External Sector Policies

1. External Sector Policies ThorvaldurGylfason Singapore, February 2008

2. Outline • Real vs. nominal exchange rates • Exchange rate policy and welfare • The scourge of overvaluation • From exchange and trade policies to economic growth • Capital flows • Exchange rate regimes • To float or not to float

3. 1 Real vs. nominal exchange rates Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

4. Real vs. nominal exchange rates Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

5. Three thought experiments 1. Suppose e falls Then more baht per dollar, so X rises, Z falls 2. Suppose P falls Then X rises, Z falls 3. Suppose P* rises Then X rises, Z falls Summarize all three by supposingQ falls Then X rises, Z falls

6. 2 Exchange rate policy and welfare Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

7. Exchange rate policy and welfare • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in the balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account • = 0

8. Exchange rate policy and welfare R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

9. Exchange rate policy and welfare Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Demand (imports) Deficit Foreign exchange

10. 3 The scourge of overvaluation • Governments may try to keep the national currency overvalued • To keep foreign exchange cheap • To have power to ration scarce foreign exchange • To make GNP look larger than it is • Other examples of price ceilings • Negative real interest rates • Rent controls

11. Inflation and overvaluation • Inflation can result in an overvaluation of the national currency • Remember: Q = eP/P* • Suppose e adjusts to P with a lag • Then Q is directly proportional to inflation • Numerical example

12. Inflationand overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 Average 105 100 Time

13. Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag Inflation and overvaluation Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average 100 Time

14. How to correct overvaluation • Under a floating exchange rate regime • Adjustment is automatic: e moves • Under a fixed exchange rate regime • Devaluation will lower e and thereby also Q – provided inflation is kept under control • Does devaluation improve the current account? • The Marshall-Lerner condition

15. The Marshall-Lerner condition: Theory Suppose prices are fixed, so that e = Q B = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps T Let’s do the arithmetic Bottom line is: Devaluation strengthens the current account as long as Valuation effect arises from the ability to affect foreign prices a = elasticity of exports b = elasticity of imports

16. TheMarshall-Lerner condition - + Import elasticity Export elasticity -a b 1 1

17. TheMarshall-Lerner condition Assume X = Z/e initially X if Appreciation weakens current account

18. The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, Devaluation strengthens the current account

19. Empirical evidence from developing countries Elasticity of Elasticity of exports imports Argentina 0.6 0.9 Brazil 0.4 1.7 India 0.5 2.2 Kenya 1.0 0.8 Korea 2.5 0.8 Morocco 0.7 1.0 Pakistan 1.8 0.8 Philippines 0.9 2.7 Turkey 1.4 2.7 Average 1.1 1.5

20. The small country case • Small countries are price takers abroad • Devaluation has no effect on the foreign currency price of exports and imports • So, the valuation effect does not arise • Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged • Hence, if a > 0 or b > 0, devaluation strengthens the current account

21. The importance of appropriate side measures Remember: It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in real devaluation

22. 4 From exchange and trade policies to growth Governments may try to keep the national currency overvalued Or inflation may result in overvaluation In either case, overvaluation creates inefficiency, and hurts growth Therefore, exchange rate policy matters for growth Need real exchange rates near equilibrium

23. From exchange and trade policies to growth • How do we ensure that exchange rates do not stray too far from equilibrium? • Either by floating … • Then equilibrium follows by itself • … or by strict monetary and fiscal discipline under a fixed exchange rate • The real exchange rate always floats • Through nominal exchange rate adjustment or price change, but this may take time

24. Why inflation is detrimental to growth • We saw before that inflation leads to overvaluation which hurts exports • So, here is one additional reason why inflation hurts economic growth • Exports and imports are good for growth • Several other reasons • Inflation distorts production and impedes financial development, and scares foreign investors away

25. How trade increases efficiency and growth • Trade with other nations increases efficiency by allowing • Specialization through comparative advantage • Exploitation of economies of scale • Promotion of free competition • Not only trade in goods and services, but also in capital and labor • “Four freedoms”

26. How trade increases efficiency and growth • Trade also encourages international exchange of • Ideas • Information • Know-how • Technology Trade is tantamount to technological progress • Tradeiseducation • Which is also good for growth!

27. Efficiency is crucial for economic growth • Need economic policies that help increase efficiency • Produce more output from given inputs • Takes fewer inputs to produce given output • More efficiency, better technology are two ways of increasing output per unit of input • So is more and better education • Trade increases efficiency and thereby also economic growth

28. Exports and economic growth 1960-2000 163 countries r = 0.26

29. Asia: Exports (% of GDP)

30. FDI and economic growth 1960-2000 152 countries r = 0.21

31. Asia: FDI net inflows (% of GDP)

32. Evolution of capital flows 5 A stylized view of capital mobility 1860-2000 Return toward financial integration First era of international financial integration Capital mobility Capital controls Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

33. Asia: Net capital flows and external debt indicators, 1980-2006 Source: WEO

34. Push vs. pull factors External factors “pushed” capital from industrial countries to LDCs • Cyclical conditions in industrial countries • Recessions in the early 1990s • Decline in world interest rates • Structural changes in industrial countries • Financial structure developments • Demographic changes

35. Push vs. pull factors Internal factors “pulled” capital into LDCs from industrial countries • Macroeconomic fundamentals • Reduction in barriers to capital flows • Private risk-return characteristics • Creditworthiness • Productivity

36. Large capital flows to Asia have resumed in recent years

37. Potential benefits of capital flows Improved allocation of global savings (allows capital to seek highest returns) Greater efficiency of investment More rapid economic growth Reduced macroeconomic volatility through risk diversification (which dampens business cycles) • Income smoothing • Consumption smoothing

38. Potential risks of capital flows Open capital accounts may make receiving countries vulnerable to foreign shocks • Magnify domestic shocks and lead to contagion • Limit effectiveness of domestic macro policy instruments Countries with open capital accounts are vulnerable to • Shifts in market sentiment • Reversals of capital inflows May lead to macroeconomic crisis • Sudden reserve loss, exchange rate pressure • Excessive BOP and macro adjustment • Financial crisis

39. Potential risks of capital flows Overheating of the economy Excessive expansion of aggregate demand with inflationary pressures, real exchange rate appreciation, widening current account deficit Increase in consumption and investment relative to GDP • Quality of investment suffers • Construction booms Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime

40. Real stock prices during inflow periods, selected countries Chile 1978-81 Mexico Venezuela Chile 1989-94 Sweden Finland Year with respect to start of Inflow period Note: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the 1980s and 1990s and for Venezuela is shown on the right. Source: World Bank (1997)

41. Stock prices in Thailand 1987-2000

42. Early warning signs Large deficits • Current account deficits • Government budget deficits Poor bank regulation • Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt • Ratio of short-term liabilities to foreign reserves Mismatches • Maturity mismatches (borrowing short, lending long) • Currency mismatches (borrowing in foreign currency, lending in domestic currency)

43. Asia: Ratio of short-term liabilities to foreign reserves in 1997

44. Large reversals

45. Country experiences with capital account liberalization • External or financial crisis followed capital account liberalization • E.g., Mexico, Sweden, Turkey, Korea, Paraguay • Response • Rekindled support for capital controls • Focus on sequencing of reforms • Sequencing makes a difference • Strengthen financial sector and prudential framework before removing capital account restrictions • Remove restrictions on FDI inflows early • Liberalize outflows after macroeconomic imbalances have been addressed

46. Some types of capital flows are riskier than others Portfolio equity High degree of risk sharing Foreign direct investment Short term debt Long term debt (bonds) No risk sharing Transitory Permanent

47. Sequencing Capital Account Liberalization Pre-conditions for liberalization • Sound macroeconomic policies • Strong domestic financial system • Strong and autonomous central bank • Timely, accurate, and comprehensive data disclosure

48. 6 Exchange rate regimes • The real exchange rate always floats • Through nominal exchange rate adjustment or price change • Even so, it makes a difference how countries set their nominal exchange rates because floating takes time • There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

49. Exchange rate regimes • There is a range of options • Monetary union or dollarization • Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) • Currency board • Legal commitment to exchange domestic for foreign currency at a fixed rate • Fixed exchange rate (peg) • Crawling peg • Managed floating • Pure floating

50. Exchange rate regimes FIXED FLEXIBLE  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Independent