1 International Macroeconomics Chapter 11: Highlighting A Few Topics

2 Chapter Outline  Deviations from purchasing power parity  Deviations from Uncovered Interest Parity  Developing countries: growth, crisis, and reform

3 Introduction Does purchasing power parity really work as a long-run theory of exchange rates? Why are price levels higher in richer countries? Does uncovered interest parity really work as a short-run theory of exchange rates? What are the common characteristics of poor countries and the challenges they are facing?

4 Deviations from PPP By now, we have learned that Purchasing Power Parity doesn’t hold, especially in the short run, and real exchange rate can deviate far from 1. So, how should we explain the deviations from PPP? Transaction costs? Trade barriers? Distance, border effect?

5 Deviations from PPP These data show that trade costs are large—and typically, they are even larger outside the advanced countries and create a very wide no-arbitrage band. Trade costs matter! Trade Costs in Practice

6 Deviations from PPP A country’s price level is strongly correlated with the level of GDP per person. Rich countries have higher price levels; their baskets cost more. In other words, the real exchange rate q = EP*/P is not equal to 1 for all countries—PPP does not hold, even in the long run. We can generally categorize goods produced in a country as traded versus nontraded. Traded goods tend to have similar prices in the global market. However, prices of nontraded goods can be drastically different. Why?

7 The Balassa-Samuelson Model Using two goods—one traded and one not traded—we can explain price level differences and deviations from PPP. The model assumptions as follows: 1.The traded good has the same price in both countries. 2. Productivity (A) in traded goods determines wages. Wage levels in each country are equal to productivity levels. 3. Wages determine the prices of nontraded goods.

8 The Balassa-Samuelson Model The conclusion from these three assumptions? Countries with higher traded goods productivity will have relatively high wages and hence relatively high prices of nontraded goods. This means they will also have relatively higher overall price levels, depending on how large the share of nontraded goods in the consumption basket is.

9 The Balassa-Samuelson Model Changes in Productivity Suppose the nontraded goods share of consumption is a (so the traded share is 1 − a): If Home productivity A increases, by ΔA/A; the price of traded goods is unchanged, at 1, and the price of nontraded goods A rises, then the (percentage) change in the Home price level is:

10 The Balassa-Samuelson Model Changes in Productivity By the same logic, a change in the Foreign dollar price level will result from a change in foreign productivity:

11 The Balassa-Samuelson Model Changes in Productivity Subtracting the first equation above from the second, the change in the real exchange rate is given by: Thus, relative productivities in the traded goods sector drive relative prices, through their effects on wages and prices in the nontraded sector.

12 The Balassa-Samuelson Model An important relationship between productivity and the real exchange rate (Balassa-Samuelson effect): When compared with other countries, a country experiencing an increase in productivity will see wages, income, and price level rise and its real exchange rate appreciate.

13 Forecasting Real Exchange Rate By comparing actual exchange rates with their predicted equilibrium values, forecasting the real exchange rate involves two steps: 1.how quickly q will return toward its equilibrium value q; 2.how quickly the equilibrium value q will change over time as a result of productivity changes. Convergence Empirical estimates indicate that real exchange rate deviations from equilibrium might decay slowly: the consensus “half life” of deviations from PPP has been reported to be five years - the rule of thumb. Trend

14 Forecasting Real Exchange Rate China’s Yuan Undervaluation? The Balassa-Samuelson model predictions: in 2000 the real exchange rate with China was q = 0.231, well below the predicted equilibrium level of q = The yuan was undervalued and would have to experience a 38% real appreciation (0.088/0.231) against the U.S. dollar. Using our rule of thumb, half of this gap or 19% would be eliminated in five years, implying an approximate 3.5% annual increase in q due to convergence. In addition, a 6% differential growth rate per year (China minus United States) would imply a further 0.4 × 6 = 2.4% per year real appreciation in the yuan.

15 Forecasting Real Exchange Rate China’s Yuan Undervaluation? Adding up both effects, the model predicts a real yuan appreciation of = 5.9% per year. This would imply either a nominal appreciation of the yuan against the dollar, or higher inflation. Inflation in China was not much higher than in the U.S. Until mid-2005 China pegged the yuan to the dollar but then switched to an unofficial crawling peg, allowing the yuan to appreciate gradually against the dollar, but very slowly. This could have been a response to protectionist pressure in the United States. But the Chinese had reasons of their own to let the yuan rise: to keep domestic inflation at a reasonable level.

16 Deviations from UIP Recall that UIP states the expected return on foreign deposits should equal the return on domestic deposits when both are expressed in domestic currency. Empirically speaking, UIP does not hold. So, what could cause deviations from UIP? Investor expectations are irrational? Investors require a premium for holding a risker currency? Can the deviations be exploited for arbitrage?

17 The Carry Trade UIP implies that the home interest rate should equal the foreign interest rate plus the rate of depreciation of the home currency. UIP rules out the naive strategy of borrowing in a low interest rate currency and investing in a high interest rate currency, an investment referred to as a carry trade. UIP implies that the expected profit from such a trade is zero:

18 The Carry Trade Carry Trades In the 1990s and 2000s, the yen had a lower interest rate than many other currencies. Carry trades borrow in low- yield yen to invest in higher-yield currencies like the Australian dollar. Such trades can be profitable for long periods, but dramatic reversals, though rare, can quickly undermine profits.

19 Peso Problems Actual returns from interest arbitrage may be nonzero for a pair of currencies that are floating, but also for two currencies that are fixed. For a credible peg with no risks premiums, the UIP condition states that the home and foreign interest rates should be equal. Investors treat domestic and foreign currency as perfect substitutes and interchangeable at a fixed rate. There is no desire for arbitrage (e.g., via the carry trade). But when pegs are not credible, risk premiums can cause large interest differentials—and cause investors to smell a profit.

20 Peso Problems Peso Problems If exchange rates are fixed (and credible), then the interest rate on the home currency and the base currency should be the same. As seen here, however, the Hong Kong dollar and Argentina peso often had large currency premiums. Hong Kong’s peg held, and carry trade profits were made. Argentina’s peg broke, and losses were massive.

21 Efficient Market Hypothesis To discover if carry trade profits disprove UIP, we rewrite Equation 11-3, replacing expected or ex ante values of the exchange rate with actual or ex post realized values. The sole difference between actual and expected profits is a forecast error, or the difference between actual and expected depreciation:

22 Efficient Market Hypothesis UIP and the Efficient Markets Hypothesis Each dot represents an actual 12-month period for a given currency versus the U.S. dollar. According to trader surveys, expected depreciations were, on average, more or less in line with UIP, as seen in panel (a), where the slope is not far from 1. But panel (b) shows that, after the fact, these forecasts were not very good, and systematically wrong, in this sample. Actual depreciations were far out of line with expectations: the slope is only On average, high-yield currencies systematically depreciated only 23% as much as the interest differential would have forecast under UIP.

23 Efficient Market Hypothesis The rational expectations hypothesis argues that, on average, all investors should make forecasts about the future that are without bias. In addition, the efficient markets hypothesis asserts that information should not be useful in forecasting future profits, i.e., one should not be able to systematically beat the market. If there are big predictable profits lying around, this appears to be an inefficient market instead.

24 Deviations from UIP Although there may be predictable excess returns in the forex market, the risk-reward ratio is typically too low to attract investors. In that sense, there is no puzzle left and arbitrage has not failed. In forex market research, nobody has yet proved that there are large amounts of low-risk money on the table. Here, there is common ground between the UIP and PPP puzzles. Limits to arbitrage in the forex market (due to risk) may allow for deviations from interest parity in some situations.

25 Rich and Poor Low income: most sub-Saharan Africa, India, Pakistan Lower-middle income: China, Caribbean countries Upper-middle income: Brazil, Mexico, Saudi Arabia, Malaysia, South Africa, Czech Republic High income: U.S., Singapore, France, Japan, Kuwait Indicators of Economic Welfare for 4 groups of countries, 2005 GDP per capita (2000 US$) Life expectancy Low income48160 Lower-middle income Upper-middle income High income Source: World Bank

Rich and Poor (cont.) GDP per capita (2000 US $)annual growth rate Country average United States Singapore Hong Kong Canada Sweden France Ireland United Kingdom Japan Italy Spain Taiwan South Korea Chile

Rich and Poor (cont.) GDP per capita (2000 U.S. $)annual growth rate Country average Malaysia Argentina Mexico Brazil Thailand Venezuela Colombia Paraguay Peru China Zimbabwe Senegal Kenya Nigeria

Characteristics of Poor Countries What causes poverty? A difficult question, but low income countries have at least some of following characteristics, which could contribute to poverty: 1.Government control of the economy –Restrictions on trade –Direct control of production in industries and a high level of government purchases relative to GNP –Direct control of financial transactions –Reduced competition reduces innovation; lack of market prices prevents efficient allocation of resources

Characteristics of Poor Countries 2.Unsustainable macroeconomic polices which cause high inflation and unstable output and employment 3. Lack of financial markets that allow transfer of funds from savers to borrowers 4. Weak enforcement of economic laws and regulations 5. A large underground economy relative to official GDP and a large amount of corruption 6. Low measures of literacy, numeracy, and other measures of education and training: low levels of human capital

Borrowing and Debt in Low and Middle Income Economies Another common characteristic for many low and middle countries is that they have traditionally borrowed from foreign countries. A financial crisis may involve 1.a debt crisis: an inability to repay sovereign (government) or private sector debt. 2.a balance of payments crisis under a fixed exchange rate system. 3.a banking crisis: bankruptcy and other problems for private sector banks.

The Problem of “Original Sin” Sovereign and private sector debts in the U.S., Japan, and European countries are mostly denominated in their respective currencies. But when poor and middle income countries borrow in international financial capital markets, their debts are almost always denominated in U.S.$, yen or euros: a condition called “original sin”. So, what are the effects of a depreciation/devaluation of domestic currencies on countries’ net foreign wealth (assets vs. debts)?

32 East Asian Financial Crises Before the 1990s, Indonesia, Korea, Malaysia, Philippines, and Thailand relied mostly on domestic saving to finance investment. But afterwards, foreign funds financed much of investment, and current account balances turned negative. Despite the rapid economic growth in East Asia between 1960–1997, growth was predicted to slow as economies “caught up” with Western countries.

33 East Asian Financial Crises (cont.) More directly related to the East Asian crises are issues related to economic laws and regulations: 1.Weak of enforcement of financial regulations and a lack of monitoring caused commercial firms, banks and borrowers to engage in risky or even fraudulent activities: moral hazard. –Ties between commercial firms and banks on one hand and government regulators on the other hand allowed risky investments to occur.

34 East Asian Financial Crises (cont.) 2.Nonexistent or weakly enforced bankruptcy laws and loan contracts worsened problems after the crisis started. –Financially troubled firms stopped paying their debts, and they could not operate without cash, but no one would lend more until previous debts were paid. –But creditors lacked the legal means to confiscate and sell assets to other investors or to restructure the firms to make them productive again.

35 East Asian Financial Crises (cont.) The East Asian crisis started in Thailand in 1997, but quickly spread to other countries. –A fall in real estate prices, and then stock prices, weakened aggregate demand and output in Thailand. Malaysia, Indonesia, Korea, and the Philippines soon faced speculations about the value of their currencies. Most debts of banks and firms were denominated in U.S. dollars, so that devaluations of domestic currencies would make the burden of the debts in domestic currency increase. To maintain fixed exchange rates would have required high interest rates and a reduction in government deficits, leading to a reduction in aggregate demand, output and employment.

36 Lessons of Crises 1.Fixing the exchange rate has risks: governments desire to fix exchange rates to provide stability in the export and import sectors, but the price to pay may be high interest rates or high unemployment. 2. Weak enforcement of financial regulations can lead to risky investments and a banking crisis when a currency crisis erupts or when a fall in output, income and employment occurs. 3. Liberalizing financial asset flows without implementing sound financial regulations can lead to capital flight when investments lose value during a recession. 4. The importance of expectations: even healthy economies are vulnerable to crises when expectations change. 5. The importance of having adequate official international reserves.