Transcript Currency Wars: Global Money in 2011 Jeffrey Frankel Harpel Professor of Capital Formation & Growth, Harvard University MAS Sponsored Public Lecture, Singapore, March 2011

Currency Wars:
Global Money in 2011
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth,
Harvard University
MAS Sponsored Public Lecture, Singapore, March 2011
1

What are the currency wars?
• Review of the last 6 months.
• Is the currency war metaphor appropriate?

Which emerging markets are intervening the most
to dampen the appreciation of their currencies?
• What is the right way to measure it?
• What should they be doing? Lessons from recent crises.

The 3 big currencies
• $
• RMB
• €
2

Who is doing how much?
• It is not enough to look at increases in FX reserves.
• The question:
for a given increase in Exchange Market Pressure
(EMP), how much does the central bank absorb as an
rise in the value of its currency (exchange rate) versus
how much as an increase in the quantity (reserves).

How much should it intervene, vs. appreciate?
• What can we learn from recent crises?
3
Currency Wars chronology, 2010
June
China announces more flexibility in RMB,

• after postponement of Treasury report on
undervaluation, thereby saving face;
• but little appreciation follows. (Repeat of 2005.)

September 15
Japan buys $20 b for ¥,
• after 6-year absence from FX markets;
• thereby joining Switzerland, the other floater to
have appreciated in 2008-09 GFC and to have
fought it by FX intervention.
4
Currency Wars chronology, continued
September 27
warning from Brazil’s Finance
Minister Guido Mantega:
“We’re in the midst of
an international currency war,
a general weakening of currency.
This threatens us because it takes away our
competitiveness.”
 I.e., countries everywhere are trying
to push down the value of their currencies,
to gain exports and employment,

• a goal that is not globally consistent.
5


Some consider FRB policy another instance.

Renewed flows to emerging markets
have met with intervention
• e.g., by Korea, host of November G20 summit.
• Brazil, Thailand, India & others must decide how to manage
inflows:




Capital controls?
Appreciation?
Buying $ to prevent appreciation
China’s RMB remains the dominant issue.
6
Currency Wars chronology,

Nov.2010
As European sovereign debt crisis resurfaces
in Ireland, (1.3 $/€
).
Nov.17

Chinese government,
responding to 4.4% inflation
in October
• raises i,
• reserve requirements,
• & price controls.

US core inflation falls to 0.6% for year,
• the lowest since 1957.
7
Chinese inflation
reached 8% in 2008
and climbed back up
to 4.9% as of Feb.2011
Source: WSJ
8
US core inflation is the lowest in 50 years
9
Jan 2011
Currency Wars chronology, Nov.2010
G20 Summit in Korea is first
chaired by a non-G8 country
10
Currency Wars chronology, Nov.2010

Nov. 12: G-20 Summit in Seoul
judged a failure, at least for Obama:
• Rebuff of US proposal for cap on Current
Account surpluses at 4% of GDP.
• No pledge to refrain from “competitive
undervaluation”
• A suggestion to countries with widely used
currencies like the $ to “be vigilant against
excess volatility,” a warning against loose
monetary policy.
11
Currency Wars chronology, Nov. 2010

Nov.21: Fed announces QE2 decision -• Will purchase $600b in bonds.
• Short-term market reaction -- $ depreciates.
• Critiques -

Sarah Palin & John Taylor:
“US is debauching its currency.”
Germany, China & Brazil:
“$ depreciation = deliberate salvo in currency wars.”
12
Currency Wars chronology, Jan. 2011


Jan.14, 2011:
Geithner notes that -- including China’s higher
inflation -- RMB is appreciating at 10% per year.
That suggests (appropriately) lower USG priority
on the currency issue
• than on IPR, North Korea
& other issues

in Jan.19
Obama-Hu summit.
13
5% nominal appreciation per annum
+ 5% inflation differential
≈ 10% real appreciation per annum
over last half-year
14
Global Macro Monitor
Data sources: The Economist, BLS, CEIC, Thomson Reuters
Currency Wars chronology, 2011

Feb. 4, 2011
• In biannual report to Congress, U.S.Treasury
calls RMB "substantially undervalued."
• But it once again refrains from naming China
a currency manipulator.
• and points out real appreciation is at 10%.
15
Currency Wars chronology
Feb. 15, 2011:
US Treasury
Secretary Geithner
fails to convince
Brazil to jointly
pressure China.
Mantega responds:
“the $ is as much a
problem as the RMB.”
Financial Times Feb. 16, 2011
16
Feb. 18-19, 2011:



First meeting of G20 ministers
in France’s year as host.
Sarkozy no longer talking
of “a new Bretton Woods.”
But G20 goes ahead with
a system of indicators,
• including probably currency reserves,
exchange rates, current account balances,
budget deficits and sovereign debt levels.
17
Is the currency war metaphor applicable?

Fear of non-cooperative “competitive devaluation”
is an argument for fixed exchange rates
• rooted in the 1930s.
• That is why the architects of
the post-war monetary order
chose fixed exchange rates
at Bretton Woods, NH, in 1944.

But it is now used to argue that China
should move from fixing to floating.
• US Congressmen don’t
care about regimes;
• they just want a stronger RMB vs. $.
18
Intervention in emerging markets
to fight currency appreciation

Who is doing how much?
• It is not enough to look at increases in FX reserves.
• The question:
for a given increase in Exchange Market Pressure
(EMP), how much does the central bank absorb as an
rise in the value of its currency (exchange rate) versus
how much as an increase in the quantity (reserves).

How much should it intervene, vs. appreciate?
• What can we learn from recent crises?
19
Is the currency war metaphor applicable?


Meanwhile, fear of “competitive devaluation”
is also used as an argument against
US monetary expansion.
But monetary expansion is not
a “beggar-thy-neighbor” policy:
• Although in theory it should depreciate $,
• at the same time it boosts US growth & so imports.
• The net of the two effects on trade balance
is ambiguous in theory and ≈ 0 in practice.
• Do other countries want a U.S. “double dip” ?
20
Is the currency war metaphor applicable?



continued
Economic historians have decided
competitive devaluation under 1930s
conditions was not a problem after all.
True, countries couldn’t all devalue
against each other,
But they could and did all devalue against gold
• which worked to ease global monetary policy,


just what was needed.
The same was needed in 2008-09
21
Is the currency war metaphor applicable?

continued
The currency war talk – especially the criticism of
US monetary policy -- seems to forget the point of
floating rates:
• Different countries will always have different needs
at any point in time


e.g., high unemployment in US & European periphery,
while China & Brazil & India are overheating.
• The point of a floating rate system is that US can
choose its easy monetary policy and Brazil its tight
monetary system, with appreciation of $ vs. real
accommodating the divergence.

Multilateral cooperation is not necessary for this.
22
Is the currency war metaphor applicable? continued

But other kinds of international cooperation are needed;
• the currency war & 1930s metaphors are not totally misplaced:

Currency war could turn into trade war
• if Congress follows through on legislation to impose (WTO-illegal)
tariffs on China as punishment for non-appreciation.
• Until now, the US & G20 have held the line on protectionism


compared to the milder recessions of 1991 & 2001,
let alone the Smoot Hawley tariff of 1930.
23
Ideally the US & China would reach agreement
on how to address current account imbalances:

China would take some responsibility
• to reallocate its economy away from
exclusive reliance on exports & manufacturing

toward domestic consumption & services,
• health, education, housing, environment, insurance & other services.
• How? By allowing the RMB to appreciate,
• but also by increasing domestic demand.

Meanwhile, the US would ideally also take responsibility.
• Even while prolonging expansionary policy this year,

including fiscal expansion designed with high bang-for-the-buck,
• the US should take steps today to lock
in a future return to fiscal responsibility,

e.g., by putting Social Security on a firm footing.
24
Intervention in emerging markets
to fight currency appreciation

Who is doing how much?
• It is not enough to look at increases in FX reserves.
• The question:
for a given increase in Exchange Market Pressure
(EMP), how much does the central bank absorb as an
rise in the value of its currency (exchange rate) versus
how much as an increase in the quantity (reserves).

How much should it intervene, vs. appreciate?
• What can we learn from recent crises?
25
Capital flows to emerging markets, especially Asia,
recovered quickly from the 2009 recession.
These countries again show big balance of payments surpluses
Goldman Sachs
26
China gets the most attention,
partly because it is so large in trade and
partly because it absorbs most of its Exchange Market
Pressure as FX intervention, rather than appreciation
%
27
Korea (& Singapore & Taiwan) are also
adding heavily to reserves.
GS Global ECS Research
28
But that’s partly because Singapore
& Korea faced the greatest total
Exchange Market Pressure in 2010
29
Goldman Sachs Global Economics Weekly 11/07
Feb. 16, 2011
Since 2008, India, followed by Indonesia, have had
the greatest tendency to float, given EMP;
Hong Kong & Singapore the least, followed by Malaysia & China.
30
Goldman Sachs Global Economics Weekly 11/07
Feb. 16, 2011
Korea’s intervention to dampen won appreciation
has been largely on the forward market
Goldman Sachs 31
Global Economics Weekly
11/07 Feb. 16, 2011
India & Malaysia in 2010 took the inflows
in the form of currency appreciation,
more than reserve accumulation.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
GS Global ECS Research
32
In Latin America, renewed inflows
are reflected mostly as reserve accumulation in Peru,
but as appreciation in Chile & Colombia.
more-managed floating
less-managed floating
(“more appreciation-friendly”)
33
GS Global ECS Research
If a country faces an increase in
exchange market pressure, should
it appreciate? Or intervene?


It is the old debate over floating
versus fixed exchange rate.
What can we learn about the answer
from recent crises?
34
Two lessons from the 1990s emerging
market currency crises

Advantages of floating:
• Speculators don’t have a target to shoot at;
• Accommodate shocks;
• Discourage unhedged $ liabilities.

Advantages of holding forex reserves
• Reduces danger of crisis.

How did these lessons fare in the crises
of 2008-09?
35
EWIs: The variables that show up as the strongest
predictors of country crises in 83 studies are:
(i) reserves and (ii) currency overvaluation
0%
10%
20%
30%
40%
50%
60%
70%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
External Debt
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
36
Source: Frankel & Saravelos (2010)
Best and Worst Performing Countries -- F&S (2010), Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bottom 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
37
10%
Table Appendix 6
Coefficients of Bivariate Regressions of Crisis Indicators on Each Independent Variable* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower, dark er color shading equivalent to higher statistical significance
Currency
Market
Equity
Market
Recourse to
IMF
Industrial
Production
GDP
S ignif ic a nt a nd
C o ns is t e nt
S ign?^
Reserves (% GDP)
0.082
(2.52)
0.850
(1.6)
-1.020
(-1.92)
0.155
(2.22)
0.008
(0.27)
Yes
Reserves (% external debt)
-0.000
(-1.42)
0.000
(2.11)
-0.010
(-3.42)
0.000
(3.62)
0.000
(3.07)
Yes
Reserves (in months of imports)
0.002
(1.58)
0.103
(4.71)
-0.089
(-3.31)
0.006
(1.48)
0.001
(0.75)
Yes
M2 to Reserves
0.000
(0.14)
-0.026
(-3.81)
-0.067
(-1)
-0.001
(-2.46)
0.000
(1.44)
Yes
Short-term Debt (% of reserves)
-0.000
(-2.6)
-0.007
(-4.45)
0.000
(1.18)
-0.000
(-1.7)
-0.000
(-2.93)
Yes
REER (5-yr % rise)
-0.293
(-5.4)
-0.303
(-0.32)
0.889
(0.99)
-0.000
(-0.01)
-0.029
(-0.85)
REER (Dev. from 10-yr av)
-0.292
(-2.93)
-0.920
(-0.81)
0.671
(0.58)
-0.000
(-0.01)
-0.041
(-0.91)
GDP growth (2007, %)
0.003
(1.7)
0.078
(1.58)
0.039
(1.63)
0.010
(2.59)
-0.002
(-1.21)
GDP Growth (last 5 yrs)
0.002
(1.08)
0.118
(2.14)
0.052
(1.68)
0.009
(2.14)
-0.003
(-1.21)
GDP Growth (last 10 yrs)
0.005
(1.59)
0.087
(1.06)
0.042
(1.2)
0.016
(2.63)
-0.004
(-0.76)
GDP per capita (2007, constant 2000$)
-0.003
(-0.7)
-0.296
(-4.69)
-0.221
(-3.23)
-0.027
(-2.48)
-0.010
(-1.74)
Change in Credit (5-yr rise, % GDP)
-0.029
(-0.83)
-1.979
(-5.42)
0.139
(0.37)
-0.092
(-1.67)
-0.065
(-2.34)
Yes
Change in Credit (10-yr rise, % GDP)
-0.024
(-2.84)
-0.904
(-3.9)
-0.011
(-0.08)
-0.046
(-1.58)
-0.019
(-1.13)
Yes
Credit Depth of Information Index (higher=more)
-0.005
(-1.34)
-0.115
(-1.72)
0.009
(0.19)
0.006
(0.57)
-0.003
(-0.47)
Bank liquid reserves to bank assets ratio (%)
0.000
(1.52)
0.022
(1.51)
-0.000
(-13.97)
0.002
(2.34)
0.001
(2.58)
Yes
Current Account (% GDP)
0.001
(1.57)
0.032
(2.18)
-0.032
(-3.46)
0.000
(0.42)
0.000
(0.78)
Yes
Current Account, 5-yr Average (% GDP)
0.001
(1.31)
0.030
(1.66)
-0.032
(-2.76)
0.000
(0.53)
0.000
(0.42)
Current Account, 10-yr Average (% GDP)
0.000
(0.72)
0.034
(1.46)
-0.038
(-2.63)
0.000
(0.15)
0.001
(1.59)
Net National Savings (% GNI)
0.000
(0.9)
0.048
(4.5)
-0.020
(-1.88)
0.003
(2.42)
0.002
(2.92)
0.000
0.047
-0.028
0.003
0.002
F & Saravelos (2010): Bivariate
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Gross National Savings (% GDP)
Yes
38
Yes
Yes
Table Appendix 7
Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower
F & Saravelos
(2010):
Multivariate
Exchange
Market
Pressure
Currency % Recourse to
Changes
IMF
(H208-H109
(SBA only)
Equity
%Chng
(Sep08Mar09)
Equity %
Chng
(H208H109)
S ignif ic a nt
a nd
C o ns is t e nt
S ign?^
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Reserves (% GDP)
0.164
(3.63)
0.087
(2.98)
-1.069
(-1.66)
0.011
(0.12)
0.010
(0.14)
Yes
Reserves (% external debt)
0.000
(1.06)
0.000
(1.1)
-0.006
(-2.29)
0.000
(1.81)
0.000
(2.65)
Yes
Reserves (in months of imports)
0.004
(2.25)
0.003
(1.95)
-0.119
(-3.01)
0.006
(1.32)
0.009
(2.32)
Yes
M2 to Reserves
0.000
(0.27)
0.000
(0.76)
-0.044
(-0.91)
0.000
(0.02)
-0.000
(-0.09)
Short-term Debt (% of reserves)
-0.000
(-1.97)
-0.000
(-4.22)
0.000
(2.13)
-0.001
(-2.89)
-0.001
(-3.11)
Yes
REER (5-yr % rise)
-0.440
(-5.55)
-0.210
(-3.19)
1.728
(2.15)
-0.182
(-1.24)
-0.185
(-1.61)
Yes
REER (Dev. from 10-yr av)
-0.475
(-3.96)
-0.230
(-2.47)
2.654
(2.56)
-0.316
(-1.71)
-0.316
(-2.1)
Yes
GDP growth (2007, %)
-0.000
(-0.2)
0.001
(0.94)
0.070
(2.58)
-0.001
(-0.1)
-0.007
(-0.71)
GDP Growth (last 5 yrs)
-0.003
(-0.81)
0.000
(0.26)
0.084
(2.4)
-0.003
(-0.26)
-0.014
(-1.15)
GDP Growth (last 10 yrs)
0.000
(0.14)
0.001
(0.43)
0.064
(1.66)
-0.012
(-0.67)
-0.020
(-1.12)
Change in Credit (5-yr rise, % GDP)
-0.021
(-0.36)
-0.035
(-0.98)
0.552
(1.02)
-0.274
(-2.97)
-0.248
(-4.13)
Change in Credit (10-yr rise, % GDP)
-0.017
(-0.93)
-0.011
(-1.05)
0.210
(1.03)
-0.089
(-1.65)
-0.089
(-2.35)
Credit Depth of Information Index (higher=more)
-0.008
(-1.06)
0.000
(0.05)
0.224
(2.4)
-0.006
(-0.37)
-0.018
(-1.33)
Bank liquid reserves to bank assets ratio (%)
0.000
(3.84)
0.000
(0.5)
-0.000
(-11.44)
-0.002
(-0.54)
-0.002
(-0.79)
Yes
Current Account (% GDP)
0.001
(1.48)
0.002
(2.7)
-0.023
(-2.09)
0.009
(3.84)
0.007
(3.95)
Yes
Current Account, 5-yr Average (% GDP)
0.000
(0.48)
0.001
(1.82)
-0.025
(-1.72)
0.007
(2.4)
0.006
(2.74)
Yes
Current Account, 10-yr Average (% GDP)
0.000
(0.14)
0.002
(1.39)
-0.035
(-2.11)
0.008
(2.21)
0.007
(2.44)
Yes
Net National Savings (% GNI)
0.002
(1.6)
0.001
(2.33)
-0.013
(-1.22)
0.006
(2.92)
0.004
(2.28)
Gross National Savings (% GDP)
0.003
(2.01)
0.001
(2.53)
-0.015
(-1.36)
0.008
(3.42)
0.006
(3.03)
Yes
39 Yes
Yes
Reserves


Even though many developing & emerging market
countries described themselves as floating,
most took advantage of the boom of 2003-2008
to build up reserves to unheard of heights,
• in the aftermath of the crises of 1994-2001.

in contrast to past capital booms (1975-81, 1990-97).
40

When the 2008-09 global financial crisis hit,
• those countries that had taken advantage of
the 2003-08 boom to build up reserves did better.



E.g., Obstfeld, Shambaugh & Taylor (2009)
Frankel & Saravelos (2010),
This had also been the most common finding
in the many studies of Early Warning Indicators
in past emerging market crises.
41
Poland, the only continental EU member with a floating
exchange rate, was also the only one to escape
negative growth in the global recession of 2009
% change in GDP
Poland
Lithuania
Latvia
Estonia
Slovakia
Czech Republic
Hungary
2006
2007
2008
2009
2010
6.2 6.8 5.1 1.7 3.5f 7.8 9.8 2.9 -14.7 -0.6f 12.2 10.0 -4.2 -18.0 -3.5f 10.6 6.9 -5.1 -13.9 0.9f 8.5 10.6 6.2 -4.7 2.7f 6.8 6.1 2.5 -4.1 Source: Cezary Wójcik, 2010
1.6f Exchange Rate
Floating
(de facto)
Fixed
Fixed
Fixed
Euro
Flexible
42
Flexible
The Polish exchange rate increased by 35%.
Depreciation boosted net exports; contribution to GDP growth > 100%
4,7
Source:
Cezary Wójcik
28,0
4,5
zlotys / $
23,0
4,2
Contribution of Net X to GDP:
4,0
2009: 2,5
3,4
3,2
GDP growth rate:
3,7
3,5
3,4
18,0
1,7
kroon / $
Estonia
13,0
lats / $
Latvia
3,2
8,0
I
III
V
VII
IX
XI
I
III
V
VII
IX
XI
I
III
V
VII
IX
43
2008
2009
2010
44
Appendices: The 3 big currencies
Appendix I: The end of $ hegemony?
Appendix II:
Is RMB appreciation in China’s own interest?
Appendix III: Predictions –
Sovereign debt troubles & the €
Appendix IV: More on the trend
to a multiple reserve system
45
Appendix 1:
The end of dollar hegemony ?

Some argue the US current account
deficit is sustainable indefinitely.
• They believe that the US will continue to enjoy
its unique “exorbitant privilege,”


able to borrow unlimited amounts in its own currency
because it is the dominant international reserve asset.
46
“Bretton Woods II”

Dooley, Folkerts-Landau, & Garber (2003) :
• today’s system is a new Bretton Woods,

with Asia playing the role that Europe played
in the 1960s—buying up $ to prevent
their own currencies from appreciating.
• More provocatively:
China is piling up dollars
not because of myopic mercantilism,
but as part of an export-led development strategy
that is rational given China’s need to import workable
systems of finance & corporate governance.
47
My own view on Bretton Woods II:
•
•
The 1960s analogy is indeed apt,
but we are closer to 1971 than to 1944 or 1958.
•
Why did the BW system collapse in 1971?

The Triffin dilemma could have taken decades
to work itself out.

But the Johnson & Nixon
administrations accelerated
the process by fiscal & monetary expansion
(driven by the Vietnam War & Arthur Burns, respectively).

These policies produced: declining external balances,
$ devaluation, & the end of Bretton Woods.
48
There is no reason to expect better today:
1)
Capital mobility
is much higher now than in the 1960s.
2)
The US can no longer rely
on support of foreign central banks:

neither on economic grounds
(they are not now, as they were then,
organized into a cooperative framework where
each agrees explicitly to hold $ if the others do),

nor on political grounds
(these creditors are not the staunch allies
the US had in the 1960s).
49
The financial crisis caused a flight to quality
which evidently still means a flight to US $.


US Treasury bills in 2008-09 were more in demand
than ever, as reflected in very low interest rates.
The $ appreciated, rather than depreciating as the “hard
landing” scenario had predicted.

=> The day of reckoning had not yet arrived.

Chinese warnings (2009) may be turning point:
• Premier Wen worried US T bills will lose value.
• PBoC Gov. Zhou proposed
replacing $ as international
currency.
50
Multiple international
reserve asset system

The € now exists as a rival to the $.

The ¥ & SF are also safe havens.

The SDR came back
from the dead in 2009.

Gold made a comeback as
an international reserve too.

Someday the RMB will join the roster
though it is just beginning now.

= a multiple international reserve currency system.
51
Appendix II: What is in China’s interest?

Countries should have the right to fix
their exchange rate if they want to.
True, the IMF Articles of Agreement
and the US Omnibus Trade Act of 1988
call for action in the event that a country
is “unfairly manipulating its currency”.

But

• Few countries have been forced to appreciate.
• Pressure on surplus countries to appreciate will inevitably
be less than pressure on deficit countries to depreciate.
• I support ending the language of “manipulation.”



Usually, it is hard to say when a currency is undervalued.
Don’t cheapen the language that is appropriate to WTO rules.
China should do what is in its own long-term interest.
52
Five reasons why China should let
the RMB appreciate, in its own interest
1.
Overheating of economy
2.
Reserves are excessive.
•
3.
It gets harder to sterilize the inflow over time.
Attaining internal and external balance.
•
•
To attain both, need 2 policy instruments.
In a large country like China,
expenditure-switching policy should be the exchange rate.
4.
Avoiding future crashes.
5.
RMB undervalued, judged by
Balassa-Samuelson relationship.
53
1. Overheating of economy:

Bottlenecks.
Pace of economic growth is outrunning:
• raw material supplies, and
• labor supply in coastal provinces
• Also:
• physical infrastructure
• environmental capacity
• level of sophistication of financial system.

Asset bubbles.
• Shanghai stock market bubble in 2007.

Inflation 6-7% in 2007
=> price controls
 shortages & social unrest.

All of the above was suspended in late 2008,
• due to global recession.
• But it is back again now; skyrocketing real estate prices.
54
Attempts at “sterilization,” to insulate
domestic economy from the inflows


Sterilization is defined as offsetting
of international reserve inflows,
so as to prevent them from showing up
domestically as excessive money growth & inflation.
For awhile PBoC successfully sterilized…
• until 2007-08.
• The usual limitations finally showed up:




Prolongation of capital inflows <= self-equilibrating mechanism shut off.
Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate
Failure to sterilize: money supply rising faster than income
Rising inflation (admittedly due not only to rising money supply)
55
2. Foreign Exchange Reserves
Excessive:

•
•
•

Though a useful shield against currency crises,
China has enough reserves: $2 ½ trillion by April 2010;
& US treasury securities do not pay high returns.
Harder to sterilize
the inflow over time.
56
The Balance of Payments
≡ rate of change of foreign exchange reserves (largely $),
rose rapidly in China over past decade,
due to all 3 components:
trade balance, Foreign Direct Investment, and portfolio inflows
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
57
Attempts
tosterilization
sterilize reserve
inflow:
Successful
in China:
2005-06
High reserve growth
=> steady money
offset by cuts in
domestic credit
While reserves (NFA) rose rapidly, the growth of the monetary base
was kept
to the
growth of the real
economy – even
in 2005-06.
were
remarkably
successful
inreduced
2005-06.
58
In 2007-08 China began to have more
trouble sterilizing the reserve inflow

PBoC began to pay higher interest rate
domestically, & receive lower
interest rate on US T bills
=> quasi-fiscal deficit.

Inflation became a serious problem.
• True, global increases in food & energy prices
were much of the explanation.
• But



China’s overly rapid growth itself contributed.
Appreciation is a good way to put immediate downward
pressure on local prices of farm & energy commodities.
Price controls are inefficient and ultimately ineffective.
59
Sterilization faltered in 2007 & 2008
Monetary base
accelerated
Growth of China’s
monetary base,
& its components
60
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
Foreign exchange
reserves held by
the People’s Bank
of China are
approaching
$3 trillion in 2011.
61
New York Times Jan 12, 2011
The Chinese money
supply has almost
doubled in the last
3 years, contributing
to a rapid growth
aggregate demand
as reflected in nominal GD
No wonder inflation i
rising again.
62
New York Times Jan 12, 2011
3. Need a flexible exchange rate to
attain internal & external balance

Internal balance ≡

External balance ≡ appropriate balance of payments.

General principle: to attain both policy targets,
a country needs to use 2 policy instruments.

For a country as large as China, one of those policy
instruments should be the exchange rate.

demand neither too low (recession) nor too high
(overheating).
To reduce BoP surplus without causing higher unemployment,
China needs both
• currency appreciation, and
• expansion of domestic demand
 gradually replacing foreign demand,
 developing neglected sectors:
63
health, education, environment, housing, finance, &
4. Avoiding future crashes
Experience of other emerging
markets suggests it is better to exit
from a peg in good times, when the
BoP is strong, than to wait until the
currency is under attack.
Introducing some flexibility
now, even though not ready
for free floating.
64
5. Longer-run perspective:
Balassa-Samuelson relationship

Prices of goods & services in China are
low
• compared at the nominal exchange rate.
• Of course they are a fraction of those in the U.S.: <
¼ .
• This is to be expected,
explained by the Balassa-Samuelson effect


which says that low-income countries have lower price
levels.
As countries’ real income grows, their currencies experience
65
real appreciation: approx. .3% for every 1 % in income
per capita.
1
.5
-1
-.5
0
The Balassa-Samuelson Relationship
2005
-3
-2
-1
0
1
Log of Real Per capita GDP (PPP)
2
coef = .23367193, (robust) se = .01978263, t = 11.81
Source: Arvind Subramanian, April 2010,
“New PPP-Based Estimates of Renminbi Undervaluation
and Policy Implications,” PB10-08, Peterson Institute for International Economics
Undervaluation of RMB in the regression estimated above = 26%.
Estimated undervaluation averaging across four such estimates = 31%.
Compare to Frankel (2005) estimate for 2000 = 36%.
66
Appendix III: Debt Predictions

Greece will need
to re-structure its debt.

The euro will survive.
• There is no legal provision
for members to leave the euro zone.

Prices of government bonds in
advanced countries in general will fall.
67
The euro project is looking
far less successful than just a few years ago

Many predictions of euro skeptics have come true:
• Periphery countries and core countries have had trouble
reconciling asymmetric monetary needs.
• Euro members have not had enough labor mobility
or flexibility to make up for it.
• Efforts to prevent excessive debt & bailouts have failed:


The Stability & Growth Pact failed with members big & small.
The “No bailout clause” has failed with Greece.
68
Frankfurt & Brussels
made 4 mistakes regarding Greece

2001: They let Greece into the euro

2002-09: ECB accepted Greek debt as collateral
• despite consistent violation of SGP.
• => Did not allow interest rate spreads to open up.


Winter 2010: Did not tell Greece to go to the IMF.
Preferred instead to “handle it internally.”
Still today: No “Plan B” to restructure Greek debt
(and save the bailout fund for more deserving banks & PIIGs).
69
Judging from spreads, 2001-07,
investors put zero odds on a default by Greece
or other Mediterranean countries
Council on Foreign Relations
70

Suddenly, in 2010, the Greek sovereign spread
shot up, exceeding 800% by June.

Even when the Greek crisis erupted,
leaders in Brussels & Frankfurt
seemed to view it as a black swan,
• instead of recognizing it as a close cousin
of the Argentine crisis of ten years earlier,

and many others in history,
• including among European countries.
71
Sovereign debt worries
...
• The next big asset market to fall
• after the stock market in 2000
• the housing market in 2006
• and banking in 2008
• will likely be sovereign debt
• among the advanced economies.
• The major emerging market countries
are in much better shape,
• in an amazing & historic role reversal.
72
Sovereign spreads for 5 euro countries
shot up in the 1st half of 2010
Creditworthiness: Some advanced economics
have fallen, as emerging markets have risen.
73
A remarkable role-reversal:
• Debt/GDP of the top 20 rich countries
(≈ 80%) is already twice that
of the top 20 emerging markets;
• and rising rapidly.
• By 2014 (at ≈ 120%), it could be triple.
74
Even judged by ratings of credit
agencies, emerging markets are now
intermingled with advanced countries
•
•
•
•
•
•
•
•
Singapore’s credit rating is now above Belgium’s
China’s rating rose above Japan’s in January
Taiwan is above Italy
Chile is above Israel
Korea is above Portugal
Malaysia is above Ireland
South Africa is above Iceland
India is above Greece.
75
Ratings for “Advanced Economies”
Ratings for “Emerging Economies”
76
Appendix IV: More on the trend from
$ hegemony to a multiple reserve system
When does the “privilege” become “exorbitant?”



if it accrues solely because of size and history, without
the US having done anything to earn
the benefit by virtuous policies such as budget
discipline, price stability & a stable exchange rate.
Since 1973, the US has racked up $10 trillion
in debt and the $ has experienced a 30% loss
in value compared to other major currencies.
It seems unlikely that macroeconomic policy discipline
is what has earned the US its privilege !
77
Some argue that the privilege to incur $
liabilities has been earned in a different way:

Global savings glut

The US appropriately exploits its comparative advantage
in supplying high-quality assets to the rest of the world.
(Bernanke)
• “Intermediation rents…pay for the trade deficits.”
-- Caballero, Farhi & Gourinchas (2008)
• In one version, the US has been operating as the World’s
Venture Capitalist, accepting short-term liquid deposits and
making long-term or risky investments -- Gourinchas & Rey (2008).
• US supplies high-quality assets:
Cooper (2005); Forbes (2008); Ju & Wei (2008);
Hausmann & Sturzenegger (2006a, b);
Mendoza, Quadrini & Rios-Rull (2007a, b)…
78


The argument that the US offers assets of superior
quality, and so has earned the right to finance its
deficits, was undermined by the dysfunctionality
revealed in the financial crisis of 2007-08.
American financial institutions suffered a severe
loss of credibility (corporate governance, accounting
standards, rating agencies, derivatives, etc.),

How could sub-prime mortgages be
the superior type of assets that uniquely
merit the respect of the world’s investors?
79

But the events of 2008-09 also
undermined the opposing interpretation,
the unsustainability position:


Why no hard landing for the $, as long feared?
The $ appreciated after Lehman Brothers’
bankruptcy, & US T bill interest rates fell.

Clearly in 2008 the world still viewed
•
the US Treasury market as a safe haven and
•
the US $ as the premier international currency.
80
Though arguments about the unique high quality
of US private assets have been tarnished,
the idea of America as World Banker is still alive:
the $ is the world’s reserve currency,
by virtue of US size & history.


Is the $’s unique role
an eternal god-given constant?
Or will a sufficiently long record of deficits &
depreciation induce investors to turn elsewhere?
81
Historical precedent: £’s loss of premier
international currency status in 20th century

By 1919, US had passed UK in
1. output (1872)
2. trade (1914)
3. net international creditor position (1914-19)

Subsequently,
$ passed £ as #1 reserve currency (1940-45).
82
From the literature
on reserve currencies
Determinant:
Proxy:
1.
Size
GDP
2.
Depth of Fin.mkt.
FX turnover
3. Rate of return
inflation,
LR depreciation,
Exch. rate variance
83
From the literature, continued
Network externalities
=> Tipping
captured by:
1)
Inertia
lags
2)
Nonlinearity
in determinants
logistic functional form
or
dummy for leader GDP
84
Projection of $ vs €
as shares of central banks’ foreign exchange reserves:
a function of country size, financial market depth, & rate of return,
with parameters estimated on 1973-98 data.
1.0
Simulation assumes $ depreciation continues at 2001-04 rate.
USD
Chinn & Frankel
(2005)
0.8
0.6
0.4
0.2
0.0
birth
of €
DEM
EUR
This scenario showed €
overtaking $ as top international
reserve currency in 2022.
85
75 80 85 90 95 00 05 10 15 20 25 30 35 40
More on a multiple-asset
international reserve system
International Currency Roles
Table B
Adapted from Kenen
Function
of
money:
Store of
value
Medium
of
exchange
Unit of
account
Governments
Private actors
International reserve
holdings
Vehicle currency for
foreign exchange
intervention
Anchor for pegging
local currency
Currency substitution
(private dollarization)
Invoicing trade and
financial transactions
Denominating trade and
financial transactions
86

A multiple reserve currency system is inefficient,
in the same sense that barter is inefficient:
money was invented in the first place to cut down
on the transactions costs of exchange.

Nevertheless, if sound macro policies
in the leader country cannot be presumed,
the existence of competitor currencies gives
the rest of the world protection against the leader
exploiting its position by running up too much
debt and then inflating/depreciating it away.
87
Gold

Gold was seen as an anachronism just a few years ago:
• the world’s central banks were selling off their stocks.

Gold re-joined the world monetary system in 2009:
• The PBoC, RBI, & other Asian central banks
bought gold, to diversify their reserves.
• Even in advanced countries, central banks
appear to have stopped selling.
88
Special Drawing Rights






The SDR has made a surprising comeback as a potential
international money, from near-oblivion.
The G20 in 2009 decided to create new SDRs ($250b).
Shortly later, PBoC Gov. Zhou proposed replacing
the $ as lead international currency with the SDR.
The IMF is now borrowing in SDRs.
The proposal has been revived for an international
substitution account at the IMF, to extinguish an unwanted
$ overhang in exchange for SDRs.
The SDR has little chance of standing up as a competitor
to the € or ¥, let alone to the $.
Still, it is back in the world monetary system.
89

http://ksghome.harvard.edu/~jfrankel/index.htm
90