Exchange Rates in Small Open Economies PFTAC/CCBS Course August, 2010

1. Exchange Rates in Small Open Economies PFTAC/CCBS Course August, 2010 Matt Davies IMF/PFTAC Coordinator

2. Outline • Exchange rate choices in small open economies. • Theory • Evidence (Pacific and elsewhere) • Macro effects of exchange rate choices in the Pacific • Assessments of exchange rate level. • Theory • Application to the Pacific • Moving towards flexibility.

3. Fixed exchange rates make sense for small open economies. • Reduces transaction costs and exchange rate risks in substantial proportion of economy. • Stabilises domestic prices—which react rapidly to nominal exchange rate changes. • Transparent nominal anchor. • Reduces need for establishing complex institutions in situations of scarce resources (financial and human). • Relatively small probability of speculative attacks. • But policy inconsistency can still be damaging.

4. Floating is difficult in small economies • Institutional infrastructure • Complex monetary policy environment • ‘capital’ movements and supply shocks • exchange rate changes rapidly affect inflation • Interest rate pass through weak • Foreign exchange markets are illiquid • “Fear of floating”

5. Types of Fix • Dollarization – Tuvalu, North Pacific, Cook Islands • Political / historic drivers (and admin simplicity) • Imports credibility and eases transaction costs • Difficult to reverse • Currency Board • Domestic currency fully backed by foreign reserves. • Robust statement of credibility • Less frequently used these days (remain in the Carribbean?

6. Types of Fix(cont) • Pegged exchange rate • To single currency or to a basket • Fluctuation within a narrow trading band • Occasional re/de valuations. • More modern phenomenon (since 1970s) • Typically in larger small-states • More flexibility than other regimes.

7. Choosing between pegs • Credibility • Seignorage • Policy discretion • Institutional costs • Lender of last resort

8. Reality follows theory • Imam (2009) looked specifically at “microstates” • Only 4 (Mauritius, Iceland, Sao Tome, Seychelles) did not fix. • Smaller ones dollarized • Larger pegged.

9. The Pacific largely follows suit. • All currencies have been pegged and most still are. • Systems evolved over time—policy trade-offs. • occasional revaluations and one float. • Now mostly to a trade-weighted currency basket • Backed up with capital controls. • And some limited current account restrictions.

10. Small open economy issues relevant to the Pacific • Remittances (Tonga, Samoa, Fiji) • mixed effects, • depends on usage • and economic development, • but tends towards real appreciation. • Commodities (PNG, Solomons) • Real appreciation tendencies • Dutch disease

11. Some small open economy issues • Tourism – IMF paper on ECCU • Also tends to reinforce real appreciation • ToT effect, like commodity prices • Increase wages in other sectors (Balassa Samuelson) • Some countervailing pressures, openess to markets and competition makes prices less sticky and mitigates shocks • ECCU not fond to be overvalued despite hard peg and tourism

12. What has happened in the Pacific? • Exchange rates • Nominal • Real • Balance of payments • Current account • Reserves

13. Recent Nominal Effective Rates

14. Real Effective Exchange Rates

15. Current Account Balances

16. Reserves

17. Some tentative evidence of overvaluation.. • Real effective appreciation in a number of countries • High and increasing current account deficits • Weak export sectors • But there are explanatory factors. • Can we be more scientific?

18. Exchange rate assessments • IMF Surveillance has moved towards more explicit assessment of exchange rate levels. • 2007 Surveillance Decision. • Is the real exchange rate in line with medium-term external stability? • Exclude temporary factors • Acknowledge impact of domestic policies/stability

19. Assessing the Equilibrium Exchange Rate • IMF analysis based around Consultative Group on Exchange Rates (CGER) • Conceptually difficult even for large economies. • No clear superior methodology • Can get divergent results from different methods • Data restrictions. • 4 main methodologies, generally used as a suite….

20. Comparisons with historical trend and competitors (PPP)

21. Macro Balance Approach • Calculates the difference between an estimated equilibrium current account and projected balance at prevailing exchange rates • Required exchange rate adjustment calculated from calculated elasticities • Typical variables: • Fiscal balance; • growth; • NFA • demographics; • Oil balance • Remittances/grants/FDI • Quantified in relation to trading partners

22. Equilibrium Real Exchange Rate Approach • Directly estimates a ERER from fundamentals • Typical variables: • NFA; productivity differentials; Terms of Trade; Government consumption Application to Tonga (2008,above) and Vanuatu (2009, below)

23. External Sustainability • Calculates difference between projected current account balance and the balance that would stabilize the NFA position of the country. • Uses same elasticities as MB approach to calculate required exchange rate adjustments. • Not data hungry • But assumes current position is appropriate benchmark

24. Application to the Pacific • Combination of approaches taken. • All face data problems. • Given this, many assessments are based on judgements on a wide range of variables.

25. Samoa (2010) – in line with fundamentals • Compares Current Account Balance with estimated norm from 55 low-income countries. • Also looks at other indicators: • Reserve movements, export receipts, remittances

26. Tonga (2010) – moderately overvalued • Macrobalance and PPP approaches • Sample of 140 economies • 10-15% overvaluation • Considerable uncertainty • Data problems (NFA) • Other indicators don’t suggest overvaluation • CA deficit and reserves stable • inflation easing, • exports growing

27. Fiji (2009) – moderately overvalued • Macrobalance and external sustainability approach – imply overvaluation • ERER approach – in line with fundamentals • Supported by other indicators • Tourism and reserves

28. Vanuatu (2009) – in line with fundamentals • ERER – using fiscal position and ToT • Data constraints precluded using MB and ES approaches • Export growth reflects structural rather than XR factors

29. Solomon Islands – substantial overvaluation • Real appreciation driven by inflation and US dollar movements. • ERER estimation suggests 26 percent overvaluation • Modified MB approach (impact of REER changes on reserves) suggests a 20% overvaluation.

30. PNG – in line with fundamentals

31. Summary: an imprecise science • Estimation suggests that exchange rates in the Pacific tend to be moderately overvalued. • Implies lower imported inflation and lack of export competitiveness. • And requires supporting macro policies to sustain peg • But large degrees of error and data deficiencies • Some intuitive indicators work in opposite direction • Abrupt movements in international rates complicate the analysis.

32. Exchange rates have been used to respond to past crises. • Mostly through occasional devaluations of pegs. • Fiscal indiscipline has put pressure on pegs—contributed to float in PNG. • Depreciations occurred around Asian crisis and recently in Fiji—coincident with domestic instability. • Have proved successful • Some greater flexibility adopted more gradually—adjustment bands.

33. Can more flexibility help in the future? • Can improve external position • Assuming structural impediments can be overcome • Frees monetary policy to respond to external shocks • Reduces FX related risks (one way bets, implicit guarantees) • Stimulates financial market development. • Benefits generally greater in countries that are more developed and integrated with international financial markets • Perceived costs: • Losing policy credibility; • Competitiveness/inflationary effects; • Lack of institutional capacity and market depth to implement alternative monetary policy responses

34. International experience with transition • Majority of transitions from fixed regimes to floats have been disorderly. • Orderly exits generally involved intermediate steps. • Pegs • Crawling pegs • Crawling Bands • Four ingredients for a successful transition…

35. A deep and liquid foreign exchange market • Key ingredient: emergence of two way risk in FX market. • Reduce central bank’s market making role • Increase information flows • Phasing out regulations that stifle market activity • Improving market microstructure

36. A coherent intervention policy • Several legitimate reasons for intervention under a float • Correct short-term misalignments • Calm disorderly markets • Accumulate FX reserves / supply market with FX • But, misalignment is hard to identify and intervention has high information content to the market. • And the effectiveness of intervention is open to question.

37. An appropriate alternative nominal anchor • Monetary control particularly important following exits from pegs—destabilized expectations. • Recommended anchor is inflation targeting • But requires substantial institutional capacity. • Clear priority to price stability • Operational independence for central bank • Transparency/accountability in monetary policy operations • Capacity to forecast inflation • Many countries have used intermediate monetary targeting until these conditions are fulfilled. • With limited flexibility in transition fiscal policy is important in reinforcing credibility.

38. Managing and supervising exchange rate risks. • A floating rate transfers FX risk from public to private sector • And exposes previously protected public sector bodies. • Needs improved risk management in public and private sectors. • Need to focus on currency and liquidity mismatches.

39. Pace of exit • Periods of tranquility are the ideal time for an exit from a fixed regime • But more often than not changes are enforced. • A gradual build up of institutions to support exchange rate flexibility is desirable—even if an exit is not currently foreseen. • Risks involved in liberalizing capital accounts before floating exchange rates.

40. Some references • Exchange rate regimes in an increasingly integrated world economy. IMF Occasional Paper 193 • Moving to Greater Exchange Rate Flexibility. IMF Occasional Paper 256 • Grants, Remittances and the Equilibrium Real Exchange Rate in Sub-Saharan African Countries. IMF Working Paper 09/75

41. Some references • Exchange rate Choices of Microstates. IMF Working Paper 10/12 • Pacific Island Countries: Possible Common Currency Arrangement IMF Working Paper 06/234 • Assessing Exchange Rate Competitiveness in the Eastern Caribbean Currency Union. IMF Working Paper 09/78

42. Discussion • Is increasing exchange rate flexibility appropriate in the Pacific? • What are the key institutional capacity issues that need to be addressed in the near and medium-term? • What is required of other macro policies?