What’s Up with the Exchange Rate? What’s Up with the Exchange Rate? Andrew K. Rose UC Berkeley, NBER and CEPR December, 2009

Exchange Rates2 The Basic Long-Run Issue  America’s Current Account Deficit –2008: $706.1 billion deficit (!)  4.9% of American GDP  Implies required Capital Inflows of over $2300 per person annually (!)  High, but actually declining recently –2009Q2: deficit declining to $98.8 billion –Almost all Goods (Services in surplus but small)  Small persistent income surplus  Trade imbalance shrinking because of imports (!)

US as International Debtor  Stock of US Net International Debt: $3,469.2 billion (end 2008) –Around 24% of American GDP –Around $11,400 per American –Up from $2,139.9 billion in 2007 –Continuing flows of deficits add to stock of debt –America: persistent current account deficits since 1991 Exchange Rates3

4 Causes  Some Dispute among Economists  Current Account is difference between (low) Domestic Savings and (higher) Investment  Low American Savings chief reason –Personal Savings very low lately  Sometimes negative, though recent increase –Public Sector also dis-saving (Federal deficits)  Very large increase of late (stimulus, TARP, …)  Lack of Investment outside US possible

Exchange Rates5 Current Account: Sustainable?  Size of Debt Stocks unprecedented for US –Deficit Flow near all-time high as well  Also unprecedented for “Anchor” country –US now takes >75% all global savings flows  Capital running “uphill” from poor to rich (!)  Growing US external debt

Exchange Rates6 Adjustment must involve Prices  For current account to close, savings must rise (or investment fall, or both)  Symmetrically, exports must rise dramatically, while import growth slows  Exchange Rate one of the key adjustment mechanisms  So long-run depreciation of Dollar is likely –Special role of dollar in commodity prices

Long-Run Trend: Depreciation  Interrupted Briefly by Financial Crisis in Fall 2009 –US Treasuries acted as “safe haven” –Very low (negative!) interest rates –Temporary Dollar Appreciation Exchange Rates7

Trend Clear in Data Exchange Rates8

9 How Much More?  Many Different Estimates, Little Consensus  Most expect at least another 10-25% on overall (multilateral) rate, sometimes more  Exchange Rates often overshoot  Timing: almost impossible

Exchange Rates10 Where will Effects be Felt?  Three Big Currencies in World: –Dollar  Periphery of countries that fix against dollar  Ex: China, HK, Panama, Ecuador, … –Euro  Periphery of euro-fixers  Ex: Baltics, Bulgaria, Denmark, … –Yen

Exchange Rate Policy Varies  Dollar floats freely against many currencies –Major currencies (Euro and Yen) –True also of Inflation Targeters  Europeans (UK, Norway, Switzerland, …)  Latins (Brazil, Mexico, Argentina, …)  Others (Canada, NZ, Australia, Korea, …) Exchange Rates11

Trend and Transient Appreciation Exchange Rates12

Exchange Rates13 Much of Asia is Different  Asians take Exchange Rate Policy Seriously  Almost all East Asians manage currencies, will continue to do so  Part a Legacy of Asian Crisis of ’97-’98  Part a Development Strategy … –Which Leads us to China

China Manages Exchange Rate Exchange Rates14

Exchange Rates15 How to Think about the Yuan?  Chinese Communist Party Needs Growth to Survive Politically –Growth is Required to Absorb Massive Unemployment in Chinese Countryside  Agricultural Peasants Must Be Transformed Into Manufacturing Workers –Exports Provide One Possible Outlet

Exchange Rates16 Asian Paradigm for Development  Competitive (Cheap) Unemployed Labor Absorbed into Manufactured Sector –Example of key theory of W.A.Lewis (Nobel Laureate)

Exchange Rates17 Implications for West  China has every incentive to maintain under-valued exchange rate –Under-valuation the key to rapid export growth –Right in theory –Effective in practice (past twenty years!) –Hence rapid accumulation of US$ reserves, as China maintains under-valued peg to US –Reserves act as “collateral”, encourage FDI

Exchange Rates18 Special Role of USA  US is issuer of $, global reserve currency  Many East Asians fixe against US$  US is largest, most open economy  US willing to handle large, persistent current account deficits

Exchange Rates19 Special Role of USA, contd  American FDI high in Asia –High Returns on Asian Investments help protect against American Protectionism –China Importing Financial Services, since Domestic Financial Sector Weak –US also premier provider of collateral service (hence Asian pegs against $)

Exchange Rates20 Where Does Europe Fit In?  No Direct Role  Still, Large Indirect Role –Euro floats against $ –Europe has powerful central bank with independent monetary policy

Exchange Rates21 Dollar Depreciation Likely to be Mostly against Euro, non-Asians  Some Already Occurred  Dollar depreciated from.8$/euro to 1.5$/euro already –Also pound and other Europeans –Ditto Japan, Canada, Mexico, Australia, …  More likely to come!

Exchange Rates22 Asia and the Euro  Crisis in Confidence Possible –American Current Account Deficits large  5% GDP, highly persistent  Dollar Depreciation Resisted by Asians –But Euro Floats Freely!  Euro Likely to Continue to Appreciate Against Dollar and Asians over long Term

Exchange Rates23 It isn’t Only China!  Other Asian Economies Waiting in Line behind China –India –Indonesia –Vietnam …

Exchange Rates24 Historical Precedent  European Development in 1950s and 1960s  Export-Lead Growth to transfer under- employed Europeans from countryside to manufacturing  Revival of “Bretton Woods” regime, prevailed before 1971

Exchange Rates25 Conclusion  Dollar Decline likely to continue  Probably Most Dramatically Against Euro –Also Japan, small inflation-targeters (Canada, Mexico, Korea, Norway, …)  Good argument for foreign diversification!