Exchange Rate Crisis - Essay Example

Running head: International Business International Business [The of the appears here] [The of appears here] Exchange Rate Crises Exchange rate adjustments often result from crises. The monetary agency's powers and scope are important determinates of the currency board's ability to weather crises. Consider five types of crises and how a currency board system handles them. First, a government's policies can create an economic crisis, particularly if it is running excessively expansionary policies that generate inflationary pressures in excess of those in the reserve currency country. The principle argument in favor of a currency board--discipline--is precisely that a currency board helps prevent this situation from arising. A powerful, active monetary agency can, however, undercut the board's discipline; to prevent self-inflicted inflationary crises, a nonexistent or weak monetary agency (one limited to, say, prudential regulation) is desirable. Even if there is no monetary agency, a government can create an inflation/debt crisis by excessive spending financed by domestic and international borrowing. Mutatis mutandis, the same considerations apply to a central bank that has the same degree of strictness as the currency board. (Betts, C. and Devereux, M, 2000) Second, world securities markets might crash as, for example, in October 1987 or in the October 1989 mini-crash. Many countries' central banks expanded their stocks of high-powered money to provide liquidity to markets as investors fled from equities and corporate bonds and to high-quality assets such as U.S. T-bills and T-bonds. A currency board is ill-equipped to handle this type of crisis. At a time when it need to increase liquidity by expanding the domestic supply of money, a currency board is likely to have domestic currency presented for conversion to the reserve currency, as international investors who fled to U.S. government securities did in the 1987 and 1989 crises. This flight reduces the stock of domestic currency as well as that part of the country's international reserves that the currency board holds. In turn, domestic banks are less willing to provide liquid assets, and depositors are more interested in holding the reserve currency directly (or liabilities of the reserve-currency country). (Jan Winiecki, 2002). A domestic monetary agency parallel to the currency board might expand liquidity, as measured by the domestic money stock, through open market operations. There may well be a flight from domestic assets to reserve currency assets. The monetary agency can preserve the exchange rate by selling reserve currency obtained from selling its own liquid holdings denominated in the reserve currency or by borrowing reserve-currency assets, either commercially from foreign banks or from the reserve-currency central bank. A small country with only a brief track record and low international holdings will likely find it difficult to preserve the exchange rate parity; a monetary agency that has the holdings and power to preserve the parity is likely also to have the power to undercut currency board discipline over monetary and fiscal policy. Disturbances to Equilibrium Real Exchange Rates Third, the currency to which the board pegs may come under pressure from output market disturbances in the reserve-currency country. An example is the pressure on the European Exchange Rate Mechanism (ERM) after German reunification to either revalue the German mark or devalue the other ERM currencies relative to the German mark. The interpretation of the September 1992 and July-August 1993 crises in the European Monetary System is that they arose in substantial part from the reunification of Germany. German aggregate demand rose substantially more than German aggregate supply. This increase caused upward pressure on German interest rates (with some observers arguing that the increase in interest rates was exacerbated by German reluctance to use taxes rather than bond issuance to finance the increased spending); in addition, the Bundesbank put upward pressure on interest rates to combat the increased inflation arising from reunification. With narrow exchange rate bands, interest rates in ERM countries had to rise along with German rates. This rise in interest rates led, ceteris paribus, to a fall in aggregate demand in these countries. In one line of analysis, the rise in interest rates reduced the market value of assets in place relative to their replacement costs and so, ceteris paribus, reduced expenditures on new plant and equipment. In net present value terms, the rise in interest rates increased the discount rate and reduced projects' net present value. These countries' prices had to fall to raise aggregate demand to its previous level; in net present value terms, the cost of the investment had to fall to make net present value positive. One way to accomplish this price-cost change was revaluation of the German mark or devaluations of the other ERM currencies. Many of these countries, particularly France, opposed any parity changes. The only remaining route for changing real exchange rates within ERM was for the group's non-German members to run inflation rates lower than Germany's for however long it took to reduce the real exchange rate to a new equilibrium level. Before the July 1993 crisis, commentators pointed out that France's inflation was lower than Germany's and sometimes argued that pressure on the franc was thus misguided. These views missed the point: there would be pressure on the franc until France had inflation rates lower than Germany's for a sufficient period to reduce the French real exchange rate to the appropriate new equilibrium level. (Dedola, L. and Leduc, S, 2001) A country pegged to the German mark through a currency board would face the same kind of deflationary/recessionary pressure that the U.K. faced before it allowed the pound to depreciate in September 1992, or France faced before the ERM abandoned its narrow bands in August 1993. France was able to hold out against realignment in part because its central bank was free to do many things closed to an orthodox currency board. For example, the Banque de France borrowed German marks that it then used to intervene to keep the franc within its narrow parity band. Recent evidence supports the view that sterilized intervention affects nominal exchange rates; thus, the Banque de France's strategy can be interpreted as at least partially sterilized intervention that kept the French money stock from falling as it would have under unsterilized intervention. The result of this strategy was a smaller fall in aggregate demand for French output, less unemployment, and more gradual adjustment. A currency board would be unable to sterilize the effect of capital outflows on the domestic money stock. Rather it would have to rely on monetary contraction and hence recessionary pressure on output to reduce domestic prices and wages to accomplish a change in the real exchange rate. A currency board that successfully maintained its peg would thus lead to a quicker adjustment of prices than a central bank that pursued the more gradualist policies used by the Banque de France; a currency board unsuccessful in maintaining its peg would have to adjust the peg sooner than the Banque de France did. My view is that France was misguided to stick to its parity. Someone thinking France was correct is, at least marginally, nudged to favor a monetary agency with substantial powers. Fourth, a large real shock to the currency-board country can destroy the parity. As an example, consider Estonia and suppose that Russia makes threats, moves forces to the border, and perhaps occupies several border posts (the example could be in terms of Lithuania and its currency board). Estonia's German mark peg likely could not survive in free markets. Many crises last a few days and are then resolved one way or another: in this example, Russia might occupy Estonia; Estonia might defuse the crisis with political concessions, for example, regarding rights of ethnic Russians in Estonia; U.N. Security Council actions might cause Russia to back down; Russia might declare that the whole situation was a misunderstanding and withdraw. A quick resolution that leaves Estonia free and its economy unhampered might allow a quick return to the previous level of the peg. A prolonged though low-level crisis would require a depreciation of Estonia's real exchange rate with Germany. If the pegged rate were maintained, real exchange rate depreciation would require price and wage cuts in Estonia that might be achieved only over a substantial, painful period. A rich and insulated enough monetary agency might be able to maintain the peg through a protracted deflation. But one must ask, why would this be good for the country (Kyung Tae Lee, 2002). Under the current regime of managed floating, real exchange rates have shown substantial variability. An index of the U.S./German real exchange rate, normalized to average 100, varied from a low of 60 to a high of over 130 during the 1980s. As is well known, much of the change in the real exchange rate can be attributed, in at least in an accounting sense, to variations in the nominal exchange rate. It is not, of course, clear how much of this real exchange rate variability was excessive relative to equilibrium real rates (perhaps arising from excessive nominal exchange rate variability) and how much arose from shifts in equilibrium real rates. But suppose that as much as half of variations arose from equilibrating changes in real rates. Then the equilibrium U.S./German real exchange rate fluctuated by perhaps 40 percent (from say 80 to 115). In the absence of nominal exchange rate changes, the absolute value of the sum of the percentage changes in U.S. and German prices would have to be approximately 40 percent, a huge change. Germany's prices and wages appear to be substantially less flexible than the U.S.'s, and the U.S.'s appear to be less flexible now than before the First World War and in the interwar period. It is useful to recall that even during the Great Depression, it took about three years-- from the Depression's start in late 1929 to its nadir in early 1933--for U.S. prices and wages to fall by approximately one-third. (Devereux, M. and Engel, C, 1999) Establishing a rigorous currency board that pegs to the German mark then makes most sense if (1) most of the variations in the U.S./German real exchange rate in the 1980s were due to excessive nominal exchange rate volatility (that could be cured by pegging the rate); (2) the pegging country has substantially less variability of its equilibrium real exchange rate relative to Germany than does the U.S.; and (3) the pegging country has substantial price and wage flexibility. Judging real exchange rate volatility by looking at cases with the U.S. as the base country can easily overstate the problems faced by an emerging market economy considering a currency board that pegs to the German mark. It is conventional to view the United States and the European Union as competing blocks with large changes in the equilibrium real exchange rate between the blocks as compared to changes in equilibrium real rates within Europe. There is much to this view. For example, compare the percentage changes in Belgium's real exchange rate relative to the U.S. dollar and its real rate relative to the German mark. Over the two decades 1973 through 1993, the standard deviation relative to the U.S. dollar is 3.53 percent per month, relative to the German mark 0.87 percent per month (Jorion and Sweeney 1996). The disequilibrium in real exchange rates may still be large even among the European Union's members. As one indication, the day the U.K. left the ERM in September 1992, the pound fell approximately 10 percent relative to the German mark and the other ERM currencies that remained (in effect) pegged to German mark--a 10 percent real depreciation of the pound. Over the next several months, France complained that this gave the U.K. an unfair competitive trade advantage. Bubbles and Fads Fifth, speculative bubbles or fads might put pressure on the exchange rate. As opposed to managed floating, pegged rate systems may have an advantage in fighting exchange rate bubbles and fads by not letting them get started--it may be that speculators have to see the bubble/fad in action for the bubble to become self-feeding. (Jean-Olivier Hairault, Thepthida Sopraseuth, 2003). A currency board fights fads and bubbles in exchange rates by not letting its exchange rate change as speculation drains domestic currency from system--this is unsterilized intervention. A central bank pegged-rate system can use owned or borrowed reserves to sterilize intervention. For a given amount of speculative capital flight, a central bank causes less pain for the domestic economy than does a currency board. Given the output-employment pain a country is willing to endure to break a bubble, a central bank system is lower cost and more effective than a currency board. It is a question whether the pain that speculators see the currency board endure causes flight to be smaller than under a central bank system; a tough currency board may be able to break a run that a central bank cannot break if the central bank cannot endure the pain that a currency board can. Price-wage flexibility can reduce the real output-employment costs a currency board has to endure (though these are not the only costs involved; instability in financial markets can have substantial costs). (Hans Genberg, Alexander K. Swoboda, 2005). Adopting a currency board might endogenously increase the pain that a country is willing to endure, because of the higher costs of changing arrangements, and thus a currency board might be better able to resist peg changes than a central bank. In this case, adoption of the currency board is a forecast of the country's increased willingness to face a crunch, perhaps without the government fully understanding this implication of adopting a currency board. Alternatively, adoption of a currency board might be a signal that the country understands and is willing to endure pain; in this case, the causation runs from willingness to the currency board as a signal. Thus, adoption of a currency board system raises the issue of causation versus correlation; a country less willing to bear pain than are countries with successful currency boards will find its currency board less credible and less successful. (Dominick Salvatore, James W. Dean, Thomas D. Willett, 2003). If bubbles/fads are important, frequent or dominant problems, a central bank seems to be the better pegging system. But this view ignores the possibility that fads and bubbles are partly endogenous and will be less likely to arise under a currency board than a central bank system: a country with a history of poor central bank performance may find fewer and less severe fads and bubbles by going to a currency board. Alternatively, output market shocks requiring real exchange rate adjustments may be important, frequent or dominant problems. By the same reasoning, a central bank that can and does refrain from changing the nominal exchange rate to adjust the real rate causes extra pain for the economy. A conventional currency board is designed to hold out even longer and thus causes more pain, though this view ignores the fact that wages and prices may become more flexible when an economy has a currency board. A currency board that is designed to or that will tacitly give up and adjust the rate may be less costly than a conventional currency board or even than a central bank. The problem is how to accommodate real exchange rate changes. If most pressure for exchange rate changes comes from changes in the equilibrium real rate, nearly automatic nominal rate changes would be beneficial. This could occur under a currency board designed for this purpose, and indeed costs may be lower in this case than under a central bank. (Edward Tower, 2003). Suppose a country has a serious discipline problem but pressures for real rate changes tend strongly to be equilibrating. In this case, it would be desirable for the currency board to strongly resist government pressure, but to give in relatively easily to exchange-market pressure. If the government has few discipline problems, and applies little pressure for monetary ratification, if there are few and small changes in equilibrium real exchange rates, and if there are major problems of bubbles or fads, then an independent central bank devoted to pegging the exchange rate may well work better than a currency board supplemented only by a weak monetary agency. (Dani Rodrik, 2001). Frequently, observers believe they see circumstances that make the choice between a currency board and a central bank hard. When discipline is a major problem, and bubbles and fads are important and/or frequent, it is desirable to have the strength of a currency board to resist government pressure, and the strength of a powerful central bank to resist speculative pressure. (Benigno, G. and Benigno, P, 2002) Reference: Benigno, G. and Benigno, P. (2002) Price stability in open economies. Review of Economic Studies, forthcoming. Betts, C. and Devereux, M. (2000) Exchange rate dynamics in a model of pricing-to-market. Journal of International Economics, 50(1) Dani Rodrik (2001). Trading in Illusions; Foreign Policy, March Dedola, L. and Leduc, S. (2001) Why is the business cycle behavior of fundamentals alike across exchange rate regimes International Journal of Finance and Economics Devereux, M. and Engel, C. (1999) The optimal choice of exchange rate regime: price-setting rules and internationalized production. Dominick Salvatore, James W. Dean, Thomas D. Willett (2003). The Dollarization Debate; Oxford University Press Edward Tower (2003). Too Sensational: On the Choice of Exchange Rate Regimes; Southern Economic Journal, Vol. 70 Hans Genberg, Alexander K. Swoboda (2005). Exchange Rate Regimes: Does What Countries Say Matter IMF Staff Papers, Vol. 52 Jan Winiecki (2002). Transition Economies and Foreign Trade; Routledge Jean-Olivier Hairault, Thepthida Sopraseuth (2003). Exchange Rate Dynamics: A New Open Economy Macroeconomics Perspective; Routledge Jorion, Philippe, and Richard J. Sweeney (1996). "Mean Reversion in Real Exchange Rates: Evidence and Implications for Forecasting." Journal of International Money and Finance 15( 4) Kyung Tae Lee (2002). Globalization and the Asia Pacific Economy; Routledge Read More