Otaviano Canuto Vice-President, PREM Network The World Bank March 2012

The Subject of Our Concern Real exchange rate under-valuation as a distortion in the global trading system If so, would a mechanism for the international coordination of exchange-rate policies provide global welfare gains?

Outline Why would countries want to maintain under-valued real exchange rates? Can under-valuation boost exports? What Affects the RER? Policies & other determinants Can we identify real exchange rate targeting? Measuring and correcting misalignments Implications for international coordination mechanism

Under-valuation as Development Policy The argument: Under-valuation stimulates economic growth through trade (Rodrik, 2008) Export growth spurs investment and technical change Particularly true for developing countries Tradables suffer disproportionately from government and market failures Undervaluation allows a level-playing field Under-valuation can be effective only if Nominal wages do not increase with rise of exchange rate It does not lead to macro instability Mainly domestic (not imported) inputs are used

Exchange Rate-Trade Nexus: Some Ambiguity Effect of change in exchange rate on trade is a priori ambiguous Impact depends on: Extent to which exporters hedge against foreign exchange risk (Fabling and Grimes, 2008) Currency in which they invoice their products (Staiger and Sykes, 2010) Import content of exports (Evenett, 2010) Extent of price pass-through (Berman, Martin and Mayer, 2012) Role of FDI (Lederman, 2011)

Might Work for LICs in the Short Run Source: Haddad and Pancaro (2010). Impact of 50% (in one measure of) RER Under-valuation on 1)Exports/GDP And 2) GDPPC Growth

Might Work on the Intensive but Not on the Extensive Margin Source: Taglioni (forthcoming) % change in export growth due to a 10% decrease in the real exchange rate Intensive margin MKD: 13.4%

Under-valuation Can Be Costly, Unsustainable and Regressive Over-accumulation of foreign reserves (opportunity costs of capital) Liquidity growth and inflationary pressures Constraints on monetary policy Tax on tradable consumption; regressive (Fajnzylber & Lederman, 2012) Difficult to exit Requires issuing sovereign bonds (with fiscal costs) under sterilization Cannot be used to target exchange rate other than that dictated by fundamentals in the long run (Eichengreen, 2008)

Policies that Can Affect the RER: Targeted and Untargeted Targeted monetary and fiscal policy Other policies: distorting private savings (among others) Subsidized savings (financial repression) Tax consumption Weak social protection systems Restricted access to global financial markets

Other Determinants of Exchange Rates Financial underdevelopment Precautionary savings motive, exodus of savings, exporting firms with better access to credit (Klapper, 2000; Melitz,2003) Closed economies (trade and capital) tend to have an under-valued exchange rate Commodity prices Natural resource discoveries Demographics (e.g., old age dependency ratio)

Policies that Affect the Exchange Rate Do Not Equate to Targeting Policies that affect dependency ratio unintentionally lead to higher domestic savings and a depreciated exchange rate Financial underdevelopment implies: High household saving because of inability to properly insure against shocks High corporate saving because of lack of financial options (deep corporate bond market) and incentive to retain earnings Macro prudential regulations may require capital controls Frictions working in the opposite direction: Labor rigidities keeping labor in rural, low productivity agriculture

Measuring Misalignments Is Difficult Requires estimates of equilibrium exchange rate and current account This is a challenge! Large number of determinants Complexity of the mechanisms at play Hence abundance of methods Little consensus as to the best approach

The Experts in the Room: The IMFs Approaches Thus Far Three methods used by the IMF: Macroeconomic balance approach (MB) Equilibrium real exchange rate approach (ERER) External sustainability approach (ES) … and their correlations: Source: Eden and Nguyen, forthcoming

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: MB and ERER Methods Source: Eden and Nguyen, forthcoming

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: MB and ES Methods Source: Eden and Nguyen, forthcoming

Dispersion of Country-Specific Estimates of Misalignment Can Be Large: ERER and ES Methods Source: Eden and Nguyen, forthcoming

Correcting RER Misalignment: Conceptual and Practical Issues Distinction between policy-driven misalignment and exogenous RER movements hard to assess, yet crucial for introducing the right policy to eliminate misalignment If exogenous distortions difficult to eliminate (e.g., underdeveloped financial system), a policy aimed at restoring equilibrium RER may lead to further distortions

Conditions for Success of International Coordination Mechanisms The extent of exchange-rate misalignment needs to be observable Unlike tariffs, misalignment is not directly observed Hard estimate because of endogeneity and reverse causality Uncertainty about the proper methodology in academia and in policy (IMF currently re-evaluating its three methodologies) None directly measures whether a country has unexploited gains from growing the tradable sector The gains and losses of other countries from the devaluation of one country need to be estimated Unlike tariffs, country gains or losses spread across industries Potential gains for many, e.g., low global interest rates

Multilateral Disciplining of Currency Practices Is Difficult Technicalities matter! Difficult to introduce coordination mechanism over a distortion that is not directly observed Under-valuation might be desirable under certain circumstances (e.g., capital controls during crisis) Scope for international coordination to achieve Pareto improving outcomes is small

Multilateral Coordination and Peer Pressure Should Rather Focus on Achieving Good Fundamentals Across Countries Improving economic structures, running viable fiscal frameworks and achieving macroeconomic stability Enabling reforms to have efficient and market driven wage and price settings Enabling reforms to boost productivity and growth Enabling reforms in financial market and social protection systems

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