Exchange Rate Regimes and Global Imbalances Kuala Lumpur, 28 March 2006 An Overview

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Exchange Rate Regimes andGlobal ImbalancesKuala
Lumpur, 28 March 2006An Overview

• Andrew Sheng
• Tun Ismail Ali Chair in Monetary and Financial
  Economics,
• University of Malaya

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Global Prices, Flows and Balance Sheet Effects

• The Exchange Rate is both a price and policy
  tool. In theory, the exchange rate balances the
  trade and capital account flows between a country
  and the rest of the world. The balance sheet
  changes because of exchange rate as asset price
  (valuation changes) and flows.
• Four types of global flows-
• World trade in goods and services is already
  US11 trn in 2004.
• FDI flows of US648 bn in 2004
• FPI flows of US4,213 bn in 2004 (CPIS data for
  top 10)
• Gross daily turnover of FX of US1.9 trn in 2004,
  derivatives trading of US5.7 trn (BIS Triennial
  Survey 2004)
• Central Bank holdings of FX reserves in 2003
  reached US3 trn. Global gross external assets
  amounted to US37.9 trn, of which EMC accounted
  for 4.9), up 12 times gross external asset of
  US3.1 trn in 1980 (of which EMC 3.7)
• Globalization is accelerating, but imbalances
  have also grown in size
• Source IMF WEO

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Exchange Rate Regimes ClassificationSource
Ghosh, Gulde Wolf
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Real vs.. Nominal Exchange Rates

• Real Exchange Rate
• Price of Tradable Goods _______________________
  __
• Price of nontradable goods
• RER is a proxy for degree of competitiveness.
  Decline in RER implies real exchange rate
  appreciation or deterioration in competitiveness.
• SourceSebastian Edwards Exchange Rate
  Misalignment in Developing Countries, World Bank
  1988

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Samuelson-Balassa Effect

• The Samuelson-Balassa hypothesis states that the
  real exchange rate tends to appreciate in
  countries experiencing rapid growth. This is
  because productivity improvement is more rapid in
  countries with higher growth rates than those
  with lower ones.
• In faster growing countries, technological
  progress is biased toward the tradable sector,
  leading to a rise in the economy-wide real wage.
  This creates an an increase in the price of
  nontradables relative to tradables.
• The result is that real exchange rate rises for
  fast growing economies.

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The Washington View

• ?.... the choice of appropriate exchange rate
  regime, which, for economies with access to
  international capital markets, increasingly means
  a move away from the middle ground of pegged but
  adjustable fixed exchange rates towards the two
  corner regimes of either flexible exchange rates
  or a fixed exchange rate supported, if necessary,
  by a commitment to give up altogether an
  independent monetary policy.? Lawrence H. Summers
  (2000), p. 8.
• for countries open to international capital
  flows (i) pegs are not sustainable unless they
  are very hard indeed but (ii) that a wide
  variety of flexible rate arrangements are
  possible and (iii) that it is to be expected
  that policy in most countries will not be
  indifferent to exchange rate movements. Stan
  Fischer (2001)

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The Fischer View

• In the last decade, share of both hard pegs and
  floating gaining at the expense of soft pegs.
• Main reason is that soft pegs are crisis-prone
  and not viable over long periods. This is
  primarily due to the logic of the impossible
  trinity.
• Polarization is towards currency boards,
  dollarization, or currency unions on one side,
  and towards a variety of floating rate
  arrangements, including managed floating, on the
  other.
• As exchange rate flexibility increases, a country
  needs to determine the basis for its monetary
  policy. The record of inflation targeting has
  been a good one in this regard.
• The choice between a hard peg and floating
  depends in part on the characteristics of the
  economy, and in part on its inflationary history.
  The choice of a hard peg makes sense for
  countries with a long history of monetary
  instability, and/or for a country closely
  integrated in both its capital and current
  account transactions with another or a group of
  other economies.
• An exchange rate peg can and has been
  successfully used to disinflate from high
  inflation, without a crisis, but it is important
  to exit from the peg during the process. That is
  most easily done under pressure to appreciate.
• When misalignments among big three currencies
  become extremely large, the authorities tend to
  intervene to try to move exchange rates in the
  direction of equilibrium. This is loose and
  informal system, with no commitments to
  numerical ranges, as there would be in a formal
  target zone system.

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Global Imbalances AVERAGE CURRENT ACCOUNT
BALANCES IN USBnSOURCE IMF
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Global Imbalances - Four Historical Episodes -

• 19th Century classic gold standard, adjustment
  through gold flows, no role for monetary policy.
• Interwar years failed gold standard as surplus
  countries (US, France) imposed burden of
  adjustment on UK and Germany, so burden of
  deflation and recession.
• Bretton Woods I adjustment between surplus and
  deficit countries through IMF assistance under
  fixed rate system. Broke down when US abandoned
  gold link and became inflationary 1965-71
• Managed Floating abandonment of exchange
  controls, and adjustments have been a combination
  of exchange rate, relative prices and domestic
  expenditure
• Conclusion Past collapse was due to fundamental
  flaws and pursuit of inappropriate policies by
  major countries. No need for policy coordination
  and reinvent Bretton Woods

Michael Bordo (May 2005)
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Regional Features Compared Asia is still
smaller than NAFTA EU
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Structural Imbalances persist despite high
volatility of exchange rates

• US imbalances growing while Japanese surplus
  remains strong
• EU trade balance with US has remained stable at
  roughly US100 bn despite wide FX swings
• Asians fear sharp swings in exchange rates would
  be destabilizing.
• Pre-crisis, developing Asia in deficit, strong
  surplus post-crisis to build up reserves against
  future crisis.
• Chinas surplus is growing, but much of exports
  are from US, EU, Japan, Korea and other companies
  operating out of China
• Do you blame imbalances on host country or home
  countries in terms of ownership of exporters?

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Current Account Balances 2004 - Deficits are
largely in Anglo-sphere

• Anglo Sphere (a) Asia
• Total US Euro
  Japan China Other area
  East Asia
• of GDP -4.7 -5.7 0.5 3.7
  4.2 6.3
• US billion -734 -668 47 172
  69 118

(a) Australia, Canada, New Zealand, United
Kingdom, United States Source IMF, MacFarlane,
Reserve Bank of Australia
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US External Position - from world banker to
venture capitalist

• US went from net creditor position (10 of GDP in
  1952) to net debt position (-26 of GDP) by 2003
• End 2004, US net external debt (with FDI at
  market value) was US2.5 trillion or 22 of US
  GDP. Foreign assets of US10 trn (85 of GDP),
  liabilities of US12.5 trn (107)
• 70 of US foreign assets are in FX, but all
  liabilities in US. 10 US depreciation
  transfers 5.9 of US GDP to US.
• Over period 1952-2003, average real rate of
  return on asset (5.72) higher than average real
  rate of return on liabilities (3.61), averaged
  2.11.
• Since 1973, average asset return increased to
  6.82, liability cost was 3.5, leading to
  increased excess return of 3.32.
• 2 excess return allows US to accumulate debt
  exceeding assets by 30 and still have excess
  income.
• But leverage (liabilities greater than assets)
  reaching 1.34 in 2004 may be reaching tipping
  point.

Source Gourinchas and Rey, Sept 2005
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US External Position - from world banker to
venture capitalist

• US went from net creditor position (10 of GDP in
  1952) to net debt position (-26 of GDP) by 2003
• End 2004, US net external debt (with FDI at
  market value) was US2.5 trillion or 22 of US
  GDP. Foreign assets of US10 trn (85 of GDP),
  liabilities of US12.5 trn (107)
• 70 of US foreign assets are in FX, but all
  liabilities in US. 10 US depreciation
  transfers 5.9 of US GDP to US.
• Over period 1952-2003, average real rate of
  return on asset (5.72) higher than average real
  rate of return on liabilities (3.61), averaged
  2.11.
• Since 1973, average asset return increased to
  6.82, liability cost was 3.5, leading to
  increased excess return of 3.32.
• 2 excess return allows US to accumulate debt
  exceeding assets by 30 and still have excess
  income.
• But leverage (liabilities greater than assets)
  reaching 1.34 in 2004 may be reaching tipping
  point.

Source Gourinchas and Rey, Sept 2005
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Is US External Position unsustainable? US
Congress research

• As long as US assets yield higher risk-adjusted
  return than foreign assets, foreigners will buy
  US assets.
• EU area holds 53 of wealth in home assets and
  10 in US assets, whereas Japan hold 63 in home
  assets and 4 in US assets.
• Trade alone wont solve deficit. Truman
  estimates that if current account reaches 6 of
  GDP, net income payments will be 4.5 of GDP, so
  trade deficit accounts for 1.5 GDP
• 2000-2004, US earned 9.6 on foreign assets, and
  paid 0.9 of foreign liabilities.
• Obstfeld Rogoff (2004)- US need to
  depreciate 14.7-33.6 for elimination of CA
  deficit.
• Blanchard, Giavazzi Spa (2005) - depreciation
  of 56 for CA deficit to go to 0.75 of GDP.
• Edwards (2005), US net debt would reach 60 of
  GDP by 2010, CA deficit would peak at 7.5 of GDP
  in four years. Real value of US need to decline
  by 21 in first three years.

Source Labonte, Congress Research Service, Dec
2005
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Some Chinese Views on Global Imbalances

• Four factors why RMB revaluation will not help
  reduce US-China trade deficit
• 55 of Chinese exports are in processed trade,
  with imports from Japan, South Korea and Taiwan
  (revaluation will make imports cheaper)
• Export-tax rebate, now account for US24 bn or
  one quarter of Chinas trade surplus with US.
  Removing this would be equivalent to revaluation
• Large labour surplus would still ensure export
  competitiveness.
• FDI inflows make Chinese exporters consistently
  more productive and competitive
• Domestic considerations-
• Internal financial markets and banking system
  still undergoing restructuring - risks not small
• China being large economy, changes to internal
  structure would have to take place before further
  liberalization

Li-Gang Liu (March 2005)
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Impediments to Asia adjusting its structural
imbalances

• High Asian savings are a demographic story of a
  young educated work force accumulating savings
  during its high growth stage. But parts of Asia
  is also aging.
• Two reasons why domestic expenditure cannot rise
  faster-
• After Asian crisis, huge cut back in fiscal
  expenditure, especially social infrastructure
  which are badly needed. Emphasis was on
  FX-earning exports to build up reserves against
  future crisis
• Asian financial systems are not as developed as
  EU/US, being too fragmented, lacking breadth and
  depth in skills, liquidity and institutional
  strength (property rights infrastructure)

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Raguram (IMF) October 2005

• US running current account deficit of 6.25 of
  GDP and over 1.5 of world GDP, requiring
  financing equivalent to 70 of global capital
  flows.
• In OECD countries, government savings have
  dropped (esp. US Japan), while householder
  savings disappeared with housing boom.
• Emerging markets running current account
  surpluses, so world needs two kinds of
  transition
• Consumption needs to move to higher investments,
  especially in EMC, oil producers and low-income
  countries
• Demand from deficit countries need to move to
  surplus countries
• Two greatest worries -
• US will slow abruptly
• Financing of US deficit will change. US current
  account deficit is financed by foreign private
  investors, while US private investments abroad
  are financed by foreign central banks.

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Global Imbalances - Five Views

• Deutsche Bank's "Bretton Woods Two" No need to
  change fiscal balances, current account balances
  or exchange rates.
• Ron McKinnon the US fiscal deficit is the
  problem but the Chinese/Asian currencies do not
  need to move.
• Fed's views the US current account deficit
  derives from a "global savings glut" rather than
  a lack of US savings. US fiscal deficits may be a
  problem but their reduction may not shrink a US
  current account deficit whose source is foreign,
  not domestic. Global savings glut will continue
  due to the high growth and returns of the US.
• Richard Cooper's View the current account is
  sustainable as foreign investors love to invest
  into safe US assets also a Chinese currency move
  is inappropriate as it would seriously hurt
  China's growth.
• Roubini and Setser (and consensus view) global
  rebalancing requires both US fiscal adjustment
  (and private savings increase) and a
  Chinese/Asian currency appreciation.

Source Nouriel Roubini, May 2005
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Global Assets Under Management (US trillion end
2003)

• International Banking Assets (BIS data)
  23.6
• International debt securities 14.6
• Insurance companies 13.5
• Pension Funds 15.0
• Investment Companies 14.0
• Hedge Funds 0.8
• Other Institutional Investors 3.4
• Total 84.9
• Memo OTC Derivative Contracts (notional)
  270.1
• Source BIS, IMF

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The Bretton Woods Architecture

• International Monetary Fund, total quota
  (capital) of SDR213 bn (USD306 bn), 184 members
  (2005 data)
• World Bank (International Bank for Reconstruction
  and Development), capital US38.6 bn, assets
  US222 bn
• Other development banks, ADB, African Development
  Bank, EBRD, Inter-American Development Bank etc
• Bank for International Settlements (BIS), owned
  by member central banks, equity of US14.9 bn and
  US260.5 bn assets
• Total asset size of these institutions (US790
  bn) is trivial (0.9) compared with size of
  global financial assets of US84.9 trn.

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Is the Bretton Woods relevant today?

• The Bretton Woods Architecture was designed when
  the rest of world was recovering post-war, with
  US in dominant surplus position.
• BW institutions could lend to help the rest of
  world adjust their net international position.
  OECD countries were basically in surplus and EMCs
  were in deficit. OECD countries control more
  than 50 of voting on BWIs.
• With globalization and US running net credit
  position, BWIs do not have enough financial
  resources and influence to make US adjust like
  any non-US member.

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Reform of IMF - Mervyn King Feb 2006

• IMF no longer can play role of lender of last
  resort (70 of IMF outstanding loans were to 3
  countries).
• Asian economies built up FX reserves that are 10
  time larger than combined reserves of G-7.
• Ratio of overseas assets and liabilities to GDP
  for G-10 countries rose from 70 in 1980 to 250
  in 2003.
• Since IMF resources too small, then its roles are
  to -
• Forum for discussion of global risks
• Independent ruthless truth-telling
• Monitor international balance sheets, look at ERR
  choices, and encourage countries to abide by
  their commitments to global stability through
  higher transparency.
• Focus on balance sheets, not just flows.

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Concluding Thoughts

• Globalization, financial innovation and changing
  international balance sheets have changed the
  Global Financial Architecture
• Exchange Rates, Capital Flows and International
  Balance Sheets are now part of global
  relationships, made much more complex as US
  becomes net debtor
• Important that everyone understand the important
  implications of this major shift in global
  balances.
• Post Asian crisis effects are now coming home to
  roost. During the Asian crisis, the periphery
  was in crisis, the center was strong.
• In this new era, the periphery has regained
  financial resource strength, but remains weak
  relative to the center in financial skills. The
  implications need to be thought through.

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• Thank you
• Questions to as_at_andrewsheng.net