Economic  Policy  #07_08 Foreign-­‐Exchange  Policy Foreign-­‐Exchange  Policy • History  of  monetary  system • Convertibility  and  exchange-­‐rate  regimes • Theory  of  optimum  currency  areas • Balance  of  payments EP#06_Foreign-­‐exchange  policy 2 Brief  history  of  the  international   monetary  system  #1 • System  of  Gold  Standard  was  extended  to  all  major   economies  in  the  1880s  and  lasted  until  WWI:  value  of   national  currency  was  determined  by  a  given  gold  weight   =>  fixed  exchange  rates  between  national  currencies. • Gold  Standard  was  temporarily  restored  in  the  end  of   19920s  but  finally  abandoned  during  1930s  as  the   countries  turned  to  protectionist  measures  and   competitive  devaluations. EP#06_Foreign-­‐exchange  policy 3 Brief  history  of  the  international   monetary  system  #2 • After  WWII  Bretton  Woods  Conference   established  a   Gold  Exchange  Standard,  where  all  currencies  were   convertible  into  gold  at  a  fixed  rate.  This  system  broke   down  in  1972. • In  1979  European  Monetary  System  (EMS)  was   established,  whereby  all  cross  exchange  rates  had  to   fluctuate  within  margins  of  +/-­‐ 2.25  %  (in  some  cases  +/-­‐ 6  %)  around  a  central  rate. • In  1999  European  monetary  union  was  initiated. EP#06_Foreign-­‐exchange  policy 4 International  financial  integration,   1870-­‐2007 EP#06_Foreign-­‐exchange  policy 5 5 De facto international financial integration 1870-2007 Average of absolute values of current accounts to GDP ratios for major countries. Source: Taylor (1996), updated by Bénassy-Quéré et al. (2012) Source:  Bénassy-­‐Quéré (2012) Currency  convertibility  and  exchange   rate  regimes Governments  need  to  make  two  crucial  decisions: • on  the  conditions  for  exchanging  the  domestic  currency   for  foreign  currencies  =>  currency  convertibility • on  the  extent  of  exchange  rate  flexibility  =>  exchange   rate  regime EP#06_Foreign-­‐exchange  policy 6 Currency  convertibility Currency    is  nonconvertible if  the  government  set  the  value   of  the  exchange-­‐rate   and  submit  foreign-­‐exchange   transactions  to  prior  authorization  (e.g.  Soviet  bloc  before   1990). It  is  useful  to  distinguish: • current  account  convertibility:  the  currency  can  be   exchanged  freely  for  the  purpose  of  importing  good  and   services,  current  transfers  and  factor  income • financial  account  convertibility:  direct  investments,   portfolio  investments  and  bank  loans  without  restriction   (=>  capital  mobility) EP#06_Foreign-­‐exchange  policy 7 Financial  openness While  advanced  economies  have  liberalized   capital  flows  in  the   1980s,  this  movement  is  still  incomplete  in  developing  countries. 4 Source: Chinn and Ito (2011). De jure financial openness lows allow for: o differ from – M = (X-M) on vings are highly Horioka Bénassy-Quéré, Economic Policy, 2012-13 EP#06_Foreign-­‐exchange  policy 8 The  pros  and  cons  of  capital  openness   #1 • Theoretical  advantages: – enables  the  capital  to  flow  to  the  most  efficient  places   – helping  both  investors  as  well  as  all  stakeholders – enable  emerging  economies  to  diversify  narrow   production  base  while  simultaneously  benefiting  from   technological   spillover   – capital  flows  from  capital  rich  to  capital  poor  countries   as  they  should  have  higher  returns   • reduce  cost  of  capital   • enable  investments • increase  growth   EP#06_Foreign-­‐exchange  policy 9 The  pros  and  cons  of  capital  openness   #2 • Potential  problems: – fear  of  appreciation   of  domestic  currency    and  making   domestic  manufacturers  less  competitive  in  global   markets   – fear  of  hot  money;  sudden  injection  of  funds  into   small  markets  can  cause  initial  dislocation  and  strains   associated  with  sudden  withdrawal – fear  of  large  capital  inflows,  that  can  cause   dislocations  in  the  financial  system  and  fuel  asset   price  bubbles   – fear  of  loss  of  monetary  autonomy;  see  impossible   trinity EP#06_Foreign-­‐exchange  policy 10 Exchange-­‐rate  regimes  #1 8 A continuum of exchange-rate regimes High flexibility ‘Dollarization’, ‘euroization’ Monetary union Soft peg with fluctuation band Fixed exchange rate Currency board Crawling peg Managed float Free float Low flexibility Intermediate regimesHard pegs Bénassy-Quéré, Economic Policy, 2012-13 EP#06_Foreign-­‐exchange  policy 11 Exchange-­‐rate  regimes  #2 • ’Dollarization’,  ’euroization’:  the currency of another country  circulates as  the sole  legal tender:  dollar (e.g.   Panama,  Ecuador),  euro  (e.g.  Montenegro and  San   Marino).  Another option is that the same legal tender  is shared by  members of monetary union. • Currency board:  explicit  legislative commitment to   exchange domestic currency at a  fixed rate,  issuance of domestic currency is backed by  foreign assets only.   • Fixed exchange rates:  the country  pegs its currency within margins of +/-­‐ 1  %  or less vis-­‐à-­‐vis  another currency (or basket  of currencies) EP#06_Foreign-­‐exchange  policy 12 Exchange-­‐rate  regimes  #3 • Soft  pegs with fluctuation band:  the value of the currency is maintained within certain margins of fluctuation of more  than +/-­‐ 1  %  around a  fixed central rate • Crawling pegs:  the central rate is adjusted periodically,   usually in  response  to  changes in  selective quantitative indicators (e.g.  inflation differentials) • Managed floating:  The CB  attempts to  influence  the exchange rate without having a  specific exchange rate path or target • Free  floating:  the exchange rate is fully market-­‐ determined EP#06_Foreign-­‐exchange  policy 13 Exchange-­‐rate  regimes:  fear  of   floating? 10 De facto exchange-rate regimes: fear of floating? Source: Ilzetzki, Reinhart and Rogoff (2008) based on IMF data. Bénassy-Quéré, Economic Policy, 2011-12 EP#06_Foreign-­‐exchange  policy 14 Source:  Bénassy-­‐Quéré (2012) The  Exchange  Rate  Regime  Dilemma:   the  pros  and  cons  of  fixed  regime • The  risk  of  speculative  attacks  when  the  firmness  of  the   commitment  is  being  questioned  that  can  lead  to   currency  crisis. • A  country  must  keep  large  quantities  of  foreign  currency. • By  commiting to  a  fixed  rate  a  country  commits  itself  not   to  engage  in  inflationary  policies. • CB  must  give  up  independent   monetary  policy. EP#06_Foreign-­‐exchange  policy 15 The  benefits  of  pegs:  credibilityThe benefits of pegs: credibility Inflation and growth performance under various exchange-rate regimes Source: Gulde, Gosh and Ostry (1997), based on 36 countries over 1960-1990. Source: World Bank, World Development Indicators. Disinflation in Argentina The benefits of pegs: credibility Inflation and growth performance under various exchange-rate regimes Source: Gulde, Gosh and Ostry (1997), based on 36 countries over 1960-1990. Source: World Bank, World Development Indicators. Disinflation in Argentina EP#06_Foreign-­‐exchange  policy 16 The  Exchange  Rate  Regime  Dilemma:   the  pros  and  cons  of  floating • Large  exchange  rate  fluctuations  are  a  major  source  of   uncertainty. • Exchange  rate  fluctuations  affect  the  relative  value  of   assets  and  liabilities  =>  depreciation   raises  the  value  of   the  external  debt. • Monetary  independence   of  the  CB  is  sustained. • Countries  are  better  able  to  absorb  economic  shocks. EP#06_Foreign-­‐exchange  policy 17 Convertibility  and  exchange-­‐rate   regime:  a  joint  choice Mundell’s  impossible trinity 9 Convertibility and exchange-rate regime: a joint choice Independent monetary policy Fixed exchange rate Perfect capital mobility Hong Kong, Ecuador, individual Euro area member countries China, Malaysia United States, Euro area, Japan Mundell’s ‘impossible trinity’ Bénassy-Quéré, Economic Policy, 2012-13 A  country  cannot  simultaneously  enjoy  an  independent   MP,   a  stable  exchange  rate  and  a  perfectly  mobile  capital.EP#06_Foreign-­‐exchange  policy 18 Regime  choice:  the  optimum  currency   area  theory  (OCA)  #1 The  OCA  theory  predicts  that  fixed  exchange  rates  are  most   appropriate  for  areas  closely  integrated  through   international  trade  and  factor  movements. Regime choice: the optimum area theory Mundell (1 EP#06_Foreign-­‐exchange  policy 19 The  optimum  currency  area  theory  #2 • Benefits: – saving  from  avoiding  the  uncertainty,  confusion,  and   calculation  and  transaction  costs  that  arise  when   exchange  rates  float – are  higher,  the  higher  the  degree  of  economic   integration  between  the  joining  country  and  the  fixed   exchange  rate  area EP#06_Foreign-­‐exchange  policy 20 The  optimum  currency  area  theory  #3 • Costs: – arise  because  a  country  that  joins  an  exchange  rate   area  gives  up  its  ability  to  use  the  exchange  rate  and   monetary  policy  for  the  purpose  of  stabilizing  output   and  employment – are  lower,  the  higher  the  degree  of  economic   integration  between  a  country  and  the  fixed  exchange   rate  area  that  it  joins EP#06_Foreign-­‐exchange  policy 21 Is  the  euro  area  an  optimal  currency   area?  #1 An  OCA  occurs  when • Countries  have  achieved  real  convergence • They  respond  in  similar  ways  to  external  economic   shocks  or  macro  policy  changes • They  have  sufficient  flexibility  in  both  their  product   markets  and  labor  markets  to  deal  with  these  shocks – High  mobility  of  labor – Wage  and  price  flexibility  in  factor  markets • Countries  are  prepared  to  use  fiscal  transfers  to  even  out   some  of  the  regional  economic  imbalances EP#06_Foreign-­‐exchange  policy 22 Is  the  euro  area  an  optimal  currency   area?  #2 The  Euro  Zone  does  not  come  close  to  an  OCA  by  most   criteria,  because • The  core  group  of  EU  countries  are  broadly  similar   (Germany  +  France  +  Netherlands  +  Belgium)  but   peripheral   countries  have  big  structural  differences • There  are  barriers  to  the  mobility  of  labor • Price  and  wage  flexibility  is  rather  low • The  role  of  fiscal  transfers  is  limited EP#06_Foreign-­‐exchange  policy 23 Balance  of  payments  (BP) • It  is  a  double  entry  system  of  record  of  all  economic   transactions  between  the  residents  of  the  country  and   the  rest  of  the  world  carried  out  in  a  specific  period  of   time. • It  takes  into  account  the  export  and  import  of  both   visible  and  invisible  items. EP#06_Foreign-­‐exchange  policy 24 Structure  of  balance  of  payment BP  consists  of  three  accounts: • Current  account:  all  payments  from/to  the  rest  of  the   world  deriving  from  exports  of  goods  and  services,  labor   and  capital  income • Capital  account:  capital  transfers  without  a  counterpart • Financial  account  (formerly  capital  account):  all  sales  of   domestic  assets  to  the  rest  of  the  world  (capital  inflows)   and  all  purchases  of  foreign  assets  (capital  outflows). EP#06_Foreign-­‐exchange  policy 25 The  US  and  euro  area  BP  in  2008 3 The balance of payments EP#06_Foreign-­‐exchange  policy 26 Adjustment  under  fixed  and  floating   exchange  rates Net financial inflows DF = DFin - DFout > 0 Financial outflows DFout Financial inflows DFin Exports X Imports M Current account balance B = X-M < 0 Fall in foreign exchange reserve DR < 0 Exports X Financial inflows DFin Decrease in foreign exchange reserves DR < 0 Imports M Financial outflows DFout B + DFin - DFout < 0 Fixed exchange-rate regime: B + DF = DRFloating exchange-rate regime: B + DF = 0 Adjustment under fixed and floating exchange rates Current account balance B = X-M < 0 7 Bénassy-Quéré, Economic Policy, 2012-13 EP#06_Foreign-­‐exchange  policy 27 Balance  of  payment  of  the  euro  area   (as  %  GDP) EP#06_Foreign-­‐exchange  policy 28 In December 2017 the current account of the euro area recorded a surplus of €29.9 billion.[1] In the financial account, combined direct and portfolio investment recorded net disposals of assets of €24 billion and of liabilities of €23 billion. Chart 1: Balance of payments of the euro area: 12-month cumulated transactions (as a percentage of GDP) Source: ECB Current account The current account of the euro area recorded a surplus of €29.9 billion in December 2017 (see Table 1). ∠ ∠ Net  foreign  positions  of  the  US,  euro   area  and  Japan,  1970-­‐2007 EP#06_Foreign-­‐exchange  policy 29 DP m s. Net foreign assets -30% -20% -10% 0% 10% 20% 30% 40% 50% %ofGDP USA Japan Eurozone Source: Lane and Milesi-Feretti, 2006. Assets and liabilities in market value. Source:  Bénassy-­‐Quéré (2012) Remittances  vs.  other  international   financial  flows  to  developing  countries   (1990-­‐2009) EP#06_Foreign-­‐exchange  policy 30 –200 –100 0 100 200 300 400 500 600 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 ODA FDI Remittances Portfolio investment Billionsofdollars Source:  Yang  (2011) Reference  textbook Bénassy-­‐Quéré,  A.  et  al.  Economic  Policy  :  Theory   and  practise.  Oxford  University  Press,  2010.   Chap.  5 EP#06_Foreign-­‐exchange  policy