Exchange Rates in Small
Open Economies
PFTAC/CCBS Course
August, 2010
Matt Davies
IMF/PFTAC Coordinator
1
Outline
Exchange rate choices in small open
economies.
– Theory
– Evidence (Pacific and elsewhere)
Macro effects of exchange rate choices in the
Pacific
Assessments of exchange rate level.
– Theory
– Application to the Pacific
Moving towards flexibility.
2
Fixed exchange rates make sense for
small open economies.
Reduces transaction costs and exchange rate risks
in substantial proportion of economy.
Stabilises domestic prices—which react rapidly to
nominal exchange rate changes.
Transparent nominal anchor.
Reduces need for establishing complex institutions
in situations of scarce resources (financial and
human).
Relatively small probability of speculative attacks.
– But policy inconsistency can still be damaging.
3
Floating is difficult in small
economies
Institutional infrastructure
Complex monetary policy environment
– ‘capital’ movements and supply shocks
– exchange rate changes rapidly affect inflation
– Interest rate pass through weak
Foreign exchange markets are illiquid
“Fear of floating”
4
Types of Fix
Dollarization – Tuvalu, North Pacific, Cook Islands
– Political / historic drivers (and admin simplicity)
– Imports credibility and eases transaction costs
– Difficult to reverse
Currency Board
– Domestic currency fully backed by foreign reserves.
– Robust statement of credibility
– Less frequently used these days (remain in the
Carribbean?
5
Types of Fix(cont)
Pegged exchange rate
– To single currency or to a basket
– Fluctuation within a narrow trading band
– Occasional re/de valuations.
More modern phenomenon (since 1970s)
Typically in larger small-states
More flexibility than other regimes.
6
Choosing between pegs
Credibility
Seignorage
Policy discretion
Institutional costs
Lender of last resort
7
Reality follows theory
Table A2.1. Small Economies (1) :
Distribution of Exchange Rate Arrangements and Selected Indicators
(1998 unl es s otherwi s e i ndi ca ted)
Exchange
Rate
Arrangement
Number
of
Countries
Average
Size of
Economy
Average
Trade
Share (2)
Average Share
Average Share of
of Largest
Tourism Receipts
Export Partners (3) in % of Exports (4)
Fraction of Countries
With Controls on
Current Account (4)
Pegged
Peg to single currency
U.S. dollar
French Franc
Other
Peg to basket of other
45
37
16
13
8
8
1.58
1.56
1.20
2.03
1.52
1.68
51.8
51.4
61.1
34.4
63.4
53.4
33.6
33.4
29.5
36.9
37.2
34.1
18.9
16.1
37.2
7.6
8.3
28.9
0.78
0.81
0.69
1.00
0.75
0.63
Flexible
Managed float
Independent float
28
11
17
2.15
2.00
2.25
51.3
69.7
38.7
34.3
27.7
38.9
9.2
7.2
10.5
0.57
0.64
0.53
Memorandum item
Small economies
73
1.80
51.6
33.9
11.5
0.70
Imam (2009) looked specifically at “microstates”
–
–
–
Only 4 (Mauritius, Iceland, Sao Tome, Seychelles) did not fix.
Smaller ones dollarized
Larger pegged.
8
The Pacific largely follows suit.
All currencies have been pegged and most still are.
– Systems evolved over time—policy trade-offs.
– occasional revaluations and one float.
– Now mostly to a trade-weighted currency basket
Backed up with capital controls.
And some limited current account restrictions.
9
Small open economy issues relevant
to the Pacific
Remittances (Tonga, Samoa, Fiji)
– mixed effects,
– depends on usage
– and economic development,
– but tends towards real appreciation.
Commodities (PNG, Solomons)
– Real appreciation tendencies
– Dutch disease
10
Some small open economy issues
Tourism – IMF paper on ECCU
– Also tends to reinforce real appreciation
ToT effect, like commodity prices
Increase wages in other sectors (Balassa
Samuelson)
– Some countervailing pressures, openess to
markets and competition makes prices less
sticky and mitigates shocks
– ECCU not fond to be overvalued despite hard
peg and tourism
11
What has happened in the Pacific?
Exchange rates
– Nominal
– Real
Balance of payments
– Current account
– Reserves
12
60
Solomons
50
40
Jan-10
Fiji
Jan-09
70
Jan-08
PNG
Jan-07
80
Jan-06
90
Jan-05
100
Jan-04
120
Jan-03
110
Jan-02
130
Jan-01
120
Jan-00
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Recent Nominal Effective Rates
110
100
90
80
Vanuatu
70
Tonga
60
Samoa
50
40
13
70
60
Fiji
100
Solomons
Jan-10
80
110
Jan-09
90
PNG
Jan-08
100
Jan-07
110
Jan-06
130
Jan-05
120
Jan-04
140
Jan-03
130
Jan-02
150
Jan-01
140
Jan-00
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Real Effective Exchange Rates
120
Vanuatu
Tonga
90
Samoa
80
70
60
14
Current Account Balances
Solomon Islands
Fiji
Vanuatu
Samoa
Papua New Guinea
Tonga
20
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
-10
-20
-30
-40
15
Reserves
Reserves Coverage (months of goods and services imports)
7
6
Vanuatu
5
PNG
4
Samoa
3
Tonga
Solomons
Fiji
2
1
0
2005
2006
2007
2008
16
Some tentative evidence of
overvaluation..
Real effective appreciation in a number of
countries
High and increasing current account
deficits
Weak export sectors
But there are explanatory factors.
– Can we be more scientific?
17
Exchange rate assessments
IMF Surveillance has moved towards more
explicit assessment of exchange rate
levels.
2007 Surveillance Decision.
– Is the real exchange rate in line with mediumterm external stability?
– Exclude temporary factors
– Acknowledge impact of domestic
policies/stability
18
Assessing the Equilibrium Exchange
Rate
IMF analysis based around Consultative
Group on Exchange Rates (CGER)
Conceptually difficult even for large
economies.
– No clear superior methodology
– Can get divergent results from different
methods
– Data restrictions.
4 main methodologies, generally used as
a suite….
19
Comparisons with historical trend
and competitors (PPP)
130
130
REER
(January 2000=100)
120
110
120
Samoa
Vanuatu
Tonga
Fiji
110
100
100
90
90
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Source: IMF, Information Notice System.
20
Macro Balance Approach
Calculates the difference between an estimated
equilibrium current account and projected balance at
prevailing exchange rates
Required exchange rate adjustment calculated from
calculated elasticities
Typical variables:
–
–
–
–
–
–
Fiscal balance;
growth;
NFA
demographics;
Oil balance
Remittances/grants/FDI
Quantified in relation to trading partners
21
Equilibrium Real Exchange Rate
Approach
130
350
Equilibrium Real Effective Exchange Rate
Directly estimates a
ERER from
fundamentals
Typical variables:
– NFA; productivity
differentials; Terms
of Trade;
Government
consumption
(2000 = 100)
120
300
110
250
100
200
90
150
80
Actual
Equilibrium
Terms of Trade (RHS)
70
60
1990/91
1994/95
100
1998/99
2002/03
50
2006/07
Application to Tonga (2008,above)
and Vanuatu (2009, below)
Real Effective Exchange Rate and Equilibrium Rate
125
125
(1990=100)
120
120
115
End-2008 level
Actual REER 1/
115
110
110
Equilibrium
Rate
105
105
100
100
95
95
90
90
1980
1984
1988
1992
1996
Sources: IFS, INS, BIS, and IMF staff calculation.
1/ Trade weight is based on data (2005–07) from the authorities.
2000
2004
2008
22
External Sustainability
Calculates difference between projected current
account balance and the balance that would
stabilize the NFA position of the country.
Uses same elasticities as MB approach to
calculate required exchange rate adjustments.
Not data hungry
But assumes current position is appropriate
benchmark
23
Application to the Pacific
Combination of approaches taken.
All face data problems.
Given this, many assessments are based
on judgements on a wide range of
variables.
24
Samoa (2010) – in line with
fundamentals
Compares Current
Account Balance with
estimated norm from 55
low-income countries.
Also looks at other
indicators:
Reserve movements,
export receipts,
remittances
25
Tonga (2010) – moderately
overvalued
Macrobalance and PPP
approaches
– Sample of 140 economies
– 10-15% overvaluation
– Considerable uncertainty
– Data problems (NFA)
Other indicators don’t suggest
overvaluation
– CA deficit and reserves stable
– inflation easing,
– exports growing
26
Fiji (2009) – moderately overvalued
Macrobalance and
external sustainability
approach – imply
overvaluation
ERER approach – in
line with fundamentals
Supported by other
indicators
– Tourism and reserves
27
Vanuatu (2009) – in line with
fundamentals
ERER – using fiscal
position and ToT
Data constraints
precluded using MB
and ES approaches
Export growth reflects
structural rather than
XR factors
28
Solomon Islands – substantial
overvaluation
Solomon Islands: Decomposition of the Real Effective Exchange Rate Movements
(April 2008–May 2009) 1/
5
5
Real appreciation (+) against USD
4
USD appreciation (+)
SBD REER appreciation (+)
4
-3
May-09
-3
Apr-09
-2
Mar-09
-2
Feb-09
-1
Jan-09
-1
Dec-08
0
Nov-08
0
Oct-08
1
Sep-08
1
Aug-08
2
Jul-08
2
Jun-08
3
May-08
3
Apr-08
Monthly percentage change
Real appreciation driven by
inflation and US dollar
movements.
ERER estimation suggests
26 percent overvaluation
Modified MB approach
(impact of REER changes
on reserves) suggests a
20% overvaluation.
Source: IMF staff estimates.
1/ Real appreciation of the Solomon Islands dollar against the U.S. dollar, and real appreciation of the U.S. dollar
against other currencies in the basket.
29
PNG – in line with fundamentals
260
Exchange Rate Assessment: Baseline Results 1/
240
260
Papua New Guinea: ERER Approach
240
220
CA/GDP
Norm
Proj. 2/
REER
Overvaluation
220
Actual
200
MB approach 3/
3.0
3.4
ERER approach 4/
…
…
160
160
3.4
140
140
120
120
100
100
80
80
Papua New Guinea: MB Approach
Fiscal balance
Income growth
Old age dependency
Fixed effect
Norm current account
2006
2007
2008
2009
Oil trade balance
Population growth
Income
Actual current account
2010
2011
2012
2013
180
Terms of trade
-0.9
1/ All results are expressed in percent.
2/ Staff projection of the underlying CA/GDP in 2014.
3/ Based on a semi-elasticity of the CA/GDP with respect to
the REER of -0.42.
4/ Overvaluation is assessed relative to January 2010.
80%
70%
60%
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
-80%
200
Equilibrium
180
2014
80%
70%
60%
50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
-40%
-50%
-60%
-70%
-80%
60
60
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
0.5
0.5
ERER Approach: Contributions to Equilibrium REER
0.4
0.4
(Log scale)
0.3
0.3
0.2
0.2
0.1
0.1
0.0
0.0
-0.1
-0.1
-0.2
Terms of trade
Fixed effect
Upper quantile
Lower quantile
-0.3
-0.4
Government consumption
-0.2
-0.3
Equilibrium REER
Actual REER
-0.4
-0.5
-0.5
1994
1998
2002
2006
2010
2014
Sources: Bank of Papua New Guinea; Bloomberg; World Economic Outlook; and IMF staff calculations.
30
Summary: an imprecise science
Estimation suggests that exchange rates in the
Pacific tend to be moderately overvalued.
– Implies lower imported inflation and lack of export
competitiveness.
– And requires supporting macro policies to sustain peg
But large degrees of error and data deficiencies
– Some intuitive indicators work in opposite direction
Abrupt movements in international rates
complicate the analysis.
31
Exchange rates have been used to
respond to past crises.
Mostly through occasional devaluations of pegs.
Fiscal indiscipline has put pressure on pegs—
contributed to float in PNG.
Depreciations occurred around Asian crisis and
recently in Fiji—coincident with domestic
instability.
– Have proved successful
Some greater flexibility adopted more
gradually—adjustment bands.
32
Can more flexibility help in the
future?
Can improve external position
– Assuming structural impediments can be overcome
Frees monetary policy to respond to external shocks
Reduces FX related risks (one way bets, implicit guarantees)
Stimulates financial market development.
Benefits generally greater in countries that are more
developed and integrated with international financial markets
Perceived costs:
– Losing policy credibility;
– Competitiveness/inflationary effects;
– Lack of institutional capacity and market depth to implement alternative
monetary policy responses
33
International experience with
transition
Majority of transitions from fixed regimes
to floats have been disorderly.
Orderly exits generally involved
intermediate steps.
– Pegs
– Crawling pegs
– Crawling Bands
Four ingredients for a successful
transition…
34
A deep and liquid foreign exchange
market
Key ingredient: emergence of two way risk
in FX market.
– Reduce central bank’s market making role
– Increase information flows
– Phasing out regulations that stifle market
activity
– Improving market microstructure
35
A coherent intervention policy
Several legitimate reasons for intervention under a
float
– Correct short-term misalignments
– Calm disorderly markets
– Accumulate FX reserves / supply market with FX
But, misalignment is hard to identify and intervention
has high information content to the market.
And the effectiveness of intervention is open to
question.
36
An appropriate alternative nominal anchor
Monetary control particularly important following
exits from pegs—destabilized expectations.
Recommended anchor is inflation targeting
But requires substantial institutional capacity.
–
–
–
–
Clear priority to price stability
Operational independence for central bank
Transparency/accountability in monetary policy operations
Capacity to forecast inflation
Many countries have used intermediate monetary
targeting until these conditions are fulfilled.
– With limited flexibility in transition fiscal policy is important
in reinforcing credibility.
37
Managing and supervising exchange
rate risks.
A floating rate transfers FX risk from public
to private sector
And exposes previously protected public
sector bodies.
Needs improved risk management in
public and private sectors.
Need to focus on currency and liquidity
mismatches.
38
Pace of exit
Periods of tranquility are the ideal time for
an exit from a fixed regime
– But more often than not changes are
enforced.
A gradual build up of institutions to support
exchange rate flexibility is desirable—even
if an exit is not currently foreseen.
Risks involved in liberalizing capital
accounts before floating exchange rates.
39
Some references
Exchange rate regimes in an increasingly
integrated world economy. IMF Occasional
Paper 193
Moving to Greater Exchange Rate
Flexibility. IMF Occasional Paper 256
Grants, Remittances and the Equilibrium
Real Exchange Rate in Sub-Saharan
African Countries. IMF Working Paper
09/75
40
Some references
Exchange rate Choices of Microstates.
IMF Working Paper 10/12
Pacific Island Countries: Possible
Common Currency Arrangement IMF
Working Paper 06/234
Assessing Exchange Rate
Competitiveness in the Eastern Caribbean
Currency Union. IMF Working Paper 09/78
41
Discussion
Is increasing exchange rate flexibility
appropriate in the Pacific?
What are the key institutional capacity
issues that need to be addressed in the
near and medium-term?
What is required of other macro policies?
42