Currency Wars Global Money in 2010 Jeffrey Frankel

Currency Wars: Global Money in 2010 Jeffrey Frankel Harpel Professor of Capital Formation & Growth, Harvard University Macquarie Securities Boston, December 8, 2010 1

Currency Wars Chronology, Fall 2010 n September 15 Japan buys $20 b, for ¥, • after a 6 -year absence from FX markets; • thereby joining Switzerland, the other floater to have appreciated in 2008 -09 GFC and to have fought it by FX intervention. 2

Currency Wars chronology, continued September 27: warning from Brazil’s Finance Minister Guido Mantega: “We’re in the midst of an international currency war, a general weakening of currency. This threatens us because it takes away our competitiveness. ” n I. e. , countries everywhere are trying to push down the value of their currencies, to gain exports & employment, n • a goal that is not globally consistent. 3

Currency Wars chronology, n continued Renewed flows to emerging markets in 2010 have met with $ purchases in FX intervention • Brazil, Korea, Thailand, India & others must manage inflows: Appreciation n Buying $ to prevent appreciation n Capital controls? n 4

Currency Wars chronology, continued October 15: U. S Treasury postpones semi-annual report to Congress on currency manipulation n • although there has clearly been little appreciation of the RMB since China announces more flexibility in June. • (All a repeat of 2005. ) 5

Currency Wars chronology, n continued November • After inflation rises to 4. 4% in October, China raises i & reserve requirements and adopts new price controls. • US core inflation falls to 0. 6% for year, the lowest since 1957. • => fears of deflation trap. 6

Currency Wars chronology, continued • Nov. 17 As European sovereign debt crisis resurfaces in Ireland, € hits 7 -week low (1. 3 $/€). • Nov. 20 -21 Fed announces QE 2 (signaled since August): will purchase $600 b. n Short-term market reaction: $ depreciates n Immediate attacks on Fed action -n • Palin & conservatives: “debauching the currency” • German & China: $ depreciation is a deliberate salvo in currency wars 7 7

The reactions of most emerging markets show they learned two lessons from the 1990 s currency crises: n Advantages of holding forex reserves: • Lower frequency & severity of crises. n Advantages of floating: • • • Speculators don’t have a target to shoot at; Accommodate shocks; Discourage unhedged $ liabilities. n n Such currency mismatch leads to bad balance sheet effects when devaluation comes. How did these lessons fare in the global crisis of 2008 -09? 8

Reserves n n Even though many developing & emerging market countries described themselves as floating, most took advantage of the boom of 2003 -2008 to build up reserves to unheard of heights, • in the aftermath of the crises of 1994 -2001. n in contrast to past capital booms (1975 -81, 1990 -97). 9

n When the 2008 -09 global financial crisis hit, • those countries that had taken advantage of the 2003 -08 boom to build up reserves did better. n n Frankel & Saravelos (2010). Aizenman (2009) and Obstfeld, Shambaugh & Taylor (2009) Vs. Blanchard (2009) and Rose & Spiegel (2009) This had also been the most common finding in the many studies of Early Warning Indicators in past emerging market crises. 10

EWIs: The variables that show up as the strongest predictors of country crises in 83 studies are: (i) reserves and (ii) currency overvaluation Source: Frankel & Saravelos (2010) 11

Best and Worst Performing Countries -- F&S (2010), Appendix 4 12

F & Saravelos (2010): Bivariate 13

F & Saravelos (2010): Multivariate 14

Floating n Most medium-income Emerging Market countries reacted to the currency crises of the 1990 s by increasing exchange rate flexibility • with the major exception of Eastern Europe. n The flexibility has helped. 15

Poland, the only continental EU member with a floating exchange rate, was also the only one to escape negative growth in the global recession of 2009 % change in GDP (de facto) Source: Cezary Wójcik, 2010 16

The Polish exchange rate increased by 35%. Depreciation boosted net exports; contribution to GDP growth > 100% Source: Cezary Wójcik zlotys / $ Contribution of Net X to GDP: 2009: 2, 5 3, 4 GDP growth rate: 3, 2 3, 4 1, 7 Estonia lats / $ kroon / $ Latvia 17

Capital flows to emerging markets, especially Asia, recovered quickly from the 2009 recession. These countries again show big balance of payments surpluses Goldman Sachs 18

Although China continues the most salient case, Korea, Singapore & Taiwan are also adding heavily to reserves. GS Global ECS Research 19

Others, such as India & Malaysia, are currently taking the inflows in the form of currency appreciation, more than reserve accumulation. more-managed floating less-managed floating (“more appreciation-friendly”) GS Global ECS Research 20

In Latin America as well, inflows have returned, reflected mostly as reserve accumulation in Peru, but as appreciation in Chile & Colombia. more-managed floating less-managed floating (“more appreciation-friendly”) 21 GS Global ECS Research

Is the currency war metaphor appropriate? n Fear of non-cooperative “competitive devaluation” is an argument for fixed exchange rates • rooted in the 1930 s. • That is why the architects of the post-war monetary order chose fixed exchange rates at Bretton Woods, NH, in 1944. n But it is now used to argue that China should move from fixing to floating. • US Congressmen don’t care about regimes; • they just want a stronger RMB vs. $. 22

Is the currency war metaphor applicable? n n n continued Economic historians have decided competitive devaluation under 1930 s conditions was not a problem after all. True, countries couldn’t all devalue against each other, But they could and did all devalue against gold • which worked to ease global monetary policy, n just what was needed. 23

Is the currency war metaphor applicable? n continued The same is true today: • The Fed’s QE 2 won’t just raise the money supply in the US; • it will also loosen globally, n to the extent that foreign central banks react by buying $ • to prevent their own currencies from appreciating. • which is what much of the world needs. n n For those who don’t need it, because they are already in danger of overheating, they can allow appreciation, and so calibrate however much expansion they want. Multilateral cooperation is not necessary for this. 24

Indeed, the currency war critics seem to have forgotten the point of a global floating system: n In some places (US), unemployment is high & inflation low, • calling for easy monetary policy; n In other places (China, Brazil, India…), economies are overheating, • calling for tight monetary policy. n n The point of a floating system is to accommodate such inevitable macro divergences smoothly. No international cooperation is needed. 25

Would this put unfair pressure on China to choose between inflation, if it continues to keep the RMB down, No. n Perhaps China can continue to sterilize inflows awhile longer, • • n n and appreciation? e. g. , raising bank reserve requirements. True, eventually it will have to give that up. But there is nothing unfair about making China choose between inflation and appreciation. Monetary expansion by the US is perfectly legitimate • especially at a time of deflation danger. • If it puts pressure on China, that is far more clearly within the “rules of the game” than threatening tariffs. 26

Is the currency war metaphor applicable? continued n Other kinds of international cooperation are needed; • the 1930 s currency war metaphors are not totally misplaced: n Currency war could turn into trade war • if Congress follows through on legislation to impose (WTO-illegal) tariffs on China as punishment for non-appreciation. • Until now, the US & G 20 have held the line on protectionism n n compared to the milder recessions of 1991 & 2001, let alone the Smoot Hawley tariff of 1930. 27

Ideally the US & China would reach agreement on how to address current account imbalances: n China would take some responsibility • to reallocate its economy away from exclusive reliance on exports & manufacturing n toward domestic consumption & services, • health, education, housing, environment, insurance & other services. • How? By allowing the RMB to appreciate, • but also by increasing domestic demand. n Meanwhile, the US would ideally also take responsibility. • Even while prolonging expansionary policy this year, n including fiscal expansion designed with high bang-for-the-buck, • the US should take steps today to lock in a future return to fiscal responsibility, n e. g. , by putting Social Security on a firm footing. 28

Will Unsustainable Current Account Deficits Lead to the End of Dollar Hegemony? n Some argue the US current account deficit is sustainable indefinitely. • They believe that the US will continue to enjoy its unique “exorbitant privilege, ” able to borrow unlimited amounts in its own currency n because it is the dominant international reserve asset. n 29

“Bretton Woods II” n Dooley, Folkerts-Landau, & Garber (2003) : • today’s system is a new Bretton Woods, n with Asia playing the role that Europe played in the 1960 s—buying up $ to prevent their own currencies from appreciating. • More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given China’s need to import workable systems of finance & corporate governance. 30

My own view on Bretton Woods II: • • The 1960 s analogy is indeed apt, but we are closer to 1971 than to 1944 or 1958. • Why did the BW system collapse in 1971? n n The Triffin dilemma could have taken decades to work itself out. But the Johnson & Nixon administrations accelerated the process by fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). n These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods. 31

There is no reason to expect better today: 1) 2) Capital mobility is much higher now than in the 1960 s. The US can no longer rely on support of foreign central banks: n neither on economic grounds (they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), n nor on political grounds (these creditors are not the staunch allies the US had in the 1960 s). 32

The financial crisis caused a flight to quality which evidently still means a flight to US $. n n US Treasury bills in 2008 -09 were more in demand than ever, as reflected in very low interest rates. The $ appreciated, rather than depreciating as the “hard landing” scenario had predicted. n => The day of reckoning had not yet arrived. n Chinese warnings (2009) may be turning point: • Premier Wen worried US T bills will lose value. • PBo. C Gov. Zhou proposed replacing $ as international currency. 33

Multiple International Reserve System n The € now exists as a rival to the $. n The ¥ & SF are also safe havens. n n The SDR came back from the dead in 2009. Gold made a comeback as an international reserve too. n Someday the RMB will join the roster. n = a multiple international reserve currency system. 34

The euro project is looking far less successful than just a few years ago n Many predictions of euro skeptics have come true: • Periphery countries and core countries have had trouble reconciling asymmetric monetary needs. • Euro members have not had enough labor mobility or flexibility to make up for it. • Efforts to prevent excessive debt & bailouts have failed: The Stability & Growth Pact failed with members big & small. n The “No bailout clause” has failed with Greece. n 35

Frankfurt & Brussels made 3 mistakes regarding Greece n n n 2002 -09: Did not allow spreads to open up between sovereign debt of Greece & Germany. Winter 2010: Did not tell Greece to go to the IMF. Preferred instead to “handle it internally. ” Still today: No “Plan B” to restructure Greek debt (and save the bailout fund for more deserving banks & PIIGs). 36

Judging from spreads, 2001 -07, investors put zero odds on a default by Greece or other Mediterranean countries Council on Foreign Relations 37

n n Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. Even when the Greek crisis erupted, leaders in Brussels & Frankfurt seemed to view it as a black swan, • instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, n and many others in history, • including among European countries. 38

Sovereign spreads for 5 euro countries shot up in the 1 st half of 2010 Creditworthiness: Some advanced economics have fallen, as emerging markets have risen. 39

Sovereign debt worries. . . • As predicted, the sovereign debt crisis in Europe is not going away. • The big emerging market countries are in much better shape, • in an amazing & historic role reversal. 40

A remarkable role-reversal: • Debt/GDP of the top 20 rich countries (≈ 80%) is already twice that of the top 20 emerging markets; • and rising rapidly. • By 2014 (at ≈ 120%), it could be triple. 41

Ratings for “Advanced Economies” Ratings for “Emerging Economies” 42

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Appendix: Will the $ lose hegemony? When does the “privilege” become “exorbitant? ” n n n if it accrues solely because of size and history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies. It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege ! 44

Some argue that the privilege to incur $ liabilities has been earned in a different way: n n Global savings glut (Bernanke) The US appropriately exploits comparative advantage in supplying high-quality assets to the rest of the world. • “Intermediation rents…pay for the trade deficits. ” -- Caballero, Farhi & Gourinchas (2008) • In one version, the US has been operating as the World’s Venture Capitalist, accepting short-term liquid deposits and making long-term or risky investments -- Gourinchas & Rey (2008). • US supplies high-quality assets: Cooper (2005); Forbes (2008); Ju & Wei (2008); Hausmann & Sturzenegger (2006 a, b); Mendoza, Quadrini & Rios-Rull (2007 a, b)… 45

n n The argument that the US offers assets of superior quality, and so has earned the right to finance its deficits, was undermined by the dysfunctionality revealed in the financial crisis of 2007 -08. American financial institutions suffered a severe loss of credibility (corporate governance, accounting standards, rating agencies, derivatives, etc. ), n How could sub-prime mortgages be the superior type of assets that uniquely merit the respect of the world’s investors? 46

But the events of 2008 -09 also undermined the opposing interpretation, the unsustainability position: n n Why no hard landing for the $, as long feared? The $ appreciated after Lehman Brothers’ bankruptcy, & US T bill interest rates fell. n Clearly in 2008 the world still viewed n • the US Treasury market as a safe haven and • the US $ as the premier international currency. 47

Though arguments about the unique high quality of US private assets have been tarnished, the idea of America as World Banker is still alive: the $ is the world’s reserve currency, by virtue of US size & history. n n Is the $’s unique role an eternal god-given constant? Or will a sufficiently long record of deficits & depreciation induce investors to turn elsewhere? 48

Historical precedent: £ ’s loss of premier international currency status in 20 th century n By 1919, US had passed UK in 1. output (1872) 2. trade (1914) 3. net international creditor position (1914 -19) n Subsequently, $ passed £ as #1 reserve currency (1940 -45). 49

From the literature on reserve currencies Determinant: Proxy: 1. Size GDP 2. Depth of Fin. mkt. FX turnover 3. Rate of return inflation, LR depreciation, Exch. rate variance 50

From the literature, continued Network externalities => Tipping 1) 2) captured by: Inertia lags Nonlinearity in determinants logistic functional form or dummy for leader GDP 51

Projection of $ vs € as shares of central banks’ foreign exchange reserves: a function of country size, financial market depth, & rate of return, with parameters estimated on 1973 -98 data. Simulation assumes $ depreciation continues at 2001 -04 rate. Chinn & Frankel (2005) birth of € This scenario showed € overtaking $ as top international reserve currency in 2022. 52

International Currency Roles 53

n n A multiple reserve currency system is inefficient, in the same sense that barter is inefficient: money was invented in the first place to cut down on the transactions costs of exchange. Nevertheless, if sound macro policies in the leader country cannot be presumed, the existence of competitor currencies gives the rest of the world protection against the leader exploiting its position by running up too much debt and then inflating/depreciating it away. 54

Gold n Gold was seen as an anachronism just a few years ago: • the world’s central banks were selling off their stocks. n Gold re-joined the world monetary system in 2009: • The PBo. C, RBI, & other Asian central banks bought gold, to diversify their reserves. • Even in advanced countries, central banks appear to have stopped selling. 55

Special Drawing Rights n n n The SDR has made a surprising comeback as a potential international money, from near-oblivion. The G 20 in 2009 decided to create new SDRs ($250 b). Shortly later, PBo. C Gov. Zhou proposed replacing the $ as lead international currency with the SDR. The IMF is now borrowing in SDRs. The proposal has been revived for an international substitution account at the IMF, to extinguish an unwanted $ overhang in exchange for SDRs. The SDR has little chance of standing up as a competitor to the € or ¥, let alone to the $. Still, it is back in the world monetary system. 56 n

http: //ksghome. harvard. edu/~jfrankel/index. htm 57