Exchange Rate Regimes and Global Imbalances Kuala Lumpur ,

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					Exchange Rate Regimes and
    Global Imbalances
Kuala Lumpur, 28 March 2006

               An Overview

                  Andrew Sheng
  Tun Ismail Ali Chair in Monetary and Financial
                   Economics,
               University of Malaya
    Global Prices, Flows and Balance
              Sheet Effects
• The Exchange Rate is both a price and policy tool. In theory,
  the exchange rate balances the trade and capital account flows
  between a country and the rest of the world. The balance sheet
  changes because of exchange rate as asset price (valuation
  changes) and flows.
• Four types of global flows:-
   –   World trade in goods and services is already US$11 trn in 2004.
   –   FDI flows of US$648 bn in 2004
   –   FPI flows of US$4,213 bn in 2004 (CPIS data for top 10)
   –   Gross daily turnover of FX of US$1.9 trn in 2004, derivatives
       trading of US$5.7 trn (BIS Triennial Survey 2004)
• Central Bank holdings of FX reserves in 2003 reached US$3 trn.
  Global gross external assets amounted to US$37.9 trn, of
  which EMC accounted for 4.9%), up 12 times gross external
  asset of US$3.1 trn in 1980 (of which EMC 3.7%)
Globalization is accelerating, but imbalances have also
  grown in size
Exchange Rate Regimes: Classification
                 Source: Ghosh, Gulde & Wolf
 Regime             Features        Pros                Cons
 Dollarization      Foreign legal   Borrowed            ERR not tool
                    tender          currency            against shocks
                                    credibility
 Currency Board Fixed               Impose fiscal &     Tough to
                exchange            productivity        maintain
                regime              discipline
 Monetary Union Safety in           Reduces             Asymmetric
                numbers             exchange rate       shock on
                                    volatility          members
 Traditional Peg    Single or       Basket reduces      Provides target
                    basket peg      volatility          for speculative
                                                        attack
 Crawling peg       Rule-based      Combines            Also target for
                    system          stability with      speculative
                                    flexibility         attacks
 Bands              Mixes market    Limits volatility   Can be subject
                    with limits                         to attacks
         Real vs.. Nominal Exchange Rates

Real Exchange Rate =

                         Price of Tradable Goods
                      _________________________
                    Price of nontradable goods

RER is a proxy for degree of competitiveness.
   Decline in RER implies real exchange rate
   appreciation or deterioration in competitiveness.


Source:Sebastian Edwards: Exchange Rate Misalignment in Developing Countries,
      World Bank 1988
    Samuelson-Balassa Effect
The Samuelson-Balassa hypothesis states that the
   real exchange rate tends to appreciate in countries
   experiencing rapid growth. This is because
   productivity improvement is more rapid in countries
   with higher growth rates than those with lower ones.
In faster growing countries, technological progress is
   biased toward the tradable sector, leading to a rise in
   the economy-wide real wage. This creates an an
   increase in the price of nontradables relative to
   tradables.

The result is that real exchange rate rises for fast
  growing economies.
            The Washington View
•  メ.... the choice of appropriate exchange rate regime,
  which, for economies with access to international
  capital markets, increasingly means a move away
  from the middle ground of pegged but adjustable
  fixed exchange rates towards the two corner regimes
  of either flexible exchange rates or a fixed exchange
  rate supported, if necessary, by a commitment to give
  up altogether an independent monetary policy.モ
  Lawrence H. Summers (2000), p. 8.
• for countries open to international capital flows: (i)
  pegs are not sustainable unless they are very hard
  indeed; but (ii) that a wide variety of flexible rate
  arrangements are possible; and (iii) that it is to be
  expected that policy in most countries will not be
  indifferent to exchange rate movements. Stan Fischer
  (2001)
                         The Fischer View
1.   In the last decade, share of both hard pegs and floating gaining at the
     expense of soft pegs.
2.   Main reason is that soft pegs are crisis-prone and not viable over long periods.
     This is primarily due to the logic of the impossible trinity.
3.   Polarization is towards currency boards, dollarization, or currency unions on
     one side, and towards a variety of floating rate arrangements, including
     managed floating, on the other.
4.   As exchange rate flexibility increases, a country needs to determine the basis
     for its monetary policy. The record of inflation targeting has been a good one
     in this regard.
5.   The choice between a hard peg and floating depends in part on the
     characteristics of the economy, and in part on its inflationary history. The
     choice of a hard peg makes sense for countries with a long history of
     monetary instability, and/or for a country closely integrated in both its capital
     and current account transactions with another or a group of other economies.
6.   An exchange rate peg can and has been successfully used to disinflate from
     high inflation, without a crisis, but it is important to exit from the peg during the
     process. That is most easily done under pressure to appreciate.
7.   When misalignments among big three currencies become extremely large, the
     authorities tend to intervene to try to move exchange rates in the direction of
     equilibrium. This is loose and informal system, with no commitments to
     numerical ranges, as there would be in a formal target zone system.
                 Global Imbalances:
         AVERAGE CURRENT ACCOUNT BALANCES IN US$Bn
                       SOURCE: IMF
PERIOD   US     OTHER   OF      LDCS   DEV.   OF      MEMO:
                HDCS    WHICH          ASIA   WHICH   WORLD
                        JAPAN                 CHINA
2000-    -403   +167    +104    +126   +96    +30     -137
2001
1995-    -169   +167    +102    -50    +35    +20     -52
1999
1990-    -82    +36     +97     -62    0      +5      -102
1994
1985-    -134   +68     +73     -7     +8     -5      -73
1989
1980-    -30    -12     +11     -21    -13    NA      -64
1984
1970-    0      -1      +5      -5     -6     NA      -16
1979
         Global Imbalances - Four Historical
                     Episodes -
 •    19th Century classic gold standard, adjustment through
      gold flows, no role for monetary policy.
 •    Interwar years: failed gold standard as surplus countries
      (US, France) imposed burden of adjustment on UK and
      Germany, so burden of deflation and recession.
 •    Bretton Woods I: adjustment between surplus and deficit
      countries through IMF assistance under fixed rate system.
      Broke down when US abandoned gold link and became
      inflationary 1965-71
 •    Managed Floating: abandonment of exchange controls,
      and adjustments have been a combination of exchange
      rate, relative prices and domestic expenditure

 Conclusion: Past collapse was due to fundamental flaws and
    pursuit of inappropriate policies by major countries. No
    need for policy coordination and reinvent Bretton Woods

Michael Bordo (May 2005)
                Regional Features Compared:
                      Asia is still smaller than NAFTA & EU
Regional          NAFTA                    EU                        East Asia
Features                                                             (ASEAN+3)


Population        430mn                    460 mn                    2 billion


Area              21 mn sq. km             4 mn sq. km               15 mn sq. km.


GDP               US$12.9 trn              US$11.7 trn               US$7 trn


No. of members    3                        25 +                      15


Concentration     US accounts for 87% of   Germany accounts for      Japan accounts for 57% of
                  the regional GDP         22% of regional GDP and   regional GDP and 65% of
                                           19% of total financial    total financial assets
                                           assets
     Structural Imbalances persist despite
        high volatility of exchange rates
1.   US imbalances growing while Japanese surplus remains
     strong
2.   EU trade balance with US has remained stable at roughly
     US$100 bn despite wide FX swings
3.   Asians fear sharp swings in exchange rates would be
     destabilizing.
4.   Pre-crisis, developing Asia in deficit, strong surplus
     post-crisis to build up reserves against future crisis.
5.   China’s surplus is growing, but much of exports are from
     US, EU, Japan, Korea and other companies operating out
     of China
6.   Do you blame imbalances on host country or home
     countries in terms of ownership of exporters?
           Current Account Balances 2004 -
                 Deficits are largely in Anglo-sphere

                 Anglo Sphere (a)                      Asia


                   Total     US        Euro           Japan     China         Other
                                       area                                East Asia



% of GDP           -4.7     -5.7       0.5              3.7          4.2        6.3

US$ billion        -734     -668      47               172           69        118



 (a) Australia, Canada, New Zealand, United Kingdom, United States

 Source : IMF, MacFarlane, Reserve Bank of Australia
    US External Position - from world banker to
                 venture capitalist
•    US went from net creditor position (10% of GDP in 1952) to
     net debt position (-26% of GDP) by 2003
•    End 2004, US net external debt (with FDI at market value) was
     US$2.5 trillion or 22% of US GDP. Foreign assets of US$10
     trn (85% of GDP), liabilities of US$12.5 trn (107%)
•    70% of US foreign assets are in FX, but all liabilities in US$.
     10% US$ depreciation transfers 5.9% of US GDP to US.
•    Over period 1952-2003, average real rate of return on asset
     (5.72%) higher than average real rate of return on liabilities
     (3.61%), averaged 2.11%.
•    Since 1973, average asset return increased to 6.82%, liability
     cost was 3.5%, leading to increased excess return of 3.32%.
•    2% excess return allows US to accumulate debt exceeding
     assets by 30% and still have excess income.
•    But leverage (liabilities greater than assets) reaching 1.34 in
     2004 may be reaching tipping point.

Source: Gourinchas and Rey, Sept 2005
    US External Position - from world banker to
                 venture capitalist
•    US went from net creditor position (10% of GDP in 1952) to
     net debt position (-26% of GDP) by 2003
•    End 2004, US net external debt (with FDI at market value) was
     US$2.5 trillion or 22% of US GDP. Foreign assets of US$10
     trn (85% of GDP), liabilities of US$12.5 trn (107%)
•    70% of US foreign assets are in FX, but all liabilities in US$.
     10% US$ depreciation transfers 5.9% of US GDP to US.
•    Over period 1952-2003, average real rate of return on asset
     (5.72%) higher than average real rate of return on liabilities
     (3.61%), averaged 2.11%.
•    Since 1973, average asset return increased to 6.82%, liability
     cost was 3.5%, leading to increased excess return of 3.32%.
•    2% excess return allows US to accumulate debt exceeding
     assets by 30% and still have excess income.
•    But leverage (liabilities greater than assets) reaching 1.34 in
     2004 may be reaching tipping point.

Source: Gourinchas and Rey, Sept 2005
     Is US External Position unsustainable?
                        US Congress research
•    As long as US assets yield higher risk-adjusted return than
     foreign assets, foreigners will buy US assets.
•    EU area holds 53% of wealth in home assets and 10% in US
     assets, whereas Japan hold 63% in home assets and 4% in
     US assets.
•    Trade alone won’t solve deficit. Truman estimates that if
     current account reaches 6% of GDP, net income payments
     will be 4.5% of GDP, so trade deficit accounts for 1.5% GDP
•    2000-2004, US earned 9.6% on foreign assets, and paid 0.9%
     of foreign liabilities.
•    Obstfeld + Rogoff (2004)- US$ need to depreciate 14.7%-
     33.6% for elimination of CA deficit.
•    Blanchard, Giavazzi + Spa (2005) - depreciation of 56% for
     CA deficit to go to 0.75% of GDP.
•    Edwards (2005), US net debt would reach 60% of GDP by
     2010, CA deficit would peak at 7.5% of GDP in four years.
     Real value of US$ need to decline by 21% in first three years.

Source: Labonte, Congress Research Service, Dec 2005
 Some Chinese Views on Global Imbalances
Four factors why RMB revaluation will not help reduce US-
    China trade deficit
•   55% of Chinese exports are in processed trade, with
    imports from Japan, South Korea and Taiwan (revaluation
    will make imports cheaper)
•   Export-tax rebate, now account for US$24 bn or one
    quarter of China’s trade surplus with US. Removing this
    would be equivalent to revaluation
•   Large labour surplus would still ensure export
    competitiveness.
•   FDI inflows make Chinese exporters consistently more
    productive and competitive
Domestic considerations:-
•   Internal financial markets and banking system still
    undergoing restructuring - risks not small
•   China being large economy, changes to internal structure
    would have to take place before further liberalization
  Li-Gang Liu (March 2005)
    Impediments to Asia adjusting its
             structural imbalances
• High Asian savings are a demographic story of a young
  educated work force accumulating savings during its
  high growth stage. But parts of Asia is also aging.
• Two reasons why domestic expenditure cannot rise
  faster:-
   – After Asian crisis, huge cut back in fiscal
     expenditure, especially social infrastructure which
     are badly needed. Emphasis was on FX-earning
     exports to build up reserves against future crisis
   – Asian financial systems are not as developed as
     EU/US, being too fragmented, lacking breadth and
     depth in skills, liquidity and institutional strength
     (property rights infrastructure)
           Raguram (IMF) October 2005
• US running current account deficit of 6.25% of GDP
  and over 1.5% of world GDP, requiring financing
  equivalent to 70% of global capital flows.
• In OECD countries, government savings have
  dropped (esp. US Japan), while householder savings
  disappeared with housing boom.
• Emerging markets running current account surpluses,
  so world needs two kinds of transition:
   – Consumption needs to move to higher investments, especially
     in EMC, oil producers and low-income countries
   – Demand from deficit countries need to move to surplus
     countries
• Two greatest worries -
   – US will slow abruptly
   – Financing of US deficit will change. US current account deficit
     is financed by foreign private investors, while US private
     investments abroad are financed by foreign central banks.
        Global Imbalances - Five Views
•    Deutsche Bank's "Bretton Woods Two": No need to change
     fiscal balances, current account balances or exchange rates.
•    Ron McKinnon: the US fiscal deficit is the problem but the
     Chinese/Asian currencies do not need to move.
•    Fed's views: the US current account deficit derives from a
     "global savings glut" rather than a lack of US savings. US
     fiscal deficits may be a problem but their reduction may not
     shrink a US current account deficit whose source is foreign,
     not domestic. Global savings glut will continue due to the
     high growth and returns of the US.
•    Richard Cooper's View: the current account is sustainable as
     foreign investors love to invest into safe US assets; also a
     Chinese currency move is inappropriate as it would seriously
     hurt China's growth.
•    Roubini and Setser (and consensus view): global
     rebalancing requires both US fiscal adjustment (and private
     savings increase) and a Chinese/Asian currency
     appreciation.

Source: Nouriel Roubini, May 2005
     Global Assets Under Management
                    (US$ trillion end 2003)


International Banking Assets (BIS data)       23.6
International debt securities                 14.6
Insurance companies                           13.5
Pension Funds                                 15.0
Investment Companies                          14.0
Hedge Funds                                   0.8
Other Institutional Investors                 3.4
Total:                                        84.9


Memo: OTC Derivative Contracts (notional)     270.1

Source: BIS, IMF
    The Bretton Woods Architecture
   International Monetary Fund, total quota
    (capital) of SDR213 bn (USD306 bn), 184
    members (2005 data)
   World Bank (International Bank for
    Reconstruction and Development), capital
    US$38.6 bn, assets US$222 bn
        Other development banks, ADB, African Development
        Bank, EBRD, Inter-American Development Bank etc

   Bank for International Settlements (BIS), owned
    by member central banks, equity of US$14.9 bn
    and US$260.5 bn assets
   Total asset size of these institutions (US$790
    bn) is trivial (0.9%) compared with size of global
    financial assets of US$84.9 trn.
    Is the Bretton Woods relevant today?
   The Bretton Woods Architecture was designed
    when the rest of world was recovering post-war,
    with US in dominant surplus position.
   BW institutions could lend to help the rest of
    world adjust their net international position.
    OECD countries were basically in surplus and
    EMCs were in deficit. OECD countries control
    more than 50% of voting on BWIs.
   With globalization and US running net credit
    position, BWIs do not have enough financial
    resources and influence to make US adjust like
    any non-US member.
      Reform of IMF - Mervyn King Feb 2006
   IMF no longer can play role of lender of last resort (70% of
    IMF outstanding loans were to 3 countries).
   Asian economies built up FX reserves that are 10 time
    larger than combined reserves of G-7.
   Ratio of overseas assets and liabilities to GDP for G-10
    countries rose from 70% in 1980 to 250% in 2003.
   Since IMF resources too small, then its roles are to: -
         Forum   for discussion of global risks
         Independent    “ruthless truth-telling”
         Monitor  international balance sheets, look at ERR
         choices, and encourage countries to abide by their
         commitments to global stability through higher
         transparency.
   Focus on balance sheets, not just flows.
               Concluding Thoughts
   Globalization, financial innovation and changing
    international balance sheets have changed the Global
    Financial Architecture
   Exchange Rates, Capital Flows and International Balance
    Sheets are now part of global relationships, made much
    more complex as US becomes net debtor
   Important that everyone understand the important
    implications of this major shift in global balances.
   Post Asian crisis effects are now coming home to roost.
    During the Asian crisis, the periphery was in crisis, the
    center was strong.
   In this new era, the periphery has regained financial
    resource strength, but remains weak relative to the center
    in financial skills. The implications need to be thought
    through.
            Thank you
Questions to as@andrewsheng.net