Exchange Rate Volatility at the EMU Periphery

1. Exchange Rate Stabilization and Growth in Small Open Economies at the EMU PeripheryGunther SchnablLeipzig University & CESifo University of MünsterMünster, 29 May 2008 Gunther Schnabl, Leipzig University & CESIfo

2. Exchange Rate Volatility at the EMU Periphery Gunther Schnabl, Leipzig University & CESIfo

3. Exchange Rate Volatility at the EMU Peripheryand East Asia Gunther Schnabl, Leipzig University & CESIfo

4. Exchange Rate Volatility at the EMU PeripherySub-Samples Gunther Schnabl, Leipzig University & CESIfo

5. Table of Content • Exchange Rate Regime and Growth • Balassa-Samuelson and Exchange Rate Regime • Adjustment on the Nominal Appreciation Path • Empirical Evidence • Outlook Gunther Schnabl, Leipzig University & CESIfo

6. 1. Exchange Rate Regime and Growth Mixed empirical evidence • Ghosh, Gulde and Wolf (2003): weak evidence that exchange rate stability affects growth in a positive or negative way (large sample). • Edwards and Levy-Yeyati (2003): countries with more flexible exchange rates grow faster (large sample). • Eichengreen and Leblang (2003): strong negative relationship between exchange rate stability and growth for 12 countries over a period of 120 years. • Aghion et al. (2006): Positive impact of the exchange rate stability and growth for countries with underdeveloped financial sectors. • De Grauwe and Schnabl (2005): Positive impact of the exchange rate stability on growth for the EU new member states. Alternative approach (EMU periphery sample) • Countries in the economic catch-up process (underdeveloped financial sectors) • with (mostly) open capital accounts. Gunther Schnabl, Leipzig University & CESIfo

7. 2. Balassa-Samuelson and Exchange Rate Regime (perfect markets and profit maximization) (perfect labor mobility) (relative productivity gains imply relative increase of non-traded goods prices) Gunther Schnabl, Leipzig University & CESIfo

8. Policy Options (real appreciation) Purchasing power parity Pegging the exchange rate and higher inflation Inflation close to the EMU level and nominal appreciation „pathological appreciation pressure“ Gunther Schnabl, Leipzig University & CESIfo

9. 3. Adjustment on the Nominal Appreciation Path Trade and capital flows as (standard) transmission channels • both micro- and macroeconomic dimensions Sustained appreciation expectations affect • adjustment of labour markets • adjustment of asset markets • monetary policy decision making Kinds of uncertainty • exchange rate risk (trade and capital flows) • labour and capital market adjustment • wage bargaining • international asset market equilibrium • macroeconomic stabilization • stop-and-go in monetary policies • fiscal policies and structural reforms Gunther Schnabl, Leipzig University & CESIfo

10. Adjustment of Labour Markets Lindbeck (1979) model of wage adjustment • with fixed rates workers bargain for productivity gains • starting in the tradable sector (extending to non-tradables) • uncertainty is less if exchange rates are fixed Equilibrium in labor markets • constant productivity and prices in the anchor country • with fixed exchange rate (ê=0, =0) • with flexible exchange rates (ê < 0,  < 0) Stylized adjustment pattern under a free float • in addition to predictions of productivity growth (and inflation) • exchange rate appreciation has be predicted (ê < 0) • enterprises are less eager to increase real wages • in average real wage increases will be less Gunther Schnabl, Leipzig University & CESIfo

11. Japan: Wage Growth and Inflation Differential with US Gunther Schnabl, Leipzig University & CESIfo

12. Adjustment of Asset Markets Forward-looking asset markets • sustained appreciation expectation affect interest rates • exchange rate volatility implies a positive risk premium () Augmented equilibrium in international assets markets • i = i€ + ê +  • i = i€ with fixed exchange rates (ê = 0,  = 0) • i < > i€ with flexible exchange rates (ê<> 0,  > 0) “Stylized” adjustment pattern of monetary policy • domestic monetary policy tar gets (inflation targets) • exchange rate appreciation (ê < 0) • slow-down of economic growth • (partially) unsterilized intervention or interest rate cuts • stop-and-go in monetary policy making • increasing uncertainty (risk premium) Gunther Schnabl, Leipzig University & CESIfo

13. Short-Term Interest Rates in Bulgaria and Poland Gunther Schnabl, Leipzig University & CESIfo

14. Short-Term Risk Premia in the New Member States(1999-2007) Gunther Schnabl, Leipzig University & CESIfo

15. 4. Empirical Evidence • Theoretical and empirical evidence has remained mixed • Sample and Observation Period • Fragmented cross-country panel for 41 EMU periphery countries • 17 central, eastern and southeastern countries (€) • 6 non-euro area industrialized European countries (€) • 9 CIS countries ($, €) • 9 Mediterranean countries ($, €) • Observation period • 1994-2005 • Volatility Measures • volatility around a constant level (standard deviation σ) • the trend of the exchange rate path (mean μ) • Z-score (Ghosh, Gulde and Wolf 2003) as a measure of both • year-over-year percent changes () • against the dollar, euro and both (min) Gunther Schnabl, Leipzig University & CESIfo

16. Model Specification Growth is explained by • exchange rate volatility measures (, , z, ) • transmission channels • interest rates (short-term) • exports (percent changes) • macroeconomic stability (inflation) • dummies • inflation targeting • crisis (1998, 2001) • capital controls (financial account + errors & omissions) Estimation model and method • . • GLS / GMM Gunther Schnabl, Leipzig University & CESIfo

17. EMU Periphery Sample 1994-2005 (min) (GMM) Gunther Schnabl, Leipzig University & CESIfo

18. Emerging Europe 1994-2005 (Min) (GMM) Gunther Schnabl, Leipzig University & CESIfo

19. Non-EMU Industrialized Europe 1994-2005 (Min) (GLS) Gunther Schnabl, Leipzig University & CESIfo

20. CIS 1994-2005 (Min) (GLS) Gunther Schnabl, Leipzig University & CESIfo

21. Mediterranean Countries 1994-2005 (Min) (GLS) Gunther Schnabl, Leipzig University & CESIfo

22. East Asia 1980-2005 ($) (GLS) Gunther Schnabl, Leipzig University & CESIfo

23. 5. Conclusion • The panel estimations for the EMU periphery provide strong evidence in favour of a negative impact of exchange rate volatility on growth. • This result is independent from the anchor currency. • Trade, capital flows and macroeconomic stability are important transmission channels from exchange rate stability to growth. • The effects are most pronounced for Emerging Europe which has widely dismantled capital controls. • For the industrialized European countries exchange rate stability seem to matter less. • The effect is less pronounced for the Mediterranean countries where financial repression and capital controls prevail. • Introducing East Asia into the sample strengthens the evidence in favour of a positive impact of exchange rate stability on growth. Gunther Schnabl, Leipzig University & CESIfo

24. Thank you for your attention! Münster, May 29 2008 Gunther Schnabl, Leipzig University & CESIfo