Global Growth, Current Account Imbalances and Exchange Rates

1. Global Growth, Current Account Imbalances and Exchange Rates Kenneth Rogoff, Harvard University Pedro Barrie Lectures (3) November 22, 2005 Vigo, Spain

2. We take up one piece of adjustment: Asian exchange rates • We focus on China, which today is the lynchpin of the system. • US Treasury has put tremendous pressure on China to revalue (appreciate) its currency. (IMF NEEDS TO PLAY LEAD ROLD.) From a global perspective, an essential element of the adjustment process. But what about from China’s perspective? Complex question

3. Summary of recent research on exchange rates, growth and inflation • For poor developing countries -- especially financially underdeveloped countries with a low degree of international capital market integration, fixed exchange rate regimes have performed reasonably well, highly durable. • For rich countries, true floating exchange rates works best • For emerging markets --countries more integrated with international markets -- an intermediate flexible system is desirable.

4. Intermediate exchange rate regimes – where some exchange rate movements are permitted but extreme volatility is avoided– are already most popular. In 1975, almost 2/3s of all countries had a pegged exchange rate. Today, almost 2/3s of all countries have an intermediate regime. Likely many more by 2020. Few countries have pure floats (euro-dollar, pound dollar, Austrialian dollar and South African Rand are examples of pure floats.)

5. Regimes of the Future(?)

6. Where should the world exchange rate system be in 2050? • Mundell: One world currency! • My view: At least three to four major currencies (to ensure competition). Yuan, Dollar, Euro, plus “commodity linked” currencies for oil exporters and major commodity exporters. Also, there will always be problem countries on periphery.

7. What about China today? Recent move to greater flexibility is both necessary and desirable. Over long term, as China’s financial markets develop and as trade expands, fixed exchange rate is not a viable option if China wants to retain any autonomy over its own monetary policy

8. Why is flexibility inevitable? • Effectiveness of capital controls will weaken over time as financial sector develops and as trade expands. This is experience of European countries in the 1950s. • As capital controls weaken, China will increasingly be forced to follow US monetary policy to maintain peg. But a large region like China needs to be able to choose its own monetary policy

9. Why have more flexibility now? • Pressures on China’s exchange rate may turn some day. Even China’s vast foreign exchange reserves (over 700 billion dollars) can still be overwhelmed by global foreign exchange markets (where trade is over $2 trillion per day.) • It is better to exit a fix from strength • Better too soon than too late…

10. China no longer needs exchange rate as an inflation anchor • Improvements in monetary policy – independent central banks, inflation targetting – have made it possible for most countries to control inflation without exchange rate anchor. (In 1992, over 40 countries had inflation over 40%. Today, only Zimbabwe does. Even the Republic of the Congo has single digit inflation now.)

11. Risk of immediate financial crisis not large • Big problems occur when countries are forced to drop pegs from weakness. Sharp drop in the exchange rate raises burden of foreign debts, can cause crisis. But China’s exchange rate will likely need to go up in the short run. (It the long run, it will sometimes move down, trend unclear)

12. Comparisons with 1980s Japan are questionable. • McKinnon, Mundell and others have suggested that Japan’s economic malaise in the 1990s was caused by the mid-1980s Plaza accord on exchange rates. (An idea muted earlier by Posen.) • But Japan’s economic problems did not follow until many years later. Catastrophic mishandling of macroeconomic policy almost certainly the main driver.

13. Governments often fear allowing some exchange rate flexibility • But adverse effects of exchange rate volatility, while perhaps present, are in fact very difficult to detect empirically • Based on other countries’ experiences, likely case is that country will adjust to exchange rate flexibility very quickly without major negative consequence

14. Rise in unemployment? No significant macroeconomic effect. • Economy is creating over 10 million jobs per year. Trade policy will not affect more than a very small fraction of these. • A stronger exchange rate may weaken demand for exports but only slightly. However, a lower cost of capital goods imports will fuel investment. • Production and investment outside export sector is enhanced.

15. Is long-term trend upwards for Yuan? Probably, but not simple. Current upward pressure on yuan is driven not only by trade balance surplus, but by capital inflows. Capital controls are assymmetric; money can get in more easily than it can get out. If controls were symmetric, pressure might be downwards.

16. True, by many measures Yuan is currently undervalued. • TRADE BALANCE SURPLUS IS GROWING. Official surplus likely over 100 billion dollars for 2005. (True surplus probably 25-50% larger.) • Foreign Exchange Reserves are over 700 billion and will soon pass Japan. 1,000 billion by mid 2006? (Can China invest reserves more productively??)

17. Purchasing Power: By some indices, Yuan is very low Euro Area $3.58 United States $3.06 Canada $2.63 Mexico $2.58 Brazil $2.39 Japan $2.34 China $1.27

18. The rate of growth in China’s trade has been typical of countries after economic liberalization (the following graphs dates China’s economic liberalization from 1979, and looks at trade growth versus years from liberalization.

19. China’s Opening Up--Real Export Growth (Log of exports divided by U.S. GDP deflator; beginning period = 1) NIEs (1966=1) Japan (1955=1) China (1979=1) +25 +5 +40 +20 0 +30 +35 +10 +15 +45

20. BUT REAL EXCHANGE RATE PICTURE IS QUITE ATYPICAL. China’s real exchange rate (inflation adjusted exchange rate) has moved in the opposite direction as Japan’s did post liberalization.

21. China’s Opening Up--Exchange Rate (Log real exchange rate, beginning period = 1) Solid line: Real exchange rate Dashed line: Real effective exchange rate Japan (1955=1) NIEs (1966=1) China (1979=1) +25 +5 +40 +20 0 +30 +35 +10 +15 +45

22. Normally, richer countries have higher price levels, adjusted for exchange rates, as the following graph illustrates

24. But normal Belassa Samuelson effect may not hold in China • Normally, a fast growing country experiences an appreciating real exchange rate, as high productivity growth bids up wages. But the globalized part of China is still experiencing huge labor inflows from the non-globalized part of China. Labor inflows keep down wage growth, restrain price increases.

25. Regardless of China’s policies, over longer term, financial crises are difficult to avoid entirely.

26. External Debt Defaults in Emerging Markets 1824-2001 .

27. China default • China defaulted on external debt 1924-1936 • Earlier financial crises?

28. Today’s Emerging Markets didn’t invent serial default

29. An Early History of Default Number of defaults

30. So why the upward pressure on the Yuan? • Giant US current account and trade balance deficits are overwhelming other factors. There is significant trend upward pressure on dollar exchange rates in most countries. • US Federal Reserve’s aggressive policy of raising very short-term interest rates is putting short-term upward pressure on the dollar. TEMPORARY EFFECT.

31. Current situation where United States is absorbing 3/4s of global savings cannot be “ideal” Poor developing countries should not be paying for profligacy in the world’s richest country.

32. China is only a small share of overall US trade imbalances

33. Yes, Yuan flexibility will help global trade imbalances • ….but by only a modest amount. • Obstfeld and Rogoff (2005) find that a halving of global trade imbalances, if driven by a generalized rebalancing of global demand, would be accompanied by an 18% appreciation of ALL Asian currencies. • BUT if Asian currencies appreciate by 20% without accompanying policy adjustments, global imbalances would decline by much less

34. Although other regions can help • Faster growth in Europe will raise investment there and lower surpluses • High oil prices have made OPEC surpluses a growing factor – but past experience suggests these country’s expenditures will adjust and/or prices will fall. • Latin America will surely not run surpluses much longer.

35. Exchange rate flexibility and capital market integration closely related

36. Summary on Exchange Rates • Pegged exchange rates problematic everywhere? NO • poorer developing countries: fixed regimes associated with lower inflation and relatively high durability. • Emerging and advanced economies • absence of robust relation between economic performance and regime. • However, emerging markets have • less durable regimes (in general) and • more frequent crises under pegged regimes

37. Exchange Rate Regime perhaps less important than • Quality of Financial Regulation • Maintaining Low Levels of Corruption • Independence and Transparency of Central Bank • Controlling Level of Government and International Debt

38. Where does China fit in? • Arguably, fasting growing coastal China is an emerging market that clearly benefits from a relatively flexible exchange rate. But interior is much less economically developed, might benefit more from a less flexible rate. • Difficult tension

39. But only if extremes avoided • Multiple Exchange Rate Practices (Dual and Parallel Rates) are deeply problematic for growth, inflation, corruption. • Heavy-handed capital controls are similarly problematic • Fixed exchange rate regimes are an extremely risky strategy for most emerging market economies

40. Conclusion • Contrary to prevailing empirical and theoretical literature, exchange rate regime does seem to matter. • No one size fits all, but a useful baseline formula: As a country becomes richer, and as institutions become better developed, presumption that a move to greater exchange rate flexibility and greater capital market integration is highly advisable.

41. Background Papers by Kenneth Rogoff “Exchange Rate Durability and Performance in Developing versus Advanced Economies,” (with A. Husain and A. Mody) Journal of Monetary Economics 52 (Jan. 2005), 3 "The Modern History of Exchange Rate Arrangements: A Reinterpretation," (with C. M. Reinhart) Quarterly Journal of Economics 119(1) Feb. 2004. Evolution and Performance of Exchange Rates Regimes, (with A. Husain, A. Mody, R. Brooks, and N. Oomes), IMF Occasional Paper 229, 2004. The Effects of Financial Globalization on Developing Countries: Some Empirical Evidence (with E. Prasad, S. Wei and A. Kose), IMF Occasional Paper 220, 200 Exchange Rate Regimes and Growth, with P. Aghion, P. Bacchetta, and R. Ranciere