Otaviano CanutoVice-President, PREM NetworkThe World BankMarch 2012

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?

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

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

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)

Might Work for LICs in theShort Run

Source: Haddad and Pancaro (2010).

Impact of 50% (in one measure of) RER Under-valuation

on

1)Exports/GDP

And

2) GDPPC Growth

Might Work on the Intensive but Not on the Extensive

Margin

Source: Taglioni (forthcoming)

% c

hange in e

xport

gro

wth

due t

o a

10

%

decr

ease

in t

he r

eal exch

ange r

ate

-2.00

-1.00

0.00

1.00

2.00

3.00

4.00

Intensive margin

Firm entries

Market entries

Product entries

Firm exits Market exits

Product exits

CHL MKD TUR

Intensive margin MKD: 13.4%

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)

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

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)

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

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

The Experts in the Room: The IMF’s 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

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: MB and ERER Methods

Source: Eden and Nguyen, forthcoming

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: MB and ES Methods

Source: Eden and Nguyen, forthcoming

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: ERER and ES Methods

Source: Eden and Nguyen, forthcoming

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

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

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

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

Thank you

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