International Coordination, Exchange Rates, and Trade: A Development Perspective

1. Otaviano Canuto Vice-President, PREM Network The World Bank March 2012 International Coordination, Exchange Rates, and Trade:A Development Perspective

2. 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?

3. 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

4. Why Would Countries Want to Maintain Under-valued Exchange Rates?

5. 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

6. Can Under-Valuation Boost Exports?

7. 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)

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

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

10. What Affects the Exchange Rate? Policies and Other Determinants

11. 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)

12. 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

13. Other Determinants ofExchange 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)

14. Can We Identify Real Exchange Rate Targeting?

15. 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

16. Measuring and Correcting “Misalignment”

17. 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

18. The Experts in the Room: The IMF’s 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

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

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

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

22. 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

23. Implications for International Coordination Mechanisms

24. 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

25. 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

26. 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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