‘Unequal Partners’: The Role of International Financial Flows and the Exchange Rate Regime

1. ‘Unequal Partners’: The Role of International Financial Flows and the Exchange Rate Regime Eric Kam Ryerson University John Smithin York University

2. Introduction - what CCP meant by the term “unequal partners” was: • LDCs (basic economic growth and development) • MINs (limited domestic market creates perennial competitive disadvantage) - we examine the effects of: • financial flows • monetary policy • alternative exchange rate regimes

3. Introduction (cont.) - design policies promoting growth and development; apply with equal effectiveness to LDCs and MINs - historically “monetary mercantilism” strategies were employed by nations that did succeed in reaching higher growth paths; why not the same for today’s LDCs and MINs? - contrast with policy initiatives of orthodox theory (austerity-based programs) suggested by international bureaucracies - where does the “money” come from?; it is “endogenous”, created domestically; requires the appropriate set of domestic financial (and political) institutions

4. Under Floating Exchange Rates - BP is the current account (CA) plus the capital account (KA): BP = CA + KA (1) - CA is given by: CA = X – IM + FII (2) (X stands for exports, IM for imports, FII for foreign investment income, OF is “official financing”) - in a pure floating exchange rate system: domestic authority does not intervene in foreign exchange market BP deficits and surpluses do not exist; eliminated through exchange rate changes OF = BP = 0 (3)

5. Under Floating Exchange Rates (cont.) • KA and CA must move in opposite directions such that: CA = - KA (4)

6. “Monetary Mercantalism” - growth strategy implied by “monetary mercantilism” is that (e.g.) domestic monetary authorities follow an expansionary monetary policy and lower real interest rates: • stimulates growth • causes capital outflows (negative KA) – but this is not necessarily a “bad thing” • depreciates the real exchange rate • leads to a further export-led stimulus to growth (positive CA) - can be argued that following nations all did something like this in their rise to prominence as “capitalist” powers (not necessarily always with floating rates): • 17th century Holland • 18th and19th century Britain • 20th century America • late 20th century Japan • contemporary China

7. “Monetary Mercantalism” (cont). - in each historical case, possible to identify the competitive advantage for the domestic economy over its rivals in terms of: • cost and provision of finance • a competitive real exchange rate • a positive CA • capital outflows leading to creditor position (just recently in China)

8. Objections from Orthodox Economic Theory - deny that domestic monetary authority has power to stimulate the economy in the suggested manner: • it is argued that the interest rate cannot be affected by monetary policy and is a “natural” rate determined by forces of productivity and thrift; monetary authority has no control over its determination and value • not a valid theoretical proposition for a monetary economy - argue that “monetary mercantilism” is merely inflationary: • lower real interest rates and other expansionary policy in a domestic economy can result in higher inflation rates, but not “ever-accelerating” inflation • only if interest rate policy is conducted in nominal not real terms is there a danger that inflation is unstable and unmanageable.

9. Objections from Orthodox Economic Theory (cont.) - argue that exchange rate depreciation/capital outflows may be destabilizing and indefinite • no, if interest rate policy is defined in real terms, there is always a new equilibrium value for real exchange rates and the foreign credit position - argue that only one country can succeed; it is a “beggar-thy- neighbour” policy • false, if one country pursues low interest rate and others do not, it will indeed benefit from the policy and others will not; but if all countries pursue such a policy, growth increases in all, and BP will be in balance

10. Fixed Exchange Rates - BP surpluses/deficits are reflected in changes in FE reserves held by the domestic central bank, instead of exchange rate changes: OF = BP = CA + KA (5) - CA equals capital outflows plus changes in foreign exchange reserves: CA = -KA + OF (6) - it is theoretically possible for both CA and KA to increase at the same time under a fixed rate regime (assuming a large rise in FE reserves): CA + KA = OF (7)

11. Fixed Exchange Rates (cont.) - question: how to pursue monetary mercantilism under a fixed exchange rate regime? - main option seem to be a starting value of the nominal exchange rate low enough to be a real undervaluation at beginning levels of foreign/domestic prices; then there will be a CA surplus and build-up of FE reserves - downside: this is not sustainable; even if nominal exchange rate is fixed, the real exchange rate can change due to changes in domestic and/or foreign prices - if the pursuit of a successful “mercantilist” policy leads to build-up of FE reserves and causes inflation, the advantage first obtained by the undervalued exchange rate is eliminated by rising domestic prices

12. National Income Accounting for the Open Economy - gross domestic product Y is: Y = C + I + G + (X-IM)(8) - distinguish between GDP and GNP: GNP = Y + FII (9) - disbursement of GNP is given by: GNP = C + S + T (10) - use (8), (9) and (10), cancel Cs and rearrange: (G - T) + (I - S) = -CA (11)

13. National Income Accounting for the Open Economy (cont.) (G - T) + (I - S) = -CA (11) hence the “twin deficits” argument; but there is no basis for the I = S assumption on which the twin deficit theory rests; a more meaningful version of (11) is: [(G – T) + I] – S = KA – OF (12) - “net national dissaving” must be financed by capital inflows or selling FE reserves - this method of describing economic relationships directly assigns emphasis on KA as the active element in BP dynamics, this is consistent with the “monetary mercantilism” argument - however, expressions such as (11) and (12) are not helpful in discussing BP causality as they are accounting identities; all components are endogenous

14. Purchasing Power Parity - PPP argues that real exchange rate is determined by barter terms of trade and cannot be manipulated by domestic economy policy; would rule out strategies depending on real exchange rate depreciation Q = E P/P* (13) (E is nominal exchange rate; the foreign price of domestic currency, Q is real exchange rate, P* is the foreign or world price level, P is the domestic price level) - two versions of PPP theorem: absolute PPP and relative PPP - in absolute PPP (“law of one price”) equilibrium real exchange rate is Q = 1; this is a convenient assumption to illustrate orthodox models; makes no difference to the claim that Q is exogenous (cannot be permanently changed except by changes in barter terms of trade)

15. Purchasing Power Parity (cont.) - using absolute PPP, the theory of nominal exchange rates is simple: E = P*/P (14) - PPP conforms well with the beliefs of orthodox theory, but cannot survive criticism - the nature of the exchange rate regime itself is the decisive factor in determining whether PPPhas practical relevance - with flexible exchange rates, PPP does not hold and the real exchange rate is an endogenous variable - to construct an economic system where PPP holds demands the artificial construction of an “IFA” seemingly almost designed to block economic growth and development

16. Various Definitions of the Interest Parity Condition - the “covered interest parity” (CIP) condition holds in the case of “perfect capital mobility”; if E is nominal spot exchange rate i is domestic nominal interest rate, i* is the foreign nominal interest rate, and F is “forward exchange rate” ): i – i* = (E – F)/E (15) - seems to imply restrictions on behaviour of the domestic interest rate and the ability of domestic monetary authorities to influence trade policy ; a much stronger condition than CIP is “uncovered interest parity” (UIP), this holds in case of “perfect asset substitutability”; if E’ is expected future spot rate: i* - i = (E’ – E) /E (16)

17. Various Definitions of the Interest Parity Condition (cont.) - asssuming CIP and UIP both hold: F = E’ (17) - if (and only if) CIP, UIP and PPP all hold: r = r* (18) - this is real interest rate parity (RIP), which states that domestic real interest rates conform to those in world markets; blocks monetary mercantalism; (open economy version of Wicksell?)

18. Problems with Interest Parity and PPP Assumptions - RIP cannot be assumed to hold in general, the various assumptions on which RIP is founded may be challenged; CIP is either a consequence of perfect capital mobility in the global economy, or “cambist” behaviour by international financial institutions - no reason to assume UIP holds in general; even if financial capital is completely mobile, UIP should only hold up to the inclusion of a “currency risk premium” even if financial can capital cross borders instantly, assets denominated in different currencies, and where exchange rates are liable to change, are not perfect substitutes; if z is the risk premium: i - i* = (E - E’)/E + z (19)

19. Problems with Interest Parity and PPP Assumptions(cont.) - the forward exchange rate is not equal to the expected future spot exchange rate: F = E’ + z (20) - the assumption of PPP itself (within RIP) is also a problem, PPP fails to withstand empirical tests, suggests that the real exchange rate could be an endogenous not an exogenous variable; in the case where the null hypothesis is absolute PPP: Q* -/-/- 1 (22)

20. Problems with Interest Parity and PPP Assumptions (cont.) - when Q* is endogenous there is no meaning in the PPP theorem In its usual ex post sense - if UIP and PPP fail to hold, RIP cannot hold; the real interest rate differential between the domestic and foreign economy is given by: r – r* = (Q – Q’)/Q + z (22) - with separate monetary systems, flexible exchange rates and perfect capital mobility, domestic real interest rates can vary from foreign real interest rates by the expected real appreciation or depreciation of the domestic currency plus the risk premium - “monetary mercantilism” is a feasible option in these circumstances

21. Fixed Exchange Rates and the Domestic Rateof Interest - in a credible fixed exchange rate regime, the domestic monetary authority loses control over the domestic interest rate; with fixed exchange rates; the nominal exchange rate is not expected to change, so E - E’ = 0; if the fixed exchange rate regime is “credible” (expected to continue with certainty) it must also be true that z = 0: i = i* (23) - the definition of a credible fixed exchange rate regime is strong, and in the case of uncertainty regarding the permanence of the fixed exchange rate regime, or if periodic exchange rate adjustment is permitted, results may be softened - for example, suppose that the exchange rate regime is not actually expected to change, but there is residual uncertainty, then: i - i* = z (24) - ironically achieving a degree of policy independence under a fixed exchange rate regime implies that the regime is not “perfect”

22. Fixed Exchange Rates and the Domestic Rate of Interest(cont.) - real interest rates could still differ if there were any residual inflation differentials but in this case, there would still be no scope for domestic monetary policy to influence the inflation rate, real exchange rate, or the real interest rate - in the absence of any residual inflation differentials, we would have Q’ = Q, referred to as ex-ante PPP (not to be confused with the genuine ex-post PPP theorem), so that: r = r* (25) - this is the RIP condition above but is now imposed by the nature of the exchange rate regime

23. Conclusions - a priority for economic development and growth: independent nations must first build relevant financial and monetary institutions domestically, such that developing economies can create capital at a reasonable cost rather than borrowing capital from abroad - the domestic economy supplies its own capital, and may export capital to the rest of the world, as opposed to buying capital abroad - some form of “monetary mercantilist” strategy is the logical advice for LDCs and MINs seeking to improve their international position - choosing to fix or peg the exchange rate, support an overvalued domestic currency, set up a currency board, join a currency union, etc., will only block the strategy and preserve the unwanted status as an “unequal partner”