Download Key Issues in Monetary and External Sector Policies

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