Download This PDF is a selection from a published volume from... of Economic Research Volume Title: NBER International Seminar on Macroeconomics 2012

This PDF is a selection from a published volume from the National Bureau
of Economic Research
Volume Title: NBER International Seminar on Macroeconomics 2012
Volume Author/Editor: Francesco Giavazzi and Kenneth D. West,
organizers
Volume Publisher: University of Chicago Press
Volume ISBN: 978-0-226-05313-4 cloth; 978-0-226-05327-1 paper;
0-226-05327-X paper
Volume URL: http://www.nber.org/books/giav12-1
Conference Date: June 15-16, 2012
Publication Date: August 2013
Chapter Title: Comment on "Capital Account Policies and the Real
Exchange Rate"
Chapter Author(s): Lars E. O. Svensson
Chapter URL: http://www.nber.org/chapters/c12770
Chapter pages in book: (p. 49 - 54)
Comment
Lars E. O. Svensson, Sveriges Riksbank, Stockholm University, CEPR, and NBER
Olivier Jeanne has provided us with a very elegant and clear paper
on the problem of capital account policies and the real exchange rate,
precisely the kind of clear analysis of an important problem that he
has provided many times before. The paper presents a model of how
a small open economy can undervalue its real exchange rate using its
capital account policies. It uses China to motivate and exemplify. The
model’s predictions concerning rates of returns on domestic and foreign assets are in line with empirical observations.
The model is entirely real—there is no money and no explicit monetary policy. A representative and infinitely-lived consumer maximizes
utility. The consumer receives endowments of two goods—tradable
and nontradable—and can hold domestic and foreign assets. The government keeps the capital account closed and is the only agent that can
trade foreign assets. The government thus controls the current account
and the trade balance. The real exchange rate is determined by the trade
balance.
The results are the following: the government can depreciate the currency by closing the capital account and accumulating reserves. Such
capital account policies can achieve the same outcomes as trade policies
(a tariff/subsidy on imports/exports). The cumulated excess return on
domestic bonds during the time appreciation is resisted is larger than
the initial undervaluation. With a tax on domestic bonds, the domestic
currency can be depreciated, but with no more than the tax rate. Resisting a real appreciation reduces domestic welfare. The welfare loss
increases more than proportionately with the size of the initial undervaluation.
In line with the model’s prediction, the dollar return on Chinese
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50
Svensson
fixed-income assets was higher on average (2000 to 2011) than that on
US ones. An estimate of the flow welfare cost for 2010 and 2011 of the
Chinese policy is about 1.1 percent of GDP.
I do not find the model or the results particularly controversial. The
model is very clean and the analysis very clear. But I think one can
question somewhat the realism of the model. In the model, capital controls work perfectly. How well do the Chinese capital controls work in
the real world? How much leakage is there? What are the experiences
of the effectiveness of capital controls in other countries? I welcome the
discussion of this in Section II.
In the model there is Ricardian equivalence, in the specific sense that
the private sector internalizes the government’s intertemporal budget
restriction and behaves as if it owns the assets and liabilities of the government. However, I am not sure that the general public in China feels
that it necessarily owns these assets and liabilities, and I would not be
surprised if there are large groups in Chinese society that do not internalize them in their private decisions.
When it comes to the welfare analysis, I think there is room for further analysis. One may ask why the Chinese authorities are doing what
they are doing if a relatively straightforward analysis shows that it is
detrimental to welfare. As Olivier notes, making productivity growth
endogenous could allow some nontrivial welfare analysis where capital
account and undervaluation policies have some benefits in addition to
the costs analyzed in the paper.
The Chinese do save a lot. There is some indication that they save too
much, that this high level of saving is due to distortions. Reasons mentioned are financial repression with low returns to saving, lack of social
security, and limited access to assets. Deposits pay very low returns, the
Shanghai stock exchange has not had large returns, and an investment
in an overheated housing market seems for many to be the best way to
save. The distortions and the capital controls may imply that we do not
know what a reasonable equilibrium exchange rate is. If capital controls were lifted, many Chinese, perhaps because of uncertain property
rights, might prefer to put their money abroad, in which case we would
see a net outflow of capital rather than an inflow, and perhaps a weaker
currency than now.
A somewhat related issue, I believe, is the fact that several emergingmarket economies have been subject to increased inflows of foreign
capital over the last few years, and some emerging-market policymakers
have expressed concerns about the related risks of bubbles and other neg-
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Comment
51
ative effects. IMF (2011b) examined international capital flows over the
last 30 years and found that net capital flows to emerging markets have
been strongly correlated with changes in global financing conditions, rising sharply during periods with relatively low global interest rates.
Based on these and similar observations, some observers have concluded that the effects on capital flows to other countries should be
taken into account in, for instance, Federal Reserve policy decisions.
For example, Eichengreen, Rajan, and Prasad (2011) find that the political authorities in large economies “should let considerations of these
external effects play an explicit role in the monetary policy framework.
Central banks in these countries should pay more attention to their collective policy stance and its global implications.”1
I do not agree with this conclusion. The Federal Reserve’s mandate
concerns US inflation and employment, and the Federal Reserve is not
responsible for inflation, real developments, and monetary policy in
other countries except as they feed back into the United States. That
responsibility rests with the policy authorities in those countries. Countries that choose to stabilize their dollar exchange rate or even peg to
the dollar will tend to import US expansionary monetary policy to their
own country. This monetary policy may in many cases be too expansionary for the countries concerned, creating an overheated economy
with risks for bubbles and other negative consequences. A flexible exchange rate would give the countries the option of conducting an independent monetary policy appropriate for the country in question. In
particular, they would be able to respond appropriately to changes in
interest rates and other variables in the rest of the world. If countries
nevertheless choose to peg to the dollar, with capital inflows, bubbles,
and other negative effects, they are themselves responsible for those
effects.
Consider the following thought experiment.2 Let the world consist
of two large economies, called the domestic and foreign economy, respectively. Let the domestic economy be an emerging-market economy
with flexible inflation targeting, a flexible exchange rate, and free capital flows. Suppose that the domestic economy is initially in an equilibrium with the inflation forecast on the inflation target, the resourceutilization forecast at a sustainable level, a constant exchange- rate
forecast, zero capital flows, and a given policy-rate path consistent with
this. Suppose the foreign interest rate falls, due to more expansionary
monetary policy in the foreign economy in order to increase demand
and activity in the foreign economy. Everything else equal, this has two
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52
Svensson
consequences for the domestic economy. First, due to increased foreign
activity, foreign demand for domestic exports increases somewhat. Second, the interest-rate differential between the domestic and foreign interest rates increases. This will trigger an incipient capital inflow into
the domestic economy and appreciation of the domestic currency. Suppose the appreciation is so large as to trigger depreciation expectations
that balance the increased interest-rate differential. This will again stabilize the capital flow at zero. Everything else equal, the appreciation
of the currency is a real appreciation, which is contractionary for the
tradable- goods sector. Assume that this contractionary effect dominates over the initial increase in export demand, so the net effect on the
tradable-goods sector is contractionary. Demand for, and the output of,
nontradable goods may expand somewhat from the appreciation, but
assume that the contraction of the tradable-goods sector dominates so
the net effect on domestic output is a contraction. The appreciation also
leads to lower inflation, through lower prices on imported goods. The
resource-utilization and inflation forecasts will fall below a sustainable
level and the inflation target, respectively.
The monetary-policy response that is consistent with flexible inflation targeting and thus stabilizes inflation around the target and resource utilization around a sustainable level is then to lower the policy
rate and the policy-rate path. This will stimulate the economy, moderate the nominal and real appreciation, and shift up the forecasts of
inflation and resource utilization toward the target and a sustainable
level, respectively. In the new equilibrium, the currency has appreciated somewhat in real terms, the nominal and real interest rate will be
lower, the tradable-goods sector may have contracted somewhat, and
the nontradable-goods sector may have expanded somewhat. This is
the monetary-policy response that I vote for when this situation arises
for Sweden.
Suppose that for some reason the central bank is not willing to accept the nominal and real appreciation of the currency when foreign
interest rates fall. By lowering the domestic interest rate and the policyrate path so as to keep the interest-rate differential and its forecast unchanged, the central bank could in principle maintain a fixed exchange
rate and zero capital flow. But the lower nominal and real interest-rate
paths are expansionary, and the inflation and resource-utilization forecasts will shift up, above the inflation target and a sustainable level,
respectively. The domestic economy is effectively importing the foreign
economy’s monetary policy, which is too expansionary for the domes-
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Comment
53
tic economy. The increased growth and activity and the expectation
that the central bank may eventually have to accept an appreciation
may then still lead to a capital inflow, even though the interest-rate
differential is unchanged. In order to prevent an appreciation, the
central bank has to intervene and buy foreign exchange. This leaves
more time for capital inflows, and the accumulated capital inflow may
grow. The economy starts becoming overheated, asset prices grow, and
bubbles may develop. In order to prevent the situation from becoming
more problematic, the central bank may consider what the IMF calls
capital-flow management measures (CFMs), including capital controls
(residency-based CFMs) (IMF 2011a). The authorities may also consider
a fiscal contraction and financial-stability measures as responses to the
situation.
This is a highly stylized and very simplified thought experiment.
Still, I think it conveys an important insight, namely that a substantial
part of the problem is due to the central bank’s unwillingness to accept
the nominal and real appreciation, even though this appreciation is a
natural equilibrium response to the lower world interest rate. Are the
reasons for that unwillingness so important that they take precedence
over the problematic consequences?3
Endnotes
Presented at the ISOM meeting in Oslo, June 15–16, 2012. For acknowledgments,
sources of research support, and disclosure of the author’s material financial relationships, if any, please see http://www.nber.org/chapters/c12770.ack.
1. Eichengreen, Rajan, and Prasad are members of the Committee on International
Economic Policy and Reform, a nonpartisan independent group of experts (academics
and former government and central bank officials). In its September 2011 report (Eichengreen et al. 2011), the committee suggests that “[m]echanisms should . . . be developed to
encourage large-country central banks to internalize the spillover effects of their policies.
Specifically, we call for the creation of an International Monetary Policy Committee composed of representatives of major central banks that will report regularly to world leaders
on the aggregate consequences of individual central bank policies.”
2. Ferrero, Gertler, and Svensson (2009) provide a suitable model for such thought
experiments: a new Keynesian dynamic stochastic general equilibrium (DSGE) model of
a world with two large countries and tradable and nontradable goods.
3. The policy response to recent capital inflows to emerging-market economies is further discussed in the IMF staff framework for policy advice on managing capital inflows
(IMF 2011a).
References
Eichengreen, Barry, Mohamed El-Erian, Arminio Fraga, Takatoshi Ito, Jean
Pisani-Ferry, Eswar Prasad, Raghuram Rajan, et al. 2011. Rethinking Central
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All use subject to JSTOR Terms and Conditions
54
Svensson
Banking. Report from the Committee on International Economic Policy and
Reform. www.brookings.edu.
Eichengreen, Barry, Raghuram Rajan, and Eswar Prasad. 2011. “Central Banks
Need a Bigger and Bolder Mandate.” Financial Times, October 24.
Ferrero, Andrea, Mark Gertler, and Lars E. O. Svensson. 2009. “Current Account Dynamics and Monetary Policy.” In International Dimensions of Monetary Policy, edited by Jordi Galí and Mark Gertler. Chicago: University of
Chicago Press.
IMF. 2011a. Recent Experiences in Managing Capital Inflows—Cross-Cutting Themes
and Possible Policy Framework. Washington, DC: International Monetary Fund.
www.imf.org.
———. 2011b. World Economic Outlook. Washington, DC: International Monetary Fund. www.imf.org.
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