Day 3: Monetary Regimes For Commodity-Producing Developing Countries

1. Day 3: Monetary Regimes For Commodity-Producing Developing Countries Jeffrey Frankel Harvard University & NBER Monetary Policy & Commodity PricesStudy Center Gerzensee23-25 June, 2014

2. The Choice of Monetary Regimes for Emerging Markets / Developing Countries • How are DCs structurally different from Advanced Economies? • Choice of exchange rate regime • Alternative anchors for monetary policy-- Proposal for Nominal GDP Targeting

3. I. How are EMs & Developing Countries different from Advanced Economies? • Need for monetary credibility. • Supply shocks. • Terms of trade shocks.

4. How are EMs different from Advanced Economies? continued • Monetary policy-makers have more need for credibility a) due to high-inflation histories, b) absence of credible institutions, c) or political pressure to monetize big budget deficits. A. Fraga, I. Goldfajn & A. Minella(2003), “Inflation Targeting in Emerging Market Economies,” NBER Macro Annual 2003, K.Rogoff&M.Gertler, eds. (MIT Press).

5. How are EMs different from Advanced Economies? continued • The economy is more exposed to supply shocks a) such as natural disasters (hurricanes, cyclones, earthquakes, tsunamis…) b) other weather events (droughts…), c) social unrest (strikes…), d) productivity shocks (“Are we the next Tiger economy?”). • And more exposed to terms of trade shocks. • Volatility in price of export commodity on world markets • Volatility in price of imports on world markets.

6. Trade & Supply Shocks are More Common in Emerging Markets & Low-Income Countries IMF SPRD & World Bank PREM, 2011, “Managing Volatility in Low-Income Countries: The Role and Potential for Contingent Financial Instruments,” approved by R.Moghadam & O.Canuto

7. II. What is the desirable exchange rate regime? • Advantages of fixing. • Advantages of floating. • Which dominate? • Optimum Currency Area criteria • Other criteria • Intermediate exchange rate regimes • E.g., systematic managed float.

8. Advantages of fixed rates • Encourage trade <= lower exchange risk & lower transaction costs. E.g., Rose (2000): currency unions triple trade among members. 2) Encourage investment <= cut currency premium out of interest rates. 3) Provide nominal anchor for monetary policy • Barro-Gordon model of time-consistent inflation-fighting • But which anchor? Exchange rate target vs. Alternatives. 4) Avoid competitive depreciation (“currency wars”) 5) Avoid speculative bubbles that afflict floating. (vs. if variability is fundamental real exchange rate risk, it will just pop up in prices instead of nominal exchange rates).

9. Advantages of floating rates • Monetary independence • Automatic adjustment to trade shocks • Retain seigniorage • Retain Lender of Last Resort ability • Avoiding crashes that hit pegged rates. (This is an advantage especially if origin of speculative attacks is multiple equilibria, not fundamentals.) Professor Jeffrey Frankel

10. Which dominate: advantages of fixing or advantages of floating? The answer depends on circumstances. No one exchange rate regime is rightfor all countries or all times. • Traditional criteria for choosing - Optimum Currency Area. Focus is on stabilization of trade balance & business cycle. • 1990s criteria for choosing – Focus is on stabilization of financial markets. • Additional criteria relevant for developing countries - -- Financial development -- Terms of trade volatility.

11. Optimum Currency Area Theory (OCA) Broad definition: An optimum currency area is a region that should have its own currency and own monetary policy. This definition can be given more content: An OCA can be defined as: a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into sub-regions with different currencies. Professor Jeffrey Frankel

12. Optimum Currency Area criteria for fixing exchange rate: Small size and openness because then the advantages of fixing are large. Symmetry of shocks because then giving up monetary independence is a small loss. Labor mobility because then it is possible to adjust to shocks even without ability to expand money, cut interest rates or devalue. Fiscal transfers in a federal system because then consumption is cushioned in a downturn. Professor Jeffrey Frankel

13. (i) Level of financial development Fixed rates are better for countries with low financial development because markets are thin: => costs of financialshocks outweigh benefits of accommodating realshocks. As financial markets develop, exchange flexibility becomes more attractive. Estimated threshold: Private Credit/GDP > 40%. Aghion, Bacchetta, Ranciere & Rogoff(2005). • For richer & more financially developed countries, flexible rates work better: • more durable & deliver higher growth without inflation • Husain, Mody & Rogoff(2005). Professor Jeffrey Frankel

14. (ii) External Shocks An old wisdom regarding the source of shocks: Fixed rates work best if shocks are mostly internal demand shocks (especially monetary); floating rates work best if shocks tend to be real shocks (especially external terms of trade). One case of supply shocks: natural disasters R.Ramcharan (2007) finds support. Most common case of real shocks: trade Professor Jeffrey Frankel

15. Terms-of-trade volatility Prices of crude oil and other agricultural & mineral commodities spiked in 2008 & 2011. => Favorable terms of trade shocks for some (oil producers, Africa, Latin America, etc.); => Unfavorable terms of trade shock for others (oil importers like Japan, Korea). Textbook theory says a country where trade shocks dominate should accommodate by floating. Confirmed empirically: Developing countries facing terms of trade shocks do better with flexible exchange rates than fixed exchange rates. Broda (2004), Edwards & L.Yeyati (2005), Rafiq (2011), and Céspedes & Velasco (2012). Professor Jeffrey Frankel

16. Céspedes&Velasco(Nov.2012) NBER WP 18569 “Macroeconomic Performance During Commodity Price Booms & Busts” Constant term not reported. (t-statistics in parentheses.) ** Statistically significant at 5% level. Across 107 major commodity boom-bust cycles,output loss is bigger, the bigger is the commodity pricechange &the less isexchangerate flexibility.

17. Conclusion: Desirable exchange rate regime • Very small, very open, economies usually find that the advantages of fixing dominate. • Very large countries like US & euroland usually find that the advantages of floating dominate. • Most countries are in between, • particularly middle-sized middle-income countries. • Most of these countries should have intermediate exchange rate regimes, • neither firm fixing nor free floating. • Intermediate regimes include band & basket arrangements.

18. Distribution of EM exchange rate regimes The big rise is in the “managed float” category Distribution of Exchange Rate Regimes in Emerging Markets, 1980-2011 (percent of total) } Atish Ghosh, Jonathan Ostry & Mahvash Qureshi, 2013, “Exchange Rate Management and Crisis Susceptibility: A Reassessment,” IMF ARC , Nov..

19. So I reject the Corners Hypothesis. • But Stan Fischer has a good point: giving speculators a target to shoot at is often a losing proposition, • such as the boundary of a declared band. • Aparticular intermediate regime could be useful, a systematic managed float.

20. A systematic managed float • Proposed rule: for every 1% of Exchange Market Pressure, the central bank takes x% as appreciation of the currency & (1-x) % as an increase in reserves (relative to the monetary base). • This arrangement, though rather obvious, has seldom been formalized. • The parameter x calibrates exchange rate flexibility, • and can range from 0 (fixing) to close to 1 (full flexibility). • Thus one can have ½ monetary independence + ½ exchange rate stability.

21. Systematic managed floating • refutes the corners hypothesis, • but without capital controls, • without violating the Impossible Trinity, • and even without giving speculators a line to shoot at. • ≈ what some central banks do anyway. • Attempts at econometric estimation • G.Adler & C.Tovar, 2011, “Foreign Exchange Intervention: A Shield Against Appreciation Winds?” IMF WP 11/165. • J.Frankel & D, Xie, 2010, “Estimation of De Facto Flexibility Parameter and Basket Weights in Evolving Exchange Rate Regimes,” AER.

22. Systematic managed float (“leaning against the wind”): Turkey’s central bank buys lira when it depreciates,and sells when it is appreciates. KaushikBasu & AristomeneVaroudakis, Policy RWP 6469, World Bank, 2013,“How to Move the Exchange Rate If You Must: The Diverse Practice of Foreign Exchange Intervention by Central Banks and a Proposal for Doing it Better” May, p. 14

23. Korea & Singapore took them mostly in the form of reserves, Example: Renewed capital inflows to Asia in 2010 while India & Malaysia took them mostly in the form of currency appreciation. Slope = 1/x more-managed floating less-managed floating GS Global ECS Research

24. Renewed inflows in 2010 in Latin America were reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating Slope = 1/x less-managed floating Source: GS Global ECS Research

25. III: If the exchange rate is not to be the anchor for monetary policy, what is? • The need for an alternative anchor led many EMs to Inflation Targeting (IT), • after the currency crises of the late 1990s pushed them off exchange rate targets.

26. Fashions in international currency policy 1980-82: Monetarism (target the money supply) 1984-1997: Fixed exchange rates (incl. currency boards) 1993-2001: The corners hypothesis 1998-2008: Inflation targeting (+ currency float)became the new conventional wisdom Among academic economists among central bankers and at the IMF. IT was in many ways successful. IT Professor Jeffrey Frankel

27. Drawbacks to IT have been revealed • since 2008, • analogously to how the currency crashes of the 1990s revealed the drawbacks of exchange rate targets. • Two problems with IT: • Neglect of asset bubbles • Neglect of supply & trade shocks.

28. If the exchange rate is not to be the monetary anchor, what is? Cont. • IT’s neglect of supply & trade shocks. • Remember the textbook maxim: the exchange rate should accommodate terms of trade shocks. • If IT sets the CPI, it doesn’t allow the exchange rate to rise & fall with the terms of trade. • When the world price of copper exports falls, a CPI target does not allow the currency to depreciate. • When the world price of imported oil rises, a literal CPI target says to tighten monetary policy enough to appreciate the currency, = the opposite of accommodating the adverse trade shock.

29. Nominal GDP Targeting • NGDPT is more robust with respect to supply shocks & terms of trade shocks, • compared to the alternatives of ITor exchange rate targets. • And more robust with respect to velocity shocks, • compared to M targets. • The logic holds whether the immediate aim is • disinflation (as in 1980s, and again today among many EMs & developing countries); • monetary stimulus (as among big Advanced Cs recently); • or just staying the course.

30. Figure 2: When a Nominal GDP TargetDelivers a Better Outcome than IT Supply shock is split between output & inflation objectives rather than falling exclusively on output as under IT (at B).

31. Figure 3: When IT Delivers a Better Outcomethan a Nominal GDP Target …if the Aggregate Supply curve is steep (b is low, relative to a, the weight on the price stability objective)

32. NGDPT for Developing Countries • The proponents of Nominal GDP Targets have focused on the biggest countries. • But middle-size, middle-income countries are better candidates. • Why? They suffer bigger supply shocks & trade shocks. • Evidence suggests that the AS curve is indeed sufficiently steep so that NGDPT minimizes quadratic loss function, • for the cases of Kazakhstan and India: • “Nominal GDP Targeting for Middle-Income Countries,” June 2014 for Central Bank Review, of CB R Turkey. • Recommendation: EM/DCs should consider NGDPT as a serious alternative to IT & exchange rate targeting.

33. . Mathematical analysis:Which regime best achieves objectivesof price stability and output stability? • The goal is to minimize a quadratic loss function: where p ≡ the inflation rate,y ≡ the log of real output, ≡ the preferred level of output; a ≡ the weight assigned to the price stability objective.

34. Which regime best achieves objectives of price & output stability? continued . • Any nominal rule, provided it is credible, can set expected inflation at the desired level (say, 0), • e.g., eliminating the inflation bias that comes with discretion • in Barro-Gordon (1982) model of dynamic inconsistency, • where the Aggregate Supply relationship is y = + b(p – pe) + u, • and ≡potential output.

35. Which regime best achieves objectives of price & output stability? continued • But different rules => different outcomes, when shocks hit • Rogoff (1985) & Fischer (1990). • IT & NGDPT both neutralize AD shocks so far as possible. • That leaves AS shocks, u. • NGDP rule dominates IT, if… a < (2 + b)b; • Example 1: holds if b>a(AS flat, vs. loss function lines). • Example 2: holds if a = 1 (as in Taylor rule) and AS slope 1/b< 2.414. • Under these conditions, the economy looks more like Figure 2 than like Figure 3: • If inflation were not allowed to rise in response to an AS shock, the resulting loss in GDP could be severe=> NGDPT dominates IT.

36. Which regime best achieves objectives of price and output stability? continued • For Kazakhstan, an oil exporter, over the period 1993-2012: the estimated AS slope is 1.66 and statistically < 2.41. • For India, an oil importer, over the period 1996-2013: • AS slope at the 1-year horizon ranges from .38 to .67. • Each estimate of the slope coefficient is not only > 0 statistically, but significantly < 2.41. • Here the annual monsoon rain is one important supply shock. • Thus under the assumptions we have made, it is estimated that Nominal GDP Targeting dominates Inflation Targeting • in terms of achieving the objectives of output & price stability, • at least for these two countries. • Frankel, 2013, “Exchange Rate and Monetary Policy for Kazakhstan in Light of Resource Exports,” CID, Harvard. • Bhandari & Frankel, 2014, “The Best of Rules and Discretion:A Case for Nominal GDP Targeting in India,”HKS, June.

37. Estimation of AS curve for Kazakhstan& other oil exporters Regression of inflation against GDP growth, to estimate Aggregate Supply for oil-exporting countries – Table 4, Frankel (2013), thanks to GulzarNatarajan Note: For some countries, estimated slope did not come out significantly > 0 .

38. Estimation of AS curve for India Bhandari & Frankel (2014), Table 1: Estimation of Supply Curve Slope 1st stage dependent variable: output gap 2nd stage dependent Variable: inflation surprises (winarm/ginarm/ginrw)Note: First stage non-IV variables not shown. Memo: List of variables with brief descriptionWINGAP &GINGAP: Annual inflation rate minus expected inflation rate derived from an ARMA model for WPI inflation &GDP deflator respectivelyGINRW: Annual inflation rate - expected inflation rate derived from random walk assumptionOGAP: Output gap. Potential calculated by passing through HP filterAggregate demand instruments: WG: World annual GDP growthNREG: Dummy variable = 0 when the program had not started and the value of ratio of districts covered when it was operatingAggregate supply shocks:OIL (-2): Terms of trade variable calculated as US$ price of a barrel of oil xUSDINR exchange rate, to get the Rupee value of oil; then deflated by WPI inflation index to convert to real terms. Quarterly change in the real value of oil. 2quarter lag worked best. RAINS: Percentage deviation of monsoon rains from normal. Std. errors in parentheses*** p<0.01, ** p<0.05, * p<0.10

39. Figure 2: When a Nominal GDP TargetDelivers a Better Outcome than IT Estimates Suggest: Supply shock is split between output & inflation objectives rather than falling exclusively on output as under IT (at B).

41. Appendix 1:Rules vs. discretion Appendix 2:Are Emerging Markets vulnerableto a global financial shock?

42. Appendix 1:Why constrain monetary policy by a rule? In the dynamic consistency model (Barro-Gordon, 1982) discretion leads to a positive bias in inflation. A credible rule can eliminate that inflation bias.

43. Dynamic inconsistency: The Intuition • Assume governments, if operating under discretion, choose monetary policy and hence AD so as to maximize a social function of Y & π. • => Economy is at tangency of AS curve & one of the social function’s indifference curves. • Assume also that the social function centers on > , even though this point is unattainable, at least in the long run. • Assume W & P setters have rational expectations • => πe (& AS) shifts up if rationally-expected E π shifts up • => πe = E π = π on average. • economy is at point B on average. Inflationary bias: πe=E π > 0. • Lesson: The authorities can’t raise Y anyway, so they might as well concentrate on price stability at point C. Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

44. 3. But πe adjusts upward in responseto observed π>0. The LR or Rational Expectations equilibrium must feature πe = π. Result: inflationary bias π>0, despite failure to raise Y above . π ● πe 2. If πe would stay at 0, ● then to get the higher Y it would be worth paying the price of π>0. 4. The country would be better off “tying the hands” of the central bank. Result: Y = (no worse on average than under discretion),and yet π=0. ● • Barro-Gordon innovation: It can be useful to think of society’s 1st choice as Y= • (& π=0), even if it is unattainable. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Harvard University

45. TIME-INCONSISTENCY OF NON-INFLATIONARY MONETARY POLICY (Romer 11.53) + Policy-maker minimizes quadratic loss function: where the target. => (11.54) Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

46. Given discretion, the CB chooses the rate of money growth and inflation (assuming it can hit it) where . Take the mathematical expectation: + Rational expectations: => (10.15), the inflationary bias. (11.58) Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

47. ADDRESSING THE TIME-INCONSISTENCY PROBLEM • How can the CB credibly commit to a low-inflation monetary policy? • Announcing a policy target π = 0 is time-inconsistent, because a CB with discretion will inflate ex post, and everyone knows this ex ante. • CB can eliminate inflationary bias only by establishing non-inflationary credibility, • which requires abandoning the option of discretion. • so public will see the CB can’t inflate even if it wants to. • CB “ties its hands,” as Odysseus did in the Greek myth. Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

48. Addressing the Time-Inconsistency Problem (continued) • Reputation • Delegation. Rogoff (1985): Appoint a CB with high weight on low inflation a′ >> a , and grant it independence.It will expand at only << inflationary bias of discretion. • Binding rules.Commit to rule for a nominal anchor: 1. Price of gold 2. Money growth3. Exchange rate 4. Nominal GDP 5. CPI 6. GDP deflator 4. Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

49. Appendix 2:Are Emerging Markets vulnerableto a global financial shock? • Boom-bust cycle in EM capital flows • External shocks • “Risk off” • US interest rates • Which countries withstand shocks • In 2008-09 and previous crises? • In 2013 US “taper tantrum”?

50. 3 waves of capital flows to Emerging Markets: late 1970s, ended in the intl. debt crisis of 1982-89; 1990-97, ended in East Asia crisis of 1997-98; and 2003-2008, ended … when? IIF http://www.iif.com/press/press+406.php