On Global Currencies

I approach the state of global currency issues by identifying eight concepts that I see as having recently "peaked" and eight more that I see as currently rising in relevance. Those that I see as having already seen their best days are: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I see as receiving increased emphasis in the future are: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

A Solution to Overoptimistic Forecasts and Fiscal Procyclicality: The Structural Budget Institutions Pioneered by Chile

Historically, many countries have suffered a pattern of procyclical fiscal policy: spending too much in booms and then forced to cut back in recessions, thereby exacerbating the business cycle. This problem has especially plagued Latin American commodity-producers. Since 2000, fiscal policy in Chile has been governed by a structural budget rule that has succeeded in implementing countercyclical fiscal policy. The key innovation is that the two most important estimates of the structural versus cyclical components of the budget - trend output and the 10-year price of copper - are made by expert panels and thus insulated from the political process. Chile's fiscal institutions could usefully be emulated everywhere, but especially in other commodity-exporting countries. This paper finds statistical support for a series of hypotheses regarding forecasts by official agencies that have responsibility for formulating the budget. 1) Official forecasts of budgets and GDP in a 33-country sample are overly optimistic on average. 2) The bias toward over-optimism is stronger the longer the horizon 3) The bias is greater among European governments that are politically subject to the budget rules in the Stability and Growth Pact (SGP). 4) The bias is greater at the extremes of the business cycle, particularly in booms. 5) In most countries, the real growth rate is the key macroeconomic input for budget forecasting. In Chile it is the price of copper. 6) Real copper prices mean-revert in the long run, but this is not always readily perceived. 7) Chile's official forecasts are not overly optimistic on average. 8) Chile has apparently avoided the problem of official forecasts that unrealistically extrapolate in boom times. The conclusion: official forecasts, if not insulated from politics, tend to be overly optimistic, and the problem can be worse when the government is formally subject to budget rules. The key innovation that has allowed Chile in general to achieve countercyclical fiscal policy, and in particular to run surpluses in booms, is not just a structural budget rule in itself, but a regime that entrusts to panels of independent experts the responsibility for estimating the extent to which contemporaneous copper prices and GDP have departed from their long-run trends.

Monetary Policy in Emerging Markets: A Survey

The characteristics that distinguish most developing countries, compared to large industrialized countries, include: greater exposure to supply shocks in general and trade volatility in particular, procyclicality of both domestic fiscal policy and international finance, lower credibility with respect to both price stability and default risk, and other imperfect institutions. These characteristics warrant appropriate models. Models of dynamic inconsistency in monetary policy and the need for central bank independence and commitment to nominal targets apply even more strongly to developing countries. But because most developing countries are price-takers on world markets, the small open economy model, with nontraded goods, is often more useful than the two-country two-good model. Contractionary effects of devaluation are also far more important for developing countries, particularly the balance sheet effects that arise from currency mismatch. The exchange rate was the favored nominal anchor for monetary policy in inflation stabilizations of the late 1980s and early 1990s. After the currency crises of 1994-2001, the conventional wisdom anointed Inflation Targeting as the preferred monetary regime in place of exchange rate targets. But events associated with the global crisis of 2007-09 have revealed limitations to the choice of CPI for the role of price index. The participation of emerging markets in global finance is a major reason why they have by now earned their own large body of research, but it also means that they remain highly prone to problems of asymmetric information, illiquidity, default risk, moral hazard and imperfect institutions. Many of the models designed to fit emerging market countries were built around such financial market imperfections; few economists thought this inappropriate. With the global crisis of 2007-09, the tables have turned: economists should now consider drawing on the models of emerging market crises to try to understand the unexpected imperfections and failures of advanced-country financial markets.

New Estimation of China's Exchange Rate Regime

The paper updates the answer to the question: what precisely is the exchange rate regime that China has put into place since 2005, when it announced a move away from the dollar peg? Is it a basket anchor with the possibility of cumulatable daily appreciations, as was announced at the time? We apply to this question a new approach to estimating countries' de facto exchange rate regimes, a synthesis of two techniques. One is a technique that has been used in the past to estimate implicit de facto currency weights when the hypothesis is a basket peg with little flexibility. The second is a technique used to estimate the de facto degree of exchange rate flexibility when the hypothesis is an anchor to the dollar or some other single major currency. Since the RMB and many other currencies today purportedly follow variants of Band-Basket-Crawl, it is important to have available a technique that can cover both dimensions, inferring weights and inferring flexibility. The synthesis adds a variable representing "exchange market pressure" to the currency basket equation, whereby the degree of flexibility is estimated at the same time as the currency weights. This approach reveals that by mid-2007, the RMB basket had switched a substantial part of the dollar's weight onto the euro. The implication is that the appreciation of the RMB against the dollar during this period was due to the appreciation of the euro against the dollar, not to any upward trend in the RMB relative to its basket.

On the Rand: Determinants of the South African Exchange Rate

This paper is an econometric investigation of the determinants of the real value of the South African rand over the period 1984-2006. The results show a relatively good fit. As so often with exchange rate equations, there is substantial weight on the lagged exchange rate, which can be attributed to a momentum component. Nevertheless, economic fundamentals are significant and important. This is especially true of an index of the real prices of South African mineral commodities, which even drives out real income as a significant determinant of the rand's value. An implication is that the 2003-2006 real appreciation can be attributed to the Dutch Disease. In other respects, the rand behaves like currencies of industrialized countries with well-developed financial markets. In particular, high South African interest rates raise international demand for the rand and lead to real appreciation, controlling for a forward-looking measure of expected inflation and a measure of default risk or country risk. It is in the latter respects, in particular, that the paper hopes to have improved on earlier studies of the rand.

On the Renminbi: The Choice between Adjustment under a Fixed Exchange Rate and Adjustment under a Flexible Rate

Fixed and flexible exchange rates each have advantages, and a country has the right to choose the regime suited to its circumstances. Nevertheless, several arguments support the view that the de facto dollar peg may now have outlived its usefulness for China. (1) China's economy is on the overheating side of internal balance, and appreciation would help easy inflationary pressure. (2) Although foreign exchange reserves are a useful shield against currency crises, by now China's current level is fully adequate, and US treasury securities do not pay a high return. (3) It becomes increasingly difficult to sterilize the inflow over time, exacerbating inflation. (4) Although external balance could be achieved by expenditure reduction, e.g., by raising interest rates, the existence of two policy goals (external balance and internal balance) in general requires the use of two independent policy instruments (e.g., the real exchange rate and the interest rate). (5) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. (6) The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong, rather than waiting until times are bad and the currency is under attack. (7) From a longer-run perspective, prices of goods and services in China are low -- not just low relative to the United States (.23), but also low by the standards of a Balassa-Samuelson relationship estimated across countries (which predicts .36). In this specific sense, the yuan was undervalued by approximately 35% in 2000, and is by at least as much today. The paper finds that, typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. These seven arguments for increased exchange rate flexibility need not imply a free float. China is a good counter-example to the popular "corners hypothesis" prohibition on intermediate exchange rate regimes.

The Effect of Monetary Policy on Real Commodity Prices

Commodity prices are back. This paper looks at connections between monetary policy, and agricultural and mineral commodities. We begin with the monetary influences on commodity prices, first for a large country such as the United States, then smaller countries. The claim is that low real interest rates lead to high real commodity prices. The theory is an analogy with Dornbusch overshooting. The relationship between real interest rates and real commodity prices is also supported empirically. One channel through which this effect is accomplished is a negative effect of interest rates on the desire to carry commodity inventories. The paper concludes with a consideration of implications for monetary policy.