The U.S. dollar has depreciated by about 25 percent in real effective terms since early 2002, in what has been one of the largest sustained episodes of dollar depreciation in the post-Bretton Woods era. The largest previous such episode-where the dollar depreciated by over 30 percent in real effective terms-took place between 1985 and 1991, also against the background of a large U.S. current account deficit. In both episodes, the pace of depreciation was relatively gradual, with daily changes below 2-3 percent in nominal effective terms. In both cases, the US currency in broad terms moved in line with shifts in interest rate differentials. Moreover, in the earlier case, the dollar depreciation episode ended with the U.S. currency's level roughly consistent with broad, medium-term equilibrium, as per Fund calculations. Following the post-2002 decline, we assess that the U.S. currency today is the closest to its medium-term equilibrium value in a decade.
During the 1985-91 episode, the US current account deficit narrowed from a high of 3½ percent of GDP in 1987 to about balance in 1991. In contrast, the current episode has not been associated with a quick and sharp adjustment in U.S. current account balances. Indeed, in the recent episode, the current account widened initially to reach an all time high of nearly 7 percent of GDP in late-2005. It began to moderate only in 2006, and remained at around 5 percent of GDP in the first quarter of 2008. This modest shift has created doubts about the impact of exchange rate flexibility. However, when the change in the current account balance over the two episodes is deconstructed, accounting for some lags to adjust for the timing of the export and import responses to the depreciation, it becomes clear that two key factors are driving the difference in the behavior of the current account in the two episodes.
· The first is the oil trade balance. In the previous episode, the price of oil initially fell and then remained roughly flat in US dollar terms. This led to an very modest improvement in the oil trade balance of 0.1 percent of GDP between 1987 and 1991. By contrast, oil prices have risen rapidly over the past few years to a record high. Thus, between 2004 and 2008, the U.S. oil balance is expected to have deteriorated by 1.3 percent of GDP.
· The second key factor underpinning the difference in the current account behavior is the receipt of large transfers associated with the first Gulf War in 1991-amounting to as much as 0.7 percent of GDP. Similar transfers have not occurred in the current episode.
The implication is that, after stripping out the oil trade balance and war-related transfers, the change in the US current account between the two episodes in fact appears to have been roughly similar. The "underlying" current account (excluding oil and transfers) improved by 2.7 percent of GDP in the previous episode, compared with 2.4 percent in the current period. Moreover, in the earlier episode, the depreciation was more "front loaded", with the bulk of the depreciation occurring between 1985 and 1989. In the current episode, half of the depreciation has taken place since 2006. Given the long lags (up to 2 years) in the current account response to exchange rate changes, we expect to see further improvement in this "underlying" current account in the coming years.
Abstract: The impermanence of fixed exchange rates has become a stylized fact in international finance. The combination of the “mirage” view that pegs do not really peg with the “fear of floating” view that floats do not really float generates the conclusion that exchange rate regimes are, in practice, unimportant for the behavior of the exchange rate. This is consistent with evidence on the irrelevance of exchange rate regimes for general macroeconomic performance. Recent studies, however, show that the exchange rate regime matters. This can be understood by considering the dynamics of exchange rate regimes. We demonstrate that the “mirage” view is somewhat misleading and incomplete. Pegs frequently break, but many do last. Also, there is a high degree of flipping, that is, the re-formation of pegs that have broken. Thus, a fixed exchange rate today is a good predictor that one will exist in the future. We also investigate the quantitative effect of fixed exchange rates. While the “fear of floating” view suggests little actual difference in fixed and floating rates with respect to exchange rate volatility, we show that fixed exchange rates exhibit considerably greater bilateral exchange rate stability than flexible rates, both today and in the future.
Director, ladies and gentlemen, this might well be the first time in LSE’s history that we have awarded an honorary degree to an illustrious academic who has racked up, at last count, six distinct appearances on the late-night US comedy talk show The Late Show with David Letterman. In one of these appearances Prof. Mundell recites the lyrics to the song Bootylicious by Destiny’s Child. In another, he reads out excerpts from Paris Hilton’s memoirs. But in his October 2002 appearance, his debut but the last video segment that I found, all is redeemed when Prof. Mundell tells the TV audience his Top 10 list, “The Ways My Life has Changed Since Winning the Nobel Prize.”
10. Can end almost any argument by asking, "And did you ever win a Nobel Prize?"
9. Whenever I bring it to Applebee's restaurant, I get a free plate of riblets heading my way
8. When I enter a room, I shout, "Nobel Prize winner in the hizzouse!"
7. At most 7-11s, I can get service even if I choose not to wear shoes or a shirt
6. Instead of saying, "Kiss my ass" to guys who cut me off in traffic, I now say, "Kiss my Nobel Prize-winning ass"
5. I've been banned from casinos in seven states
4. When I call K-Rock to request Aerosmith, they play Aerosmith
3. Any meaningless crap I say, the next day it's in the Wall Street Journal
2. Another Friday, another P. Diddy party
1. In Stockholm, I get more tail than Frank Sinatra
The Mercatus Center at George Mason University is please to host Dr. Anne Krueger of Johns Hopkins University. Dr. Krueger will address the implications of a weak dollar on the US economy, as well as answer specific questions and concerns, such as:
* Does a falling dollar lead to a weakening economy?
* What repercussions will a weak dollar have on demographics, GDP, inflation, unemployment, and the future of the US economy?
* What should be done, if anything, to keep the dollar strong?
There are volumes of academic research on this topic, which one can find easily online, and much of the academic literature on capital controls concludes that capital controls are indeed generally bad for financial market development. To summarize, this research finds that despite the possibility for short-run volatility in financial markets after liberalization (i.e., elimination of capital controls), in the long-run such liberalization results in larger, more stable financial markets with greater liquidity.
However, looking across the horizon at Asia, where most countries have some form of capital controls, it’s difficult to draw the conclusion that capital controls have hindered the (recent) development of the financial markets. Such a broad conclusion would be supported by the school of thought that supports the use of capital controls. In Asia, Malaysia is held up as the example (pdf) to show that the controls the country put into place in 1998 in the aftermath of the Asian financial crisis helped to produce faster economic recovery and turn around of the stock market as compared to other countries in the region (i.e., Thailand and Korea) that did not impose controls. Of course, there are also counter-arguments to this conclusion with some (pdf) research pointing to strong fundamentals in Malaysia being the driving recovery factor.
So, after all of the years of experience and reams of paper used in the research of topic of capital controls, what can policy makers across Asia make of all of this in terms of financial sector development policy? Are there any specific lessons that can be applied across countries in Asia or is issue this simply too complex to be dealt with on a regional or multilateral basis?
Conference participants agreed on the need for a compilation guide for securities statistics, because no international standard for compiling these statistics exists. The intention is to have a concise reference document that will address the key methodological issues identified at the conference. The guide, which will include some templates and a list of reference metadata, will focus initially on statistics on debt securities issued but will eventually be expanded to cover other securities and securities holdings. The manual will also include an assessment of costs and benefits of security-by-security databases.
Ronald McKinnon Professor Emeritus of Economics at Stanford and Senior Fellow of SIEPR and SCID, John B. Taylor, Professor of Economics at Stanford and Hiroshi Watanabe, Special Advisor to the Japan Center for International Finance spoke about What Will Happen to the Dollar? Managing International Exchange Rates at a SCID SIEPR breakfast on February 20.
Two aspects of global imbalances -- undervalued exchange rates and sovereign wealth funds (SWFs) -- require a multilateral response. For reasons of inadequate leverage and eroding legitimacy, the International Monetary Fund (IMF) has not been effective in dealing with undervalued exchange rates. In this working paper, CGD senior fellow Arvind Subramanian and his co-author propose new rules in the World Trade Organization (WTO) to discipline cases of significant undervaluation that are clearly attributable to government action. The rationale for WTO involvement is that there are large trade consequences of undervalued exchange rates, which act as both import tariffs and export subsidies, and that the WTO's enforcement mechanism is credible and effective. The WTO would not be involved in exchange rate management, and the author's proposals do not entail the WTO displacing the IMF. Rather, they would harness the comparative advantage of the two institutions, with the IMF providing the essential technical expertise in the WTO enforcement process. On SWFs, there is a bargain to be struck between countries with SWFs, which want secure and liberal access for their capital, and capital-importing countries that have concerns about the objectives and operations of SWFs. The WTO is the natural place to strike this bargain. Its services agreement, the General Agreement on Trade in Services (GATS), already covers investments by SWFs, and other agreements offer a precedent for designing disciplines for SWFs. Placing exchange rates and SWFs on the trade negotiating agenda may help revive the Doha Round by rekindling the interest of a wide variety of groups, many of whom are currently disengaged from the round.
Looking at some of the domestic and external economic indicators, India seems to have come a long way since the 1991 balance of payment crisis. The liberalization process started in the 1980s giving an impetus to exports and oil imports. This lead to trade and current account deficits which were mainly financed by high-cost short-term external commercial loans. Medium and long-term external commercial loans also rose. By 1990, the debt-service ratio rose to 35.3% while the ratios of short-term debt to forex reserves and debt to current receipts reached highs of 382.1% and 328.9%. In 1991, political instability at home and a global oil price spike led to further deterioration in the trade and current account deficits, falling to -3% and -3.1% of GDP, even as export growth and remittances declined. Downgraded credit ratings harmed investor sentiment as short-term investors and Non-Resident Indians (NRI) withdrew money from the country and foreign banks were reluctant to roll-over debt. Trying to defend the currency, the Reserve Bank of India’s (RBI) foreign currency assets fell from $3.1 bn in August 1990 to $975 mn in July 1991, inadequate to fund even three weeks of imports. Economic growth and industrial output slowed and inflation surged. India pledged gold to the Bank of England to finance its imports and also sought bilateral and IMF assistance to repay its debt to avoid rescheduling.
However, the crisis paved way for further liberalization of the economy and since then trade, foreign investment and exchange rate reforms have been undertaken. Post-2002, booming economic growth, domestic investment activity, eased restrictions on capital flows and interest rate differentials have led to a rise in FDI, portfolio investment, NRI deposits and external commercial borrowings (ECBs) by domestic firms, leading to a surplus on capital account. However, the country runs trade and current account deficits due to oil and non-oil imports, not withstanding the growth in exports (esp. in services) and remittances. Apart from the surge in these capital inflows, RBI has been resistant to exchange rate appreciation to protect exports, though India is a domestic demand driven economy, and structural factors more than currency value constrain export growth. This has resulted in the rapid growth in forex reserves from a mere $5.8 bn in 1991 (Fiscal Year in India is from April-March) to $76 bn in 2002, $141 bn in 2004, $199 bn in 2006 to close to $290 bn by Feb 2008. Foreign investment followed by External Commercial Borrowings by domestic firms have accounted for this rise in forex reserves.
The Republic of Korea has recently experienced: (i) large capital inflows, in particular a surge in portfolio inflows, and (ii) an appreciation of asset prices, including stock prices, land prices, and nominal and real exchange rates. We first document the recent trend in capital inflows and asset prices in Korea, and review how a surge in capital inflows can increase asset prices. Then, we empirically investigate the effects of capital inflows on asset prices using a VAR model. The empirical results suggest that capital inflows shocks increased the stock prices but not land prices. The effects on the nominal and real exchange rates are limited, and this is related to the accumulation of foreign exchange reserves. A catch-all solution to the problems that capital inflows present does not seem to exist. Therefore, the most should be made of the available instruments at hand.
Stanley Fischer is a different kind of Bank of Israel governor. His worldview does not resemble that of his two predecessors, Jacob Frenkel and David Klein. While his goal, too, is price stability, he also takes growth and employment into consideration.
For Klein and Frenkel, price stability was the only goal. They used to say that the Bank of Israel has only one tool, that of interest rates, with which only one issue can be addressed: inflation. It should be remembered that they held their posts during a more difficult period, when a strict monetary policy was needed to bring down inflation. That approach is suitable for the European Central Bank, which also sees its only purpose as dealing with inflation.
But Fischer was educated in the United States, where the approach is different. There, the head of the Federal Reserve (parallel to Israel's central bank governor), weighs the state of inflation as well as growth and employment trends. That is how legendary Fed chief Alan Greenspan acted in lowering interest rates sharply after the attack on the World Trade Center in 2001. He left it very low (1 percent) for a long time to fight the danger of the American economy sliding into a recession.
The current Federal Reserve head, Ben Bernanke, did the same in January, sharply lowering U.S. interest rates by 1.25 percent to a low 3 percent - to fight the unfolding economic slowdown.
Let there be no confusion: Fischer's primary goal is still price stability. But the moment interest rates can be lowered without compromising stability too greatly - he will do it.
Fischer should have actually lowered interest rates a month ago. It was a mistake to leave the February rate at 4.25 percent. Even then it was clear that inflation is declining and the world economy is slackening. In a meeting at that time one senior director voted to lower rates, but the majority was against it. Thus the reduction was put off until March, and will only go into effect today.
Fischer decided to lower rates in one fell swoop by half a percent because he did not want to do it piecemeal; that would only cause unnecessary pain. Many were surprised at the news, but Fischer knows that Bernanke will lower interest rates again on March 18 by another half a percent and he does not want to widen the gap with U.S. rates.
The governor also knows that the forces working against inflation have grown stronger in recent weeks. There are signs of recession in the U.S., as well as in Europe and Japan, which will slow growth and lower inflation in Israel.
The weakening of the dollar and the euro since mid-December has lessened economic pressures. It is also reasonable to assume that the actions and pressure by Shraga Brosh, president of the Manufacturers Association, to lower interest rates also had their effect on the governor and his people.
Nevertheless, interest rates are an instrument that is limited in its effect. Real factors have a greater impact. The economy is still growing, exports are flourishing and the balance of payments is in the black. A steady stream of foreign investments and unilateral transfers also continues. All this means a surplus of foreign currency, leading to a weakening of the dollar and the euro.
We seem to be suffering from "Dutch disease." This is what happened to Holland in the 1960s when large reserves of natural gas were discovered offshore. After the discovery, Dutch exports increased and the local currency grew stronger. This damaged the country's traditional export industries, which is what is happening to us.
But we have no natural gas. We have high tech and the Internet, which are our natural resources. They have buoyed exports in recent years, leading to a surplus in the balance of payments.
Therefore, a major devaluation will not be the outcome of a small change in interest rates, but rather the outbreak of a third intifada or a missile from Tehran landing in the middle of Tel Aviv. If that happens, the flow of capital to Israel will cease, exports will suffer, and the exchange rate will soar back toward NIS 5 to the dollar.
