Exchange Rate Regimes and Competitiveness

Exchange Rate Regimes andcompetitiveness

The case of Greece

Dimitris Routos

Trade and Economic Integration in Eastern

and South-Eastern Europe

Exchange rate Regimes & Competitiveness - Routos 2

CONTENTS

Abstract 3

Introduction 4

Exchange rate regime and competitiveness 5

The case of Greece 7

Conclusions 15

References 16


ABSTRACT

The optimal choice of an exchange rate regime is often connected with inflationexpectations, output growth, and economic integration. The impact of theexchange rate regime on the competitiveness of a country, althoughcontroversial, is considered to be a major factor in this respect. The case ofGreece is portrayed as an example regarding the consequences of either afloating exchange rate regime or a fixed one, on the competitiveness of thecountry towards its trading partners and the rest of the world. The adoption ofthe Euro as Greece’s national currency, affected its ability to intervene throughmonetary measures in order to fix the balance of trade disequilibria, anddeteriorated its export performance during the last decade.


INTRODUCTION

Exchange rate regimes can be categorized in three major groups: a) fixed or peggedexchange rate regimes, where a currency's value is fixed against the value of another singlecurrency or to a basket of other currencies, or to another measure of value, such as gold, b)flexible or floating exchange rate regimes, where the value of a currency against othercurrencies is determined by the market forces of supply and demand, and c) managedfloating exchange rate regimes, that are hybrids of fixed and floating exchange rate regimes.

The choice of an exchange rate regime is directly associated with country-specificcharacteristics. Three competing approaches in the relevant literature explain the choice ofan exchange rate regime and underline those characteristics: The optimal currency area(OCA), the financial view, and the political view. According to the OCA theory, the choice ofthe exchange rate regime is related with the country’s size, trade links, openness, and thekind of shocks that the country is vulnerable to. The financial view is concentrated on theconsequences of international financial integration, while the political view interprets thechoice of an exchange rate regime as a ‘buffer’ in the absence of nominal and institutionalcredibility.1

The concept of competitiveness as applied to economies has no clear or agreed definitionamong scholars. Still less is there any consensus regarding the factors that contribute tonational competitiveness. Nevertheless improving a nation’s competitiveness is frequentlypresented as a central goal of economic policy and in this respect the following definition byOECD (OECD, Technology and the Economy: the Key Relationships, 1992) can describe theoutlines of the term: "Competitiveness may be defined as the degree to which, under openmarket conditions, a country can produce goods and services that meet the test of foreigncompetition while simultaneously maintaining and expanding domestic real income". Whatwould be the characteristics of a competitive economy are described in the EU reportEuropean Competitiveness Report (2000) as follows: “An economy is competitive if itspopulation can enjoy high and rising standards of living and high employment on asustainable basis. More precisely, the level of economic activity should not cause anunsustainable external balance of the economy nor should it compromise the welfare offuture generations”.

The impact of the exchange rate regime on competitiveness and economic development of acountry was extensively debated during the last fifty years. One general understanding isthat the nominal depreciation of the currency of a country with a floating exchange ratesupports its competitiveness in the short-term by making its exports cheaper. Howeverthere are other factors that can neutralize the short-term effects of a nominal depreciationsuch as, rise in the prices of imported goods, inflation pressures, wages and inflationexpectations. These factors are playing a decisive role in small open economies, with limited

1 Levy-Yeyati Eduardo, Sturzenegger Federico, and Reggio Iliana (2009), On the Endogeneity of Exchange RateRegimes, European Economic Review V. 54 No. 5 (2010) pp. 659–677.


opportunities for implementing autonomous monetary policies. Therefore in the mediumterm the nominal depreciation of the currency does not lead to a sustainable improvementof competitiveness.2 In this respect McKinnon (1963) argued that a floating exchange rateregime is desirable if a nation’s exports are limited to one or few goods, while a peggedregime is chosen if tradable goods represent a large proportion in a nation’s GDP.

EXCHANGE RATE REGIME and COMPETITIVENESS

Earlier studies on the difference between floating and pegged exchange rate regimes arebased on the external shocks, and the OCA theory. More recent approaches focus on thetrade-off between flexibility and credibility, or the economic performance and currencycrisis.

In the classical literature the choice is portrayed as either completely fixed exchange rate, orfully flexible. The general approach of the classical literature is that the prices of thecommodities are relatively sticky regarding exchange rates, thus shocks to the economy leadto fluctuations in the economic activity. Major contributors to the classical exchange rateliterature are among others Friedman (1953), Fleming (1962), Mundell (1961, 1963),McKinnon (1963), and Kenen (1969). Friedman argued that in the presence of sticky prices,floating exchange rates would insulate the economy from foreign shocks, by allowingrelative prices to adjust faster. Mundell (1963), explored the role of capital mobility in thechoice of exchange rate regimes. Under this approach, the choice between fixed and floatingdepends on the sources of shocks in an economy, whether they are real or nominal, and thedegree of capital mobility. In an open economy with high degree of capital mobility afloating exchange rate provides insulation against real shocks, such as a change in thedemand for exports or in the terms of trade, because under a floating rate system theexchange rate can adjust quickly and restores equilibrium, rather than requiring price levelchanges. On the other hand, a fixed exchange rate is desirable in the case of nominal shockssuch as a shift in money demand, because money supply automatically adjust to changes inmoney demand without interest rate changes or price level changes (Mundell, 1963;Fleming, 1962). The assumption in Mundell – Fleming framework is that capital mobilityimplies international arbitrage across countries in the form of uncovered interest parity. Andthe conclusion is that it is impossible to achieve simultaneously the three domestic goals:exchange rate stabilization, capital market integration and independent monetary policy,known as the impossible trinity. Also Mundell (1961) stressed the fundamentals of theoptimal currency theory (OCA), defining the characteristics of areas in which it is optimal toadopt a single currency. The OCA approach weights out the trade and welfare gains from astable exchange rate against the benefits of exchange rate flexibility as a shock absorber inthe presence of nominal rigidities. According to OCA theory, the advantages of fixedexchange rates increase with the degree of economic integration among countries.

2 See: Rose A. (1999); Klein M. & Shambaugh J.(2006); Adam C.& Cobham D. (2007).


McKinnon (1963) focused on the criterion of the openness of an economy. He argued thateconomic size and openness of an economy are the fundamentals for OCA theory, and thatsmall and open economies tend to adopt fixed exchange rate regimes than large andrelatively close economies. Also Kenen (1969) argued that product diversification in trade,should be considered as a major determinant of whether a country should adopt a fixedexchange rate regime, or not. He also argues that countries with very concentratedproduction structures are more likely to adopt flexible exchange rates than countries withdiversified production.

Inflation and growth play an important role on a government’s choice of exchange rateregimes. Recent literature has attempted to explain the impact of exchange rate regimes oneconomic performance. Ghosh et al. (1997) examine the effects of the exchange rate regimeon inflation and economic growth. Their results suggest that both the level and variability oninflation is lower under fixed exchange rates than floating ones. Levy-Yeyati andSturzenegger (2001) demonstrate that developing countries with pegged regimes areassociated with lower inflation than developing countries under floating rates, but peggedregimes are associated with slower growth. Rogoff et al. (2003) study the link betweenexchange rate regimes and economic performance and according to their results, forcountries at a relatively early stage of financial development and integration, fixed regimesappear to offer anti-inflation credibility gain without compromising growth objectives. Onthe contrary, flexible exchange rate regimes seem to offer higher growth without any cost tocredibility for developed countries that are not in a currency union. Obstfeld and Taylor(2002) link the evolution of exchange rate regimes to the various phases of financialglobalization, based on this “impossible trinity” argument. They argue that, while capitalmobility prevailed at a time when monetary policy was subordinated to exchange ratestability (as in the gold standard), as soon as countries attempted to use monetary policy torevive their economies during WWI, they had to impose controls to curtail capitalmovements.

Another approach in modern literature has studied the use of the exchange rate as anominal anchor to reduce inflation. In particular, Giavazzi and Pagano (1988) argue thatgovernments with a preference for low inflation but facing low institutional credibility, inorder to convince the public of their commitment to nominal stability, may chose a peg as a“policy crutch” to tame inflationary expectations. They also argue that countries with a poorinstitutional track record may be more eager to rely on fixed exchange rate arrangements asa second best solution to a commitment problem. As the argument goes, weak governmentsthat are more vulnerable to “expansionary pressures” (i.e., pressures from interest groupswith the power to extract fiscal transfers), may choose to use a peg as a buffer against thesepressures.

The variety of definitions regarding competitiveness not only among scholars but alsobetween national and international organizations dealing with its measurement,demonstrates the ambiguity of the term. Prominent academics decline even its use as anindicator of nations’ international performance and called it a dangerous obsession; it has


been also characterized as vague and ill-measured concept, while some argue that it isproductivity that matters for a nation’s international advantage, and not competitiveness.3

Nevertheless as the rhetoric for competitiveness has become predominant among opinionleaders throughout the world, arguments in favor of competitiveness as an indicator ofnational competitive success are pervasive in the academic literature. Labor costs, interestrates, exchange rates and economies of scale are considered to be the most influentialdeterminants of competitiveness. In terms of preconditions for the achievement of anation’s competitive advantage, four attributes are playing a decisive role: a) Factorconditions, that is the nation’s position in factors of production, such as skilled labor orinfrastructure, necessary to compete in a given industry, b) Demand conditions, that is thenature of home-market demand for products or services, c) Related and supportingindustries, that is the presence or absence in the nation of supply industries that areinternationally competitive, and d) Firm strategy, structure and rivalry, that is the conditionsin the nation governing how companies are created, organized, and managed, as well as thenature of domestic rivalry.4

The ideal indicator for measuring competitiveness has been a controversial issue amongscholars for more than a decade. Real Effective Exchange Rates (REER), and Unit Labor Costs(ULC), are used more frequently for this purpose. Nevertheless other indicators such asrelative export prices are also used for competitiveness measurement.5

THE CASE of GREECE

The options for choosing an exchange rate regime after WW II, were mainly determined forGreece by international developments, particularly the choices of Western Europeancountries and the subsequent priorities of the political and economic leadership of thecountry. Immediately after the war, the allied countries with the initiative of USA and the UKestablished a new international monetary order, focusing on the dollar, with which othercurrencies were pegged. This system, known as the monetary system of Bretton Woods,managed to ensure international monetary stability for almost two decades. Greeceparticipated in this system in 1953. After the collapse of the Bretton Woods system in 1971,Greece chose in line with other Western European countries a floating exchange rateregime, up to 1997. Since 1998 Greece participated in ERM I and ERM II, while since January1st 2002 adopted the Euro as its national currency.

The period of the Bretton Woods system was for Greece a period of stability regardingexchange rate fluctuations and the Drachma remained pegged with the US Dollar with itsinitial rate 1 USD=30 drachmas (it must be noted that drachma devaluated 50% against theUS dollar, just before the participation of Greece in the Bretton Woods system). This

3 See: Krugman P. (1994); Thompson R. (2003).4 Porter Michael (1990), The Competitive Advantage of Nations, Harvard Business Review, March–April 1990,pp.73-91.5 Ca’ Zorzi Michele, Schnatz Bernd (2007), Explaining and Forecasting Euro Area Exports- Which CompetitivenessIndicator Performs Best?, ECB Working Paper Series, No 833, November 2007.


remarkable stability was mainly derived from the fact that after the civil war of 1944-1949,there were no pressures from any credible political opposition towards the alteration of theeconomic and political goals of the elites. The adoption of the floating exchange rate regimein Greece was simultaneous with the first oil crisis. Upon the announcement of the end ofthe gold standard (end of the Bretton Woods system, August 1971), drachma remained in afixed parity with the US dollar (1 USD=30 drachmas), despite the fact that other WesternEuropean countries created a new monetary mechanism known as ‘the snake in the tunnel’,which allowed major European currencies to fluctuate ±2,25% relatively the US dollar. Dueto the fact that the US dollar devaluated against the European currencies, Greece managedto improve its current account balance as Greek tradable goods became cheaper comparedwith those of its European trade partners. On the other hand, Greek economy suffered fromhigh rates of imported inflation, as imported goods became more expensive, and of coursedue to the oil crisis effects. Therefore the fixed parity of drachma with the US dollar lastedup to October 1973, when it started to fluctuate freely against all currencies after a 10%revaluation. Since then and up to 1998, drachma entered in a period of continuous slidingagainst major currencies, in an attempt to neutralize the negative consequences from hugedifferences in the level of inflation in comparison with the European trade partners ofGreece.6 In table 1 the “de jure” drachma devaluations are depicted.

DRACHMA DEVALUATIONS (and a revaluation)1953 50% against USD (1USD = 30.000 GRD from 1USD = 15.000 GRD).1983 15,5% against major currencies.1985 15% against major currencies.1998 12,3% against ECU. Drachma’s participation in ERM. 1 ECU = 357 GRD.1999 Drachma participates in ERM II. 1€ = 353,11 GRD.2000 3,5% revaluation against the Euro. 1€ = 340,75 GRD.

Table 1

Devaluations of the Greek drachma were used extensively during the 80’s and 90’s, as a toolfor fixing the disequilibria in the balance of trade. In the period April 1981 – December2000, drachma devaluated (either “de jure” or “de facto”) against the US dollar and theGerman mark, 714% and 709% respectively (figure 1).

6 Σαχινίδης Φ. (2006), Το συναλλαγματικό καθεστώς της Ελλάδος: Από την πρόσδεση της δραχμής στο δολάριομέχρι την Ο.Ν.Ε., unpublished.


Source: Federal Reserve Bank of St. Louis, own calculations Figure 1

The main policy objective of the devaluation, apart from taming imported inflation, is toimprove the balance of payments performances through external competitiveness allowingthe nominal exchange rate to depreciate. The price ratio of tradable to non-tradable is amethod, which generally measures the internal competitiveness). Domestic price level hassubstantial influence on RER. Increasing of domestic price level at a higher rate relative toforeign price levels directly affects the RER in terms of appreciation of domestic currency inreal terms eroding the external competitiveness. Nominal devaluation in turn leads toincrease in the domestic price level (Hinkle and Montiel, 1999). As stated earlier, the mainobjective of the devaluation or depreciation is to gain external competitiveness and balanceof payments improvement in an economy. Under this scenario the policy makers should facecertain dilemma in terms of increasing price level and eroding competitiveness under asingle policy variable if the pass-through of exchange rate is substantial (figure 2).


Figure 2

The competitiveness of the Greek economy remained weak after WW II, regardless theadoption of a floating or a fixed exchange rate regime. An indication of this argument isshown in table 2. Greek exports as a percentage of GDP, never exceeded 25% on average forvarious periods with different exchange rate arrangements.

Source: EU AMECO Database, Own Calculations Table 2

Measuring competitiveness of the Greek economy is an inherently difficult issue. Estimatescan differ, depending on whether competitiveness is measured on the basis of relative pricesor relative unit labor costs, on whether one uses nominal or real unit labor costs, on whichcountries one compares Greece with and, finally, on the relative weight of each country inthe index. In addition to that measurement of competitiveness must be focused on theexport sector, i.e. tradable goods and services, not the whole economy, since a large part ofgoods and services produced in the Greek economy are non-tradable due to the fact thatthe Greek public sector is quite large. REERs for Greece either UCL based or CPI based, aswell nominal ULCs are presented in table 3. The differences occurred are due to differentmethodologies and different base years.

EXPORTS as % of GDP•1953 – 1971 Bretton Woods. 10,48% (1960-1971 )•1972 – 1987 Free Floating. 19,12%•1988 – 1997 “Hard drachma” policy. 18,36%•1998 – 2001 Participation in ERM and ERM II. 23,27%•2002 – 2012 Participation in the Euro zone. 23,06%


Source: Eurostat Ameco database, Bank of Greece Table 3

The following analysis will be based on the CPI based REERs produced by Bank of Greecebecause CPI based REERs are demonstrating in relative accuracy the competitive advantagesor disadvantages of the Greek economy. In order to quantify the competitiveness of theGreek economy, the structure of the economy (proportion in GDP of the primary, secondary,and tertiary sectors) must be taken into account. According to EU statistics the relativenumbers are 7%, 23,9% and 69%.7 Moreover, it must be taken into account that exporters ofgoods often face different competitors than exporters of services such as the touristindustry. For example, Germany is one of the biggest export markets of Greek goods andGreek exporters of industrial goods face fierce competition from German producers.However, Germany is not a competitor for Greece’s tourist industry because it offers wintertourism, whereas Greece offers summer vacations. As a result, in measuringcompetitiveness of Greek exports of industrial goods, Germany should have a large weight,

7 http://ec.europa.eu/agriculture/statistics/rural-development/2012/indicators_en.pdf

REERs and nominal ULCs

REER (ULCbased)

2005=100*

BROADREER (CPI

based)2000=100**

EU REER (CPIbased)

2000=100***NOMINALULC ****

1995 101,3 N/A N/A 66,51996 100,9 N/A N/A 70,41997 100,6 N/A N/A 76,91998 100,3 N/A N/A 80,71999 99,5 N/A N/A 83,42000 98,0 100 100 85,02001 92,2 101,1 99,9 84,72002 98,9 103,7 101,5 93,32003 97,3 109,4 102,8 94,72004 98,6 111,5 103,7 96,82005 100 111,4 105,1 1002006 97,4 112,2 106,3 98,92007 97,4 114 107,2 101,42008 97,6 116,8 108,1 106,62009 99,3 118,7 109,2 113,22010 99,2 118,1 112,6 113,12011 96,3 118,5 113 111,02012 88,2 114,6 112,1 104,1

* AMECO: REER, based on ULC (total economy)- Performance relative to the rest of 36 industrial countries: double**BOG: REER Broad CPI based index, includes the 28 main trading partners of Greece

***BOG: REER EU CPI based index includes the rest 16 Euro area countries****AMECO: Nominal unit labour costs: total economy (Ratio of compensation per employee to real GDP per personemployed).


while in measuring competitiveness of Greek services, Germany should have a low (in factzero) one. The opposite holds for Spain, or Portugal, which have a low weight in Greece’smanufacturing exports but are at the same time some of Greece’s major competitors intourist services. Greece is one of the major European tourist destinations and the touristsector is Greece’s biggest export industry. In contrast to the goods exporters,competitiveness of exporters of services such as tourism may depend more on prices ofservices in Greece relative to competitor countries than on relative ULCs. A tourist in Greecedoes not care so much about how much personnel is paid in a Greek hotel, but he definitelycares about how much one week of his stay in Greece will cost him relative to one week in asimilar tourist resort in Spain or Portugal. Therefore CPI based REERs are considered betterindicators for measuring the competitiveness of the Greek economy.

Since the adoption of Euro as Greece’s national currency, the ability of autonomousmonetary policy has been abolished. Consequently, the Greek authorities had not in theirpossession any more, a useful tool in order to intervene in monetary terms for fixingdisequilibria in the balance of trade. The deterioration in the REER Index is shown in figure 3,relatively to 28 main trading partners and the rest Euro area countries, for the period 2000-2012. Since 2001 we observe an acute deterioration, especially towards the 28 main tradingpartners, which continues up to 2009. From 2010 a gradual reversal is being observed.

Source: Bank of Greece, Bulletin of conjunctural indicators 148, Jan-Feb 2013 Figure 3

The sharp deterioration in the competitiveness of the Greek economy is also clearly depictedin figures 4, 5 & 6. In figure 4 it can be noticed that while from 1996 till 2000, there is apositive trend in Greek exports as a percentage of GDP relative to three core Eurozonecountries (Germany, Austria and the Netherlands), since 2000 there is a negative downturnwhich is being reversed in 2003, when a stagnation period follows up to 2008.

100

102

104

106

108

110

112

114

116

118

120

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

CPI based REER INDEX (2000=100)

Broad index (28main tradingpartners)EU17 Index (the rest16 EA countries)


Source: EU AMECO Statistical Database Figure 4

In a comparison of the Greek exports as a percentage of GDP with three Eurozone peripherycountries (Spain, Italy and Portugal) in figure 5, the convergence noticed from 1993 till 2000,is reversed in 2000, a more sharp decline is depicted through 2003, and a relativedeterioration from 2004 up to 2008.


15,00%

25,00%

35,00%

45,00%

55,00%

65,00%

75,00%

85,00%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

EXPORTS as % of GDP

Germany Greece Netherlands Austria

15,00%

20,00%

25,00%

30,00%

35,00%

40,00%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

EXPORTS as % of GDP

Greece Spain Italy Portugal


Finally in figure 6 the comparison of the Greek exports as a percentage of GDP relative to the27 European countries and the 17 Eurozone countries shows the convergence period from1996 up to 2000, the negative trend from 2000 till 2003, and the stagnation period from2004 until 2008.


Since 2009, the Greek exports as a percentage of GDP, follow an upside trend similar to theone experienced by the rest Eurozone and EU27 countries. This is a result of theimprovement in the CPI REERs as shown in figure 3.

15,00%

20,00%

25,00%

30,00%

35,00%

40,00%

45,00%

50,00%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

EXPORTS as % of GDP

European Union (27 countries) Euro area (17 countries) Greece


CONCLUSIONS

The choice of an exchange rate regime affects the international competitiveness of acountry. Greece was suffering from chronic disequilibria in its balance of payments.Devaluation of the drachma was a cure to its well lasting imbalances up to 2000. Greece’sentrance into the EMU was based rather on political than economic criteria. It was clearlyevident that Greece in 2001 was lacking behind the rest of the EMU countries in terms ofeconomic development and convergence. Although considerable improvement had beenrecorded in various economic indicators in the years preceding the entrance to EMU,alarming signals of structural problems in the Greek economy were present. Upon theadoption of the Euro as its national currency, and the subsequent abolition of anindependent monetary policy, its competitiveness towards its trading partners both in theEU, and internationally worsened. Although EMU joining decision was cheerfully celebratedin Greece, it concealed the need for an incremental adjustment of the Greek economy in theyears following the accession, due to the fact that it was not adequately reformed, beforeadopting the Euro as its national currency. Greek political and economic elites proved to beincapable in imposing the needed reforms that would enable Greece to experiencesustainable growth along with fiscal discipline and social prosperity. The inability of theGreek elites to impose these necessary reforms for the Greek economy and society is themain cause for today’s problems.


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Exchange Rate Regimes and Competitiveness