MAS Sponsored Public Lecture, Singapore, March 2011

1. Currency WarsAPPENDICESJeffrey FrankelHarpel Professor of Capital Formation & Growth, Harvard University MAS Sponsored Public Lecture, Singapore, March 2011

2. Appendices: The big 3 currencies Appendix I: The end of $ hegemony? Appendix II: Is RMB appreciation in China’s own interest? Appendix III: Predictions – Sovereign debt troubles & the € Appendix IV: More on the trend to a multiple reserve system

3. Appendix 1: The end of dollar hegemony ? • Some argue the US current account deficit is sustainable indefinitely. • They believe that the US will continue to enjoy its unique “exorbitant privilege,” • able to borrow unlimited amounts in its own currency • because it is the dominant international reserve asset.

4. “Bretton Woods II” • Dooley, Folkerts-Landau, & Garber (2003) : • today’s system is a new Bretton Woods, • with Asia playing the role that Europe played in the 1960s—buying up $ to prevent their own currencies from appreciating. • More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance.

5. My own view on Bretton Woods II: • The 1960s analogy is indeed apt, • but we are closer to 1971 than to 1944 or 1958. • Why did the BW system collapse in 1971? • The Triffin dilemma could have taken decades to work itself out. • But the Johnson & Nixon administrations accelerated the processby fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). • These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

6. There is no reason to expect better today: • Capital mobilityis much higher now than in the 1960s. • The US can no longer rely on support of foreign central banks: • neither on economic grounds(they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), • nor on political grounds(these creditors are not the staunch allies the US had in the 1960s).

7. The financial crisis caused a flight to quality which evidently still means a flight to US $. • US Treasury bills in 2008-09 were more in demand than ever, as reflected in very low interest rates. • The $ appreciated, rather than depreciating as the “hard landing” scenario had predicted. • => The day of reckoning had not yet arrived. • Chinese warnings (2009) may have been a turning point: • Premier Wen worried US T bills will lose value. • PBoC Gov. Zhou proposed replacing $ as international currency, with SDR.

8. Multiple international reserve asset system • The € now exists as a rival to the $. • The ¥ & SF are also safe havens. • The SDR came back from the dead in 2009. • Gold made a comeback as an international reserve too. • Someday the RMB will join the roster though it is just beginning now. • = a multiple international reserve currency system. SDR

9. Appendix II: What is in China’s interest? • Countries should have the right to fix their exchange rate if they want to. • True, the IMF Articles of Agreement and the US Omnibus Trade Act of 1988 call for action in the event that a country is “unfairly manipulating its currency”. • But • Few countries have been forced to appreciate. • Pressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. • I support ending the language of “manipulation.” • Usually, it is hard to say when a currency is undervalued. • Don’t cheapen the language that is appropriate to WTO rules. • China should do what is in its own long-term interest.

10. Five reasons why China should let the RMB appreciate, in its own interest • Overheating of economy • Reserves are excessive. • It gets harder to sterilize the inflow over time. • Attaining internal and external balance. • To attain both, need 2 policy instruments. • In a large country like China, expenditure-switching policy should be the exchange rate. • Avoiding future crashes. • RMB undervalued, judged by Balassa-Samuelson relationship.

11. 1. Overheating of economy: • Bottlenecks. Pace of economic growth is outrunning: • raw material supplies, and • labor supply in coastal provinces • Also: • physical infrastructure • environmental capacity • level of sophistication of financial system. • Asset bubbles. • Shanghai stock market bubble in 2007. • Inflation 6-7% in 2007 => price controls • shortages & social unrest. • All of the above was suspended in late 2008, • due to global recession. • But it is back again now; skyrocketing real estate prices.

12. Attempts at “sterilization,” to insulate domestic economy from the inflows • Sterilization is defined as offsettingof international reserve inflows,so as to prevent them from showing updomestically as excessive money growth & inflation. • For awhile PBoC successfully sterilized… • until 2007-08. • The usual limitations finally showed up: • Prolongation of capital inflows <= self-equilibrating mechanism shut off. • Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate • Failure to sterilize: money supply rising faster than income • Rising inflation (admittedly due not only to rising money supply) • Rising asset prices

13. After the interruption of mid-2008 to mid-2009(<= big one-year loss of China’s exports due to global recession),overheating resumed: rapid rise of land prices Real Beijing land prices

14. 2. Foreign Exchange Reserves • Excessive: • Though a useful shield against currency crises, • China has enough reserves: $2 ½ trillionby April 2010; • & US treasury securities do not pay high returns. • Harder to sterilize the inflow over time.

15. The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

16. Attempts to sterilize reserve inflow: Successful sterilization in China: 2005-06 High reserve growth =>steadymoney offset by cuts indomestic credit While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. were remarkably successful in 2005-06.

17. In 2007-08 China began to have more trouble sterilizing the reserve inflow • PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit. • Inflation became a serious problem. • True, global increases in food & energy priceswere much of the explanation. • But • China’s overly rapid growth itself contributed. • Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities. • Price controls are inefficient and ultimately ineffective.

18. Sterilization faltered in 2007 & 2008 Monetary baseaccelerated Growth of China’smonetary base,& its components Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

19. Foreign exchange reserves held by the People’s Bank of China are approaching $3 trillion in 2011. New York Times Jan 12, 2011

20. The Chinese money supply has almost doubled in the last 3 years, contributing to a rapid growth aggregate demandas reflected in nominal GDP. No wonder inflation is rising again. New York Times Jan 12, 2011

21. 3. Need a flexible exchange rate to attain internal & externalbalance • Internal balance ≡ demand neither too low (recession) nor too high (overheating). • External balance ≡ appropriate balance of payments. • General principle: to attain both policy targets, a country needs to use 2 policy instruments. • For a country as large as China, one of those policy instruments should be the exchange rate. • To reduce BoP surplus without causing higher unemployment, China needs both • currency appreciation, and • expansion of domestic demand • gradually replacing foreign demand, • developing neglected sectors: health, education, environment, housing, finance, & services.

22. 4. Avoiding future crashes Experience of other emerging markets suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. Introducing some flexibility now, even though not ready for free floating.

23. 5. Longer-run perspective:Balassa-Samuelson relationship • Prices of goods & services in China are low • compared at the nominal exchange rate. • Of course they are a fraction of those in the U.S.: < ¼ . • This is to be expected, explained by the Balassa-Samuelson effect • which says that low-income countries have lower price levels. • As countries’ real income grows, their currencies experience real appreciation: approx. .3% for every 1 % in income per capita. • But China is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

24. The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics Undervaluation of RMB in the regression estimated above = 26%. Estimated undervaluation averaging across four such estimates = 31%. Compare to Frankel (2005) estimate for 2000 = 36%.

25. Appendix III: Debt Predictions Greece will needto re-structure its debt. The euro will survive. There is no legal provision for members to leave the euro zone. Prices of government bonds in advanced countries in general will fall.

26. The euro project is lookingfar less successful than just a few years ago Many predictions of euro skeptics have come true: Periphery countries and core countries have had trouble reconciling asymmetric monetary needs. Euro members have not had enough labor mobility or flexibility to make up for it. Efforts to prevent excessive debt & bailouts have failed: The Stability & Growth Pact failed with members big & small. The “No bailout clause” has failed with Greece.

27. Frankfurt & Brussels made 4 mistakes regarding Greece 2001: They let Greece into the euro 2002-09: ECB accepted Greek debt as collateral despite consistent violation of SGP. => Did not allow interest rate spreads to open up. Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally.” Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs).

28. Judging from spreads, 2001-07, investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations

29. Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. • Even when the Greek crisis erupted, leaders in Brussels & Frankfurt seemed to view it as a black swan, • instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, • and many others in history, • including among European countries.

30. Sovereign debt worries... • The next big asset market to fall • after the stock market in 2000 • the housing market in 2006 • and banking in 2008 • will likely be sovereign debt • among the advanced economies. • The major emerging market countries are in much better shape, • in an amazing & historic role reversal.

31. Sovereign spreads for 5 euro countries shot up in the 1st half of 2010 Creditworthiness: Some advanced economics have fallen, as emerging markets have risen.

32. A remarkable role-reversal: • Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets; • and rising rapidly. • By 2014 (at ≈ 120%), it could be triple.

33. Even judged by ratings of credit agencies, emerging markets are now intermingled with advanced countries • Singapore’s credit rating is now above Belgium’s • China’s rating rose above Japan’s in January • Taiwan is above Italy • Chile is above Israel • Korea is above Portugal • Malaysia is above Ireland • South Africa is above Iceland • India is above Greece.

34. Ratings for “Advanced Economies” Ratings for “Emerging Economies”

35. Appendix IV: More on the trend from $ hegemony to a multiple reserve system When does the “privilege” become “exorbitant?” • if it accrues solely because of size and history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. • Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies. • It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !

36. Some argue that the privilege to incur $ liabilities has been earned in a different way: • Global savings glut(Bernanke) • The US appropriately exploits its comparative advantage in supplying high-quality assets to the rest of the world. • “Intermediation rents…pay for the trade deficits.” -- Caballero, Farhi & Gourinchas(2008) • In one version, the US has been operating as the World’s Venture Capitalist, accepting short-term liquid deposits and making long-term or risky investments-- Gourinchas & Rey(2008). • US supplies high-quality assets:Cooper (2005); Forbes (2008);Ju & Wei (2008);Hausmann & Sturzenegger (2006a, b);Mendoza, Quadrini & Rios-Rull(2007a, b)…

37. The argument that the US offers assets of superior quality, and so has earned the right to finance its deficits, was undermined by the dysfunctionality revealed in the financial crisis of 2007-08. • American financial institutions suffered a severe loss of credibility (corporate governance, accounting standards, rating agencies, derivatives, etc.), • How could sub-prime mortgages be the superior type of assets that uniquely merit the respect of the world’s investors?

38. But the events of 2008-09 also undermined the opposing interpretation, the unsustainability position: • Why no hard landing for the $, as long feared? • The $ appreciated after Lehman Brothers’ bankruptcy, & US T bill interest rates fell. • Clearly in 2008 the world still viewed • the US Treasury market as a safe haven and • the US $ as the premier international currency.

39. Though arguments about the unique high quality of US private assets have been tarnished, the idea of America as World Banker is still alive: the $ is the world’s reserve currency, by virtue of US size & history. • Is the $’s unique role an eternal god-given constant? • Or will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere?

40. Historical precedent: £’s loss of premier international currency status in 20th century • By 1919, US had passed UK in • output (1872) • trade (1914) • net international creditor position (1914-19) • Subsequently, $ passed £ as #1 reserve currency (1940-45).

41. Determinant: Size Depth of Fin.mkt. 3. Rate of return Proxy: GDP FX turnover inflation, LR depreciation, Exch. rate variance From the literatureon reserve currencies

42. From the literature, continued Network externalities => Tipping captured by: • Inertia lags • Nonlinearity logistic functional form in determinants or dummy for leader GDP

43. Projection of $ vs € as shares of central banks’ foreign exchange reserves: a function of country size, financial market depth, & rate of return, with parameters estimated on 1973-98 data.Simulation assumes $ depreciation continues at 2001-04 rate. Chinn & Frankel (2005) birth of € This scenario showed € overtaking $ as top international reserve currency in 2022.

44. More on a multiple-asset international reserve system International Currency Roles

45. A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: money was invented in the first place to cut down on the transactions costs of exchange. • Nevertheless, if sound macro policies in the leader country cannot be presumed, the existence of competitor currencies gives the rest of the world protection against the leader exploiting its position by running up too much debt and then inflating/depreciating it away.

46. Gold • Gold was seen as an anachronism just a few years ago: • the world’s central banks were selling off their stocks. • Gold re-joined the world monetary system in 2009: • The PBoC, RBI, & other Asian central banks bought gold, to diversify their reserves. • Even in advanced countries, central banks appear to have stopped selling.

47. SDR Special Drawing Rights • The SDR has made a surprising comeback as a potential international money, from near-oblivion. • The G20 in 2009 decided to create new SDRs ($250b). • Shortly later, PBoC Gov. Zhou proposed replacing the $ as lead international currency with the SDR. • The IMF is now borrowing in SDRs. • The proposal has been revived for an international substitution account at the IMF, to extinguish an unwanted $ overhang in exchange for SDRs. • The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $. • Still, it is back in the world monetary system.

48. http://ksghome.harvard.edu/~jfrankel/index.htm