Thorvaldur Gylfason

Macroeconomic challenges and the choice of exchange rate regimes in resource-rich countries ThorvaldurGylfason IMF-Middle East Center for Economics and Finance (CEF) Course on Macroeconomic Management in Natural Resource-Rich Countries KuwaitCity, Kuwait, 6-17 January 2013

outline • Real vs. nominal exchange rates • Dutch disease, overvaluation, and volatility • Exchange rate regimes • To float or not to float • How many currencies?

1 Background: real vs. nominal exchange rates Increase in Q means real appreciation e refers to number of units of foreign currency needed to purchase one unit of local currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Background: real vs. nominal exchange rates Devaluation or depreciation of e makes Q also depreciate unless P rises so as to leave Q unchanged Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

Three thought experiments 1.Suppose e falls Then more dinars per dollar, so X rises, Z falls 2.Suppose P falls Then X rises, Z falls 3.Suppose P* rises Then X rises, Z falls Capture all three by supposing Q falls Then X rises, Z falls X = exports Z = imports

2 Dutch disease See my “Dutch Disease” in New Palgrave Dictionary of Economics Online • Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness • In 1960s, Netherlands discovered natural resources (gas deposits) • Currency (Dutch guilder) appreciated • Exports of manufactures and services suffered, but not for long • Not unlike natural resource discoveries, aid inflows could trigger the Dutch disease in receiving countries

Dutch disease: How oil exports crowd out nonoil exports Oil discovery leads to appreciation, and reduces nonoil exports Imports C B Real exchange rate A Exports with oil Exports without oil Composition of exports matters Foreign exchange

Migration mitigates increase in real exchange rate Imports C B Imports with immigration Real exchange rate Immigration means more income and imports as well as remittances abroad D A Exports with oil Exports without oil Foreign exchange

Two main channels • Spending effect • Increased income from booming natural resource sector boosts private and public spending, raising prices and output in non-tradables sector • In non-natural resource tradables sector (“manufacturing”), prices are fixed at world levels, profits are squeezed by rising wages, and increased demand is met out of rising imports • Resource movement effect • Natural resource boom attracts capital and labor away from rest of economy • Output declines in non-resource economy, esp. in tradables, where prices are fixed at world levels

Declining manufactures, rising currencies • Both effects result in • Decrease in output share of non-natural resource tradables relative to non-tradables • Appreciation of real exchange rate • So, decline of manufacturing and appreciation of currencies in real terms tend to go hand in hand • Extensive theoretical literature behind this result • What do the data say? • Recent literature survey by Magud and Sosa (2010) • “When and Why Worry About Real Exchange Rate Appreciation? The Missing Link between Dutch Disease and Growth,” IMF WP/10/271

Summary of results • Dutch disease does exist • Resource booms make currencies appreciate • When currency appreciates in real terms, factors of production are reallocated and production switches away from manufacturing • Exchange rate volatility hampers economic growth (not shown here, will see later) • Misalignment of real exchange rate from its fundamental value also lowers growth • Overvaluation is always bad for growth • Evidence on the effect of undervaluation on growth is inconclusive

M = Money D = Domestic credit R = Reserves Dutch disease • Foreign exchange earnings are converted into local currency and used to buy domestic goods • Fixed exchange rate regime • Reserve inflow causes expansion of money supply that leads to inflation and appreciation of domestic currency in real terms • Flexible exchange rate regime • Increase in supply of foreign exchange leads to nominal appreciation of currency, so real exchange rate also appreciates M = D + R Q = eP/P*

Dutch disease: How foreign aid crowds out exports Trade vs. aid Foreign aid leads to appreciation, and reduces exports (e.g., Zambia) Imports C B Real exchange rate A Exports with aid Exports without aid Foreign exchange

Dutch disease: How capital inflow crowds out exports Capital account liberalization leads to appreciation, and sometimes instability when inflow stops or reverses itself Imports C B Real exchange rate A Exports with inflow Exports without inflow Crises Foreign exchange

Netherlands: Exports 1960-2010 (% of GDP)

different manifestations: volatility • Volatility of commodity prices leads to volatility in exchange rates, export earnings, output, and employment • Volatility can be detrimental to investment and growth • Hence, natural-resource rich countries may be prone to sluggish investment and slow growth due to export price volatility • Likewise, high and volatile exchange rates tend to slow down investment and growth

Which income stream would you prefer? (100 over 4 years) Uneven income stream Even income stream

Volatility and growth • Inverse cross-country correlation between per capita growth and GDP volatility • GDP volatility is defined as the standard deviation of per capita growth • 163 countries, 1960-2000 r = -0.47 Output volatility and economic growth 1960-2000

3 Exchange rate regimes • The real exchange rate always floats • Through nominal exchange rate adjustment or price change • Even so, it matters how countries set their nominal exchange rates because floating takes time • There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

Exchange rate regimes • There is a range of options • Monetary union or dollarization • Means giving up your national currency or sharing it with others (e.g., EMU, CFA, EAC) • Currency board • Legal commitment to exchange domestic for foreign currency at a fixed rate • Fixed exchange rate (peg) • Crawling peg • Managed floating • Pure floating

Exchange rate regimes FIXED FLEXIBLE  Currency union or dollarization  Currency board  Peg Fixed Horizontal bands  Crawling peg Without bands With bands  Floating Managed Independent

Basically fixed Dollarization • Use another country’s currency as sole legal tender Currency union • Share same currency with other union members Currency board • Legally commit to exchange domestic currency for specified foreign currency at fixed rate Conventional (fixed) peg • Single currency peg • Currency basket peg

intermediate Flexible peg • Fixed but readily adjusted Crawling peg • Complete • Compensate for past inflation • Allow for future inflation • Partial • Aimed at reducing inflation, but real appreciation results because of the lagged adjustment Fixed but adjustable

Basically floating Managed floating • Management by sterilized intervention • I.e., by buying and selling foreign exchange • Management by interest rate policy, i.e., monetary policy • E.g., by using high interest rates to attract capital inflows and thus lift the exchange rate of the currency Pure floating

The scourge of overvaluation • Governments may try to keep the national currency overvalued • To keep foreign exchange cheap • To have power to ration scarce foreign exchange • To make GDP look larger than it is • Other examples of price ceilings • Negative real interest rates • Rent controls in cities

Inflation and overvaluation • Inflation can result in an overvaluation of the national currency • Remember: Q = eP/P* • Suppose e adjusts to P with a lag • Then Q is directly proportional to inflation • Numerical example

Inflation and overvaluation Real exchange rate Suppose inflation is 10% per year 110 Average 105 100 Time

Inflation and overvaluation Hence, increased inflation lifts the real exchange rate as long as the nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20% 120 110 Average 100 Time

From overvaluation to undervaluation • If overvaluation of currency hurts exports, undervaluation must by similar logic help exports • Yet, as we saw, empirical evidence is mixed • Some countries – e.g., China – have kept their currencies undervalued to boost exports and contain imports • Undervaluation as export promotion policy • Undervaluation leads to buildup of foreign exchange reserves • Reserve buildup raises some of the same issues as natural resources booms

why we have Fewer currencies than countries • In view of the success of the EU and the euro, economic and monetary unions appeal to many other countries with increasing force • Consider four categories • Existing monetary unions • De facto monetary unions • Planned monetary unions • Previous – failed! – monetary unions

Existing monetary unions • CFA franc • 14 African countries • CFP franc • 3 Pacific island states • East Caribbean dollar • 8 Caribbean island states • Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note • Euro, more recent • 17 EU countries plus 6 others • Thus far, at least until recently (Greece), a success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

De facto monetary unions • Indian rupee • India plus Bhutan • South African rand • South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe • US dollar • US plus Ecuador, El Salvador, Panama, and 6 others • Swiss franc • Switzerland plus Liechtenstein (pop. 30,000) • Australian dollar • Australia plus 3 Pacific island states (small populations) • New Zealand dollar • New Zealand plus 4 Pacific island states (small pop.)

Planned monetary unions • East African shilling • Burundi, Kenya, Rwanda, Tanzania, and Uganda • Eco • Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia) • Common currency for four GCC countries • Bahrain, Kuwait, Qatar, and Saudi-Arabia • Other, more distant plans • Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa • African Union aims to launch the afro in 2029 Time tables have been relaxed

Previous monetary unions 99.95% • Danish krone 1886-1939 • Denmark and Iceland 1886-1939: 1 IKR = 1 DKR • 2009: 2,500 IKR = 1 DKR (due to inflation in Iceland) • Scandinavian monetary union 1873-1914 • Denmark, Norway, and Sweden • East African shilling 1921-69 • Kenya, Tanzania, Uganda, and 3 others • Mauritius rupee • Mauritius and Seychelles 1870-1914 • Southern African rand • South Africa and Botswana 1966-76 • Many others No significant divergence of prices or currency rates following separation

Conflicting forces • Centripetal tendency to join monetary unions, thus reducing number of currencies • To benefit from stable exchange rates at the expense of monetary independence • Centrifugal tendency to leave monetary unions, thus increasing number of currencies • To benefit from monetary independence often, but not always, at the expense of exchange rate stability • With globalization, centripetal tendencies appear stronger than centrifugal ones

Impossible trinity Free to choose only two of three options; must sacrifice one of the three FREE CAPITAL MOVEMENTS 2 Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

Impossible trinity Free to choose only two of three options; must sacrifice one of the three FREE CAPITAL MOVEMENTS 2 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

Impossible trinity Free to choose only two of three options; must sacrifice one of the three FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

Impossible trinity Free to choose only two of three options; must sacrifice one of the three FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

Fix or flex? • If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … • … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates • Cannot have both! • Either type of regime has advantages as well as disadvantages • Let’s quickly review main benefits and costs

Benefits and costs

Benefits and costs To eliminate high inflation, need fixed exchange rate for a time • In view of benefits and costs, no single exchange rate regime is right for all countries at all times • The regime of choice depends on time and circumstance • If inefficiencyand slow growth due to currency overvaluation are the main problem, floating rates can help • If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation • Ones both problems are under control, time may be ripe for monetary union What do countries do?

Natural resources, inflation, and exchange rates • There is no evidence that countries with abundant natural resources are more prone to inflation than other countries • They tend to grow more slowly, yes, but their inflation record is indistinguishable from others • Therefore, as far as inflation is concerned, choice between fixed and floating rates is essentially the same in natural-resource rich countries and elsewhere • Volatility of export earnings in natural-resource rich countries calls for flexibility – if not in exchange rate, then, e.g., in migration

EXCHANGE ARRANGEMENTS AND MONETARY POLICY FRAMEWORKS 2012

Mena region: exchange arrangements

What countries actually do (2012, 190 countries) These slides will be posted on my website: www.hi.is/~gylfason No national currency 7% Currency board 6% Conventional fixed rates 31% Intermediate pegs 21% Managed floating 19% Pure floating 16% 100% 65% 35% The End There is a gradual tendency towards floating, from 10% of LDCs in 1975 to 35% of all countries today, followed by increased interest in fixed ratesin economic and monetary unions

Thorvaldur Gylfason