What’s Up with the Exchange Rate?

What’s Up with the What’s Up with the Exchange Rate? Exchange Rate?

Andrew K. RoseAndrew K. Rose

UC Berkeley, NBER and CEPRUC Berkeley, NBER and CEPR

Exchange RatesExchange Rates 22

The Basic Long-Run IssueThe Basic Long-Run Issue

America’s Current Account DeficitAmerica’s Current Account Deficit– 2006: $811.5 billion deficit (!)2006: $811.5 billion deficit (!)

6.2% of American GDP6.2% of American GDP Implies annual Capital Inflows of $2700 per Implies annual Capital Inflows of $2700 per personperson

annually (!)annually (!)

– 2007Q1: deficit of $192.6 billion2007Q1: deficit of $192.6 billion– Almost all Goods (Services in surplus but small)Almost all Goods (Services in surplus but small)

Small persistent income surplusSmall persistent income surplus


CausesCauses

Some Dispute among EconomistsSome Dispute among Economists Still, Low American Savings chief reasonStill, Low American Savings chief reason

– Personal Savings very low lately, often negative Personal Savings very low lately, often negative – Public Sector also dis-saving (Federal deficits)Public Sector also dis-saving (Federal deficits)

Lack of Investment outside US also possible Lack of Investment outside US also possible issueissue


Current Account: Sustainable?Current Account: Sustainable?

Size of Deficit unprecedented for AmericaSize of Deficit unprecedented for America Also unprecedented for “Anchor” countryAlso unprecedented for “Anchor” country US now taking over 75% of all global US now taking over 75% of all global

savings flowssavings flows Capital running “uphill” from poor to rich (!)Capital running “uphill” from poor to rich (!) Growing US external debtGrowing US external debt


Adjustment must involve PricesAdjustment must involve Prices

For current account to close, savings must For current account to close, savings must rise (or investment fall, or both)rise (or investment fall, or both)

Symmetrically, exports must rise Symmetrically, exports must rise dramatically, while import growth slowsdramatically, while import growth slows

Exchange Rate one of the key adjustment Exchange Rate one of the key adjustment mechanismsmechanisms

So long-run depreciation of Dollar is likelySo long-run depreciation of Dollar is likely


How Much?How Much?

Many Different Estimates, Little ConsensusMany Different Estimates, Little Consensus Most expect at least another 15-25%, Most expect at least another 15-25%,

sometimes moresometimes more Exchange Rates often overshootExchange Rates often overshoot Timing: almost impossibleTiming: almost impossible


Where will Effects be Felt?Where will Effects be Felt?

Three Big Currency Zones in World:Three Big Currency Zones in World:– Dollar, Asian-zone, EuropeansDollar, Asian-zone, Europeans– But exchange rate policy varies across worldBut exchange rate policy varies across world

Dollar floats freely against Many CurrenciesDollar floats freely against Many Currencies– Europeans (including UK, Norway)Europeans (including UK, Norway)– Also Canada, NZ, Australia, etcAlso Canada, NZ, Australia, etc


But Asia is DifferentBut Asia is Different

Asians take Exchange Rate Policy SeriouslyAsians take Exchange Rate Policy Seriously Almost all East Asians manage currencies, Almost all East Asians manage currencies,

will continue to do sowill continue to do so Part a Legacy of Asian Crisis of ’97-’98Part a Legacy of Asian Crisis of ’97-’98 Part a Development Strategy …Part a Development Strategy …

– Which Leads us to ChinaWhich Leads us to China


How to Think about the Yuan?How to Think about the Yuan?

Chinese Communist Party Needs Growth to Chinese Communist Party Needs Growth to Survive PoliticallySurvive Politically– Growth is Required to Absorb Massive Growth is Required to Absorb Massive

Unemployment in Chinese CountrysideUnemployment in Chinese Countryside

Agricultural Peasants Must Be TransformedAgricultural Peasants Must Be Transformed

Into Manufacturing WorkersInto Manufacturing Workers– Exports Provide Only Possible OutletExports Provide Only Possible Outlet


Asian Paradigm for DevelopmentAsian Paradigm for Development

Competitive (Cheap) Unemployed Labor Competitive (Cheap) Unemployed Labor Absorbed into Manufactured SectorAbsorbed into Manufactured Sector– Example of key theory of W.A.Lewis (Nobel Example of key theory of W.A.Lewis (Nobel

Laureate)Laureate)


Implications for WestImplications for West

China has every incentive to maintain China has every incentive to maintain under-valued exchange rateunder-valued exchange rate– Under-valuation the key to rapid export growthUnder-valuation the key to rapid export growth– Right in theoryRight in theory– Effective in practice (past twenty years!)Effective in practice (past twenty years!)– Hence rapid accumulation of US$ reserves, as Hence rapid accumulation of US$ reserves, as

China maintains under-valued peg to USChina maintains under-valued peg to US– Reserves act as “collateral”, encourage FDIReserves act as “collateral”, encourage FDI


Special Role of USASpecial Role of USA

US is issuer of $, global reserve currencyUS is issuer of $, global reserve currency East Asians fixes against US$East Asians fixes against US$ US is largest, most open economyUS is largest, most open economy US willing to handle large, persistent current US willing to handle large, persistent current

account deficitsaccount deficits


Special Role of USA, contdSpecial Role of USA, contd

American FDI high in AsiaAmerican FDI high in Asia– High Returns on Asian Investments help protect High Returns on Asian Investments help protect

against American Protectionismagainst American Protectionism– China Importing Financial Services, since China Importing Financial Services, since

Domestic Financial Sector WeakDomestic Financial Sector Weak– US also premier provider of collateral service US also premier provider of collateral service

(hence Asian pegs against $)(hence Asian pegs against $)


Where Does Europe Fit In?Where Does Europe Fit In?

No Direct RoleNo Direct Role Still, Large Indirect RoleStill, Large Indirect Role

– Euro floats against $Euro floats against $– Europe has powerful central bank with Europe has powerful central bank with

independent monetary policyindependent monetary policy


Dollar Depreciation Likely to be Dollar Depreciation Likely to be Mostly against EuroMostly against Euro

Some Already OccurredSome Already Occurred Dollar depreciated from .8$/euro to Dollar depreciated from .8$/euro to

1.4$/euro already1.4$/euro already Worse for pound!Worse for pound! More likely to come!More likely to come!


Asia and the EuroAsia and the Euro

Crisis in Confidence PossibleCrisis in Confidence Possible– American Current Account Deficits large American Current Account Deficits large

>6% GDP, highly persistent>6% GDP, highly persistent

Dollar Depreciation Resisted by AsiansDollar Depreciation Resisted by Asians– But Euro Floats Freely!But Euro Floats Freely!

Euro Likely to Continue to Appreciate Euro Likely to Continue to Appreciate Against Dollar over long TermAgainst Dollar over long Term


It isn’t Only China!It isn’t Only China!

Other Asian Economies Waiting in Line Other Asian Economies Waiting in Line behind Chinabehind China– IndiaIndia– IndonesiaIndonesia– Vietnam …Vietnam …


Historical PrecedentHistorical Precedent

European Development in 1950s and 1960sEuropean Development in 1950s and 1960s Export-Lead Growth to transfer under-Export-Lead Growth to transfer under-

employed Europeans from countryside to employed Europeans from countryside to manufacturingmanufacturing

Revival of “Bretton Woods” regime, Revival of “Bretton Woods” regime, prevailed before 1971prevailed before 1971


ConclusionConclusion

Dollar Decline likely to continueDollar Decline likely to continue Probably Most Dramatically Against EuroProbably Most Dramatically Against Euro Good argument for foreign diversification!Good argument for foreign diversification!

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What’s Up with the Exchange Rate?