Currency Wars: Global Money in 2011

1. Currency Wars:Global Money in 2011Jeffrey FrankelHarpel Professor of Capital Formation & Growth, Harvard University MAS Sponsored Public Lecture, Singapore, March 2011

2. What are the currency wars? • Review of the last 6 months. • Is the currency war metaphor appropriate? • Which emerging markets are intervening the most to dampen the appreciation of their currencies? • What is the right way to measure it? • What should they be doing? Lessons from recent crises. • The 3 big currencies • $ • RMB • €

3. Who is doing how much? • It is not enough to look at increases in FX reserves. • The question: for a given increase in Exchange Market Pressure (EMP), how much does the central bank absorb as an rise in the value of its currency (exchange rate) versus how much as an increase in the quantity (reserves). • How much should it intervene, vs. appreciate? • What can we learn from recent crises?

4. Currency Wars chronology, 2010 • June China announces more flexibility in RMB, • after postponement of Treasury report on undervaluation, thereby saving face; • but little appreciation follows. (Repeat of 2005.) • September 15Japan buys $20 b for ¥, • after 6-year absence from FX markets; • thereby joining Switzerland, the other floater to have appreciated in 2008-09 GFC and to have fought it by FX intervention.

5. Currency Wars chronology, continued • September 27 warning from Brazil’s Finance Minister Guido Mantega: “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness.” • I.e., countries everywhere are trying to push down the value of their currencies, to gain exports and employment, • a goal that is not globally consistent.

6. Some consider FRB policy another instance. Renewed flows to emerging markets have met with intervention e.g., by Korea, host of November G20 summit. Brazil, Thailand, India & others must decide how to manage inflows: Capital controls? Appreciation? Buying $ to prevent appreciation China’s RMB remains the dominant issue.

7. Currency Wars chronology,Nov.2010 • As European sovereign debt crisis resurfaces in Ireland, (1.3 $/€Nov.17). • Chinese government, responding to 4.4% inflation in October • raises i, • reserve requirements, • & price controls. • US core inflation falls to 0.6% for year, • the lowest since 1957.

8. Chinese inflation reached 8% in 2008 and climbed back up to 4.9% as of Feb.2011 Source: WSJ

9. US core inflation is the lowest in 50 years Jan 2011

10. Currency Wars chronology, Nov.2010 G20 Summit in Korea is first chaired by a non-G8 country

11. Currency Wars chronology, Nov.2010 • Nov. 12: G-20 Summit in Seoul judged a failure, at least for Obama: • Rebuff of US proposal for cap on Current Account surpluses at 4% of GDP. • No pledge to refrain from “competitive undervaluation” • A suggestion to countries with widely used currencies like the $ to “be vigilant against excess volatility,” a warning against loose monetary policy.

12. Currency Wars chronology, Nov. 2010 • Nov.21: Fed announces QE2 decision -- • Will purchase $600b in bonds. • Short-term market reaction -- $ depreciates. • Critiques -- • Sarah Palin & John Taylor: “US is debauching its currency.” • Germany, China & Brazil: “$depreciation=deliberatesalvo in currencywars.”

13. Currency Wars chronology, Jan.2011 • Jan.14, 2011: Geithner notes that -- including China’s higher inflation -- RMB is appreciating at 10% per year. • That suggests (appropriately) lower USG priority on the currency issue • than on IPR, North Korea & other issues • in Jan.19 Obama-Hu summit.

14. 5% nominal appreciation per annum + 5% inflation differential ≈ 10% real appreciation per annumover last half-year Global Macro Monitor Data sources: The Economist, BLS, CEIC, Thomson Reuters

15. Currency Wars chronology, 2011 • Feb. 4, 2011 • In biannual report to Congress, U.S.Treasury calls RMB "substantially undervalued." • But it once again refrains from naming China a currency manipulator. • and points out real appreciation is at 10%.

16. Currency Wars chronology Feb. 15, 2011:US Treasury Secretary Geithner fails to convince Brazil to jointly pressure China.Mantega responds:“the $ is as much a problem as the RMB.” Financial Times Feb. 16, 2011

17. Feb. 18-19, 2011: • First meeting of G20 ministers in France’s year as host. • Sarkozy no longer talking of “a new Bretton Woods.” • But G20 goes ahead with a system of indicators, • including probably currency reserves, exchange rates, current account balances, budget deficits and sovereign debt levels.

18. Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates rooted in the 1930s. That is why the architects of the post-war monetary order chose fixed exchange rates at Bretton Woods, NH, in 1944. But it is now used to argue that China should move from fixing to floating. US Congressmen don’t care about regimes; they just want a stronger RMB vs. $. Is the currency war metaphor applicable?

19. Intervention in emerging markets to fight currency appreciation • Who is doing how much? • It is not enough to look at increases in FX reserves. • The question: for a given increase in Exchange Market Pressure (EMP), how much does the central bank absorb as an rise in the value of its currency (exchange rate) versus how much as an increase in the quantity (reserves). • How much should it intervene, vs. appreciate? • What can we learn from recent crises?

20. Is the currency war metaphor applicable? • Meanwhile, fear of “competitive devaluation” is also used as an argument against US monetary expansion. • But monetary expansion is nota “beggar-thy-neighbor” policy: • Although in theory it should depreciate $, • at the same time it boosts US growth & so imports. • The net of the two effects on trade balance is ambiguous in theory and ≈ 0 in practice. • Do other countries want a U.S. “double dip” ?

21. Economic historians have decided competitive devaluation under 1930s conditions was not a problem after all. True, countries couldn’t all devalue against each other, But they could and did all devalue against gold which worked to ease global monetary policy, just what was needed. The same was needed in 2008-09 Is the currency war metaphor applicable?continued

22. Is the currency war metaphor applicable?continued The currency war talk – especially the criticism of US monetary policy -- seems to forget the point of floating rates: Different countries will always have different needs at any point in time e.g., high unemployment in US & European periphery, while China & Brazil & India are overheating. The point of a floating rate system is that US can choose its easy monetary policy and Brazil its tight monetary system, with appreciation of $ vs. real accommodating the divergence. Multilateral cooperation is not necessary for this.

23. Is the currency war metaphor applicable?continued But other kinds of international cooperation are needed; the currency war & 1930s metaphors are not totally misplaced: Currency war could turn into trade war if Congress follows through on legislation to impose (WTO-illegal) tariffs on China as punishment for non-appreciation. Until now, the US & G20 have held the line on protectionism compared to the milder recessions of 1991 & 2001, let alone the Smoot Hawley tariff of 1930.

24. China would take some responsibility to reallocate its economy away from exclusive reliance on exports & manufacturing toward domestic consumption & services, health, education, housing, environment, insurance & other services. How? By allowing the RMB to appreciate, but also by increasing domestic demand. Meanwhile, the US would ideally also take responsibility. Even while prolonging expansionary policy this year, including fiscal expansion designed with high bang-for-the-buck, the US should take steps today to lock in a future return to fiscal responsibility, e.g., by putting Social Security on a firm footing. Ideally the US & China would reach agreement on how to address current account imbalances:

25. Intervention in emerging markets to fight currency appreciation • Who is doing how much? • It is not enough to look at increases in FX reserves. • The question: for a given increase in Exchange Market Pressure (EMP), how much does the central bank absorb as an rise in the value of its currency (exchange rate) versus how much as an increase in the quantity (reserves). • How much should it intervene, vs. appreciate? • What can we learn from recent crises?

26. Capital flows to emerging markets, especially Asia, recovered quickly from the 2009 recession.These countries again show big balance of payments surpluses Goldman Sachs

27. China gets the most attention, partly because it is so large in trade andpartly because it absorbs most of its Exchange Market Pressure as FX intervention, rather than appreciation %

28. Korea (& Singapore & Taiwan) are also adding heavily to reserves. GS Global ECS Research

29. But that’s partly because Singapore & Korea faced the greatest total Exchange Market Pressure in 2010 Goldman Sachs Global Economics Weekly 11/07Feb. 16, 2011

30. Since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; Hong Kong & Singapore the least, followed by Malaysia & China. Goldman Sachs Global Economics Weekly 11/07Feb. 16, 2011

31. Korea’s intervention to dampen won appreciation has been largely on the forward market Goldman Sachs Global Economics Weekly 11/07 Feb. 16, 2011

32. India & Malaysia in 2010 took the inflows in the form of currency appreciation, more than reserve accumulation. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research

33. In Latin America, renewed inflows are reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research

34. If a country faces an increase in exchange market pressure, should it appreciate? Or intervene? • It is the old debate over floating versus fixed exchange rate. • What can we learn about the answer from recent crises?

35. Two lessons from the 1990s emerging market currency crises • Advantages of floating: • Speculators don’t have a target to shoot at; • Accommodate shocks; • Discourage unhedged $ liabilities. • Advantages of holding forex reserves • Reduces danger of crisis. • How did these lessons fare in the crises of 2008-09?

36. EWIs: The variables that show up as the strongest predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation Source: Frankel & Saravelos (2010)

37. Best and Worst Performing Countries -- F&S (2010), Appendix 4

38. F & Saravelos(2010):Bivariate

39. F & Saravelos (2010):Multivariate

40. Reserves • Even though many developing & emerging market countries described themselves as floating, • most took advantage of the boom of 2003-2008 to build up reserves to unheard of heights, • in the aftermath of the crises of 1994-2001. • in contrast to past capital booms (1975-81, 1990-97).

41. When the 2008-09 global financial crisis hit, • those countries that had taken advantage of the 2003-08 boom to build up reserves did better. • E.g., Obstfeld, Shambaugh & Taylor (2009) • Frankel & Saravelos (2010), • This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises.

42. Poland, the only continental EU member with a floating exchange rate, was also the only one to escape negative growth in the global recession of 2009 % change in GDP (de facto) Source: Cezary Wójcik, 2010

43. The Polish exchange rate increased by 35%. Depreciationboostednetexports; contribution to GDPgrowth > 100% Source: Cezary Wójcik zlotys / $ Contribution of Net X to GDP: 2009: 2,5 3,4 3,2 3,4 GDP growth rate: 1,7 kroon / $ Estonia lats / $ Latvia

45. Appendices: The 3 big currencies Appendix I: The end of $ hegemony? Appendix II: Is RMB appreciation in China’s own interest? Appendix III: Predictions – Sovereign debt troubles & the € Appendix IV: More on the trend to a multiple reserve system

46. Appendix 1: The end of dollar hegemony ? • Some argue the US current account deficit is sustainable indefinitely. • They believe that the US will continue to enjoy its unique “exorbitant privilege,” • able to borrow unlimited amounts in its own currency • because it is the dominant international reserve asset.

47. “Bretton Woods II” • Dooley, Folkerts-Landau, & Garber (2003) : • today’s system is a new Bretton Woods, • with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating. • More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

48. My own view on Bretton Woods II: • The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or 1958. • Why did the BW system collapse in 1971? • The Triffin dilemma could have taken decades to work itself out. • But the Johnson & Nixon administrations accelerated the processby fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). • These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

49. There is no reason to expect better today: • Capital mobilityis much higher now than in the 1960s. • The US can no longer rely on support of foreign central banks: • neither on economic grounds(they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), • nor on political grounds(these creditors are not the staunch allies the US had in the 1960s).

50. The financial crisis caused a flight to quality which evidently still means a flight to US $. • US Treasury bills in 2008-09 were more in demand than ever, as reflected in very low interest rates. • The $ appreciated, rather than depreciating as the “hard landing” scenario had predicted. • => The day of reckoning had not yet arrived. • Chinese warnings (2009) may be turning point: • Premier Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency.