This Document Contains Chapters 19 to 21 INTRODUCTION This is the first of two chapters covering exchange rate issues. It contains considerable preliminary material on definitions etc. but has enough interesting ideas to keep it from being too dry. Even though the balance of payments is always quite heavy going, most students do appreciate the opportunity to understand concepts that they have read about in newspapers etc. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER To put exchange rate determination into context, it may help to start with the material at the beginning of Chapter 20 on the size of the FX market. CHAPTER GUIDE 19.1 Types of Exchange Rate. Historically, Sterling, The Euro, The Australian and New Zealand dollars were quoted in terms of US dollars per unit of local currency because one unit of these currencies was worth more than one US dollar. Now only sterling and the Euro are worth more than one dollar (and the Euro was below 1 dollar for much of its short history). 19.2 Law of One Price. Recent estimates of the border effect suggest that the price differences between Japan and the US are equivalent to a pure distance effect of 43 trillion miles! (i.e. prices differ by as much as you would expect between two places in the same countries that are 43 trillion miles apart). 19.3 Purchasing Power Parity. The OECD also publishes estimates of PPP (based on a basket of goods, not just Big Macs!). Note how poorer countries tend to look undervalued relative to their PPP rates in both the Big Mac and OECD figures (e.g. the Chinese Yuan is worth roughly half its Big Mac rate). This is due to the Balassa Samuelson effect. 19.4 The Balance of Payments. Another useful balance of payments definition is the Basic Balance. This is the current account plus long term capital flows (i.e. FDI and Portfolio flows). It is an important figure if you think 1) that shorter term flows (e.g. short term bank lending) are more likely to leave rapidly (they are often called ‘hot money’) 2) that longer-term flows such as FDI are more growth enhancing (see Background Material to Chapter 5). If these propositions are valid, countries with a large current account deficit but a basic balance near zero or in surplus do not have an underlying balance of payments problem (see the Case Study on Chile). CHAPTER 19: EXCHANGE RATE DETERMINATION I This Document Contains Chapters 19 to 21 The IMF has calculated that adding together all the world’s current accounts produces an overall deficit of about $40 billion. Unless some countries are engaging in extra-terrestrial trade, this is an indication of errors in data collection. The Background Material contains further information on the global balance of payments. 19.5 Who is Rich and Who is Poor? The Case Study on Chile shows how the acquisition of foreign debt can actually be good for growth. The experience of highly indebted countries is less favorable (see Case Study to Chapter 7). 19.6 Current and Capital Accounts and the Real Exchange Rate Note that the rise in Germany’s real exchange rate around the time of German Re-unification was one of the key underlying causes of the ERM crisis. Other European countries pegged to the DM could not justify a comparable exchange rate appreciation. CASE STUDY: THE REAL PROBLEM WITH THE EURO. It is arguable that the current problems experienced by a subset of Euro-area countries related to their lack of competitiveness. What evidence is there for this view? If it is true, how did it come about? Exhibit 1 shows the relationship between relative price levels and GNI per capita (see figure 19.6) for a number of European countries either in the Euro or applying to enter the euro. Countries on the right of the line have, arguably, overvalued real exchange rates (and vice versa for those on the left) Exhibit 1: EXCHANGE RATE VALUATION: SELECTED EUROPEAN COUNTRIES Ratio of Market Real Exchange Rate to PPP rate (2010) Current account data seem to support this interpretation (overvalued countries have large deficits) Poland Belgium Cyprus Czech Finland France Germany Greece Hungary Ireland Italy Malta Netherlands Portugal Slovak Slovenia Spain y = 36789x - 17988 R² = 0.919 GNI Per Capita ($ 2000) PPP Market Exchange Rate Ratio Exhibit 2: Current Account Balances (% of GDP) 2011 Exhibit 3 suggests that it was higher inflation post EMU entry that was the course of these overvaluations Exhibit 3: Total increase in Consumer Prices since the introduction of the Euro And the developing overvaluations may explain the low growth in some euro countries post 2005 Exhibit 4: Average Growth since the introduction of the Euro and since 2005 Discussion Questions 1) Is exchange rate competitiveness the key problem within the Euro-Area? 2) Why has inflation continue to vary within the Euro-area? 3) What action can policy-makers take to deal with differences in competitiveness with the euro-area? Background Material THE GLOBAL CURRENT ACCOUNT The table below shows the global current account which, of course, should be in balance. Although the global current account deficit seems to be declining (there was even a surplus in Average Growth since 1999 Average Growth since 2005 1997), this is not due to an overall improvement in data collection but simply to increasing and offsetting errors in the income balance and the trade balance figures. The Global Current Account ($bn) 199 1 199 2 199 3 199 4 199 5 199 6 199 7 199 8 Averag e 1991- 98 Current Account Balance -102 -102 -62 -36 -34 -19 32 -37 -45 Trade Balance 33 39 67 97 115 98 117 80 81 Services Balance -40 -28 -18 -4 -13 -1 17 12 -9.6 Income Balance -65 -70 -67 -74 -88 -84 -83 -109 -80 Current transfers balance -30 -42 -44 -56 -48 -31 -19 -20 -36 Source: IMF Additional Questions Question 1) The Table below shows balance of payments data for Sri Lanka in 2001 ($ million). a) Fill in the cells marked y) and z) b) How could have Sri Lanka financed its overall balance of payments deficit Balance of Trade -1406 Capital Account 55 Balance of Services 272 Net direct Investment 252 Investment Income -251 Net Portfolio Flow 2 Net Transfers 1097 Net Other -456 Current Account y) Errors & Omissions z) Overall Balance -331 Answer 1a) y) = -290 (simply the sum of all the figures above) z) = 106 (overall balance - current account - sum of all figures above errors & omissions) Answer 1b) It could run down its FX reserves or get some financing from the IMF Question 2) Look at the chart of Malawi’s real and nominal effective exchange rate (REER and NEER respectively). Describe what is happening to Malawi’s inflation rate and overall competitiveness Malawi: real and nominal effective exchange rate REER NEER Source: EcoWin 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 Index Number 0 250 500 750 1000 1250 1500 1750 Answer 2) Over the period 1980 to 2000, Malawi’s inflation rate is clearly far higher than that of its trading partners, thus the NEER declines sharply whilst the REER declined only marginally. However, the fact that the REER is declining indicates that Malawi’s competitiveness is improving (though in periods of high inflation, price mis-measurement may be a problem) Answers to Analytical Questions Chapter 19 Exchange Rate Determination I: The Real Exchange Rate 1. Assume that the effective exchange rate was at level 100 at the start of year 0. We assume also that exchange rates are quoted as units of domestic currency against the US dollar. By the end of year 2 the currency of the Republic of Oz is at the same rate as at the start (having risen by 4% in value and then depreciated by 4%). The currency of the FTS is 5% higher. In other words the US dollar has depreciated by 5% against the FTS currency. The currency of the Banana Republic has fallen in value by 17% - the dollar has appreciated by 17%. Given the relative weights of trade the effective exchange rate index of the US dollar has changed by: 0.30 x 0% + 0.25 x -5% + 0.45 x 17% = -1.25% + 7.65% = +6.4% So the index is at 106.4 at the end of year 2. 2. PPP implies that the same commodity costs the same in each currency. Here we have 6 commodities so there are potentially 6 different estimates of the PPP exchange rate. The implied PPP rates (measured as units of currency of the Republic of Oz per unit of currency of United States of Albion) are: 1. Gasoline PPP rate 180/120 = 1.5 Meat PPP rate 140/80 = 1.75 Books PPP rate 33/20 = 1.65 Fruit Juice PPP rate 40/40 = 1.0 Coffee PPP rate 10/15 = 0.67 Clothes PPP rate 160/70 = 2.29 Clearly there is great variability in these estimates. This could reflect variations in transportation costs, tariffs or other import barriers. The average of the above, which is probably the best estimate in the absence of further information, is 1.48. 3. i) With a capital account deficit of 3% GDP per year and no growth, capital gains or change in the exchange rate after one year the IIP is 3% GDP, after 2 years it is 6% and 3 years it is 9%. ii) After 1 year the IIP is 3% but this earns a capital gain of 10% plus there is the new capital account deficit of 3% so that at the end of Year 2 the IIP is 6.3%. Using the same logic the end of Year 3 sees an IIP of 9.93% GDP. iii) Because the foreign currency now appreciates by 10% per annum the return on overseas investment is now 20% (10% capital gain plus 10% appreciation) so that the IIP position is 3%, 6.6% and 10.92% GDP. 4. a. A fall in European investment, unless it is matched by a decline in saving, will increase net savings (ie. S-I will rise, where S is domestic saving and I is domestic investment). It follows that there must be a rise in X-M, exports minus imports. This will require a fall in the real exchange rate. Figure 1 illustrates. Figure 1 b. Net savings could depend positively upon the exchange rate if savings increase with the exchange rate or investment declines with the exchange rate. Either way the net savings schedule will be upward sloping, as illustrated in figure 2. Import controls can be expected to shift the net exports schedule to the right – at any exchange rate the level of net exports will be higher than in the absence of import controls. We show the impact of exchange controls in figure 2 by an upward shift in the net exports line. As the figure illustrates this has the dual effect of rising the exchange rate (from E0 to E1) and increasing net saving (ie raising net exports) from S0 to S1. Figure 2 Real exchange rate Fall in Investment Net exports X-M Net saving S-I E1 E0 Real exchange rate Import controls introduced Net exports X-M Net saving S-I E0 E1 S0 S1 5. With purchasing power parity there would be no change in the exchange rate following an investment surge. As figure 3 shows this means that the net exports schedule needs to be flat. If the demand for exports from overseas, or the demand for imports from overseas, were infinitely price elastic the net exports schedule would be flat and a surge in investment could generate a large change in net exports with no change in the exchange rate. For a small country producing goods for exports which were perfect substitutes with those produced in other countries the net exports schedule could be virtually flat. Figure 3 Real exchange rate Rise in Investment Net exports X-M Net saving S-I E0 INTRODUCTION This chapter introduces some tough concepts such as uncovered interest rate parity. However, the material is empirically very relevant so that creating interest in these concepts should be no problem. Getting students fully to understand them may prove a trifle more difficult. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER This chapter has two distinct sections - UIP and currency crises - which could be covered in two separate lectures. For example, UIP could be discussed along with the material in Chapter 19. CHAPTER GUIDE 20.1 The Importance of Asset Markets. The introduction of the Euro has probably resulted in a decrease in total turnover in the FX market. The Background Material shows some estimates of turnover in the DM and Euro. 20.2 Covered Interest Parity. The Background Material shows a real example of forward rates based on the market convention of quoting forward points. 20.3 Uncovered Interest Parity. FX trades that involve borrowing a low interest rate currency and investing in a high interest rate one are called ‘carry trades’. This is because you earn more interest on the investment than you have to pay on your borrowings and even if the exchange rate doesn’t move, you still earn the ‘carry’. In recent times, borrowing Japanese Yen (0% interest rates) and investing in US dollars (5% interest rates) has been a popular carry trade since Japan’s current economic weakness leads many to think that the Yen is unlikely to appreciate against the dollar. 20.4 Pinning Down the Exchange Rate with UIP. This is one of the toughest sections in the book and students who struggle with it are going to be mortified to learn that it doesn’t work in practice! 20.5 The Role of Expectations. The Background Material shows some diagrams relating to the effect of nominal and real interest rate increases 20.6 Does UIP Hold? In order to minimize the disappointment that students could feel when UIP is shown not to work, it may be worth pointing out the up-side i.e. this is a money- making strategy. 20.7 Introducing Risk-Averse Investors. Another way to look at this issue is to ask students whether the excess returns shown in the chart below are worth the volatility. CHAPTER 20: EXCHANGE RATE DETERMINATION II 20.8 What Are Exchange Rate Markets Really Like? Although many economists dismiss technical analysis (the study of charts for certain patterns that are supposed to predict future movements), there is some evidence that it actually works. For further information on technical analysis see Neely(1997) “Technical Analysis in the Foreign Exchange Market: A Layman’s Guide” Reserve Bank of St Louis Review Vol. 79 no. 5. 20.9 Global Capital Markets The second case study looks at Malaysia’s experience with capital controls. 20.10 A Home Bias Puzzle The fact the people are exposed to their own economy both through their labour income and through non-financial assets such as housing makes the home bias puzzle in financial assets even more puzzling CASE STUDY: DOES FOREIGN EXCHANGE INTERVENTION WORK? What is foreign exchange intervention? In its simplest form, foreign exchange intervention involves a Central Bank buying currency A and selling currency B with the aim of increasing the value of A against B. When currency A is the local currency, the Central Bank must run down its reserves of foreign exchange in order to buy its own currency. If it is trying to weaken it own currency, it builds up its foreign exchange reserves by selling its own currency. However, within that simple definition, there are many different forms of intervention. Below is a list that is ordered roughly in terms of effectiveness. 1) Unsterilized intervention. If a Central Bank is supporting its own currency by purchasing it using foreign exchange reserves, this will tend to reduce the money supply. If the Central Bank does nothing else (i.e. leaves the intervention unsterilized), the reduction in the money supply will increase interest rates – potentially, quite sharply. Clearly, this form of intervention - combining foreign currency intervention with interest rate changes - can be very effective. 2) Sterilized intervention. In the majority of cases, foreign exchange intervention is sterilized. The purchase of domestic currency with foreign exchange will be followed (two days later when the FX transactions settle) by the open market operation of buying domestic bonds to increase the money supply by an offsetting amount. This open market operation is said to ‘sterilize’ the money supply impact of FX intervention. The following – highly stylized – Central Bank balance sheet helps show the difference between sterilized and unsterilized intervention. Simple Central Bank Balance Sheet Assets Liabilities FX reserves Money Government Bonds Since the balance sheet has to balance (assets = liabilities), if the central bank changes FX reserves (i.e. undertakes FX intervention it must change some other part of its balance sheet as well. In unsterilized FX intervention, the change in FX reserves leads to an equal change in money supply (so an increase in FX reserves leads to an equal increase in money supply). In sterilized intervention, the Central Bank simply reconfigures the asset side of the balance sheet leaving total assets (and so total liabilities) unchanged. This means that an increase in FX reserves is offset by a decrease in holding of domestic assets (government bonds) and vice versa for a decrease in FX reserves. 3) Concerted Intervention. Since Central Banks and Finance ministries around the world are in constant contact, two or more Central Banks may choose to intervene in a certain currency together. The purpose of such concerted intervention is to demonstrate international agreement that a certain currency is out of line. G7 meetings are traditionally the venue where such agreements are made. 4) Overt or Reported intervention. Since a Central Bank only undertakes foreign exchange intervention with counterparties who are required not to reveal that the transaction has taken place, it can elect whether or not to reveal its own intervention activity. In recent years, almost all intervention in the major currencies has been overt. 5) Covert or Secret intervention. A Central Bank will sometimes choose not to reveal that it has intervened. It may so decide if it feels that foreign exchange market participants are concerned that foreign currency reserves are falling dangerously low. Is Foreign Exchange Intervention Effective? For many years, the general view of foreign exchange intervention was that unsterilized intervention could influence exchange rates but that sterilized intervention could not. In a foreign exchange market that trades over $1 trillion a day, it was argued, a few billion dollars of foreign exchange intervention is neither here nor there. The evidence for this notion lies in currency movements on a day of unsterilized intervention. There is often a tendency for the exchange rate to react initially but to fall back to its original level by the end of the day. However, as the charts below show, over longer horizons intervention does appear to work. In the major currencies at least, Central Banks have tended to buy currencies when they were low and sell them when they were high. Thus, if we use the simplest measure of effectiveness – whether the currency intervention was profitable for the Central Bank – sterilized intervention has been largely effective over the long term. In detail, the charts below show periods of dollar buying (lighter shaded) and dollar selling (darker shaded) against the Japanese Yen and German DM. Although the shaded areas show when the period of intervention began and ended, there were only a few days of actual intervention in each period. In the case of Dollar/Yen, intervention has been quite common (the Japanese authorities have long aimed to stabilize this exchange rate) and conducted over long periods. However, the chart shows how most periods of intervention were eventually followed by exchange rate moves in the desired direction so that the Bank of Japan has generally made a profit from its intervention. Intervention in Dollar/DM has been more infrequent, but does seem to have been successful. Furthermore, the recent intervention by the ECB to support the Euro (shown at the end of the chart) does appear to have succeeded. Intervention History: Dollar/Yen Source: EcoWin 8889909192939495969798990001 80 90 100 110 120 130 140 150 160 Intervention History: Dollar/DM Source: EcoWin 8889909192939495969798990001 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 Despite this successful longer-term record, economists and policy-makers are still unclear about what factors determine the success of sterilized intervention. Generally, it is felt that intervention is more successful if it is concerted and/or signals a future change in monetary policy. Allocation of Foreign Exchange Reserves. In order to be prepared to undertake foreign currency intervention, most Central Banks hold large amounts of foreign currency (usually invested in the government bonds of the relevant foreign country). As the table below shows, Far East economies in particular tend to hold large amounts of foreign currencies. Foreign Exchange Reserves: Selected Countries 1999 Country Gross Reserves US$ billion Import Cover (months)* Australia 21.6 2 Brazil 37.8 5 Canada 37.2 1 China 297.7 10 France 61.7 2 Germany 89.1 1 Japan 469.6 13 Mexico 50.7 3 Mozambique 0.8 5 Russia 48.3 6 United Kingdom 42.8 1 United States 157.8 1 Zimbabwe 0.1 0 * Import Cover is the number of months of imports that could be financed solely by foreign exchange reserves Source: World Bank Although most of these reserves are held in US dollars, many commentators expected the introduction of the Euro to alter the balance of holdings by inducing Central Banks to hold more Euros in their reserves. As the chart below shows, this has not yet happened. Currency Allocation of Global Foreign Exchange Reserves 0% 10% 20% 30% 40% 50% 60% 70% 80% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USD Euro Area JPY Source: IMF Discussion questions 1) Does sterlized FX intervention work? 2) Will the US dollar lose its dominant position as the world’s reserve currency? Does it matter if it does? Background Material FORWARD RATES IN PRACTICE The table below shows how forward rates are quoted in practice. The convention is to quote forward points – number of units that need to be added to or subtracted from the current spot rate. Confusingly, 10 forward points is actually 10/10000 for currencies quoted to four decimal places and 10/100 for currencies quoted to two decimal places. So, for example, if the spot rate is 1.0000 and the 3 month forward points are 100, the 3 month forward rate is 1.0100. Euro Forward Rates (22/7/04) Spot eur/usd 0.8837 US Interest rate Euro interest rate Eur/Usd Forward points 1 month 1.4% 2.1% -7.0 3 month 1.6% 2.1% -19 1 year 2.3% 2.3% -2 FX TURNOVER AND THE INTRODUCTION OF THE EURO FX Turnover in Euro and DM (Daily turnover in $bn) 25 35 45 55 65 January April July October $/DM turnover in 1998 EUR/$ turnover in 1999 Source: EBS The chart shows how turnover in the Euro/dollar in 1999 was lower than the dollar/DM turnover in 1998 (according to data from the EBS brokerage system). This decline added to the loss of turnover in all the other legacy currencies (e.g. French Francs and Italian Lira) implies that total FX turnover has declined since the introduction of the Euro. Additional Questions Question 1) Assuming the uncovered interest rate parity and PPP hold, sketch the predicted impact of a) a temporary rise in real interest rates b) a temporary rise in nominal interest rates matched by an equal rise in inflation Answer 1) The diagrams below go through two examples of the theoretical impact of increased interest rates on exchange rates. The first shows an increase in interest rates that is also an increase in real interest rates. The second shows an increase in nominal interest rates that is accompanied by an equal increase in inflation (i.e. unchanged real interest rates). Real and nominal interest rate increase Nominal interest rate increase only Time Nominal Ex. Rate Real Ex. Rate Nominal Interest Rate Time Nominal Ex. Rate Real Ex. Rate Nominal Interest Rate The key lesson from the diagrams is that the exchange rate will not react to an increase in interest rates if it is simply offsetting an increase in inflation. In market terms, this is called being “behind the curve” because if the Fed is seen as raising interest rates after inflation has already taken hold, the exchange rate need not rise. If they are “ahead of the curve” – raising interest rates to prevent the onset of inflation – the exchange rate may rise. Question 2) What share of currency transactions involve the US dollar? Answer 2) About 90%. Almost all exchange rates actually traded have the US dollar on one side of the transaction. So, for example, if you wanted to sell Thai Baht and buy Israeli Shekels in the FX market you would actually have to sell Thai Baht and buy US dollars and then sell US dollars and buy Israeli Shekels. Thus the US dollar acts as a vehicle currency since no market participants directly trade the Baht against the Shekel.. % share of currency transactions involving the major currencies euro = sum of legacy currencies prior to 1999 0 10 20 30 40 50 60 70 80 90 100 1992 1995 1998 2001 Dollar Euro Yen Answers to Analytical Questions Chapter 20 Exchange Rate Determination II: Nominal Exchange Rates and Asset Markets 1. The forward premium for sterling is roughly 6.7% ( ie 100 x (1.6/1.5 – 1)). The euro-sterling interest rate differential will need to be about 6.7%. The actual magnitude of the differential will depend upon the level of interest rates. If sterling rates were 3% we will require the euro interest rate, re to satisfy the equation: 1.03 = 1.5 x (1+re) / 1.6 which implies re = 9.9%. Notice that this is slightly more than 6.7% above the sterling interest rate. Only if sterling interest rates were actually zero would the interest rate differential be exactly equal to the forward premium on sterling of 6.7% 2. $10,000 can be converted into 10,000 x 100 Yen today. In a year’s time it is worth (1.01) x 10,000 x 100 Yen having earned 1% interest. Converting back into dollars at the exchange rate of 110 gives a dollar value of 1.01 x 10,000 x 100 / 110. As a return on the initial investment of $10,000 the return is therefore: 1.01 x 10 x 10,000 / (10,000 x 110 ) = 0.918 which means the rate of return is – 8.18%. The roughly 9% currency loss on the yen is offset only slightly by the 1% interest rate on yen assets to generate the overall return of roughly –8%. 3. We will require that one week interest rates on Oz assets, ro, are at a level relative to one week US rates, ru, such that the following condition holds: 1 + ru = (1 + ro ) x 0.5 + 0.5 x ( (1 + ro) x (0.7)) The left hand side of the equation is the return on saving if invested in USA assets. The right hand side is the expected value of a one week investment in Oz assets converted back into USA dollars. The conversion is either at the same exchange rate (with a 0.5 probability) or at an exchange rate of 0.7 (30% lower) with a probability also of one half. The equation implies: 1+ro = (1 + ru ) / 0.85 This means that one week Oz interest rates need to be about 18% above US rates. If US one year rates are 5% then USA one week rates are about 0.10% so 1+ru is about 1.001. This means that (1 + ro) needs to be 1.178 But remember that is close to 18% interest rate over one week! Expressed at an annual rate, as is usual, Oz interest rates need to be at about 900% ! 4. a. If the market suddenly came to believe that interest rates in the republic of Oz were to be raised to 8%, having previously believed they would remain at 6%, the value of the Oz currency would rise by close to 2%. b. If interest rates were actually only raised by 1% the Oz currency would need to be at a level only 1% higher than at the start of the day when rates in both countries were expected to stay at 6% . This implies that the Oz currency needs to fall by 1% from its level just before the rate increase, when its value reflected a belief that interest rates would rise by 2%. c. Superficially it might appear that the exchange rate-interest rate relation is all wrong. Interest rates go up 1% but the Oz currency falls 1%. But what matters is the unexpected change in interest rates and this is minus 1%. This generates a fall in 1% in the currency , but that takes it to a level 1% higher than it had been when interest rates were equal in the two countries and expected to stay there. This means that over the next year UIP will imply an anticipated depreciation of the Oz currency of 1% which would take it back to where it started. We are assuming here that the interest rate difference is in 1 year rates. 5. a. If inflation stays the same in both countries PPP implies there will be no change in exchange rates so that they remain at 1:1. b. If the inflation rate rises in the USA for only 1 year then at the end of that year 1 USA dollar buys only 0.99 units of the Oz currency. It would then settle at that level assuming inflation returned to the Oz level and PPP continued to hold. If the inflation gap of 1% remains for 20 years by the end of the period a USA dollar is worth only 0.9920 of the Oz currency and so buys only 0.818 Oz dollars. c. Interest rate rise from 4% to 5% as inflation rises from 2% to 3%. This keeps USA real interest rates at 2%, the same as in Oz. There is no change in the current exchange rate although over the next year the USA dollar depreciates by 1% as PPP requires. The difference in nominal interest rates is 1% and this exactly matches the anticipated depreciation of 1% so that UIP also holds. 6 a. The movements in national income are not perfectly positively correlated across the three countries – indeed the movements are strongly negatively correlated in some cases. This means there is scope for gains in risk sharing. This risk sharing could be achieved in various ways. For example the people in one country will find it helpful to be able to borrow from the people of another country if current income in their country is unusually, and temporarily, low while in the second country current income is unusually high. Resources will flow in the other direction at some later date when income in the first country is unusually high – so the citizens find it useful to repay debt – and income may be below average in the second country. Such episodes will occur frequently if movements in income between the two countries are negatively correlated. But they will occur even if movements in income between the two countries are not correlated at all. Risk sharing need not only arise through movements in lending between countries. It can happen via stock market investments. If profits earned by the companies within a country tend to move in line with national income then investing in the equity issued by overseas companies effectively gives people a share in their national income. So if residents in country A buy equity of companies in B and C (and residents in B buy shares in A and C and so on) then risk will have been shared. b. The average levels of income and the correlation between incomes are shown in Table 1 below. There is a strong negative correlation between output in country A and country C. This means that country A and country C will be able to trade risk very successfully. Average income in country A is 11.2 and average income in country C is 9.2. Suppose that the countries shared income in each period in the ratios 11.2 / (11.2 + 9.2) and 9.2 / (11.2 + 9.2) . Table 2 shows the resulting pattern of pooled income for A and C and compares this with national incomes. There is a dramatic decline in variability of income while each country still gets the same average income. Risk averse people who want to smooth income will find the reduction in the variance of income very useful. Table 1 Table 2 c. There are several ways in which risk trading with country B can help A in the absence of an opportunity to trade directly with C. First, the correlation between A and B income, although positive, is a lot less than 1 (in fact it is slightly less than 0.5). So even if country C did not exist risk trading between A and B is useful. Table 3 illustrates. Here we calculate pooled income each period where A and B share joint income in the ratios 11.2 / (11.2 + 9.2) and 12.1 / (11.2 + 12.1). This means they both get the same average income as in the absence of risk pooling but enjoy less variable income. Comparing table 2 and 3 we see that the reduction is risk for country A is much less than when pooling income with C, but the risk reduction relative to no pooling at all is still significant. But country B can itself enter into a risk reducing arrangement with country C and if A then enters into a second risk reduction arrangement with B it can gain, indirectly, the benefit of the risk pooling between B and C. A B C 1 10 11 10 2 8 12 12 3 7 11 13 4 9 13 11 5 10 15 11 6 14 8 7 7 12 7 9 8 16 16 5 9 18 18 4 10 8 10 10 average 11.2 12.1 9.2 correlations AB 0.437865 AC -0.97188 BC -0.39955 A C A pooled C pooled 1.00 10.00 10.00 10.98 9.02 2.00 8.00 12.00 10.98 9.02 3.00 7.00 13.00 10.98 9.02 4.00 9.00 11.00 10.98 9.02 5.00 10.00 11.00 11.53 9.47 6.00 14.00 7.00 11.53 9.47 7.00 12.00 9.00 11.53 9.47 8.00 16.00 5.00 11.53 9.47 9.00 18.00 4.00 12.08 9.92 10.00 8.00 10.00 9.88 8.12 variances 13.73 8.84 0.35 0.24 Table 3 d. If country A is 100 times larger than B or C then risk pooling will be much less valuable to it than when average incomes are fairly close. Country B and C will, however, still gain greatly from risk pooling. The reason is straightforward. Country A gains little because it is so much larger than B or C that it swamps their income so that even if it pools income completely it changes its outcomes in each period by relatively little. But for B and C the opportunity to trade with A, and with each other, is useful. Consider country C. It now finds that when its income is high (eg in periods 1 –5) income in the much larger country A is relatively low so that A wants to borrow and interest rates are likely to be high. When incomes in C are low, in periods 6-10, incomes in A are relatively high and interest rates will be low. It is helpful to C that when it wants to lend interest rates are high but when it wants to borrow interest rates are low. A B A pooled B pooled 1.00 10.00 11 10.09 10.91 2.00 8.00 12 9.61 10.39 3.00 7.00 11 8.65 9.35 4.00 9.00 13 10.58 11.42 5.00 10.00 15 12.02 12.98 6.00 14.00 8 10.58 11.42 7.00 12.00 7 9.13 9.87 8.00 16.00 16 15.38 16.62 9.00 18.00 18 17.30 18.70 10.00 8.00 10 8.65 9.35 variances 13.73 12.10 8.58 10.01 INTRODUCTION As the final chapter of the three devoted to exchange rate issues, it is something of an overview of exchange rate systems. Its discussion of global capital markets returns us to the theme of the pros and cons of international capital flows. Teaching Tips ALTERNATIVE ROUTES THROUGH THE CHAPTER Like the previous chapter, this one has two distinct sections - currency regimes and international capital flows. Currency regimes have a natural link with the material on monetary policy in Chapter 17, whilst international capital flows link into several previous chapters e.g. Chapter 7. CHAPTER GUIDE 21.1 Currency Crises. We saw in Chapter 13 (figure 13.10) that despite a number of currency crises, the popularity of fixed exchange rate regimes has hardly diminished. 21.2 First Generation Models This model shows how fiscal policy can be at the heart of currency crises and justifies the IMF’s tendency to focus on fiscal issues when it is dealing with currency crises situations (remember “Its Mostly Fiscal” from chapter 9. 21.3 Second-Generation Models Just prior to the ERM crisis, the UK government took out a large foreign currency loan – since the loan would become more expensive to pay back if sterling devalued, the loan could have been seen as a way for the UK government to publicly increase the costs of devaluation and thus make an attack less likely. 21.4 Twin Crises: Banking and Currency The IMF has been criticized heavily for its part in the Asian Crises. First by encouraging financial liberalization without a corresponding focus on improving banking regulation many argue that it sowed the seeds for the crisis. Second, when the crisis occurred, those that followed IMF advice generally did worse than those that ignored it (see case study below). 21.5 Foreign Exchange Rate Intervention see chapter 20 case study for more on FX intervention. 21.6 Sovereign Wealth Funds This can be linked to the curse of natural resources discussed in chapter 6. CHAPTER 21: CURRENCY CRISES & EXCHANGE RATE SYSTEMS 21.7 The Role of the IMF The IMF has other roles as well as lending to deal with short term balance of payment crises, though many of these are arguably the result of ‘mission creep’. 21.8 Capital Account Liberalization see case study below for the Malaysian experience. 21.9 Exchange Rate Regimes Note that dollarization has a significant financial disadvantage relative to a dollar-based currency board. A currency board is backed by interest-bearing dollar assets (such as US government bonds) while using actual US dollars is effectively giving the US government an interest free loan (i.e. greater seignoirage income). It is estimated that about two-thirds of all US dollar notes are held outside the US and that the US Treasury earns 0.2% of GDP every year from these interest free loans from foreigners (partly from dollarized economies but mainly from the black market use of US dollars). Some countries have implicit currency boards that act as a single currency. For example, Scottish pound notes (issued by the Scottish commercial banks) are backed one-for-one by Bank of England notes and are accepted almost universally as interchangeable (with the exception of London taxi drivers who presumably fear an imminent Scottish currency crisis). 21.10 Currency Boards The background material gives some details on the unsuccessful attack on the Hong Kong Currency Board during the Asian Crisis 21.11 Currency Unions The case study in chapter 20 discusses the issue of real exchange rate misalignment in the euro-area CASE STUDY: CAPITAL CONTROLS IN MALAYSIA In the middle of the Asian Crisis, Malaysia decided to impose capital controls. Although widely criticized at the time, the Malaysian experience suggests that the controls may have helped in their recovery. Introduction There is a growing acceptance that limited capital controls can be used as a prudential measure – to prevent the build-up of short-term foreign liabilities that can be de-stabilizing. In the words of the IMF’s former chief economist (Michael Mussa) “high openness to international capital flows, especially short-term credit flows, can be dangerous for countries with weak or inconsistent macro-economic policies or inadequately capitalized and regulated financial systems”. However, their use as a crisis-resolution measure, as in Malaysia in 1998, is far more controversial. The introduction of capital controls When Malaysia instituted capital controls in September 1998, the Malaysian Ringgit was under heavy speculative pressure. The measures were draconian - banning all offshore trading in Ringgit assets and imposing an exchange rate of 3.8 ringgit to the dollar. The regime was eased somewhat in 1999 in order not to penalize foreign direct investment. The overseas reaction to these measures was hostile - Forbes International declared that “Foreign investors in Malaysia have been expropriated, and the Malaysians will bear the cost of their distrust for years”. In October 1998 the IMF argued that “Capital controls may also turn out to be an important setback not only to that country’s recovery and potentially to its future development, but also to other emerging market economies”. The criticism intensified later that year when Malaysian Prime Minister Mahathir Mohammed had his free-market rival and deputy prime minister Anwar Ibrahim arrested. However, the criticism quickly subsided as, against all predictions, the Malaysian economy began a strong recovery. By October 1999, the IMF was forced to admit “a strong recovery is also now under way in response to fiscal and monetary stimulus and the pegging of the exchange rate at a competitive level”. Malaysia’s recovery – domestic or regional? While very few would argue that capital controls held back Malaysia’s recovery, was that recovery supported by controls or was it simply part of a wider regional recovery? The chart below shows that the exchange rate imposed by capital controls was little different to that experienced elsewhere in the region. The 50% appreciation of the US dollar against the Ringgit experienced after 1996 was almost identical to that experienced by Thailand and South Korea whilst the currency stability that strict capital controls created was also partially experienced by those two countries. It should however be noted that whilst both Thailand and South Korea had a partial system of capital controls in place over this period, Indonesia with no controls experienced a far sharper depreciation. Overall, however, capital controls may not have significantly altered the path of the Malaysian Ringgit. Asian Currencies against the US dollar (Index, 1996=100) Malaysia Exchange rate against US dollar (1996=100) Thailand Exchange rate against US dollar (1996=100) South Korea Exchange rate against US Dollar (1996=100) Source: EcoWin ApJruOlc9t8ApJruOlc9t9ApJruOlct 75 100 125 150 175 200 225 250 The chart below also shows that the Malaysian recovery, though strong, was not greatly different from that of other countries involved in the crisis. GDP in the Asian Crisis Countries (Index 1996=100) Malaysia GDP (1996=100) Thailand GDP (1996=100) South Korea GDP (1996=100) Indonesia GDP (1996=100) Source: EcoWin 94 95 96 97 98 99 00 75 80 85 90 95 100 105 110 115 120 125 However, Kaplan and Rodrik (2001), argue that capital controls did help Malaysia’s recovery. They point out that Korea and Thailand had just received large IMF loans that had begun to restore investor confidence. Malaysia, on the other hand, was just about to enter its own economic crisis. Since PM Mahathir was probably already considering imprisoning Anwar before imposing controls, it is clear that the controls prevented the huge outflow of foreign capital that such an event would have instigated. Given that background, one can imagine that Malaysia could easily have entered the sort of vicious circle of political and economic crisis experienced in Indonesia. While Kaplan and Rodrik’s argument is plausible, it is a counterfactual and hard to prove either way (i.e. compares the actual outcome with one that did not occur). Firmer evidence in favor of capital controls comes from Malaysian interest rates. As the table below shows, capital controls allowed Malaysia to cut their interest rate well below that of other Asian economies which needed high interest rates to prevent outflows of capital. Asian Interest rates (January 2000) Malays ia South Korea Thailan d Indones ia Nominal Interest Rate 3.1% 7.1% 5.2% 9.9% Real Interest Rate 1.5% 5.5% 4.6% 9.3% Conclusion Despite heavy criticism at the time, Malaysia’s experience of imposing capital controls in the midst of a regional crisis seems to have been favorable. It is hard to argue that the controls did any harm to the economy and it seems likely that the lower interest rates that the controls allowed probably helped the economy to recover. However, their longer-term effects on foreign direct investment have yet to be seen. Kaplan and Rodrik (2000) “Did the Malaysian Capital Controls Work?” NBER © WP8142 Background Material CURRENCY BOARDS UNDER PRESSURE: HONG KONG IN 1997/98 The failure of the Argentinian currency board was the first cases of a successful speculative attack against a board. Hong Kong in 1997/98 is a good example of how currency boards can resist speculative attacks, as Hong Kong managed to keep its link to the US dollar despite of the Asian currency crises that brought down many of its near neighbors (see additional questions for more on Hong Kong’s adjustment to the asian currency Crises. Hong Kong’s peg against the US dollar (HK$7.8 = US$1) was almost bound to come under pressure during the asian currency crises. However, the pressure lasted far longer than expected and came to a head in August 1998. It was the vulnerability of Hong Kong’s huge equity market to speculative pressure that proved to be the weak point. Speculators realized that sending the Hang Seng Index spiraling down was the best way to attack the peg. In the end, the Hong Kong Government abandoned its free market principles and undertook a massive share support operation – buying $15 billion of shares in Hong Kong companies. Hong Kong Crisis Timeline July 1997 Hong Kong handed over to China followed a day later by the collapse of the Thai Baht. August 1997 Hong Kong spends US$1bn defending its currency. October 1997 Hong Kong dollar comes under renewed pressure following the float of the New Taiwan Dollar. January 1998 Speculation that the Chinese Renminbi will devalue hits the Hong Kong Dollar. June 1998 Government announces a US$4bn housing market support program. August 1998 Hong Kong government spends $15 billion purchasing local shares after the Hang Seng Index falls 60% in a year. The Hang Seng then begins to recover. US and Hong Kong 1 month interest rates Hong Kong 1 month HIBOR interest rate, USA 1 month LIBOR interest rate Source: EcoWin May Se9pM7ay Se9pM8ay Se9pM9ay Se0pM0ay Se0p1 0 5 10 15 20 25 30 35 40 45 50 Additional Questions Question 1) Study the chart below showing Hong Kong Exchange Rates around the Asian currency crisis. Describe what happened to Hong Kong’s competitiveness before, during and after the crisis. What were the key drivers of Hong Kong’s competitive position? Hong Kong Exchange Rates US Dollar/Hong Kong Dollar Exchange Rate (LHS) Hong Kong Nominal Effective Exchange Rate Index (RHS) Hong Kong Real Effective Exchange Rate Index (RHS) Source: EcoWin Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep 96 97 98 99 00 USD/HKD 6.00 7.00 8.00 9.00 Index 92.5 95.0 97.5 100.0 102.5 105.0 107.5 110.0 112.5 115.0 117.5 Answer 1) Since Hong Kong is in a currency board pegged to the US dollar, its dollar exchange rate was unchanged throughout this period (though it did come under some pressure – see background material). However, both its nominal and real effective exchange rates changed considerably. Before the crisis the nominal exchange rate was rising (due mainly to a dramatic weakening of the Japanese Yen against the dollar – and therefore the Hong Kong Dollar - between 1994 and 1997). At the same time, the real effective exchange rate rose even faster indicating the Hong Kong’s inflation was rising faster than its trading partners (as the Hong Kong economy was over-heating). This meant that even before the Asian currency crisis occurred, Hong Kong exchange rate was quite uncompetitive. When the crisis occurred Hong Kong’s nominal and real effective exchange rates rose sharply as a number of its trading partners (e.g. Thailand, Malaysia, Indonesia and Singapore) saw their exchanges rates fall significantly against the US and Hong Kong Dollar. After the crisis, Hong Kong’s nominal effective exchange rate stayed at quite high levels, but its real exchange rate fell significantly. This occurred because of a huge disinflation in Hong Kong (by 1999 prices in Hong Kong were falling by over 7% p.a.!), the disinflation thus allowed Hong Kong to regain its competitiveness without having to devalue its currency. It is a testament to the flexibility of the Hong Kong economy that such a rapid disinflation was achieved so quickly. In the case of Argentina, the economy was not so flexible and so its inflation rate remained above that of it competitors even in the midst of recession. Question 2) Look at the chart of the Ukrainian Hryvania exchange rate against the euro and dollar below. a) can you tell from the chart what type of exchange rate regime is operated by the Ukrainian National Bank? b) Do you think this is an appropriate currency regime for Ukraine? US dollar/Ukrainian Hryvania Exchange Rate Euro/Hryvania Exchange rate Source: EcoWin 95 96 97 98 99 00 01 02 03 04 1 2 3 4 5 6 7 Answer 2a) From the fact the to Hryvania is largely stable against the US dollar but has periodic shifts, it looks like an adjustable (or intermediate) peg against the US dollar. Answer 2b) Although it is hard to make any comments about the currency regime without a detailed knowledge of the Ukrainian economy, it is worth pointing out that intermediate regimes such as this are becoming rarer and rarer. Also, a peg against the dollar is always problematic for a country that does not undertake much trade with the US (Ukraine’s major trading partners are Russia and the Euro-area. Answers to Analytical Questions Chapter 21 Currency Crises and Exchange Rate Systems 1. According to UIP (1+r(USA))/(1+r(OZ)) = Expectation (1+ Appreciation OZ Dollar) If interest rates are the same in USA and OZ then UIP requires that the exchange rate doesn’t change. If the currency has a 50% chance of falling 30% over the next YEAR then UIP requires (1+r(USA))/(1+r(OZ)) = (1-0.5 x 0.3) = 0.85 which implies that interest rates in OZ have to rise by around 15% above those in the USA. However if the market expects a 50% chance of a depreciation of 30% over the next week then OZ interest rates have to offer 15% more just over the next week or a rather startling (1.15)52 at an annualized rate! In other words, in the face of a threat of an imminent currency crises interest rates may have to rise to extremely high levels. 2. UIP does not hold as with a fixed exchange rate UIP implies there should be the same interest rates in each country. But the question tells us that USA interest rates are always 2% higher – investors always earn more by putting funds in the USA. However, modifying UIP to allow for a risk premia is consistent with the facts. However, even though UIP does not hold exactly, because the risk premium is constant there will be a stable relationship between changes in interest rates in the two economies. In other words, because USA interest rates are always 2% above those in Oz whenever one country raises rates so too does the other country. Therefore even with a risk premium, a fixed exchange rate imposes a similar monetary discipline on both countries. 3. The effective exchange rate has remained unchanged – the currency has appreciated by the same amount against the Oceania dollar as it has fallen against the Eurasian dollar. Given it does equal trade with both areas the net effect is for no change. If the Republic of Argent were to establish a fixed exchange rate system it can either target one of these currencies or an average of the two. Given the equal trade shares between these countries in this case it would be best to target an average of the currency against these two nations. 4. i) Converting foreign denominated debt into pesos the debt GDP ratio is 50% ((1bn+4bn)/10bn). ii) In peso terms interest payments are 10% on 1bn and 5% on 4bn = 0.3bn which is 3% of GDP. iii) According to UIP the peso is expected to depreciate by around 5% (the interest rate differential). iv) If the exchange rate shifts to 1 Peso = $4 then debt becomes 1bn Pesos + 16bn Pesos or 170% GDP. Interest rates become 10% on 1bn and 5% on 16bn = 0.9bn or 9% of GDP. This question reveals the danger of countries with fixed exchange rates borrowing in foreign currency terms in order to benefit from lower interest rates. So long as the exchange rate remains fixed then this strategy may be effective but in the face of sharp devaluations of the currency this policy can be disastrous. Solution Manual for Macroeconomics: Understanding the Global Economy David Miles, Andrew Scott, Francis Breedon 9781119995715
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