Global Growth, Current Account Imbalances and Exchange Rates

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Global Growth, Current Account Imbalances and
Exchange Rates
Kenneth Rogoff, Harvard University

• Pedro Barrie Lectures (3)
• November 22, 2005
• Vigo, Spain

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We take up one piece of adjustment Asian
exchange rates

• We focus on China, which today is the lynchpin of
  the system.
• US Treasury has put tremendous pressure on China
  to revalue (appreciate) its currency. (IMF NEEDS
  TO PLAY LEAD ROLD.) From a global perspective,
  an essential element of the adjustment process.
  But what about from Chinas perspective? Complex
  question

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• Summary of recent research on exchange rates,
  growth and inflation
• For poor developing countries -- especially
  financially underdeveloped countries with a low
  degree of international capital market
  integration, fixed exchange rate regimes have
  performed reasonably well, highly durable.
• For rich countries, true floating exchange rates
  works best
• For emerging markets --countries more integrated
  with international markets -- an intermediate
  flexible system is desirable.

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• Intermediate exchange rate regimes where some
  exchange rate movements are permitted but extreme
  volatility is avoided are already most popular.
  In 1975, almost 2/3s of all countries had a
  pegged exchange rate. Today, almost 2/3s of all
  countries have an intermediate regime. Likely
  many more by 2020.
• Few countries have pure floats (euro-dollar,
  pound dollar, Austrialian dollar and South
  African Rand are examples of pure floats.)

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Regimes of the Future(?)
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Where should the world exchange rate system be in
2050?

• Mundell One world currency!
• My view At least three to four major currencies
  (to ensure competition). Yuan, Dollar, Euro,
  plus commodity linked currencies for oil
  exporters and major commodity exporters. Also,
  there will always be problem countries on
  periphery.

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What about China today?

• Recent move to greater flexibility is both
  necessary and desirable.
• Over long term, as Chinas financial markets
  develop and as trade expands, fixed exchange rate
  is not a viable option if China wants to retain
  any autonomy over its own monetary policy

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Why is flexibility inevitable?

• Effectiveness of capital controls will weaken
  over time as financial sector develops and as
  trade expands. This is experience of European
  countries in the 1950s.
• As capital controls weaken, China will
  increasingly be forced to follow US monetary
  policy to maintain peg. But a large region like
  China needs to be able to choose its own monetary
  policy

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Why have more flexibility now?

• Pressures on Chinas exchange rate may turn some
  day. Even Chinas vast foreign exchange reserves
  (over 700 billion dollars) can still be
  overwhelmed by global foreign exchange markets
  (where trade is over 2 trillion per day.)
• It is better to exit a fix from strength
• Better too soon than too late

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China no longer needs exchange rate as an
inflation anchor

• Improvements in monetary policy independent
  central banks, inflation targetting have made
  it possible for most countries to control
  inflation without exchange rate anchor.
• (In 1992, over 40 countries had inflation over
  40. Today, only Zimbabwe does. Even the Republic
  of the Congo has single digit inflation now.)

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Risk of immediate financial crisis not large

• Big problems occur when countries are forced to
  drop pegs from weakness. Sharp drop in the
  exchange rate raises burden of foreign debts, can
  cause crisis. But Chinas exchange rate will
  likely need to go up in the short run. (It the
  long run, it will sometimes move down, trend
  unclear)

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Comparisons with 1980s Japan are questionable.

• McKinnon, Mundell and others have suggested that
  Japans economic malaise in the 1990s was caused
  by the mid-1980s Plaza accord on exchange rates.
  (An idea muted earlier by Posen.)
• But Japans economic problems did not follow
  until many years later. Catastrophic mishandling
  of macroeconomic policy almost certainly the main
  driver.

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Governments often fear allowing some exchange
rate flexibility

• But adverse effects of exchange rate volatility,
  while perhaps present, are in fact very difficult
  to detect empirically
• Based on other countries experiences, likely
  case is that country will adjust to exchange rate
  flexibility very quickly without major negative
  consequence

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Rise in unemployment? No significant
macroeconomic effect.

• Economy is creating over 10 million jobs per
  year. Trade policy will not affect more than a
  very small fraction of these.
• A stronger exchange rate may weaken demand for
  exports but only slightly. However, a lower
  cost of capital goods imports will fuel
  investment.
• Production and investment outside export sector
  is enhanced.

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Is long-term trend upwards for Yuan?

• Probably, but not simple. Current upward
  pressure on yuan is driven not only by trade
  balance surplus, but by capital inflows. Capital
  controls are assymmetric money can get in more
  easily than it can get out. If controls were
  symmetric, pressure might be downwards.

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True, by many measures Yuan is currently
undervalued.

• TRADE BALANCE SURPLUS IS GROWING. Official
  surplus likely over 100 billion dollars for 2005.
  (True surplus probably 25-50 larger.)
• Foreign Exchange Reserves are over 700 billion
  and will soon pass Japan. 1,000 billion by mid
  2006? (Can China invest reserves more
  productively??)

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Purchasing Power By some indices, Yuan is very
low

• Euro Area 3.58
• United States 3.06
• Canada 2.63
• Mexico 2.58
• Brazil 2.39
• Japan 2.34
• China 1.27

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The rate of growth in Chinas trade has been
typical of countries after economic
liberalization (the following graphs dates
Chinas economic liberalization from 1979, and
looks at trade growth versus years from
liberalization.
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Chinas Opening Up--Real Export Growth (Log of
exports divided by U.S. GDP deflator beginning
period 1)
NIEs (19661)
Japan (19551)
China (19791)
5
25
40
20
0
10
15
30
35
45
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• BUT REAL EXCHANGE RATE PICTURE IS QUITE ATYPICAL.
  Chinas real exchange rate (inflation adjusted
  exchange rate) has moved in the opposite
  direction as Japans did post liberalization.

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Chinas Opening Up--Exchange Rate (Log real
exchange rate, beginning period 1)
Solid line Real exchange rate Dashed line Real
effective exchange rate
Japan (19551)
NIEs (19661)
China (19791)
5
25
40
20
0
10
15
30
35
45
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• Normally, richer countries have higher price
  levels, adjusted for exchange rates, as the
  following graph illustrates

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(No Transcript)
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But normal Belassa Samuelson effect may not hold
in China

• Normally, a fast growing country experiences an
  appreciating real exchange rate, as high
  productivity growth bids up wages. But the
  globalized part of China is still experiencing
  huge labor inflows from the non-globalized part
  of China. Labor inflows keep down wage growth,
  restrain price increases.

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Regardless of Chinas policies, over longer term,
financial crises are difficult to avoid entirely.
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External Debt Defaults in Emerging Markets
1824-2001
.
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China default

• China defaulted on external debt 1924-1936
• Earlier financial crises?

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Todays Emerging Markets didnt invent serial
default
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An Early History of Default Number of defaults
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So why the upward pressure on the Yuan?

• Giant US current account and trade balance
  deficits are overwhelming other factors. There
  is significant trend upward pressure on dollar
  exchange rates in most countries.
• US Federal Reserves aggressive policy of raising
  very short-term interest rates is putting
  short-term upward pressure on the dollar.
  TEMPORARY EFFECT.

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• Current situation where United States is
  absorbing 3/4s of global savings cannot be
  ideal
• Poor developing countries should not be paying
  for profligacy in the worlds richest country.

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China is only a small share of overall US trade
imbalances
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Yes, Yuan flexibility will help global trade
imbalances

• .but by only a modest amount.
• Obstfeld and Rogoff (2005) find that a halving of
  global trade imbalances, if driven by a
  generalized rebalancing of global demand, would
  be accompanied by an 18 appreciation of ALL
  Asian currencies.
• BUT if Asian currencies appreciate by 20
  without accompanying policy adjustments, global
  imbalances would decline by much less

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Although other regions can help

• Faster growth in Europe will raise investment
  there and lower surpluses
• High oil prices have made OPEC surpluses a
  growing factor but past experience suggests
  these countrys expenditures will adjust and/or
  prices will fall.
• Latin America will surely not run surpluses much
  longer.

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Exchange rate flexibility and capital market
integration closely related
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Summary on Exchange Rates

• Pegged exchange rates problematic everywhere? NO
• poorer developing countries fixed regimes
  associated with lower inflation and relatively
  high durability.
• Emerging and advanced economies
• absence of robust relation between economic
  performance and regime.
• However, emerging markets have
• less durable regimes (in general) and
• more frequent crises under pegged regimes

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Exchange Rate Regime perhaps less important than

• Quality of Financial Regulation
• Maintaining Low Levels of Corruption
• Independence and Transparency of Central Bank
• Controlling Level of Government and International
  Debt

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Where does China fit in?

• Arguably, fasting growing coastal China is an
  emerging market that clearly benefits from a
  relatively flexible exchange rate. But interior
  is much less economically developed, might
  benefit more from a less flexible rate.
• Difficult tension

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But only if extremes avoided

• Multiple Exchange Rate Practices (Dual and
  Parallel Rates) are deeply problematic for
  growth, inflation, corruption.
• Heavy-handed capital controls are similarly
  problematic
• Fixed exchange rate regimes are an extremely
  risky strategy for most emerging market economies

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Conclusion

• Contrary to prevailing empirical and theoretical
  literature, exchange rate regime does seem to
  matter.
• No one size fits all, but a useful baseline
  formula As a country becomes richer, and as
  institutions become better developed, presumption
  that a move to greater exchange rate flexibility
  and greater capital market integration is highly
  advisable.

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Background Papers by Kenneth Rogoff

• Exchange Rate Durability and Performance in
  Developing versus Advanced Economies, (with A.
  Husain and A. Mody) Journal of Monetary Economics
  52 (Jan. 2005), 3
• "The Modern History of Exchange Rate
  Arrangements A Reinterpretation," (with C. M.
  Reinhart) Quarterly Journal of Economics 119(1)
  Feb. 2004.
• Evolution and Performance of Exchange Rates
  Regimes, (with A. Husain, A. Mody, R. Brooks, and
  N. Oomes), IMF Occasional Paper 229, 2004.
• The Effects of Financial Globalization on
  Developing Countries Some Empirical Evidence
  (with E. Prasad, S. Wei and A. Kose), IMF
  Occasional Paper 220, 200
• Exchange Rate Regimes and Growth, with P. Aghion,
  P. Bacchetta, and R. Ranciere