Thorvaldur Gylfason

1. Dutch disease, volatility, and exchange rate regime in resource-rich countries ThorvaldurGylfason Joint Vienna Institute/IMF Institute Course on Macroeconomic Management in Natural Resource-Rich Countries Vienna, 2-13 April 2012

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

3. 1 Background: real vs. nominal exchange rates Increase in Q means real appreciation e refers to foreign currency content of domestic currency Q = real exchange rate e = nominal exchange rate P = price level at home P* = price level abroad

4. 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

5. Three thought experiments 1.Suppose e falls Then more rubles 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

6. importance of appropriate side measures Remember: Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation To work, nominal devaluation must result in realdevaluation

7. 2 Exchange rate policy and welfare Payments for imports of goods, services, and capital Imports Real exchange rate Equilibrium Earnings from exports of goods, services, and capital Exports Foreign exchange

8. Exchange rate policy and welfare • Equilibrium between demand and supply in foreign exchange market establishes • Equilibrium real exchange rate • Equilibrium in balance of payments • BOP = X + Fx – Z – Fz • = X – Z + F • = current account + capital account = 0 X – Z = current account F = capital and financial account

9. Exchange rate policy and welfare R moves when e is fixed R Deficit Imports Overvaluation Real exchange rate Exports Foreign exchange

10. Exchange rate policy and welfare Overvaluation works like a price ceiling Supply (exports) Price of foreign exchange Overvaluation Deficit Demand (imports) Foreign exchange

11. 3 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

12. Impact of aid on Real Exchange Rate • Review basic theory of Dutch disease in simple demand and supply model • Analytical literature uses complex two- or three sector models • Tradable manufactures • Tradable resources • Nontradable services

13. 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

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

15. 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

16. 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,” WP/10/271

17. Empirical evidence: Literature review in numbers i Number of cases reported Dutch disease shocks Natural resources/capital inflows Source: Magud and Sosa (2011)

18. Empirical evidence: Literature review in numbers ii Number of cases reported Remittances Foreign aid Source: Magud and Sosa (2011)

19. Empirical evidence: Literature review in numbers iii Number of cases reported Empirical studies Theoretical studies Source: Magud and Sosa (2011)

20. Empirical evidence: Literature review in numbers iv Does overvaluation reduce growth? Does undervaluation? Number of cases reported Currency misalignments Exchange rate changes Source: Magud and Sosa (2011)

21. 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

22. 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*

23. 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

24. 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

25. Netherlands: Exports 1960-2010 (% of GDP)

26. 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

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

28. 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

29. risk of Dutch disease • Large inflows of foreign exchange earnings from a natural resource discovery can trigger a bout of Dutch disease • Real appreciation hurts competitiveness of exports and can thus undermine economic growth • Exports have played a pivotal role in the economic development of many countries • An accumulation of “know-how” often takes place in the manufacturing export sector, which may confer positive external benefits on the rest of the economy

30. risk of Dutch disease • Resource boom is likely to lead to Dutch disease if • It leads to high demand for nontradables • Trade restrictions may produce this outcome • Recipient country uses aid to buy nontradables (including social services) rather than imports • Production is at full capacity • Production of nontradables cannot be increased without raising wages in that sector • Resource rent is not used to build up infrastructure and relax supply constraints • Including free mobility of labor across countries • Price and wage increases in nontradables sector lead to strong wage pressure in tradables sector

31. risk of Dutch disease • The risk that resource boom might have adverse impact on economy due to, e.g., oil-induced Dutch disease crucially depends on how resource rent is used in recipient countries • We can identify four different cases based on how the rent is spent, and in which the macroeconomic implications of rent flows differ Argument also applies to inflows of foreign aid

32. risk of Dutch disease • Spending can take several forms, with different macroeconomic implications: • Case 1: Rent is saved by government • Case 2: Rent is used to purchase imported goods that would not have been purchased otherwise • Case 3: Rent is used to buy nontradables with infinitely elastic supply • Case 4: Rent is used to buy nontradables for which there are supply constraints

33. How rent is used and the risk of Dutch Disease: Case 1 • Rent is saved by government • Rent inflow leads to accumulation of foreign exchange reserves in Central Bank • … and, unlike increased rent that is spent, is not allowed to enter the spending stream • No effect on money supply • No inflation • No appreciation of currency • I.e., no increase in exchange rate • No risk of Dutch disease

34. How rent is used and the risk of Dutch Disease: Case 2 • Rent is used to purchase imported goods that would not have been purchased otherwise • Import purchases lead to transfer of real resources from abroad, but not to increased spending at home • No effect on money supply • No inflation • No appreciation of currency • No risk of Dutch disease

35. How rent is used and the risk of Dutch Disease: Case 3 • Rent is used to buy domestic nontradables with infinitely elastic supply due to underutilized resources (labor and capital) in economy • Increased demand for nontradables • Because some factors are unemployed, greater demand leads to increased supply • This has a positive impact on production without increasing nontradables prices • No risk of Dutch disease

36. How rent is used and the risk of Dutch Disease: Case 4 • Rent is used to buy nontradablesfor which there are supply constraints, with all available resources already in use (e.g., social services) • Increased demand for nontradables • Increased prices for nontradables • Shift of inputs away from tradables (exports and import-competing goods and services) into nontradables • Real appreciation of the currency • Dutch disease!

37. How rent is used and the risk of Dutch Disease: Case 4 • Monetary policy response determines if real appreciation of currency will take place through inflation or nominal appreciation • If foreign currency is used to increase Central Bank reserves, increased spending on nontradables increases money supply and inflation, so currency appreciates in real terms • If Central Bank sterilizes impact on money supply of increased spending on nontradables by selling foreign exchange, currency appreciates in nominal, and real, terms So, in either case, currency appreciates in real terms

38. How rent is used and the risk of Dutch Disease: lessons • To recapitulate, the risk of Dutch disease varies, and depends on • How rent is used (saved or spent) – CASE 1 • The presence of a rent absorption constraint – CASE 2 • The impact of rent on productivity in the nontradables sector – CASE 3 • The existence of externalities in nontradables sector affecting the rest of the economy – CASE 4

39. How rent is used and the risk of Dutch Disease: lessons • Rent inflow can give rise to Dutch disease when government uses the rent to purchase nontradables rather than imported goods and when there are constraints on increasing production in nontradables sector • The risk of Dutch disease is greater when rent is used in social sectors facing constraints on increasing their production due to resource scarcity (rent absorption constraint)

40. How rent is used and the risk of Dutch Disease: lessons • How can resource-rich countries avoid translating rent into Dutch disease? • Save the rent and increase central bank reserves (gross, not net) by not allowing the rent inflow to enter spending stream • Recall the Hartwick rule • Use rent to purchase imported goods • Boost rent absorption capacity in nontradables sector

41. risk of Dutch Disease: early warning signals • Policymakers in resource-rich countries need to pay attention to potential early warning signals of, say, oil-induced Dutch disease such as • Tendency for wages and prices in nontradables sector to increase • Decline in profitability and sales of export and import-competing industries • Rapid relative rise of per capita GDP in dollars • Recall: Argument applies to sudden inflows of foreign capital as well as natural resource booms

42. 4 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

43. 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

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

45. 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

46. 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

47. 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

48. 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

49. 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

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