March 10, 2011
The Macroeconomic Effects of Large Exchange Rate Appreciations
From the abstract to a new OECD Development Center working paper, by Marcus Kappler, Helmut Reisen, Moritz Schularick and Edouard Turkisch, the results of a large, cross-country study based upon a narrative approach to identifying appreciation episodes:
The study shows that currency appreciations can help to a certain extent in reducing global imbalances, and that it can go along with a shift from a mainly export-based model of growth towards a model with internal sources of growth. The cost in terms of growth would be very limited in the case of developed countries, but somewhat larger for developing countries.
The general results are illustrated by the impulse response functions:
Figure 1 from Kappler et al. (2011).
The effects are more pronounced when restricted to an emerging market/less developed country sample.
Figure 3 from Kappler et al. (2011).
From the conclusion:
Using data for 128 countries between 1960 and 2008, we have found 25 episodes of large sustained exchange rate revaluations, which we define as both nominal and real effective exchange rate appreciations of 10% (and more) within a two year window (or less). Studying the institutional context of each individual episode in detail, we identified 14 cases of appreciation shocks that occurred not as a result of discretionary policy action, but were passively linked to the appreciation of the anchor currency in the context of an exchange rate peg. We argue that these cases represent instances of exogenous appreciation shocks that we can use to estimate the macroeconomic impact of large appreciations and assess the robustness of estimates based on a wider definition of appreciation and revaluation events. Using a dummy-augmented autoregressive panel model we could indeed show that such large appreciations episodes have strong macroeconomic effects. Most importantly, we established four key stylised facts that can prove useful in the ongoing debate about the role of exchange rate adjustment for global rebalancing.
First, the current account balance typically falls strongly in response to large exchange rate revaluations. Three years after the revaluation, the current account balance deteriorates by about 3 pp. relative to GDP. This is due to a reduction in aggregate savings without a concomitant fall in investment. The effect on the current account balance is statistically significant and robust to variation in the country sample and the definition of appreciation events.
Second, the effects on output seem limited. Our point estimates suggest a negative effect of output growth, albeit of relatively small magnitude: on average, the aggregate level effect on output amounts to about 1% after six years. The confidence intervals are also considerably wider than for the current account. The output effects are statistically not significant.
Third, while aggregate output is not strongly affected, export growth falls significantly after appreciation shocks. Import growth remains by and large unchanged resulting in the observed deterioration in external balances. As aggregate economic growth is much less affected, our results point to a positive domestic demand response following appreciation episodes.
Fourth, these effects seem to be more pronounced in developing countries. The sensitivity of the current account balance to revaluation shocks is higher. The effect reaches almost 4 percentage points of GDP after three years and is statistically significant. But also the potentially negative effects on output are larger. Our point estimates indicate a loss in output of 2% over ten years. But confidence intervals remain wide, so that these results miss statistically significant levels. Why these effects are stronger in developing countries will be an important question that we aim to address in future research.
In sum, the historical record of large exchange rate revaluations that we have studied in this paper lends some support to the idea that large exchange rate appreciations and revaluations have an impact on the current account as they lead to marked changes of savings and investment within countries. Appreciation shocks impact external balances, but this effect potentially comes at the cost of a reduction of dynamism in exports. While the domestic economy seems to pick up some of the external slack, leaving overall growth relatively unaffected, the prospect of sharp decelerations in export growth will remain a concern for policy-makers and bears watching especially in the context of developing countries.
It is interesting to consider these results in the context of other studies. In particular, Eichengreen and Rose (2010) conducted an study of "...what happens to economies when they exit exchange rate pegs that are resisting appreciation. Data from 27 cases suggest that growth slows but only modestly, and there is no evidence of economic and financial damage as a result -- certainly nothing like the fears that China's next decade could look like Japan's lost decade." [pdf].
Eichengreen and Rose find a detectable growth decrease, but hardly a collapse --, using a different approach to identifying appreciation episodes. Taken together, research seems to suggest that a substantial growth slowdown in the wake of a large currency appreciation is unlikely.
Posted by Menzie Chinn at March 10, 2011 08:05 AMdigg this | reddit
"Why these effects are stronger in developing countries will be an important question that we aim to address in future research."
It also draws into question the validity of their results.
"...what happens to economies when they exit exchange rate pegs that are resisting appreciation. Data from 27 cases suggest that growth slows but only modestly, and there is no evidence of economic and financial damage as a result -- certainly nothing like the fears that China's next decade could look like Japan's lost decade."
But certainly also Japan seems to offer the closest parallel, having had an enormous property bubble and an extreme currency misalignment.
Posted by: don at March 10, 2011 10:11 AM
If your currency appreciates, then you are wealthier, assuming that you're buying stuff from places with now relatively cheaper currency. And the appreciation blunts the inflation resulting from the cheaper currency. So it's nice when data supports logic.
As for Japan, there was a crippling credit overhang caused in large measure by social pressure to ramp up investment prices - not unique to Japan but exacerbated by cultural pressure to join the wave. The credit overhang couldn't be reduced because it was socially - and sometimes legally - difficult to force companies out of business or to write down principal or to foreclose. Banks continued to lend to debtors who couldn't pay by giving them - or at least crediting them - with funds that were then paid back to the lender as payment on the debt. That is one example of many. The structure of Japanese banking and securities firms was also very strange, with strict limits on who could make long term loans, etc. Not easy to say Japan is like China.
Posted by: jonathan at March 10, 2011 06:38 PM
Dense matrix where the effects of currencies appreciation, depreciation are not to be measured as direct impact on one currency only but to include those that are linked to a main currency.
As read the assumptions take for granted:
The sum of the parts (currencies constituents,euro for instance are equal to the whole)
The currencies misalignment are natural phenomena,readjustments will only involve I-S,C/A,output growth rebalancing
The effects of currencies appreciation are mitigated in advanced countries (P26)
These effects are more prononced for the developping economies in term of current accounts and savings.
Not exclusive, it was tempting to read the results of above in conjunction with
The empirical data as included in the study C Reinhart, K Rogoff "This time is different"
Few additional parameters are worth to be included.(P34 and after)
Capital mobility involving the possible locksteps:
Exchange rate appreciation and capital mobility (advanced countries vs developing countries)
Capital mobility and banking crisis
Banking crisis and sovereign defaults.
Current account deficits and external or domestic borrowings or the "March towards fiat money" as illustrated (P 45)
Currencies are misaligned (cf Econbrowser Exchange Rates: Two Stylized Facts and Yet Another (Consequent) and C. Engel attachment)
The causes and causations have to be exhaustively addressed.
Posted by: ppcm at March 11, 2011 04:35 AM
From the U.S. perspective, I'm more curious about the effects of a rapid currency De-preciation.
Posted by: pacer at March 11, 2011 01:27 PM
Posted by: Menzie Chinn at March 12, 2011 08:34 AM
The more or less unmentioned elephant in this room is China, which has been highly disciplined in keeping the renminbi undervalued. This policy has kept China’s current account (CA) surplus persistently high: its current external surplus currently stands at $316 billion, or over 6% of annual GDP. Many criticize this policy, saying it throws the world economy off-balance and makes it unstable and vulnerable to adverse shocks. Some also point to possible detrimental effects within China: as any student in a monetary theory class can tell you, keeping currency undervalued usually requires continuously increasing domestic money supply, which can result in inflation.
China hasn’t yet begun to feel the ramifications of strong inflationary pressures; this may be due to the continuous growth of the Chinese economy, which has allowed the renminbi to stay relatively constant without necessitating large increases in supply. However, with consumer prices rising over 5% in the first quarter of 2011, this balancing act seems primed to topple over. China currently has a stable exchange rate and autonomous monetary policy, but rising prices may soon force it to the third leg of the Impossible Trinity, free capital flows, and away from its current fixed exchange rate regime.
Recently, the IMF released a statement advising countries with large trade surpluses, such as China, that a revaluation of currency is one measure that may be undertaken to reduce a surplus without sacrificing economic growth, along with policies encouraging domestic consumption, and the pursuit of more sophisticated markets. However, Chinese policymakers have remained worried that a more expensive renminbi would cause Chinese exports, the backbone of their economy, to significantly fall; given the small profit margin on the majority of exported goods, this could quickly have a strongly negative effect on producers.
The paper presented above by Kappler, Reisen, Schularick, and Turkisch seeks to determine the truth of this statement and ascertain the effects of a large currency appreciation (defined as >10%) on an economy. They find that such an appreciation causes the CA balance to fall substantially (as one would hope, given that this is one of the main goals of the revaluation) and export growth to fall significantly (as predicted), but that the effect on overall output is relatively limited; furthermore, all of these effects are found to be stronger in developing countries.
While these conclusions are compelling, two concerns come to mind, the first of which echoes the earlier concerns of the Chinese officials. The poorer the economy, the more damaging a real appreciation is likely to be for individuals. Though the effect on overall output may have been found to be statistically insignificant for the 25 cases included in the Kappler study, the majority of those countries (especially the developing economies) were not export-driven, a factor which will most likely make China’s growth much more sensitive to changes in the value of the renminbi.
Another factor not examined in the Kappler, et al. model is that of the possible effect on the appreciation of the renminbi on other economies. China has become one of the largest importers for many East Asian countries, and a slowed Chinese aggregate demand may well have a domino affect throughout the region. In addition, many of China’s exports to the United States are in the form of intermediate inputs; if the prices of these goods increase, it may well have a marked negative effect on U.S. producers.
Posted by: Tal Manor at April 16, 2011 11:51 AM
My very first intuition was that the argument might be (perhaps unintentionally) advocating for inward-oriented economies rather than liberalized, outward-oriented ones. Although this approach to growth is intriguing, it leaves one even more confused. Taken separately, some of the arguments actually make sense; nevertheless, as a whole, they fail – in my opinion – to portray reality, or even theory.
The main purpose of this paper is to study the role of exchange rate adjustment in global rebalancing and argue that a large appreciation of the currency would leave output unchanged in developed countries, and decrease it in emerging market economies. My first criticism relates to output inelasticity. Assuming there has been a large currency appreciation and net exports decrease, the impact on output will depend on the movements of private consumption, fiscal policy, and investment. The direction and intensity of those fluctuations in turn depend on many other factors that vary from one region to another, and from one country to another. Global balancing does not mean that the aggregate result be in equilibrium; but that each country’s economy behaves efficiently, avoiding any loss. As brief examples, expectations can affect consumption and investment patterns and factors such as political motivations and structural constraints can affect taxes and government expenditures. I do agree that the impact is more pronounced in the case of emerging economies, and that makes perfect sense. Because advanced economies have relatively developed many sectors of the economy, a currency fluctuation is not likely to be the main driver of output growth. On the contrary, changes in the other variables are more easily controlled for. In the case of emerging market economies, since most of them rely on exports, one would expect them to be greatly affected by changes in exchange rates. As a parallelism: In finance, one can eliminate systematic risk by diversifying his portfolio. Same goes with economic/trade policies. Keeping this in mind, would emerging economies still want to appreciate their currency?
Although not explicitly relating this topic, this paper (http://www.imf.org/external/pubs/ft/wp/2008/wp08143.pdf, especially in part V.A.) provides an interesting observation: during the period of globalization, there has been evidence of business cycle convergence within each of these groups (industrialized versus emerging market economies) but decoupling between them, showing once again a distinct line between advanced and emerging market economies (The effect on output was different for emerging market economies than for advanced ones).
On a final note, and also intuitive, what if we consider the extreme case where all countries adopt the same strategy of appreciation? Beginning the 1930s, each country tried to escape unemployment by imposing tariffs and depreciating its currency to increase exports. Unfortunately, this strategy did not work out because all countries were equally smart and the output was non-cooperative tariffs and depreciation races that led to inflation – the contrary of what was expected. In the case of appreciation, people would be better off if we assume that the country is still importing from places with relatively cheaper currency. However, since our assumption is that all countries do the same, then this reasoning does not hold. Any kind of policy requires a clear purpose, and currency appreciation does not seem to set a beneficial purpose for countries. If they are growing already, why change policy? And if it is to strengthen/prevent their economies from future shocks, what guarantees that currency appreciation is the way to go?
Posted by: Laya Haddad at April 20, 2011 02:47 PM