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

2 What are the currency wars? What are the currency wars? Review of the last 6 months.Review of the last 6 months. Is the currency war metaphor appropriate?Is the currency war metaphor appropriate? Which emerging markets are intervening the most to dampen the appreciation of their currencies? Which emerging markets are intervening the most to dampen the appreciation of their currencies? What is the right way to measure it?What is the right way to measure it? What should they be doing? Lessons from recent crises.What should they be doing? Lessons from recent crises. The 3 big currencies The 3 big currencies $ RMBRMB €

3 Who is doing how much? Who is doing how much? It is not enough to look at increases in FX reserves.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).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? How much should it intervene, vs. appreciate? What can we learn from recent crises?What can we learn from recent crises?

4 Currency Wars chronology, 2010 June June China announces more flexibility in RMB, China announces more flexibility in RMB, after postponement of Treasury report on undervaluation, thereby saving face;after postponement of Treasury report on undervaluation, thereby saving face; but little appreciation follows. (Repeat of 2005.)but little appreciation follows. (Repeat of 2005.) September 15 Japan buys $20 b for ¥, September 15 Japan buys $20 b for ¥, after 6-year absence from FX markets;after 6-year absence from FX markets; thereby joining Switzerland, the other floater to have appreciated in GFC and to have fought it by FX intervention.thereby joining Switzerland, the other floater to have appreciated in GFC and to have fought it by FX intervention.

5 September 27 warning from Brazil’s Finance 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, 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.a goal that is not globally consistent. Currency Wars chronology, continued

6 Some consider FRB policy another instance. Some consider FRB policy another instance. Renewed flows to emerging markets have met with intervention Renewed flows to emerging markets have met with intervention e.g., by Korea, host of November G20 summit.e.g., by Korea, host of November G20 summit. Brazil, Thailand, India & others must decide how to manage inflows:Brazil, Thailand, India & others must decide how to manage inflows: Capital controls? Capital controls? Appreciation? Appreciation? Buying $ to prevent appreciation Buying $ to prevent appreciation China’s RMB remains the dominant issue. China’s RMB remains the dominant issue.

7 Currency Wars chronology, Nov.2010 As European sovereign debt crisis resurfaces in Ireland, (1.3 $/€ Nov.17 ). As European sovereign debt crisis resurfaces in Ireland, (1.3 $/€ Nov.17 ). Chinese government, responding to 4.4% inflation in October Chinese government, responding to 4.4% inflation in October raises i,raises i, reserve requirements,reserve requirements, & price controls.& price controls. US core inflation falls to 0.6% for year, US core inflation falls to 0.6% for year, the lowest since 1957.the lowest since 1957.

8 and climbed back up to 4.9% as of Feb.2011 Source: WSJ Chinese inflation reached 8% in 2008

9 US core inflation is the lowest in 50 years Jan 2011

10 Currency Wars chronology, Nov.2010 G20 Summit in Korea is first chaired by a non-G8 country

11 Currency Wars chronology, Nov.2010 Nov. 12: G-20 Summit in Seoul judged a failure, at least for Obama: 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.Rebuff of US proposal for cap on Current Account surpluses at 4% of GDP. No pledge to refrain from “competitive undervaluation”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.A suggestion to countries with widely used currencies like the $ to “be vigilant against excess volatility,” a warning against loose monetary policy.

12 Currency Wars chronology, Nov Nov.21: Fed announces QE2 decision -- Nov.21: Fed announces QE2 decision -- Will purchase $600b in bonds.Will purchase $600b in bonds. Short-term market reaction -- $ depreciates.Short-term market reaction -- $ depreciates. Critiques --Critiques -- Sarah Palin & John Taylor: “US is debauching its currency.” Sarah Palin & John Taylor: “US is debauching its currency.” Germany, China & Brazil: “$ depreciation = deliberate salvo in currency wars.” Germany, China & Brazil: “$ depreciation = deliberate salvo in currency wars.”

13 Jan.14, 2011: Geithner notes that -- including China’s higher inflation -- RMB is appreciating at 10% per year. 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 That suggests (appropriately) lower USG priority on the currency issue than on IPR, North Korea & other issuesthan on IPR, North Korea & other issues in Jan.19 Obama-Hu summit. in Jan.19 Obama-Hu summit. Currency Wars chronology, Jan. 2011

14 Data sources: The Economist, BLS, CEIC, Thomson Reuters 5% nominal appreciation per annum + 5% inflation differential ≈ 10% real appreciation per annum over last half-year Global Macro Monitor

15 Currency Wars chronology, 2011 Feb. 4, 2011 Feb. 4, 2011 In biannual report to Congress, U.S.Treasury calls RMB "substantially undervalued."In biannual report to Congress, U.S.Treasury calls RMB "substantially undervalued." But it once again refrains from naming China a currency manipulator.But it once again refrains from naming China a currency manipulator. and points out real appreciation is at 10%.and points out real appreciation is at 10%.

16 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 Currency Wars chronology

17 Feb , 2011: First meeting of G20 ministers in France’s year as host. First meeting of G20 ministers in France’s year as host. Sarkozy no longer talking of “a new Bretton Woods.” Sarkozy no longer talking of “a new Bretton Woods.” But G20 goes ahead with a system of indicators, But G20 goes ahead with a system of indicators, including probably currency reserves, exchange rates, current account balances, budget deficits and sovereign debt levels.including probably currency reserves, exchange rates, current account balances, budget deficits and sovereign debt levels.

18 Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates rooted in the 1930s.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.That is why the architects of the post-war monetary order chose fixed exchange rates at Bretton Woods, NH, in But it is now used to argue that China should move from fixing to floating. But it is now used to argue that China should move from fixing to floating. US Congressmen don’t care about regimes;US Congressmen don’t care about regimes; they just want a stronger RMB vs. $.they just want a stronger RMB vs. $. Is the currency war metaphor applicable?

19 Intervention in emerging markets to fight currency appreciation Who is doing how much? Who is doing how much? It is not enough to look at increases in FX reserves.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).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? How much should it intervene, vs. appreciate? What can we learn from recent crises?What can we learn from recent crises?

20 Meanwhile, fear of “competitive devaluation” is also used as an argument against US monetary expansion. 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: But monetary expansion is not a “beggar-thy-neighbor” policy: Although in theory it should depreciate $,Although in theory it should depreciate $, at the same time it boosts US growth & so imports.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.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” ?Do other countries want a U.S. “double dip” ? Is the currency war metaphor applicable?

21 Economic historians have decided competitive devaluation under 1930s conditions was not a problem after all. Economic historians have decided competitive devaluation under 1930s conditions was not a problem after all. True, countries couldn’t all devalue against each other, True, countries couldn’t all devalue against each other, But they could and did all devalue against gold But they could and did all devalue against gold which worked to ease global monetary policy,which worked to ease global monetary policy, just what was needed. just what was needed. The same was needed in The same was needed in Is the currency war metaphor applicable? continued

22 The currency war talk – especially the criticism of US monetary policy -- seems to forget the point of floating rates: 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 timeDifferent countries will always have different needs at any point in time e.g., high unemployment in US & European periphery, e.g., high unemployment in US & European periphery, while China & Brazil & India are overheating. 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.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. Multilateral cooperation is not necessary for this. Is the currency war metaphor applicable? continued

23 But other kinds of international cooperation are needed; But other kinds of international cooperation are needed; the currency war & 1930s metaphors are not totally misplaced:the currency war & 1930s metaphors are not totally misplaced: Currency war could turn into trade war 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.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 protectionismUntil now, the US & G20 have held the line on protectionism compared to the milder recessions of 1991 & 2001, compared to the milder recessions of 1991 & 2001, let alone the Smoot Hawley tariff of let alone the Smoot Hawley tariff of Is the currency war metaphor applicable? continued

24 China would take some responsibility China would take some responsibility to reallocate its economy away from exclusive reliance on exports & manufacturingto reallocate its economy away from exclusive reliance on exports & manufacturing toward domestic consumption & services, toward domestic consumption & services, health, education, housing, environment, insurance & other services. health, education, housing, environment, insurance & other services. How? By allowing the RMB to appreciate,How? By allowing the RMB to appreciate, but also by increasing domestic demand.but also by increasing domestic demand. Meanwhile, the US would ideally also take responsibility. Meanwhile, the US would ideally also take responsibility. Even while prolonging expansionary policy this year,Even while prolonging expansionary policy this year, including fiscal expansion designed with high bang-for-the-buck, 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,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. e.g., by putting Social Security on a firm footing. Ideally the US & China would reach agreement on how to address current account imbalances:

25 Intervention in emerging markets to fight currency appreciation Who is doing how much? Who is doing how much? It is not enough to look at increases in FX reserves.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).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? How much should it intervene, vs. appreciate? What can we learn from recent crises?What can we learn from recent crises?

26 Capital flows to emerging markets, especially Asia, recovered quickly from the 2009 recession. These countries again show big balance of payments surpluses Goldman Sachs

27 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 %

28 Korea (& Singapore & Taiwan) are also adding heavily to reserves. GS Global ECS Research

29 But that’s partly because Singapore & Korea faced the greatest total Exchange Market Pressure in 2010 Goldman Sachs Global Economics Weekly 11/07 Feb. 16, 2011

30 Since 2008, India, followed by Indonesia, have had the greatest tendency to float, given EMP; Hong Kong & Singapore the least, followed by Malaysia & China. Goldman Sachs Global Economics Weekly 11/07 Feb. 16, 2011

31 Korea’s intervention to dampen won appreciation has been largely on the forward market Goldman Sachs Global Economics Weekly 11/07 Feb. 16, 2011

32 India & Malaysia in 2010 took the inflows in the form of currency appreciation, more than reserve accumulation. GS Global ECS Research less-managed floating (“more appreciation-friendly”) more-managed floating

33 In Latin America, renewed inflows less-managed floating (“more appreciation-friendly”) more-managed floating GS Global ECS Research but as appreciation in Chile & Colombia. but as appreciation in Chile & Colombia. are reflected mostly as reserve accumulation in Peru,

34 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. It is the old debate over floating versus fixed exchange rate. What can we learn about the answer from recent crises? What can we learn about the answer from recent crises?

35 Two lessons from the 1990s emerging market currency crises Advantages of floating: Advantages of floating: Speculators don’t have a target to shoot at;Speculators don’t have a target to shoot at; Accommodate shocks;Accommodate shocks; Discourage unhedged $ liabilities.Discourage unhedged $ liabilities. Advantages of holding forex reserves Advantages of holding forex reserves Reduces danger of crisis.Reduces danger of crisis. How did these lessons fare in the crises of ? How did these lessons fare in the crises of ?

36 EWIs: The variables that show up as the strongest predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation Source: Frankel & Saravelos (2010)

37 Best and Worst Performing Countries -- F&S (2010), Appendix 4

38 F & Saravelos (2010): Bivariate

39 F & Saravelos (2010): Multivariate

40 Reserves Even though many developing & emerging market countries described themselves as floating, Even though many developing & emerging market countries described themselves as floating, most took advantage of the boom of to build up reserves to unheard of heights, most took advantage of the boom of to build up reserves to unheard of heights, in the aftermath of the crises of in the aftermath of the crises of in contrast to past capital booms ( , ). in contrast to past capital booms ( , ).

41 When the global financial crisis hit, When the global financial crisis hit, those countries that had taken advantage of the boom to build up reserves did better.those countries that had taken advantage of the boom to build up reserves did better. E.g., Obstfeld, Shambaugh & Taylor (2009) E.g., Obstfeld, Shambaugh & Taylor (2009) Frankel & Saravelos (2010), Frankel & Saravelos (2010), This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises. This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises.

42 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 Source: Cezary Wójcik, 2010 (de facto) % change in GDP

43 Depreciation boosted net exports; contribution to GDP growth > 100% Contribution of Net X to GDP: 2009: 2,5 3,4 3,2 3,4 GDP growth rate: 1,7 Source: Cezary Wójcik kroon / $ Estonia Latvia lats / $ zlotys / $ The Polish exchange rate increased by 35%.

44

45 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

46 Appendix 1: The end of dollar hegemony ? Some argue the US current account deficit is sustainable indefinitely. Some argue the US current account deficit is sustainable indefinitely. They believe that the US will continue to enjoy its unique “exorbitant privilege,”They believe that the US will continue to enjoy its unique “exorbitant privilege,” able to borrow unlimited amounts in its own currency able to borrow unlimited amounts in its own currency because it is the dominant international reserve asset. because it is the dominant international reserve asset.

47 “Bretton Woods II” Dooley, Folkerts-Landau, & Garber (2003) : Dooley, Folkerts-Landau, & Garber (2003) : today’s system is a new Bretton Woods,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. 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.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.

48 My own view on Bretton Woods II: The 1960s analogy is indeed apt,The 1960s analogy is indeed apt, but we are closer to 1971 than to 1944 or 1958.but we are closer to 1971 than to 1944 or Why did the BW system collapse in 1971?Why did the BW system collapse in 1971? The Triffin dilemma could have taken decades to work itself out. 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). 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. These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

49 There is no reason to expect better today: 1) Capital mobility is much higher now than in the 1960s. 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), 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). nor on political grounds (these creditors are not the staunch allies the US had in the 1960s).

50 The financial crisis caused a flight to quality which evidently still means a flight to US $. US Treasury bills in were more in demand than ever, as reflected in very low interest rates. US Treasury bills in 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 $ appreciated, rather than depreciating as the “hard landing” scenario had predicted. => The day of reckoning had not yet arrived. => The day of reckoning had not yet arrived. Chinese warnings (2009) may be turning point: Chinese warnings (2009) may be turning point: Premier Wen worried US T bills will lose value.Premier Wen worried US T bills will lose value. PBoC Gov. Zhou proposed replacing $ as international currency.PBoC Gov. Zhou proposed replacing $ as international currency.

51 Multiple international reserve asset system The € now exists as a rival to the $. The € now exists as a rival to the $. The ¥ & SF are also safe havens. The ¥ & SF are also safe havens. The SDR came back from the dead in The SDR came back from the dead in Gold made a comeback as an international reserve too. Gold made a comeback as an international reserve too. Someday the RMB will join the roster Someday the RMB will join the roster though it is just beginning now. = a multiple international reserve currency system. = a multiple international reserve currency system.

52 Countries should have the right to fix their exchange rate if they want to. 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”. 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 But Few countries have been forced to appreciate.Few countries have been forced to appreciate. Pressure on surplus countries to appreciate will inevitablyPressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. I support ending the language of “manipulation.”I support ending the language of “manipulation.” Usually, it is hard to say when a currency is undervalued. Usually, it is hard to say when a currency is undervalued. Don’t cheapen the language that is appropriate to WTO rules. Don’t cheapen the language that is appropriate to WTO rules. China should do what is in its own long-term interest. China should do what is in its own long-term interest. Appendix II: What is in China’s interest?

53 Five reasons why China should let the RMB appreciate, in its own interest 1. Overheating of economy 2. Reserves are excessive. It gets harder to sterilize the inflow over time.It gets harder to sterilize the inflow over time. 3. Attaining internal and external balance. To attain both, need 2 policy instruments.To attain both, need 2 policy instruments. In a large country like China, expenditure-switching policy should be the exchange rate.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.

54 1. Overheating of economy: Bottlenecks. Pace of economic growth is outrunning: Bottlenecks. Pace of economic growth is outrunning: raw material supplies, andraw material supplies, and labor supply in coastal provinceslabor supply in coastal provinces Also:Also: physical infrastructurephysical infrastructure environmental capacityenvironmental capacity level of sophistication of financial system.level of sophistication of financial system. Asset bubbles. Asset bubbles. Shanghai stock market bubble in 2007.Shanghai stock market bubble in Inflation 6-7% in 2007 Inflation 6-7% in 2007 => price controls  shortages & social unrest. All of the above was suspended in late 2008, All of the above was suspended in late 2008, due to global recession.due to global recession. But it is back again now; skyrocketing real estate prices.But it is back again now; skyrocketing real estate prices.

55 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. 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… For awhile PBoC successfully sterilized… until until The usual limitations finally showed up:The usual limitations finally showed up: Prolongation of capital inflows <= self-equilibrating mechanism shut off. Prolongation of capital inflows <= self-equilibrating mechanism shut off. Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate Failure to sterilize: money supply rising faster than income Failure to sterilize: money supply rising faster than income Rising inflation (admittedly due not only to rising money supply) Rising inflation (admittedly due not only to rising money supply)

56 2. Foreign Exchange Reserves Excessive: Excessive: Though a useful shield against currency crises,Though a useful shield against currency crises, China has enough reserves: $2 ½ trillion by April 2010;China has enough reserves: $2 ½ trillion by April 2010; & US treasury securities do not pay high returns.& US treasury securities do not pay high returns. Harder to sterilize the inflow over time. Harder to sterilize the inflow over time.

57 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 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

58 While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in Successful sterilization in China: Attempts to sterilize reserve inflow: were remarkably successful in High reserve growth offset by cuts in domestic credit => steady money

59 In 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. PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit. Inflation became a serious problem. Inflation became a serious problem. True, global increases in food & energy prices were much of the explanation.True, global increases in food & energy prices were much of the explanation. ButBut China’s overly rapid growth itself contributed. China’s overly rapid growth itself contributed. Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities. Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities. Price controls are inefficient and ultimately ineffective. Price controls are inefficient and ultimately ineffective.

60 Sterilization faltered in 2007 & 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Monetary base accelerated Growth of China’s monetary base, & its components

61 New York Times Jan 12, 2011 Foreign exchange reserves held by the People’s Bank of China are approaching $3 trillion in 2011.

62 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 GDP. No wonder inflation is rising again.

63 3. Need a flexible exchange rate to attain internal & external balance Internal balance ≡ demand neither too low (recession) nor too high (overheating). Internal balance ≡ demand neither too low (recession) nor too high (overheating). External balance ≡ appropriate balance of payments. External balance ≡ appropriate balance of payments. General principle: to attain both policy targets, a country needs to use 2 policy instruments. 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. For a country as large as China, one of those policy instruments should be the exchange rate. To reduce BoP surplus without causing higher unemployment, China needs both To reduce BoP surplus without causing higher unemployment, China needs both currency appreciation, and currency appreciation, and expansion of domestic demand expansion of domestic demand gradually replacing foreign demand, gradually replacing foreign demand, developing neglected sectors: health, education, environment, housing, finance, & services. developing neglected sectors: health, education, environment, housing, finance, & services.

64 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.

65 5. Longer-run perspective: Balassa-Samuelson relationship Prices of goods & services in China are low Prices of goods & services in China are low compared at the nominal exchange rate.compared at the nominal exchange rate. Of course they are a fraction of those in the U.S.: < ¼.Of course they are a fraction of those in the U.S.: < ¼. This is to be expected, explained by the Balassa-Samuelson effectThis is to be expected, explained by the Balassa-Samuelson effect which says that low-income countries have lower price levels. which says that low-income countries have lower price levels. As countries’ real income grows, their currencies experience real appreciation: approx..3% for every 1 % in income per capita. As countries’ real income grows, their currencies experience real appreciation: approx..3% for every 1 % in income per capita. But China is one of those countries that is cheap or undervalued even taking into account Balassa- Samuelson.But China is one of those countries that is cheap or undervalued even taking into account Balassa- Samuelson.

66 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%. The Balassa-Samuelson Relationship 2005

67 Appendix III: Debt Predictions Greece will need to re-structure its debt. Greece will need to re-structure its debt. The euro will survive. The euro will survive. There is no legal provision for members to leave the euro zone.There is no legal provision for members to leave the euro zone. Prices of government bonds in advanced countries in general will fall. Prices of government bonds in advanced countries in general will fall.

68 The euro project is looking far less successful than just a few years ago Many predictions of euro skeptics have come true: Many predictions of euro skeptics have come true: Periphery countries and core countries have had trouble reconciling asymmetric monetary needs.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.Euro members have not had enough labor mobility or flexibility to make up for it. Efforts to prevent excessive debt & bailouts have failed:Efforts to prevent excessive debt & bailouts have failed: The Stability & Growth Pact failed with members big & small. The Stability & Growth Pact failed with members big & small. The “No bailout clause” has failed with Greece. The “No bailout clause” has failed with Greece.

69 Frankfurt & Brussels made 4 mistakes regarding Greece 2001: They let Greece into the euro 2001: They let Greece into the euro : ECB accepted Greek debt as collateral : ECB accepted Greek debt as collateral despite consistent violation of SGP.despite consistent violation of SGP. => Did not allow interest rate spreads to open up.=> 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.” 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). Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).

70 Judging from spreads, , investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations

71 Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. 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, 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,instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, and many others in history, and many others in history, including among European countries.including among European countries.

72 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.

73 Sovereign spreads for 5 euro countries shot up in the 1 st half of 2010 Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.

74 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.

75 Even judged by ratings of credit agencies, emerging markets are now intermingled with advanced countries Singapore’s credit rating is now above Belgium’sSingapore’s credit rating is now above Belgium’s China’s rating rose above Japan’s in JanuaryChina’s rating rose above Japan’s in January Taiwan is above ItalyTaiwan is above Italy Chile is above IsraelChile is above Israel Korea is above PortugalKorea is above Portugal Malaysia is above IrelandMalaysia is above Ireland South Africa is above IcelandSouth Africa is above Iceland India is above Greece.India is above Greece.

76 Ratings for “Emerging Economies” Ratings for “Advanced Economies”

77 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. 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. 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 ! It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege ! Appendix IV: More on the trend from $ hegemony to a multiple reserve system

78 Some argue that the privilege to incur $ liabilities has been earned in a different way: Global savings glut (Bernanke) Global savings glut (Bernanke) The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world. The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world. “ Intermediation rents…pay for the trade deficits.” -- Caballero, Farhi & Gourinchas (2008)“ 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).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)…US supplies high-quality assets: Cooper (2005); Forbes (2008); Ju & Wei (2008); Hausmann & Sturzenegger (2006a, b); Mendoza, Quadrini & Rios-Rull (2007a, b)…

79 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 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 American financial institutions suffered a severe loss of credibility (corporate governance, accounting standards, rating agencies, derivatives, etc.), 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? How could sub-prime mortgages be the superior type of assets that uniquely merit the respect of the world’s investors?

80 But the events of also undermined the opposing interpretation, the unsustainability position: But the events of also undermined the opposing interpretation, the unsustainability position: Why no hard landing for the $, as long feared? Why no hard landing for the $, as long feared? The $ appreciated after Lehman Brothers’ bankruptcy, & US T bill interest rates fell. The $ appreciated after Lehman Brothers’ bankruptcy, & US T bill interest rates fell. Clearly in 2008 the world still viewed Clearly in 2008 the world still viewed the US Treasury market as a safe haven andthe US Treasury market as a safe haven and the US $ as the premier international currency.the US $ as the premier international currency.

81 Is the $’s unique role an eternal god-given constant? Is the $’s unique role an eternal god-given constant? Or will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere ? Or will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere ? 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.

82 Historical precedent: £ ’s loss of premier international currency status in 20 th century By 1919, US had passed UK in By 1919, US had passed UK in 1.output (1872) 2.trade (1914) 3.net international creditor position ( ) Subsequently, $ passed £ as #1 reserve currency ( ). Subsequently, $ passed £ as #1 reserve currency ( ).

83 From the literature on reserve currencies Determinant: 1. Size 2. Depth of Fin.mkt. 3. Rate of return Proxy:GDP FX turnover inflation, LR depreciation, Exch. rate variance

84 From the literature, continued Network externalities => Tipping captured by: 1) Inertialags 2) Nonlinearitylogistic functional form in determinantsor dummy for leader GDP

85 Chinn & Frankel (2005) 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 data. Simulation assumes $ depreciation continues at rate. birth € of € This scenario showed € overtaking $ as top international reserve currency in 2022.

86 International Currency Roles More on a multiple-asset international reserve system

87 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. 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. 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.

88 Gold Gold was seen as an anachronism just a few years ago: Gold was seen as an anachronism just a few years ago: the world’s central banks were selling off their stocks.the world’s central banks were selling off their stocks. Gold re-joined the world monetary system in 2009: Gold re-joined the world monetary system in 2009: The PBoC, RBI, & other Asian central banks bought gold, to diversify their reserves.The PBoC, RBI, & other Asian central banks bought gold, to diversify their reserves. Even in advanced countries, central banks appear to have stopped selling.Even in advanced countries, central banks appear to have stopped selling.

89 Special Drawing Rights The SDR has made a surprising comeback as a potential international money, from near-oblivion. 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). 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. Shortly later, PBoC Gov. Zhou proposed replacing the $ as lead international currency with the SDR. The IMF is now borrowing in SDRs. 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 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 $. 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. Still, it is back in the world monetary system.

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