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Exchange Rate Regimes Appendices Jeffrey Frankel Harpel Chair, Harvard University IMF Institute

Exchange Rate Regimes Appendices Jeffrey Frankel Harpel Chair, Harvard University IMF Institute  * May 28, 2010 *. Appendices. On the RMB Charts showing evolution of choices of regimes, from IMF Tables comparing economic performance of different regimes Corners Hypothesis

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Exchange Rate Regimes Appendices Jeffrey Frankel Harpel Chair, Harvard University IMF Institute

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  1. Exchange Rate Regimes Appendices Jeffrey Frankel Harpel Chair, Harvard University IMF Institute  * May 28, 2010 * Professor Jeffrey Frankel

  2. Appendices • On the RMB • Charts showing evolution of choices of regimes, from IMF • Tables comparing economic performance of different regimes • Corners Hypothesis • Do exchange rate regimes have real effects? • More on the synthesis technique for estimating de facto exchange rate regimes. Professor Jeffrey Frankel

  3. Appendix I On the RMB:More on China’s currency policy Professor Jeffrey Frankel

  4. Five reasons China should let RMB appreciate, in its own interest • Overheating of economy • Excessive reserves. • Attaining internal and external balance. • Avoiding future crashes. • RMB undervalued, judged by Balassa-Samuelson relationship. Professor Jeffrey Frankel

  5. 1. Overheating of economy: • Bottlenecks. Pace of economic growth (10%) outrunning • Raw material supplies • Physical infrastructure. • Shanghai stock market bubble (2006-07). • Inflation 6-7% => price controls(Sept. 2007), … => shortages and social unrest. • After the 2008-09 interruption, China in 2010 is again in danger of overheating • inflation • real estate bubble. Professor Jeffrey Frankel

  6. China’s CPI accelerates in 2007-08 Inflation 2002 to 2008 Q1 Professor Jeffrey Frankel Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

  7. 2. Foreign Exchange Reserves • Excessive: • Though a useful shield against currency crises, • China has enough reserves: $2 ½ trillionby mid-2010; • & US treasury securities do not pay high returns. • Harder to sterilize the inflow over time. Professor Jeffrey Frankel

  8. The Balance of Payments ≡ rate of change of foreign exchange reserves rose rapidly over last decade Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Professor Jeffrey Frankel

  9. The Balance of Payments rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows Source: Prasad & Sorkin Professor Jeffrey Frankel

  10. Not only has the level of fx reserves risen,but the rate of change(BoP surplus)shows acceleration Source: Prasad & Sorkin Professor Jeffrey Frankel

  11. Attempts to sterilize reserve inflow: Successful sterilization in China: 2005-06 High reserve growth =>steadymoney offset by cuts indomestic credit While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. were remarkably successful in 2005-06. Professor Jeffrey Frankel

  12. In 2007 China began to have more trouble sterilizing the reserve inflow (as predicted) • PBoC began to have to payhigher domestic interest rates • and to receive lower interest rate on US T bills • => quasi-fiscal deficit. • Inflation became a serious problem in 2007-08. • True, global increases in food & energy priceswere much of the explanation. • But • Appreciation is a good way to put immediate downward pressure on local prices of agricultural & mineral commodities. • Price controls are inefficient and ultimately ineffective. Professor Jeffrey Frankel

  13. In 2008, domestic Chinese interest rates went above US T bill rates=> quasi fiscal deficit Professor Jeffrey Frankel Source: Prasad & Sorkin

  14. Sterilization faltered in 2007 & 2008 Growth of China’s monetary base, & its components Professor Jeffrey Frankel Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

  15. 3. Need a flexible exchange rate to attain internal & external balance • Between 2002 and 2007, China crossed from the deflationary sideof internal balance (ES: excess supply, recession, unemployment), to the inflationary side (ED: excess demand side, overheating). • =>Moved upward in the “Swan Diagram” • => appreciation called for. • Together with expansion of domestic demand • gradually replacing foreign demand, and • developing neglected sectors: • health, education, environment, housing, finance, services • In late 2008 it probably fell back to the deflation side, temporarily. Professor Jeffrey Frankel

  16. ED & TB>0 BB: External balance CA=0 Excgange rate E China 2007 or 2010 China 2002 ED & TD ES & TB>0 YY: Internal balance Y = Potential ES & TD China is now in the overheating + surplus quadrant of the Swan Diagram Spending A Professor Jeffrey Frankel

  17. The general principle: to attain 2 policy targets (internal & external balance), • a country needs 2 policy instruments. • In a large country like China, the expenditure-switching policy should be the exchange rate. Professor Jeffrey Frankel

  18. 4. Avoiding future crashes Experience of other emerging markets suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. Introduce some flexibility now, even though not ready for free floating. Professor Jeffrey Frankel

  19. 5. Longer-run perspective:Balassa-Samuelson relationship • Prices of goods & services in China are low • compared at the nominal exchange rate. • Of course they are a fraction of those in the U.S.: < ¼ . • This is to be expected, explained by the Balassa-Samuelson effect • which says that low-income countries have lower price levels. • As countries’ real income grows, their currencies experience real appreciation: approx. .3% for every 1 % in income per capita. • But China is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson. Professor Jeffrey Frankel

  20. The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics Undervaluation of RMB in the regression estimated above = 26%. Estimated undervaluation averaging across four such estimates = 31%. Compare to Frankel (2005) estimate for 2000 = 36%. Professor Jeffrey Frankel

  21. The Balassa-Samuelson relationship has predictive power • Typically across countries, gaps are corrected halfway, on average, over subsequent decade. • => 3-4 % real appreciation on average per year for China, including effect of further growth differential. • Correction could take the form of either inflation or nominal appreciation, but appreciation is preferable. Professor Jeffrey Frankel

  22. The conclusion – that it would be in China’s interest to allow RMB to appreciate -- • has long been shared by top economic officials in China, it is believed. • But the decision is a political one: • It is a matter of Hu and Wen ! Professor Jeffrey Frankel

  23. $2 Professor Jeffrey Frankel

  24. A new irony The Chinese decision to re-establish the dollar link in 2008, has not depreciated the RMB. • If the alternative were the loose basket peg of 2008, with heavy weight on the €, the RMB would have depreciated against the $ over the three years (because the € has) ! Professor Jeffrey Frankel

  25. Appendix II Charts showing evolution of choices of regimes, from the IMF Professor Jeffrey Frankel

  26. Last de jure (end-1999).Of 185 Fund members, Have given up own currencies: 45 EMU: 11 CFA Franc Zone: 14 E.Caribbean CA 6 “dollarized” 8 Currency boards: 8 Intermediate regimes: 89 pegs to a single currency 30 pegs to a composite 13 crawling pegs 5 horizontal bands 7 crawling bands 7 managed floats 26 “independent floaters”: 51 “De facto” (end-2004) 41 12 (+ Sloven.07; Cyp.&Malta08, Slova.09) 14 6 9 (plus Montenegro in 06) 7 104 33 (incl. China) 8 6 5 (minus Slovenia in 06) 1 51 35 IMF classification Professor Jeffrey Frankel

  27. Professor Jeffrey Frankel

  28. Professor Jeffrey Frankel

  29. Appendix III Tables comparing economic performance of different regimes: • Ghosh, Gulde & Wolf • Sturzenegger & Levy-Yeyati • Reinhart & Rogoff Professor Jeffrey Frankel

  30. Professor Jeffrey Frankel

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  33. Source: Levy-Yeyati and Sturzenegger (2001). Sample: yearly observations 1974-1999. Professor Jeffrey Frankel

  34. Source: Levy-Yeyati and Sturzenegger (2001). Sample: yearly observations 1974-1999. Professor Jeffrey Frankel

  35. Appendix IV: The corners hypothesis • Aliases: • Hollowing out • Bipolarity (Stan Fischer) • The Missing Middle (The Economist) • Hypothesis of the vanishing intermediate exchange rate regime • Origins: • 1992-93 ERM crises -- Eichengreen (1994) • Late-90’s crises in emerging markets • 1994 Mexico • 1997 Thailand, Korea • 1998 Russia; Brazil • 2001 Turkey • Other supporters included: Summers Treasury, CFR, Meltzer Commission, IMF… Professor Jeffrey Frankel

  36. Are countries moving to the corners? • Fischer (2001): Intermediate pegs, at 34%, are down from 62% in 1991. Trend is toward a smaller number of blocs, each on its own currency. • But, in fact: • There are as many currencies now as in 1991. • Many de jure floaters never have been genuine. • The intermediate regimes are alive and well. • The dominant long-term trend is, rather, to flexibility. Professor Jeffrey Frankel

  37. The trend is in fact not away from intermediate regimes, but rather away from fixed exchange rates. Professor Jeffrey Frankel

  38. The Corners Hypothesis has ebbed • The hypothesis that countries could rigidly peg or freely float, but should abandon intermediate regimes like target zones, became fashionable in the late 1990s. • The pendulum has swung back: • Especially after failure of Argentina’s currency board & 2001 economic collapse • Surely an intermediate regime (BBC) is the right answer for China now. • Bottom line on corners hypothesis: • Don’t cling to overvalued pegs. • But don’t blame exchange rate regime for symptoms of other problems. Professor Jeffrey Frankel

  39. Appendix V:Do exchange rate regimes matter “real”-ly? • I.e., do nominal regimes affect real variation? • Some theoretical models say they don’t, that they only determine whether real shocks show up in the form of nominal exchange rates or prices. • History says they do. -- e.g., Mussa (1986): • The final nail in the coffin is Alan Taylor’s (2002) century-of-PPP study. Professor Jeffrey Frankel

  40. VOLATILITY OF Q DEPENDS ON REGIME • Is it coincidence? No, it can’t be. Every time a move to increased flexibility raises variability of nominal exchange rates, it also raises variability of real exchange rates. • Pre- and post-1973 • Inter-war period (Eichengreen 1988): 1922-26 float vs. 1927-31 fix • Post-war regimes (Mussa1986): - Canadian float in the 1950s - Ireland: 1957-70 $ peg; 1973-78 union with £; 1979-99 Eur. ERM • A Century of PPP (Alan Taylor2002):1870-1914 Gold standard 1914-45 Interwar 1946-71 Bretton Woods 1971-96 Float

  41. Taylor spliced together 100 years of data for 20 currencies. Professor Jeffrey Frankel

  42. Exchange rate variability across a century of regimesEach observation is a country-regime.Adapted from A.Taylor(2002). Variability of real exchange rate Variability of nominal exchange rate Professor Jeffrey Frankel

  43. Appendix VI: Synthesis Technique for Estimating De Facto Exchange Rate Regimes Frankel & Wei (IMF Staff Papers, 2008) Professor Jeffrey Frankel

  44. Synthesis of the techniques for inferring flexibility parameter and for inferring basket weights(Frankel & Wei, IMF Staff Papers, 2008) Δ log Ht = c + ∑ w(j) Δ logX(j)t + ß {Δ empt } + ut = c + w(1)Δ log $ t+ w(2) Δ log € t + w(3) Δ log ¥ t + w(4) Δ log £t + … + ß {Δ empt } + u t where H ≡ value of home currency, X(j)≡ value of foreign currency,defined in terms of suitable numeraire, like SDR w(j) ≡currency weights in basket, to be estimated; Δ empt≡ change in Exchange Market Pressure ≡ Δ log Ht + (ΔRest )/Monetary Baset ß ≡flexibility parameter, to be estimated: ß=1 => the currency floats purely (no changes in reserves);ß=0 => the exchange rate is purely fixed. Professor Jeffrey Frankel

  45. FindingsFirst we test out the synthesis techniqueon some known $ peggers • RMB(Table 2.5): • a perfect peg to the dollar during 2001-04 ($ coefficient =.99, flexibility coefficient insignificantly different from 0, & R2=.99). • In 2005-07 the EMP coefficient suggested that only 90% of increased demand for the currency shows up in reserves, rather than 100%; but the $ weight & R2 were as high as ever. • Hong Kong $(Table 2.8): • close to full weight on US$, 0 flexibility, & perfect fit. Professor Jeffrey Frankel

  46. A commodity-producing pegger • Kuwaiti dinar shows a firm peg throughout most of the period: a near-zero flexibility parameter, & R2 > .9 (IV estimates in Table 3.5; IV= price of oil). • A small weight was assigned to other currencies in the 1980s basket, • but in the 2nd half of the sample, the anchor was usually a simple $ peg. Professor Jeffrey Frankel

  47. A first official basket peggerwhich is on a path to the € • The Latvian lat(Table 2.10) • Flexibility is low during the 1990s, and has disappeared altogether since 2000. R2 > .9 during 1996-2003. • The combination of low flexibility coefficient and a high R2 during 2000-03 suggests a particularly tight basket peg during these years. • Initially the estimated weights include $-weight .4 ¥-weight .3; though both decline over time. DM-weight .3 until 1999, • then transferred to €: .2 in 2000-03 and .5 in 2004-07. Professor Jeffrey Frankel

  48. A 2nd official basket peggeralso on a path to the € • The Maltese lira(Table 2.12) • a tight peg during 1984-1991 and 2004-07 (low flexibility coefficient & high R2). • During 1980-2003, weight on the $ is .2 -.4. • During 1980-1995, the European currencies garner .3-.4, the £ .2-.3 & the ¥ .1. • At the end of the sample period, the weight on the € rises almost to .9. Professor Jeffrey Frankel

  49. 3rd official basket pegger • Norwegian kroner(Table 2.14) • The estimates show heavy intervention. • Weights are initially .3 on the $ and .4 on European currencies (+ perhaps a little weight on ¥ & £ ). • But the weight on the European currencies rises at the expense of the $, until the latter part of the sample period shows full weight on the € and none on the $. Professor Jeffrey Frankel

  50. 4th official basket pegger • Seychelles rupee(Table 2.17) • confirms its official classification, particularly in 1984-1995: not only is the flexibility coefficient essentially 0, but R2 > .97. • Estimated weights: .4 on the $, .3 on the European currencies, .2 on the ¥ and .1 on the £. • After 2004, the $ weight suddenly shoots up to .9 . Professor Jeffrey Frankel

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