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Approaches to Assessing Currency Misalignment

Approaches to Assessing Currency Misalignment. Menzie D. Chinn UW-Madison & NBER http://www.ssc.wisc.edu/~mchinn. Presentation at Office of International Affairs Department of the Treasury October 26, 2006. Outline. Caveats Methodologies Example: China New Approaches Conclusion.

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Approaches to Assessing Currency Misalignment

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  1. Approaches to Assessing Currency Misalignment Menzie D. Chinn UW-Madison & NBER http://www.ssc.wisc.edu/~mchinn Presentation at Office of International Affairs Department of the Treasury October 26, 2006

  2. Outline • Caveats • Methodologies • Example: China • New Approaches • Conclusion

  3. Key Point: There Are Many Equilibrium Exch. Rates • There is no way to get the equilibrium rate and hence misalignment • The appropriate measure depends upon the conditions of the economy you’re examining • Different models will be relevant • And different models will be consistent with different time horizons.

  4. Methodologies • Relative PPP • Absolute PPP/Deviations from Absolute PPP • Productivity based models • BEERs/Fair Value Models • Macroeconomic Balance/FEERs/External or Basic Balance

  5. Relative PPP • Assumes that relative price levels (measured by deflators, CPIs, or PPIs) adjusted by nominal exchange rates must be revert to some average level. • Other deflators possible -- ULCs • More flexible interpretations allow for reversion to trends. • A long run – goods arbitrage perspective

  6. Example: US Dollar (in real terms) Source: DB, Exchange Rate Perspectives, October 2006.

  7. Example: US Dollar (nom. terms)

  8. Example: Korean Won (nom. terms) Source: Chinn, EMR (2000)

  9. Problems • The relative PPP level must occur in the sample period. • Only if the real exchange rate is stationary is the conditional mean invariant with respect to the sample. • Related to the issue of whether the real rate is I(0), or price indices and the exchange rate are cointegrated with (1 -1 1) coefficients.

  10. Absolute PPP • Absolute PPP requires the prices of bundles of goods are equalized in common currency terms. • MacParity is a special case of absolute PPP. • But Absolute PPP doesn’t hold across countries of dissimilar incomes

  11. The Failure of Absolute PPP Note: Log “price level” & log income/capita in 2000$. Source: Cheung, et al. (2006); WDI.

  12. “Penn Effect” and MacParity Source: Pakko and Pollard, FRB SL Review (2003).

  13. Productivity Based Models • Balassa-Samuelson is the most prominent • Higher productivity levels in tradable sector induces a stronger currency in real terms. • Assumes PPP for traded goods. • Perfect factor mobility w/in countries. • Isn’t the only relevant model; in two good models, higher productivity may lead to a weaker real currency. • Also a long run/long horizon model.

  14. Example: China Source: Cheung, et al., FRB SF conference paper (2005).

  15. BEER/DEER or “Kitchen Sink” • Combination of Balassa-Samuelson, real interest differential (UIP with sticky prices), nontradables, and portfolio balance motivations (see Cheung, et al. (2005)). Source: F. Yilmaz and S. Jen, Morgan Stanley (2001). • Where does NFA come from? CA equals inverse of negative returns times NFA. See Lane and Milesi-Ferretti (2002).

  16. Macro Balance and Related Approaches • Determine a “normal” level of current account balance or “basic balance” • “Basic balance” is current account plus financial account (sometimes FDI flows). • Using price elasticities, back out the equilibrium exchange rate. • If an econometric approach is used to determine “normal” level of CA, then IMF’s “Macroeconomic Balance” approach.

  17. In-Sample Fit for CA “norms”: Korea & Emerging Asia Source: Chinn and Ito (2006)

  18. In-Sample Fit: China Source: Chinn and Ito (2006)

  19. Complications • Large prediction intervals for CA norms. • What are the relevant trade elasticities? • What are the conditioning variables (e.g., does one take budget deficits as given?) • Details? See Isard, Faruqee, Kincaid, Fetherston (2001). • FEER uses a normative assessment of equilibrium current account/basic balance. • Looking at reserve accumulation is a variation on this approach.

  20. Many Equil’m Rates: China GAO (August 2005)

  21. Relative PPP (I)

  22. Relative PPP (II)

  23. Absolute PPP and Uncertainty Source: Cheung et al. (2006)

  24. Recent Developments • The role of net foreign assets, gross assets • Measurement of the effective exchange rate

  25. Assets and Adjustment: Gourinchas-Rey • Propose a framework for NFA-ex rate movements • Builds upon reversion to trend in NFA • And an intertemporal budget constraint • So a deficit can be closed by either the traditional trade channel (net exports), or • Closed by revaluation effects • NB: depreciation works in same direction

  26. Normalized net exports/net assets • Nxa is normalized so export weight is unity • This means it’s measured in same units as exports. • Interpretation: nxa is (approx.) the %age increase in exports necessary to restore ext. balance

  27. Econometrics First part: component that f’casts future ret. Second: component that f’casts nx growth Estimate using VAR

  28. Exchange Rate Adjustment Gourinchas and Rey, “International Financial Adjustment” (2005)

  29. Approximating G-R(in-sample) Source: author’s calculations

  30. Measurement: Divisia vs. geometric? Source: Thomas and Marquez (2006)

  31. References Cheung, Yin-Wong, Menzie Chinn and Eiji Fujii, 2006, “The Overvaluation of Renminbi Undervaluation,” paper presented at the conference on “Financial and Commercial Integration,” SCCIE-JIMF conference, Santa Cruz (Sept.). http://sccie.ucsc.edu/webpages/conf/Cheung-Chinn.pdf Cheung, Yin-Wong, Menzie Chinn and Antonio Garcia Pascual, 2005 “Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?” Journal of International Money and Finance 24: 1150-1175. http://www.ssc.wisc.edu/~mchinn/FXForecast.pdf Chinn, Menzie, 2000, “Before the Fall: Were East Asian Currencies Overvalued?” Emerging Markets Review 1(2) (August 2000): 101-126. http://www.ssc.wisc.edu/~mchinn/BeforetheFall_EMR.pdf GAO, 2005, “International Trade: Treasury Assessments Have Not Found Currency Manipulation, but Concerns about Exchange Rates Continue,” Report GAO-05-351 (April).

  32. Gourinchas, Pierre-Olivier and Helene Rey, 2005, “International Financial Adjustment.” NBER Working Paper No. 11155 (February). http://www.nber.org/w11155/ Isard, Peter , Hamid Faruqee, G. Russell Kincaid, Martin Fetherston, 2001, Methodology for Current Account and Exchange Rate Assessments, IMF Occasional Paper No. 209. Lane, Philip and Gian Maria Milesi-Ferretti, 2002, “External Wealth, the Trade Balance, and the Real Exchange Rate,” European Economic Review 46: 1049-71. Pakko, Michael R. and Patricia S. Pollard, 2003, “Burgernomics: A Big Mac™ Guide to Purchasing Power Parity,” Review 85(6) Nov.: 9-28. http://research.stlouisfed.org/publications/review/03/11/pakko.pdf

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