EXCHANGE RATES AND EXTERNAL ADJUSTMENT Gian Maria Milesi-Ferretti International Monetary Fund

Global imbalances have declined…

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

…and changes in output

Some (weak) negative relation between REER and CA changes for non-peggers…

…but positive relation between CA changes and REER changes for peggers

…so real exchange rates dont 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 desirablevalues 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!

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 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