Thorvaldur Gylfason

1. 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

2. outline • Real vs. nominal exchange rates • 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 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

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 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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*

13. 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

14. 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

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

16. 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

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

18. 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

19. 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

20. 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

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

22. 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

23. 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

24. 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

25. 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

26. 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

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

28. 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

29. 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

30. 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

31. 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.

32. 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.)

33. 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

34. 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

35. 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

36. 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

37. 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)

38. 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

39. 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)

40. 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

41. Benefits and costs

42. Benefits and costs

43. Benefits and costs

44. Benefits and costs

45. Benefits and costs

46. 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?

47. 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

48. EXCHANGE ARRANGEMENTS AND MONETARY POLICY FRAMEWORKS 2012

49. Mena region: exchange arrangements

50. 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