July 05, 2011
"Effects of Abandoning Fixed Exchange Rates for Greater Flexibility"
At the recent NBER ISOM conference, Andy Rose presented a paper entitled Flexing Your Muscles: Effects of Abandoning Fixed Exchange Rates for Greater Flexibility, coauthored with Barry Eichengreen, following up on this 2010 paper, evaluating the effects of flexing (VoxEU post here).
For purposes of this short paper we examine a comprehensive data set covering over 200 countries and territories since 1957. ...
...We then narrow our focus to 51 instances where countries abandoned currency pegs for regimes of greater flexibility and allowed their exchange rates to appreciate. This permits us to examine systematically the impact of these events, which we call "flexes," on a range of macroeconomic and financial variables, including GDP growth, export growth, consumption, investment and inflation. We look for and, if necessary, correct for selectivity bias by searching for differences in country circumstances in the period before the decision to flex was taken.
In a subset of cases, however, the decision to flex is followed by a discernible slowdown in the rate of growth of the economy. Slowdowns are most likely, we show, when the investment ratio is high, consumption, investment, exports and imports are growing rapidly, and credit growth is rising. Since we only have 51 observations, we cannot hope to be precise, but our results are robust in the case of high investment rates and rapid import growth in particular; both of these presage a decline in growth following flexing. The implication is that China may have some basis for worrying about the growth effects of appreciating out of its fixed exchange rate regime. In a subset of cases, the decision to flex was also followed by a significant decline in the rate of inflation. Slower inflation is most likely, we show, in countries that are relatively open to trade (where the reduction in the rate of import price inflation presumably has the greatest impact) and with high foreign reserves (which had presumably been sterilizing capital inflows with less than complete success prior to the change in exchange rate regime). These results also have obvious implications for China, which is currently characterized by inflation and the other macroeconomic characteristics in question.
The discussion focused on some of the methodological issues; some of the identified "flexes" were associated with the end of the Bretton Woods system. The question then would be whether the lessons transferred from those episodes to more recent episodes.
In the conclusion, the authors highlight the implications for the debate of more rapid RMB revaluation.
At the same time, it is possible to pinpoint the kind of circumstances where the decision to move to greater flexibility is likely to be followed by a significant economic slowdown. The slowdown‐prone economies are those with exceptionally low consumption rates and high investment rates. They are economies where exports and domestic credit have been growing most rapidly. To put it simply, they are economies with Chinese characteristics.
These findings suggest that China may have had good reason to be cautious about not moving away from its peg to the dollar too abruptly. But they also point to the kind of policy reforms and macroeconomic rebalancing that the country should pursue in order to prepare the way for its eventual adoption of a more flexible exchange rate.
I noted that in fact Chinese policymakers themselves had pointed out the need for slower, but higher quality, growth (see  ). In that sense, the paper's finding could not be taken as an unambiguous finding that revaluation/flexing would be a net negative for China.
Note that this event approach differs that of Kappler, Reisen, Schularik and Turkisch (2011) (discussed here, who included in their sample "step revaluations", i.e, revaluations from one pegged rate to another.
Posted by Menzie Chinn at July 5, 2011 02:01 PMdigg this | reddit
Sadly, they are right. Those waiting for yuan appreciation to occur when China recognizes it is in their own best interests will have awhile to wait. Is there anyone other than Timmy still in that camp?
Posted by: don at July 5, 2011 04:17 PM
Thanks. It puts into words what seems sensible.
Posted by: jonathan at July 5, 2011 04:43 PM
Wouldn't make me rush out to re-value my currency, if I were China.
Posted by: Steven Kopits at July 6, 2011 03:38 AM
The foreign currencies exchange rates conducive of imbalances is a recurrent theme since five years.The anniversary date of peculiar attention being marked by the day "An Equilibrium Model of “Global Imbalances” and Low Interest Rates" had shown its limits.Many countries are structurally unable to gain a comparative advantage from their domestic currencies exchange rates rebalancing,few countries would.It may be worth remembering that the advantage for the USA is still debated. M Chin estimates the long run export elasticity to the exchange rate be on a long run at .75 when " 0.75 long run elasticity is quite a bit higher than the Cheung et al. (2010) estimate of between 0.34 to 0.64, estimated over the 1993-2006 period". Other countries domestic exchange rates realignment, may be heavily penalized through higher international and domestic interest rates.The timing of the exchange rates realignments is therefore crucial .B Eishengreen Rose are prompt to write "Many countries, while not attempting to maintain a peg, manage their rates heavily".The proportion of financial instruments and debts traded on the global exchanges is overwhelming more than 200 Trillions usd and very little is represented by the production.As an example, Europe euro area 15.7 trillion euros debts issues are 9.7 trillion euros are issued by financial institutions or assimilated, where general governments are adding an other 6.187 trillion euros (mainly related to bails out) and the non financial corporations 861.8 billion.
Assuming a more global realignment of the currencies exchange rates must imply de facto, a realignment of the interest rates that are likely to be going upwards.As of today and in absence of a true assessment of the solidity of the banking system, an interest rates wave chock on a part or the whole of 200 trillions usd dollars financial debts is likely to conclude the systemic risk.
(econbrowser The Yuan, the Chinese Trade Balance and the US, Again)
"Consider the first idea, that a strengthened Chinese currency would increase the growth rate of American exports to China. From 2005 to 2008, the renminbi appreciated nearly 20 percent against the dollar. Yet, American exports to China over those three years grew at a slightly slower pace than in the previous three-year period when the renminbi did not appreciate at all (71 percent versus 89 percent)."
At this juncture the overdue realignment of the currencies may for some countries be a Pyrrhic victory, when the readjustment of the current accounts must contribute more substantially to the overdue financial order.The unsustainable current accounts deficits and critical levels of public debts have to be addressed.
The G20 last meeting conclusive statement is to go along theses lines
"The IMF assessment on progress toward external sustainability, as well as the other aspects of our mutual assessment process, we will ascertain for our next meeting the corrective and preventive measures that will form the 2011 action plan to ensure Strong, Sustainable and Balanced Growth, to be discussed by Leaders at the Cannes Summit."
Posted by: ppcm at July 6, 2011 06:04 AM
It is amazing that, while Bretton Woods is mentioned in passing, Nixon taking the US off of the gold standard and blowing up the Bretton Woods system forcing the entire world onto floating currencies is simply not discussed.
Nixon floating the dollar in a world where all currencies were fixed to the dollar essentially created a condition unprecedented in world history with all world currencies with no foundation.
The monetary errors the US made moving into the 1970s are very significant factors. This is especially true considering Mundell-Fleming. The US was exporting inflation to the entire world essentially forcing the world to finance US intransigence and irresponsibility.
The study seems to be seriously lacking.
Posted by: Ricardo at July 6, 2011 07:42 AM
I find the "statistical salad" approach to economics (as embodied by this particular paper) deeply unsatisfying on multiple levels. In the end, the flavor of the salad will be determined by the ingredients added, and by the tastes of those eating it. There are so many missing scenarios, hidden variables, historical accidents and overlooked relationships in this approach that the mind recoils in horror. The real-world consequences of relying on salad-bowl economics are likely to be very distasteful!
In this particular case the Chinese "appreciation" is only against the dollar. But with the dollar sliding against much of the rest of the fiat-currency world, the Yuan was in fact depreciating right along with the U.S. So which way was China actually "flexing"? Meanwhile, the purchasing power of U.S. consumers has been artificially goosed (and then stifled) by the serial dot-com/fraud and credit/fraud bubbles... fueled in part by recycling of trade surpluses in the form of loans. With the U.S. being the larger economy, changes in the U.S. situation dwarf the small change in the "flexing" exchange rate. ... Meanwhile, from the other side, the "flexing" has never before been between the two largest economies (or 2 of the 3...), making all previous comparisons moot simply on the basis of the change in scale...
Posted by: Wisdom Seeker at July 6, 2011 09:37 PM