International Coordination, Exchange Rates, and Trade: A Development Perspective

1
International Coordination, Exchange Rates, and
TradeA Development Perspective

• Otaviano Canuto
• Vice-President, PREM Network
• The World Bank
• March 2012

2
The Subject of Our Concern

• Real exchange rate under-valuation as a
  distortion in the global trading system
• If so, would a mechanism for the international
  coordination of exchange-rate policies provide
  global welfare gains?

3
Outline

• Why would countries want to maintain
  under-valued real exchange rates?
• Can under-valuation boost exports?
• What Affects the RER? Policies other
  determinants
• Can we identify real exchange rate targeting?
• Measuring and correcting misalignments
• Implications for international coordination
  mechanism

4
Why Would Countries Want to Maintain Under-valued
Exchange Rates?
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Under-valuation as Development Policy

• The argument Under-valuation stimulates economic
  growth through trade (Rodrik, 2008)
• Export growth spurs investment and technical
  change
• Particularly true for developing countries
• Tradables suffer disproportionately from
  government and market failures
• Undervaluation allows a level-playing field
• Under-valuation can be effective only if
• Nominal wages do not increase with rise of
  exchange rate
• It does not lead to macro instability
• Mainly domestic (not imported) inputs are used

6
Can Under-Valuation Boost Exports?
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Exchange Rate-Trade Nexus Some Ambiguity

• Effect of change in exchange rate on trade is a
  priori ambiguous
• Impact depends on
• Extent to which exporters hedge against foreign
  exchange risk (Fabling and Grimes, 2008)
• Currency in which they invoice their products
  (Staiger and Sykes, 2010)
• Import content of exports (Evenett, 2010)
• Extent of price pass-through (Berman, Martin and
  Mayer, 2012)
• Role of FDI (Lederman, 2011)

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Might Work for LICs in theShort Run

• Impact of 50
• (in one measure of) RER Under-valuation on
• Exports/GDP
• And
• 2) GDPPC Growth

Source Haddad and Pancaro (2010).
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Might Work on the Intensive but Not on the
Extensive Margin
change in export growth due to a 10 decrease
in the real exchange rate
Source Taglioni (forthcoming)
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What Affects the Exchange Rate? Policies and
Other Determinants
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Under-valuation Can Be Costly, Unsustainable and
Regressive

• Over-accumulation of foreign reserves
  (opportunity costs of capital)
• Liquidity growth and inflationary pressures
• Constraints on monetary policy
• Tax on tradable consumption regressive
  (Fajnzylber Lederman, 2012)
• Difficult to exit
• Requires issuing sovereign bonds (with fiscal
  costs) under sterilization
• Cannot be used to target exchange rate other than
  that dictated by fundamentals in the long run
  (Eichengreen, 2008)

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Policies that Can Affect the RER Targeted and
Untargeted

• Targeted monetary and fiscal policy
• Other policies distorting private savings (among
  others)
• Subsidized savings (financial repression)
• Tax consumption
• Weak social protection systems
• Restricted access to global financial markets

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Other Determinants ofExchange Rates

• Financial underdevelopment
• Precautionary savings motive, exodus of savings,
  exporting firms with better access to credit
  (Klapper, 2000 Melitz,2003)
• Closed economies (trade and capital) tend to have
  an under-valued exchange rate
• Commodity prices
• Natural resource discoveries
• Demographics (e.g., old age dependency ratio)

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Can We Identify Real Exchange Rate Targeting?
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Policies that Affect the Exchange Rate Do Not
Equate to Targeting

• Policies that affect dependency ratio
  unintentionally lead to higher domestic savings
  and a depreciated exchange rate
• Financial underdevelopment implies
• High household saving because of inability to
  properly insure against shocks
• High corporate saving because of lack of
  financial options (deep corporate bond market)
  and incentive to retain earnings
• Macro prudential regulations may require capital
  controls
• Frictions working in the opposite direction
• Labor rigidities keeping labor in rural, low
  productivity agriculture

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Measuring and Correcting Misalignment
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Measuring Misalignments Is Difficult

• Requires estimates of equilibrium exchange rate
  and current account
• This is a challenge!
• Large number of determinants
• Complexity of the mechanisms at play
• Hence abundance of methods
• Little consensus as to the best approach

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The Experts in the Room The IMFs Approaches
Thus Far

• Three methods used by the IMF
• Macroeconomic balance approach (MB)
• Equilibrium real exchange rate approach (ERER)
• External sustainability approach (ES)
• and their correlations

Source Eden and Nguyen, forthcoming
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Dispersion of Country-Specific Estimates of
Misalignment Can Be Large MB and ERER Methods
Source Eden and Nguyen, forthcoming
20
Dispersion of Country-Specific Estimates of
Misalignment Can Be Large MB and ES Methods
Source Eden and Nguyen, forthcoming
21
Dispersion of Country-Specific Estimates of
Misalignment Can Be Large ERER and ES Methods
Source Eden and Nguyen, forthcoming
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Correcting RER Misalignment Conceptual and
Practical Issues

• Distinction between policy-driven misalignment
  and exogenous RER movements hard to assess, yet
  crucial for introducing the right policy to
  eliminate misalignment
• If exogenous distortions difficult to eliminate
  (e.g., underdeveloped financial system), a policy
  aimed at restoring equilibrium RER may lead to
  further distortions

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Implications for International Coordination
Mechanisms
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Conditions for Success of International
Coordination Mechanisms

• The extent of exchange-rate misalignment needs to
  be observable
• Unlike tariffs, misalignment is not directly
  observed
• Hard estimate because of endogeneity and
  reverse causality
• Uncertainty about the proper methodology in
  academia and in policy (IMF currently
  re-evaluating its three methodologies)
• None directly measures whether a country has
  unexploited gains from growing the tradable
  sector
• The gains and losses of other countries from the
  devaluation of one country need to be estimated
• Unlike tariffs, country gains or losses spread
  across industries
• Potential gains for many, e.g., low global
  interest rates

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Multilateral Disciplining of Currency Practices
Is Difficult

• Technicalities matter! Difficult to introduce
  coordination mechanism over a distortion that is
  not directly observed
• Under-valuation might be desirable under certain
  circumstances (e.g., capital controls during
  crisis)
• Scope for international coordination to achieve
  Pareto improving outcomes is small

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Multilateral Coordination and Peer Pressure
Should Rather Focus on Achieving Good
Fundamentals Across Countries

• Improving economic structures, running viable
  fiscal frameworks and achieving macroeconomic
  stability
• Enabling reforms to have efficient and market
  driven wage and price settings
• Enabling reforms to boost productivity and growth
• Enabling reforms in financial market and social
  protection systems

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• Thank you
• Visit us on www.worldbank.org/trade