Currency Wars Jeffrey Frankel Harpel Professor of Capital Formation & Growth, Harvard University

1. Currency WarsJeffrey FrankelHarpel Professor of Capital Formation & Growth, Harvard University MAS Sponsored Public Lecture, Singapore, 8 March, 2011

2. What are 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.

3. Currency Wars chronology • September 15, 2010 Japan 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.

4. 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.

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

6. Currency Wars chronology, Nov.2010 G20 Summit in Korea was the first chaired by a non-G8 country

7. Currency Wars chronology, Nov.2010 • Nov. 12: G-20 Summit in Seoul was 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.

8. 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.”

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

10. 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

11. 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 running at 10% per annum.

12. 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

13. 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 real exchange rates, current account balances, budget deficits and sovereign debt levels.

14. Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates rooted in the 1930s. It 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?

15. 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” ?

16. 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 and Fed easing supplied it. Is the currency war metaphor applicable?continued

17. 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 generally have different needs at any point in time e.g., high unemployment in US & European periphery, while China & Brazil & India are overheating.

18. Inflation has recently crept up in many of the major emerging markets Goldman Sachs BRICs Monthly, Feb.18, 2011

19. In the advanced economies, by contrast, inflation is still low Goldman Sachs BRICs Monthly,Feb.18, 2011

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

21. Meanwhile, US core inflation is the lowest in 50 years Jan 2011

22. Is the currency war metaphor applicable?continued The point of a floating rate system: the US can choose its easy monetary policy and Brazil its tight monetary system, with appreciation of US $ vs. Braz. 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 “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. Protectionism is a beggar-thy-neighbor policy unlike monetary expansion. 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 also take responsibility. 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. Bottom line on currency war metaphor • The metaphor is not fully appropriate. • Yes, China finds uncomfortable the pressure of capital inflows, • which is indeed increased by US monetary ease. • But this is a far more legitimate way to let China feel the pressure to appreciate than are US threats of WTO-illegal tariffs.

26. 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 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?

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

28. The 4th wave of inflows was reflected as an increase in Exchange Market Pressureon all Asian countries in 2010,Singapore & Korea the most. EMP is definedas the sum of currency appreciation plus increase in Reserves (Net Foreign Assets) as a fraction of Monetary Base. Goldman Sachs Global Economics Weekly 11/07Feb.16, 2011

29. Singapore has taken the inflows heavily in the form of reserves, while India & Malaysia in 2010 took the inflows in the form of currency appreciation. ↑ more-managedfloating High EMP Low EMP less-managed floating(“more appreciation-friendly”)→ GS Global ECS Research

30. 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 %

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

32. In Asia since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; HongKong & Singapore the least, followed by Malaysia&China. Goldman Sachs Global Economics Weekly 11/07Feb. 16, 2011

33. India, Indonesia, & Chinaare in danger of overheating => Indonesia & India havedone right to allow appreciation. GS Global Economics Weekly No. 11/08, Feb. 23, 2011

34. 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

35. 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?

36. 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 2008-10 crises?

37. The variables that show up as the strongest predictors of countrycrises in 83 pre-2009 studies: (i) low reserves and (ii) currency overvaluation Early Warning Indicators Source: Frankel & Saravelos (2010)

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

39. F & Saravelos (2010):Multivariate ST Debt/Res PPP CA/GDP NS/GDP

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

44. New lesson regarding exchange rate regimes • Old conventionalwisdom: The choice was between • fixing (changes in reserves; not in exchange rate) vs. • floating (changes in exchange rate; no reserves). • Now it appears that: • Intermediate regimes are indeed viable. • Holding reserves and floating are both useful.