external sector policies thorvaldur gylfason singapore, february 2008

External External Sector Sector PoliciesPolicies

Thorvaldur GylfasonThorvaldur GylfasonSingapore, February 2008Singapore, February 2008

OutlineOutline1)1)Real vs. nominal exchange ratesReal vs. nominal exchange rates2)2)Exchange rate policy and Exchange rate policy and

welfarewelfare3)3)The scourge of overvaluationThe scourge of overvaluation4)4)From exchange and trade From exchange and trade

policies to economic growthpolicies to economic growth5)5)Capital flowsCapital flows6)6)Exchange rate regimesExchange rate regimes

To float or not to floatTo float or not to float

Real vs. nominal Real vs. nominal exchange ratesexchange rates11

*PePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in Q means real appreciation

ee refers to foreign currency content of domestic currency

Real Real vs. nominal vs. nominal exchange ratesexchange rates

*PePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged

Three thought Three thought experimentsexperiments

*PePQ

1.1. Suppose e fallse fallsThen more baht per dollar, so X risesX rises, Z fallsZ falls

2.2. Suppose P fallsP fallsThen X risesX rises, Z fallsZ falls

3.3. Suppose P* risesP* risesThen X risesX rises, Z fallsZ falls

Summarize all three by supposing Q fallsQ falls Then X risesX rises, Z fallsZ falls

Foreign exchangeForeign exchange

Real

exc

hang

e ra

teRe

al e

xcha

nge

rate

Imports

Exports

Exchange rate policy Exchange rate policy and welfareand welfare22

Earnings from exports of goods, services, and capital

Payments for imports of goods, services, and capital

Equilibrium

Equilibrium between demand and supply in foreign exchange market establishes• Equilibrium real exchange rate• Equilibrium in the balance of

paymentsBOP = X + Fx – Z – Fz

= X – Z + F = current account + capital

account = 0

Exchange rate policy Exchange rate policy and welfareand welfare


Real

exc

hang

e ra

teRe

al e

xcha

nge

rate

Imports

Exports


OvervaluationDeficit

RR R moves when e is fixed


Price

of f

orei

gn e

xcha

nge

Price

of f

orei

gn e

xcha

nge

Supply (exports)

Demand (imports)


Overvaluation

Deficit

Overvaluation works like a price ceiling

The scourge of The scourge of overvaluationovervaluationGovernments may try to keep the

national currency overvalued• To keep foreign exchange cheap• To have power to ration scarce

foreign exchange• To make GNP look larger than it is

Other examples of price ceilings• Negative real interest rates• Rent controls

33

Inflation and Inflation and overvaluationovervaluationInflation can result in an

overvaluation of the national currency• Remember: Q = eP/P*Q = eP/P*

Suppose e adjusts to P with a lagThen Q is directly proportional to

inflationNumerical example

InflationInflation and and overvaluationovervaluation

Time

Real exchange rate

100

110105 Average

Suppose inflation is 10 percent per year

Inflation and Inflation and overvaluationovervaluation

Time

100

120

Real exchange rate

110 Average

Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag

Suppose inflation rises to 20 percent per year

How to correct How to correct overvaluationovervaluationUnder a floating exchange rate

regimeAdjustment is automatic: e moves

Under a fixed exchange rate regimeDevaluation will lower e and thereby

also Q – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

The Marshall-Lerner The Marshall-Lerner condition: Theorycondition: TheoryB = eeX – Z = eX(e) – Z(e)Not obvious that a lower e helps

TLet’s do the arithmeticBottom line is:Devaluation strengthens the

current account as long as1ba

Suppose prices are fixed, so that e = Q

a = elasticity of exportsb = elasticity of imports

ValuatioValuation effect n effect arises arises from the from the ability ability to affect to affect foreign foreign pricesprices

TheThe Marshall-Lerner Marshall-Lerner conditioncondition

ZeXB )()( eZeeXB

dedZ

dedXeX

dedB

eZ

Ze

dedZ

eX

Xe

dedXeX

dedB

1 1

-a b

- +

Export elasticityExport elasticity ImportImportelasticityelasticity

TheThe Marshall-Lerner Marshall-Lerner conditioncondition

eZ

Ze

dedZ

eX

Xe

dedXeX

dedB

XbabXaXXdedB

1

0dedB 1baif

X

Assume X = Z/e initially

Appreciation weakens current

account

The Marshall-Lerner The Marshall-Lerner condition: condition: EvidenceEvidenceEconometric studies indicate that

the Marshall-Lerner condition is almost invariably satisfied

Industrial countries: a = 1, b = 1Developing countries: a = 1, b =

1.5Hence,

1ba Devaluation strengthens the current account

Empirical evidence Empirical evidence from developing from developing countriescountries Elasticity of Elasticity of

exports importsArgentina 0.6 0.9Brazil 0.4 1.7India 0.5 2.2Kenya 1.0 0.8Korea 2.5 0.8Morocco 0.7 1.0Pakistan 1.8 0.8Philippines 0.9 2.7Turkey 1.4 2.7Average 1.1 1.5

The small country The small country case case Small countries are price takers

abroad• Devaluation has no effect on the

foreign currency price of exports and imports

So, the valuation effect does not arise

Devaluation will, at worst, if exports and imports are insensitive to exchange rates (a = b = 0), leave the current account unchanged

Hence, if a > 0 or b > 0, devaluation strengthens the current account

The importance of The importance of appropriate side appropriate side measuresmeasuresRemember:

It is crucial to accompany devaluation by fiscal and monetary restraint in order to prevent prices from rising and thus eating up the benefits of devaluation

To work, nominal devaluation must result in real devaluation

*PePQ

From exchange and From exchange and trade policies to trade policies to growthgrowthGovernments may try to keep the

national currency overvaluedOr inflation may result in

overvaluationIn either case, overvaluation

creates inefficiency, and hurts growth

Therefore, exchange rate policy matters for growth

Need real exchange rates near equilibrium

44

From exchange and From exchange and trade policies to trade policies to growthgrowthHow do we ensure that exchange

rates do not stray too far from equilibrium?

Either by floating …Then equilibrium follows by itself

… or by strict monetary and fiscal discipline under a fixed exchange rate

The real exchange rate always floatsThrough nominal exchange rate

adjustment or price change, but this may take time

Why inflation is Why inflation is detrimental to growthdetrimental to growthWe saw before that inflation leads

to overvaluation which hurts exports

So, here is one additional reason why inflation hurts economic growthExports and imports are good for

growthSeveral other reasons

Inflation distorts production and impedes financial development, and scares foreign investors away

How How tradetrade increases increases efficiency and growthefficiency and growthTrade with other nations

increases efficiency by allowing1. Specialization through

comparative advantage2. Exploitation of economies of scale3. Promotion of free competition

Not only trade in goods and services, but also in capital and labor“Four freedoms”

How trade increases How trade increases efficiency and growthefficiency and growthTrade also encourages international

exchange of • Ideas• Information• Know-how• Technology

Trade is tantamount to technological progress

Trade isis educationWhich is also good for growth!

EfficiencyEfficiency is crucial is crucial for economic growthfor economic growthNeed economic policies that help

increase efficiency• Produce more output from given

inputs • Takes fewer inputs to produce given

output• More efficiency, better technology

are two ways of increasing output per unit of input

• So is more and better educationTrade increases efficiency and

thereby also economic growth

ExportsExports and economic and economic growth 1960-2000growth 1960-2000

-8

-6

-4

-2

0

2

4

6

0 40 80 120 160 200

Exports (% of GDP)Per

cap

ita g

row

th a

djus

ted

for i

nitia

l inc

ome

(%)

163 countriesr = 0.26

Asia: Exports Asia: Exports (% of GDP)(% of GDP)

FDIFDI and economic and economic growth 1960-2000growth 1960-2000

152 countriesr = 0.21

-8

-6

-4

-2

0

2

4

6

8

0 2 4 6 8 10 12 14

Foreign direct investment (% of GDP)Per

cap

ita g

row

th a

djus

ted

for i

nitia

l inc

ome

(%)

Asia: FDI net inflowsAsia: FDI net inflows(% of GDP)(% of GDP)

Evolution of capital Evolution of capital flowsflows

Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846.

A stylized view of capital mobility 1860-2000

Cap

ital

mob

ility

First era of international

financial integration

Capital controls

Return toward financial

integration

55

Source: WEO

-90

-70

-50

-30

-10

10

30

50

70

90

110

130

150

170

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Bill

ions

of U

SD ($

)

Direct investment, net (left axis) Other private, net (left axis) Official capital flows, net (left axis)

Asia: Net capital flows and external Asia: Net capital flows and external debt indicators, 1980-2006debt indicators, 1980-2006

Push vs. pull factorsPush vs. pull factorsExternal factors “pushed” capital from

industrial countries to LDCs Cyclical conditions in industrial

countriesRecessions in the early 1990sDecline in world interest rates

Structural changes in industrial countriesFinancial structure developmentsDemographic changes

Push vs. pull factorsPush vs. pull factorsInternal factors “pulled” capital into

LDCs from industrial countries Macroeconomic fundamentals Reduction in barriers to capital

flows Private risk-return characteristics

CreditworthinessProductivity

Large capital flows to Asia Large capital flows to Asia have resumed in recent have resumed in recent yearsyears

Improved allocation of global savings (allows capital to seek highest returns)

Greater efficiency of investment More rapid economic growthReduced macroeconomic volatility

through risk diversification (which dampens business cycles) Income smoothing Consumption smoothing

Potential benefits Potential benefits of capital flowsof capital flows

Open capital accounts may make receiving countries vulnerable to foreign shocks Magnify domestic shocks and lead to

contagion Limit effectiveness of domestic macro policy

instrumentsCountries with open capital accounts are

vulnerable to Shifts in market sentiment Reversals of capital inflows

May lead to macroeconomic crisis Sudden reserve loss, exchange rate pressure Excessive BOP and macro adjustment Financial crisis

Potential risks Potential risks of capital flowsof capital flows

Overheating of the economy Excessive expansion of aggregate demand with

inflationary pressures, real exchange rate appreciation, widening current account deficit

Increase in consumption and investment relative to GDP

Quality of investment suffersConstruction booms

Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime

Potential risks Potential risks of capital flowsof capital flows

-3 -2 -1 0 1 2 3 4 5 6 70

100

200

300

400

500

600

-200

0

200

400

600

800

1,000

1,200

1,400

1,600

Real stock prices during inflow Real stock prices during inflow periods, selected countriesperiods, selected countries

Year with respect to start of Inflow periodNote: The Index for Finland, Mexico, and Sweden is shown on the left; the index for Chile during the

1980s and 1990s and for Venezuela is shown on the right.Source: World Bank (1997)

Sweden

Venezuela

Chile 1978-81

Mexico

Chile 1989-94

Finland

Stock prices in Thailand 1987-Stock prices in Thailand 1987-20002000

Thailand: Stock Market Index, 1987-2001

0

50

100

150

200

250

300

12/87 12/88 12/89 12/90 12/91 12/92 12/93 12/94 12/95 12/96 12/97 12/98 12/99 12/000

50

100

150

200

250

300

Bank index

Total SET

April 2, 1993 = 100

Large deficits Current account deficits Government budget deficits

Poor bank regulation Government guarantees (implicit or explicit),

moral hazardStock and composition of foreign debt

Ratio of short-term liabilities to foreign reservesMismatches

Maturity mismatches (borrowing short, lending long)

Currency mismatches (borrowing in foreign currency, lending in domestic currency)

Early warning signsEarly warning signs

Asia: Ratio of short-term Asia: Ratio of short-term liabilities to foreign reserves in liabilities to foreign reserves in 19971997

Large reversalsLarge reversals

Source: Finance and Development, September 1999.

Mexico, '93-95Korea, '96-97

Mexico, '81-83Thailand, '96-97

Venezuela, '87-90Turkey, '93-94

Venezuela, '92-94Argentina, '88-89Malaysia, '86-89

Indonesia, '84-85Argentina, '82-83

0 10 20 30 40 50 60Billion dollars

10% of GDP

12% of GDP

9% of GDP

18% of GDP

15% of GDP

11% of GDP

6% of GDP

10% of GDP

7% of GDP

5% of GDP

4% of GDP

Country experiences with Country experiences with capital account liberalizationcapital account liberalization External or financial crisis followed capital

account liberalization E.g., Mexico, Sweden, Turkey, Korea, Paraguay

Response Rekindled support for capital controls Focus on sequencing of reforms

Sequencing makes a difference Strengthen financial sector and prudential

framework before removing capital account restrictions

Remove restrictions on FDI inflows early Liberalize outflows after macroeconomic

imbalances have been addressed

Some types of capital flows are Some types of capital flows are riskier than othersriskier than others

Transitory

High degree of risk sharing

Permanent

No risk sharing

Foreign direct

investment

Long term debt

(bonds)

Portfolio equity

Short term debt

Sequencing Capital Sequencing Capital Account LiberalizationAccount LiberalizationPre-conditions for liberalizationSound macroeconomic policiesStrong domestic financial systemStrong and autonomous central bankTimely, accurate, and

comprehensive data disclosure

Exchange rate regimesExchange rate regimesThe real exchange rate always

floats• Through nominal exchange rate

adjustment or price changeEven so, it makes a difference how

countries set their nominal exchange rates because floating takes time

There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

66

Exchange rate regimesExchange rate regimesThere is a range of options

Monetary union or dollarizationMeans giving up your national

currency or sharing it with others (e.g., EMU, CFA, EAC)

Currency boardLegal commitment to exchange

domestic for foreign currency at a fixed rate

Fixed exchange rate (peg)Crawling pegManaged floatingPure floating

Currency union or dollarization Currency board Peg

Fixed Horizontal bands

Crawling peg Without bands With bands

Floating Managed Independent

FIXEDFIXED

FLEXIBLFLEXIBLEE

Exchange rate regimesExchange rate regimes

Dollarization Use another country’s currency as sole legal tender

Currency union Share same currency with other union members

Currency board Legally commit to exchange domestic

currency for specified Foreign currency at fixed rate

Conventional (fixed) peg Single currency peg Currency basket peg

Basically fixedBasically fixed

Flexible peg Fixed but readily adjusted

Crawling peg Complete

Compensate for past inflationAllow for future inflation

PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment

Fixed but adjustable

IntermediateIntermediate

Managed floating Management by sterilized intervention Management by interest rate policy, i.e.,

monetary policyPure floating

Basically floatingBasically floating

Benefits and costsBenefits and costsBenefitsBenefits CostsCosts

Fixed Fixed exchange exchange ratesrates

Floating Floating exchange exchange ratesrates



Stability of Stability of trade and trade and investmentinvestmentLow inflationLow inflation





InefficiencyInefficiencyBOP deficitsBOP deficitsSacrifice of Sacrifice of monetary monetary independenceindependence







EfficiencyEfficiencyBOP BOP equilibriumequilibrium






EfficiencyEfficiencyBOP BOP equilibriumequilibrium

Instability of Instability of trade and trade and investmentinvestmentInflationInflation

Exchange rate regimesExchange rate regimesIn view of benefits and costs, no

single exchange rate regime is right for all countries at all times

The regime of choice depends on time and circumstance• If inefficiencyinefficiency and slow growth are

the main problem, floating rates can help

• If high inflationinflation is the main problem, fixed exchange rates can help

What countries What countries actually do (2004, 193 actually do (2004, 193 countries)countries)No national currency 17%Other types of fixed rates 23Dollarization 5Currency board 4Crawling pegs 3Bilateral fixed rates 3Managed floating 26Pure floating 19 100

51%

49%

There is a gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today

Bottom lineBottom line

The EndThe End

These slides will be posted on my website: www.hi.is/~gylfason

External sector policies are important because external trade is important

Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debtMust avoid overvaluation!

Need to adopt exchange rate regime that is conducive to moderate inflation and rapid economic growth

external sector policies thorvaldur gylfason singapore, february 2008

Documents