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Thorvaldur Gylfason International Monetary Fund/Asian Development Bank Course on Financial Programming and Policies Seoul, Korea, 17-28 May 2010 Outline 1) Transmission of monetary policy 2) Taxonomy of monetary strategies 3) Real vs. nominal exchange rates 4) The scourge of overvaluation 5) Capital flows 6) Exchange rate regimes To float or not to float Impossible trinity Background Countries need to choose A monetary policy strategy An exchange rate arrangement Money growth targets Inflation targets Fixed exchange rate Floating exchange rate The two choices must be compatible Cannot fix both money growth and exchange rate What is monetary policy? Broad definition Everything the monetary authority does Narrower definition Efforts by the monetary authority to influence macroeconomic variables The Black Box: How monetary policy is transmitted MONETARY POLICY INSTRUMENTS TRANSMISSION PROCESS: INSTITUTIONAL ENVIRONMENT IN WHICH MONETARY POLICY IS FORMULATED AND IMPLEMENTED OUTCOMES OR GOALS INDIRECT POLICY INSTRUMENTS OPEN MARKET OPERATIONS ASSET PORTFOLIO REQUIREMENTS CASH RESERVE REQUIREMENTS LIQUIDITY RESERVE REQUIREMENTS OFFICIAL CENTRAL BANK LENDING RATES EMPLOYMENT DIRECT POLICY INSTRUMENTS OPEN CAPITAL MARKETS BANK LENDING RATES BANK DEPOSIT RATES HOW MUCH TO LEND TO WHICH SECTOR/FIRM EXCHANGE RATE STABILITY OTHER BANK CAPITAL REQUIREMENTS PRUDENTIAL REGULATION INFLATION GROWTH INTEREST RATE STABILITY EFFICIENT FINANCIAL INTERMEDIATION Direct instruments Who gets credit and at what price? Directed credit Interest rate ceilings Direct controls on capital inflows and outflows Bank-by-bank credit ceilings Experience with direct instruments As a rule, direct instruments do not deliver the intended results Political interference in credit allocation Credit misallocation via interest rate ceilings Hence, large volumes of nonperforming assets combined with slow growth Eventually, government has to abandon direct instruments as they become too expensive both financially and economically Indirect instruments Central Bank injects and withdraws liquidity from the financial system Financial system then decides what activities will be financed and at what price Typically, Central Bank targets a ‘base’ interest rate Market-based decisions Results of injection/withdrawal of liquidity Interest rates adjust upward or downward Exchange rates may change Credit flows from banks to customers change Incomes and prices change Indirect instruments Instruments of monetary control are variables that the central bank actually regulates to reach targets Open market operations Discount facility Reserve requirements A transmission mechanism of monetary policy Market rates Productivity Output Asset prices Aggregate Demand Monetary Policy Expectations/ Confidence Exchange rate Inflation Import prices Monetary policy strategies: Taxonomy Exchange rate targeting Targeting monetary aggregates Inflation targeting Other “eclectic” frameworks Exchange rate targeting Involves adjusting monetary policy instruments to keep exchange rate fixed within a narrow range of some announced target level (i.e., par value) Pre-World-War-I gold standard Bretton Woods regime (1945-71) European ERM (1979-92) Many low-income countries today Targeting monetary aggregates Involves adjusting monetary policy instruments to target the growth rate of some selected measure of the money supply Many industrial countries from late-1970s to mid-1980s About 22 countries today But none of the industrial countries Inflation targeting Involves adjusting monetary policy instruments to keep the central bank’s forecast of inflation consistent with an announced target About 45 industrial and emerging-market countries today First introduced by New Zealand in December 1989 Eclectic monetary policy Generally involves adjusting monetary policy instruments to pursue stable economic growth and low inflation, but with no formally announced targets United States, Japan, Switzerland, India, Singapore, and at least 20 other countries today Real vs. nominal exchange rates eP Q P* Increase in Q means real appreciation Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Real vs. nominal exchange rates eP Q P* Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad Three thought experiments eP Q P* 1. Suppose e falls Then more won per dollar, so X rises, Z falls 2. Suppose P falls Then X rises, Z falls 3. Suppose P* rises Then X rises, Z falls Summarize all three by supposing Q falls Then X rises, Z falls The scourge of overvaluation Governments 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 Inflation and overvaluation Inflation can result in an overvaluation of the national currency • Remember: Q = eP/P* Suppose e adjusts to P with a lag Then Q is directly proportional to inflation Numerical example Inflation and overvaluation Real exchange rate Suppose inflation is 10 percent per year 110 105 100 Average Time Inflation and overvaluation Real exchange rate Suppose inflation rises to 20 percent per year Hence, increased inflation increases the real exchange rate as long as the nominal exchange rate adjusts with a lag 120 110 Average 100 Time How to correct overvaluation Under a floating exchange rate regime Adjustment is automatic: e moves Under a fixed exchange rate regime Devaluation 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 condition: Theory Valuation effect arises from the ability to affect foreign prices B = eX – Z = eX(e) – Z(e) Not obvious that a lower e helps B Let’s do the arithmetic Bottom line is: Devaluation strengthens the current account as long as a b 1 a = elasticity of exports b = elasticity of imports The Marshall-Lerner condition + B eX (e) Z (e) dB dX dZ X e de de de -a dB dX X e de de b e X dZ e Z X e de Z e 1 1 The Marshall-Lerner condition dB dX e X dZ e Z X e de de X e de Z e dB X aX bX 1 a b X de dB 0 de if a b 1 X The Marshall-Lerner condition: Evidence Econometric studies indicate that the Marshall-Lerner condition is almost invariably satisfied Industrial countries: a = 1, b = 1 Developing countries: a = 1, b = 1.5 Hence, a b 1 Empirical evidence from developing countries Argentina Brazil India Kenya Korea Morocco Pakistan Philippines Turkey Average Elasticity of exports 0.6 0.4 0.5 1.0 2.5 0.7 1.8 0.9 1.4 1.1 Elasticity of imports 0.9 1.7 2.2 0.8 0.8 1.0 0.8 2.7 2.7 1.5 The small country 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 appropriate side measures Remember: eP Q P* 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 Capital flows Capital mobility A stylized view of capital mobility 1860-2000 First era of international financial integration Return toward financial integration Capital controls Source: Obstfeld & Taylor (2002), “Globalization and Capital Markets,” NBER WP 8846. Conceptual framework Real interest rate Emerging countries save a little Saving Investment Loanable funds Conceptual framework Real interest rate Industrial countries save a lot Saving Investment Loanable funds Conceptual framework Emerging countries Industrial countries Saving Borrowing Investment Loanable funds Real interest rate Real interest rate Financial globalization encourages investment in emerging countries and saving in industrial countries Lending Saving Investment Loanable funds 3 3 2 1 1 0 -1 -1 -2 Direct investment, net (left axis) Other private, net (left axis) Official capital flows, net (left axis) Direct investment/GDP (right axis) Other private/GDP (right axis) Official capital/GDP (right axis) 09 20 08 07 20 06 20 05 20 04 20 03 20 02 20 01 20 00 20 99 20 98 19 97 19 96 19 19 95 19 94 93 19 92 19 91 19 90 19 89 19 88 19 87 19 86 19 85 19 84 19 83 19 82 Source: IMF WEO 19 19 19 19 81 -2 In Percent of GDP (%) 2 80 Billions of USD ($) 700 650 600 550 500 450 400 350 300 250 200 150 100 50 0 -50 -100 -150 -200 -250 -300 -350 -400 Push vs. pull factors External factors “pushed” capital from industrial countries to LDCs Cyclical conditions in industrial countries Recessions in the early 1990s Decline in world interest rates Structural changes in industrial countries Financial structure developments Demographic changes Push vs. pull factors Internal factors “pulled” capital into LDCs from industrial countries Macroeconomic fundamentals Reduction in barriers to capital flows Private risk-return characteristics Creditworthiness Productivity Potential benefits of capital flows Improved allocation of global savings (allows capital to seek highest returns) Greater efficiency of investment More rapid economic growth Reduced macroeconomic volatility through risk diversification (which dampens business cycles) Income smoothing Consumption smoothing Potential risks of 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 instruments Countries 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 of 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 suffers Construction booms Monetary consequences of capital inflows and accumulation of foreign exchange reserves depend crucially on exchange regime Real stock prices during inflow periods, 6 0 0 selected countries Chile 1978-81 1 , 6 0 0 1 , 4 0 0 5 0 0 1 , 2 0 0 Mexico 4 0 0 1 , 0 0 0 Venezuela Chile 1989-94 8 0 0 3 0 0 6 0 0 2 0 0 4 0 0 Sweden Finland 2 0 0 1 0 0 0 0 3 2 1 0 1 2 3 4 5 6 2 0 0 7 Year with respect to start of Inflow period Note: 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) Stock prices in Thailand 1987-2000 Early warning signs Large deficits Current account deficits Government budget deficits Poor bank regulation Government guarantees (implicit or explicit), moral hazard Stock and composition of foreign debt Ratio of short-term liabilities to foreign reserves Mismatches Maturity mismatches (borrowing short, lending long) Currency mismatches (borrowing in foreign currency, lending in domestic currency) Asia: Ratio of short-term liabilities to foreign reserves in 1997 Large reversals Mexico, Korea, Mexico, Thailand, Venezuela, Turkey, Venezuela, Argentina, Malaysia, Indonesia, Argentina, '93-95 '96-97 '81-83 '96-97 '87-90 '93-94 '92-94 '88-89 '86-89 '84-85 '82-83 12% of GDP 9% of GDP 18% of GDP 15% of GDP 11% of GDP 6% of GDP 10% of GDP 7% of GDP 10% of GDP 5% of GDP 4% of GDP 0 10 20 30 40 Billion dollars Source: Finance and Development, September 1999. 50 60 Country experiences with capital account liberalization External or financial crisis followed capital account liberalization Response E.g., Mexico, Sweden, Turkey, Korea, Paraguay 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 riskier than others High degree of risk sharing Portfolio equity Foreign direct investment Short term debt Long term debt (bonds) No risk sharing Transitory Permanent Sequencing Capital Account Liberalization Pre-conditions for liberalization Sound macroeconomic policies Strong domestic financial system Strong and autonomous central bank Timely, accurate, and comprehensive data disclosure Exchange rate regimes The real exchange rate always floats • Through nominal exchange rate adjustment or price change Even 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 Exchange rate regimes There is a range of options Monetary union or dollarization Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) Currency board Legal commitment to exchange domestic for foreign currency at a fixed rate Fixed exchange rate (peg) Crawling peg Managed floating Pure floating Range of options Fixed No Independent Monetary Policy 52 Flexible Independent Monetary Policy 52 Exchange rate regimes Currency union or dollarization Currency board Peg FIXED Fixed Horizontal bands Crawling peg Without bands With bands Floating FLEXIBLE Managed Independent Basically fixed 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 specified Foreign currency at fixed rate Conventional (fixed) peg Single currency peg Currency basket peg currency for Intermediate Flexible peg Fixed but readily adjusted Crawling peg Complete Compensate for past inflation Allow for future inflation Partial Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable Basically floating Managed floating Management by sterilized intervention Management by interest rate policy, i.e., monetary policy Pure floating Floating regimes “Pure” float Independent float X - Z + F = ΔR = 0, so X – Z = -F Exchange rate is market-determined; market intervention is limited to moderating the rate of change and preventing undue fluctuations Managed float Monetary authority influences exchange rate through active intervention without specifying, or committing to, an exchange rate path Benefits and costs Benefits Fixed exchange rates Floating exchange rates Costs Benefits and costs Benefits Fixed exchange rates Floating exchange rates Stability of trade and investment Low inflation Costs Benefits and costs Fixed exchange rates Floating exchange rates Benefits Costs Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Benefits and costs Benefits Costs Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Benefits and costs Benefits Costs Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation Exchange rate regimes In 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 inefficiency and slow growth are the main problem, floating rates can help • If high inflation is the main problem, fixed exchange rates can help Why we have fewer currencies than countries In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force Consider four categories Existing monetary unions De facto monetary unions Planned monetary unions Previous – failed! – monetary unions Existing monetary unions CFA 14 African countries CFP franc 3 Pacific island states East franc Caribbean dollar 8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, early advisor to Korea, adorns the $100 note Euro, more recent 16 EU countries plus 6 or 7 others Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc. De facto monetary unions Australian Australia plus 3 Pacific island states Indian rupee India plus Bhutan (plus Nepal) New dollar Zealand dollar New Zealand plus 4 Pacific island states South African South Africa plus Lesotho, Namibia, Swaziland – and Zimbabwe Swiss franc Switzerland plus Liechtenstein US rand dollar US plus Ecuador, El Salvador, Panama, and 6 others Planned monetary unions East African shilling (2009) Eco (2009) Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia) Khaleeji (2010) Burundi, Kenya, Rwanda, Tanzania, and Uganda Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates Other, more distant plans Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa Previous monetary unions Danish krone 1886-1939 Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in Iceland) Scandinavian Denmark, Norway, and Sweden East African shilling 1921-69 Kenya, Tanzania, Uganda, and 3 others Mauritius monetary union 1873-1914 rupee Mauritius and Seychelles 1870-1914 Southern African rand South Africa and Botswana 1966-76 Many others Conflicting forces Centripetal tendency to join monetary unions, thus reducing number of currencies To benefit from stable exchange rates at the expense of monetary independence Centrifugal tendency to leave monetary unions, thus increasing number of currencies To benefit from monetary independence often, but not always, at the expense of exchange rate stability With globalization, centripetal tendencies appear stronger than centrifugal ones Impossible trinity FREE CAPITAL MOVEMENTS Monetary Union (EU) FIXED EXCHANGE RATE MONETARY INDEPENDENCE Impossible trinity FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE Capital controls (China) MONETARY INDEPENDENCE Impossible trinity FREE CAPITAL MOVEMENTS Flexible exchange rate (US, UK, Japan) FIXED EXCHANGE RATE MONETARY INDEPENDENCE Impossible trinity FREE CAPITAL MOVEMENTS Flexible exchange rate (US, UK, Japan) Monetary Union (EU) FIXED EXCHANGE RATE Capital controls (China) MONETARY INDEPENDENCE Key points Monetary authorities face a tradeoff between the degree of exchange rate stability and the extent to which they can act to stabilize economic activity and the domestic price level International capital mobility exacerbates the tradeoff Industrial country choices today Outside Europe Floating exchange rates Monetary policy used to pursue domestic stabilization objectives Removal of capital controls Within much of Europe Fixed exchange rates Common currency that floats against outside world Monetary policies highly coordinated and pooled in the European Central Bank Removal of capital controls What countries actually do (Number of countries, end-April 2008) (22) (84) (12) (44) (40) (76) (10) (66) (3) (5) (2) 76 Source: Annual Report on Exchange Arrangements and Exchange Restrictions database. What countries actually do (2008, 182 countries) No national currency Currency board Conventional fixed rates Intermediate pegs Managed floating Pure floating 6% 7% 36% 5% 24% 22% 100% 54% 46% There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed rates through economic and monetary unions Bottom line External sector policies are important because external trade is important for growth Need to maintain real exchange rates at levels that are consistent with BOP equilibrium, including sustainable debt Must avoid overvaluation! Need to adopt monetary and exchange rate regimes that is conducive to moderate inflation and rapid economic growth Bottom line These slides will be posted on my website: www.hi.is/~gylfason Monetary policy and exchange rate regimes have changed over time Over the past decade, Many countries have moved to more flexible exchange rate arrangements coupled with more independent monetary policy Others aim to form monetary unions Choice of monetary and exchange rate regime is best viewed as a means to sound fiscal, monetary, and financial policies