EXCHANGE RATES AND EXTERNAL ADJUSTMENT

Gian Maria Milesi-Ferretti

International Monetary Fund

Global imbalances have declined…

-3

-2

-1

0

1

2

3

4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Global Imbalances(percent of world GDP)

US JPN Eur surplus CHN EMA OIL ROW Eur deficit Discrepancy

How did the adjustment take place?Primarily through changes in demand

USUK

AUTBEL

DEN

FRAGER

ITA

LUXNLD

NORSWE

SWICAN

JPNFIN

GRE

ICE

IRE

PRT

ESP

TURAUS

NZE

SAF

ARGBRACHL

COL

CRI

DR

ELS

GTM

MEX

PERURU

CYP

ISR

LBN SLK

TAI

HKG

INDIDN

KOR

MYS PAKPHL

SGP

THA

MORTUN

BLR

BLG

RUS

CHN

UKR

CZE SVK

EST

LVA

SER

HUN

LIT

CRO

SLV

POL

ROM

-.4

-.2

0.2

.4C

ha

ng

e in

re

al d

om

est

ic d

em

an

d, 20

07

-10

-.1 0 .1 .2 .3change in CA balance, 2007-10

…and changes in output

US

UK

AUTBEL

DEN

FRAGER

ITA

LUXNLDNORSWE

SWICAN

JPNFIN GRE

ICE

IRE

PRTESP

TUR

AUS

NZE

SAF

ARG

BRA

CHL COLCRI

DR

ELS

GTM

MEX

PER URU

CYP

ISR

LBN

SLK

TAI

HKG

IND

IDN

KORMYS PAKPHL

SGP

THA

MORTUN

BLR

BLGRUS

CHN

UKR

CZE

SVK

EST

LVA

SER

HUN

LIT

CROSLV

POL

ROM

-.2

-.1

0.1

.2.3

Cha

nge

in r

eal

GD

P, 2

007

-10

-.1 0 .1 .2 .3change in CA balance, 2007-10

Some (weak) negative relation between REER and CA changes for

non-peggers…

US

UK

NORSWE

SWI

CAN

JPN

ICE

TUR

AUS

NZESAF

ARGBRACHL

COL

CRI

GTM

MEX

PER

URU

ISR

SLK

INDIDN

KOR

MYS

PAK

PHL

SGP

THA

MOR

TUN

RUS

CHN

UKR

CZE

HUN

POL

ROM

-15

-10

-50

51

0C

hang

e in

CA

/Y, 2

011

vs 2

005-

08

-40 -20 0 20 40Change in REER, 2011 vs 2005-08

…but positive relation between CA changes and REER changes for

peggers

AUTBEL

DEN

FRAGER ITALUX

NLD

FIN

GREIRE

PRT

ESP

ELS

CYP

TAI

HKG

BLR

BLG

SVK

EST

LVA

LIT

CROSLV

-10

01

02

03

0C

hang

e in

CA

/Y, 2

011

vs 2

005-

08

-10 0 10 20Change in REER, 2011 vs 2005-08

…so real exchange rates don’t matter for trade balances?

Yes they do…. …but many other factors at play

Key example: terms of trade (which makes CA and REER move in the same direction)

Assessing real exchange rates

Difficult to predict real exchange rates

Eminently endogenous variable, complex set of macro, financial and trade factors

Analyzed in conjunction with external balances (current account/capital flows, evolution of net foreign assets)

Assessing real exchange rates(II)

IMF approach to exchange rate and CA assessment Broad bilateral/multilateral surveillance

context Quantitative assessments

Price-based (real exchange rate dynamics) Current account balance-based (CA fundamentals

and NFA dynamics) Now re-cast more generally in the context

of an External Stability Report Still, very complex endeavor! Some

examples:

Assessing REER and CA

REER-based methods (fundamentals such as TT, NFA position, relative productivity/level of development etc)

CA (“MB” approach, now “EBA”): empirical relation of CA with macro, financial,

and structural determinants, plus policy variables

Assessment based on ‘desirable’values for policy variables

ES: is the predicted CA balance consistent with broad stabilization of the NFA position?

Assessing real exchange rates and the CA: China

Large CA surplus (now considerably narrower)

Substantial reserve accumulation (Mostly) closed capital account. Two stories:

Export-led growth High savings due to domestic distortions (lack of

social safety net, financial underdevelopment etc) In both cases, REER “depreciated” and must

eventually adjust, but “centrality” of exchange rate and need for policy adjustment different

Assessing real exchange rates and CA:

the United States US CA deficit much narrower than pre-crisis… …but still >3 percent despite sizable output gap But REER is at close to historical minima. Hard

problem!

75

85

95

105

115

125

135

FRB index (all

currencies)

The dollar's real effective exchange rate

Assessing real exchange rates and CA:

EMs and inflows Strong terms of trade gains in many EMs High capital inflows, rapid growth of

domestic demand Appreciating REER, increasing CA deficit

(despite TT gains in commodity exporters) Both structural and cyclical elements at

play in explaining inflows, REER Risk of reversals, impact on non-

commodity sector

Assessing real exchange rates and CA:EMs and inflows (II)

Are low interest rates/QE to blame? Weak US economy, financial turmoil in

Europe bad for everyone US portfolio outflows much weaker in 2010-

11 than pre-crisis However, differences in degree of openness

of capital account can imply more flows channeled to emerging economies with more open and developed debt markets

Assessing real exchange rates EMs and inflows (III)

Reversals bound to happen, essential to have defenses Appropriate macro stance, with room to

respond to shocks Reserves Avoid currency/maturity mismatches Use macro-prudential tools and K-controls

where needed to try to lengthen maturity of inflows

The need for global rebalancing Global rebalancing essential

Sustaining world growth Liquidity trap and risks of insufficient global demand

Reducing external vulnerabilities Legacy of crisis still with us for years to come

Multilateral approach needed Adjustment cannot rely exclusively on demand

compression in deficit countries

How to go about it?

Target structural and policy distortions (macro, financial, trade)

…but narrow trade lens inappropriate given complexity of underlying factors

Real exchange rates need to adjust and will adjust, whether through nominal rates or prices

Be mindful of cyclical vs structural considerations

“second-best world”