US$38.6 bn, assets US$222 bn

Other development banks, ADB, African Development Bank, EBRD, Inter-American Development Bank etc

Bank for International Settlements (BIS), owned by member central banks, equity of US$14.9 bn and US$260.5 bn assets

Total asset size of these institutions (US$790 bn) is trivial (0.9%) compared with size of global financial assets of US$84.9 trn.

The Bretton Woods Architecture

The Bretton Woods Architecture was designed when the rest of world was recovering post-war, with US in dominant surplus position.

BW institutions could lend to help the rest of world adjust their net international position. OECD countries were basically in surplus and EMCs were in deficit. OECD countries control more than 50% of voting on BWIs.

With globalization and US running net credit position, BWIs do not have enough financial resources and influence to make US adjust like any non-US member.

Is the Bretton Woods relevant today?

IMF no longer can play role of lender of last resort (70% of IMF outstanding loans were to 3 countries).

Asian economies built up FX reserves that are 10 time larger than combined reserves of G-7.

Ratio of overseas assets and liabilities to GDP for G-10 countries rose from 70% in 1980 to 250% in 2003.

Since IMF resources too small, then its roles are to: -

Forum for discussion of global risks

Independent “ruthless truth-telling”

Monitor international balance sheets, look at ERR choices, and encourage countries to abide by their commitments to global stability through higher transparency.

Focus on balance sheets, not just flows.

Reform of IMF - Mervyn King Feb 2006

Globalization, financial innovation and changing international balance sheets have changed the Global Financial Architecture

Exchange Rates, Capital Flows and International Balance Sheets are now part of global relationships, made much more complex as US becomes net debtor

Important that everyone understand the important implications of this major shift in global balances.

Post Asian crisis effects are now coming home to roost. During the Asian crisis, the periphery was in crisis, the center was strong.

In this new era, the periphery has regained financial resource strength, but remains weak relative to the center in financial skills. The implications need to be thought through.

Concluding Thoughts

Thank youQuestions to as@andrewsheng.net