Devaluations are Often Associated with Changes in Government

The possibility of devaluation is apparently an issue in the upcoming Argentine elections.  (The forward rate for next year is about 13 pesos per dollar, which is close to the informal rate and suggests a big  devaluation relative to the current official exchange rate of 8.)   In this connection, an Argentine newspaper has asked me about “Contractionary Currency Crashes,” a paper that I presented as the 5th Mundell-Fleming Lecture of the  IMF’s Annual Research Conference. 

1) Do you think the conclusions about the connections between devaluation and elections are still valid in 2015 even though your article was published in 2005?

My most relevant finding was that political leaders had historically been twice as likely to lose office in the six months following a big devaluation as otherwise.  It is true that some things have changed over the last ten years.  Medium-sized emerging market countries used to have pegs or targets as their exchange rate policies, with occasional forced devaluation.   Since the turn of the century, the typical medium-sized emerging market country has switched to a managed float.   Thus changes in the exchange rate are more commonplace.   Nevertheless, I think most of the conclusions are still relevant in 2015.

2) What would you suggest to the presidents that are in campaign? That he/she should never promises that is not going to devalue? That this promise can be very costly?

Any politician in campaign mode is familiar with the general problem that declarations which are likely to help his or her chances of being elected may create constraints that he or she regrets later when facing the realities of governing.  I am glad that I am not a politician.   But in my study we found that presidents seldom make an explicit promise not to devalue; rather, when necessary, they delegate this dangerous task to their finance minister or central bank governor.  Then the minister is the one who has to resign if the devaluation happens anyway.

3) What are the arguments to support the possibility that the “costs of a devaluation may be more political than economic”?

It is worth considering political aspects of devaluation that may hold even when devaluation has a beneficial effect on the economy.  One political aspect is the finding that ministers are more likely to lose their jobs as a result of a devaluation if they had promised not to devalue.   Another is the point that incumbent politicians often postpone a needed devaluation until after an election, so that they don’t have to take the blame.  A third is the observation that sometimes new leaders decide it is smart to get the delayed devaluation out of the way soon after taking office.

My study found that, aside from these political phenomena, the big costs arose in those cases when a devaluation contributed to an economic recession.  The most important reason why a devaluation sometimes causes an economic recession has to do with dollar debt:  If the country has previously incurred a lot of dollar-denominated debt, the devaluation confronts a currency-mismatch and so devastates the balance sheets of banks and other companies who find that they can no longer service dollar debts because dollars are now so expensive.   Fortunately during the years 2004-2008, many emerging market countries managed to switch the composition of their capital inflows away from dollar-denominated debt.  Unfortunately corporations in many Emerging Market countries have recently gone back to borrowing in dollars, which means that they are once again vulnerable to a devaluation.


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Does the Dollar Need Another Plaza?

We are at the 30th anniversary of the 1985 Plaza Accord.  It was the most dramatic intervention in the foreign exchange market since Nixon originally floated the US currency.   At the end of February 1985 the dollar reached dizzying heights, which remain a record to this day.  Then it began a long depreciation, encouraged by a shift in policy under the new Treasury Secretary, James Baker, and pushed down by G-5 foreign exchange intervention.  People remember only the September 1985 meeting at the Plaza Hotel in New York City that ratified the policy shift; so celebrations of the 30th anniversary will wait until this coming fall.

The dollar has appreciated sharply over the last year, surpassing its ten-year high.   Some are suggesting it may be time for a new Plaza, to bring the dollar down.   In its on-line “Room for Debate,” the New York Times asked, Will a strong dollar hurt the economy and should the Fed take action?”   Here is my response:

Any movement in the exchange rate has pros and cons.  When the dollar appreciates as much as it has over the last year, the obvious disadvantage is that the loss in competitiveness by US producers hits exports and the trade balance.   But if the dollar had fallen by a similar amount, there would be lamentations over the debasing of the currency!

Overall, the strong dollar is good news.  This is because of the macroeconomic fundamentals behind it.  Indeed textbook theories explain this episode unusually well.  The US economy has performed relatively strongly over the last year — compared to preceding history and to other countries).  This is why the Fed is getting ready to raise interest rates — again, in contrast to the preceding six-year period of monetary easing and also compared to other countries.  (“Divergence.”)   American economic performance and the change in monetary policy are both excellent reasons for the strong dollar.   These developments should be welcomed, taken as a whole, notwithstanding the effect on exports.

Nevertheless, the soaring dollar – especially if it goes much higher – would be a reason for the Fed to hold off past June on its long-anticipated decision to raise short-term interest rates, so as to avoid a growth slowdown or even a descent into deflation.  I believe the Fed would indeed respond in that appropriate way.   In that sense, although the dollar strength is bad for exporters, it will not be bad for output and employment in the economy as a while.

Might a more aggressive intervention to bring down the dollar be justified, in which central banks would get together to sell dollars in exchange for euros and yen?   The last major effort of that sort was the Plaza 30 years ago.  (They also did it in a more minor way, to help the undervalued euro, in 2000.)

But 2015 is not 1985.   Neither the US authorities nor those in other G-7 countries will intervene in the foreign exchange market.  (They agreed not to, two years ago.)  Nor should they, in the current context.   In the first place, the appreciation is not yet anywhere near as big as it was 30 years ago (or even 15 years ago).  In the second place, today’s dollar appreciation is fully justified by economic fundamentals, unlike in 1985.

[The response to the NYT’s question from me and the others can be viewed at Room for Debate: “The Fed and the Dollar.”]

Posted in Uncategorized

Will Fed Tightening Choke Emerging Markets?

CAMBRIDGE – As the Federal Reserve moves closer to initiating one of the most long-awaited and widely predicted periods of rising short-term interest rates in the United States, many are asking how emerging markets will be affected. Indeed, the question has been asked at least since May 2013, when then-Fed Chairman Ben Bernanke famously announced that quantitative easing would be “tapered” later that year, causing long-term US interest rates to rise and prompting a reversal of capital flows to emerging markets.

The fear, as IMF Managing Director Christine Lagarde has reminded us, is of a repeat of previous episodes, notably in 1982 and 1994, when the Fed’s policy tightening helped precipitate financial crises in developing countries. If the Fed decides to raise interest rates this year, which emerging markets are most vulnerable to a capital-flow reversal?

There is no question that emerging markets are highly sensitive to global market conditions, including not only changes in short-term US interest rates, but also other financial risks, as measured, for example, by the volatility index VIX. Capital-flow bonanzas, often spurred by low US interest rates and calm global financial markets, end abruptly when these conditions reverse.

By the end of the currency crises in East Asia and elsewhere in the late 1990s, emerging-market governments had learned some important lessons. Five reforms were particularly effective: more flexible exchange rates, larger foreign-currency holdings, less pro-cyclical fiscal policy, stronger current accounts, and less debt denominated in dollars or other foreign currencies.

Many, but not all, developing and emerging-market countries took steps to implement these desirable policies. Their choice was put to the test during the 2008-2009 global financial crisis. Countries that had adopted such reforms were, on average, less adversely affected. Those that had not, particularly middle-income countries in Central Europe and the continent’s periphery, tended to be hit the hardest.

In particular, after 2001, many developing countries overcame their historic pattern of using periods of capital inflows to finance large fiscal and current-account deficits. As a result of reduced debt and enhanced reserves, their creditworthiness improved during the 2003-2007 boom. By 2008, they were in a strong enough position to respond to the financial crisis by allowing larger budget deficits and thus mitigating the downturn in 2009. Chile was the star reformer, but other countries – including Botswana, China, Costa Rica, Malaysia, the Philippines, and South Korea – also avoided pro-cyclical fiscal policies.

Unfortunately, policy backsliding is jeopardizing this historic “graduation” from pro-cyclicality. Countries like Brazil did not take advantage of the recovery from 2010 to 2014 to strengthen their budgets, and are now in a difficult position. Some of these countries used the renewed capital inflows to run large current-account deficits after 2010 as well. Such deficits, together with high inflation rates, earned Brazil, Turkey, and South Africa their membership on the Fragile Five list of countries that were hit particularly hard by Bernanke’s announcement in 2013. India and Indonesia were on this list as well, though they have begun to move in the right direction since then (thanks in part to new governments).

Then there are the countries – including Venezuela, Argentina, and Russia – that never moved in the reform direction in the first place. They were temporarily bailed out by strong world prices for their export commodities, but that ended last year.

A less visible threat is the denomination of debt in dollars and other foreign currencies. The currency crises of the 1980s and 1990s were particularly devastating because devaluations so often hit countries that had borrowed in dollars. This resulted in a “currency mismatch” between dollar liabilities and revenues that were often denominated in local currencies. When the cost of dollars doubled in terms of pesos or rupiah, otherwise-solvent local banks and manufacturers could no longer service their dollar debts. Owing to this adverse balance-sheet effect, devaluation turned out to be contractionary, leading to severe recessions.

Most emerging-market borrowers had learned their lesson by the turn of the century, as exchange-rate volatility had made the risks of currency mismatch more tangible. When international investors came knocking again in 2003, many emerging markets declined to borrow in dollars or other foreign currencies. Instead, they took the inflows in the form of direct investment, equity, or debt denominated in local currency.

The relative absence of mismatch was one of the reasons why emerging markets did much better when their currencies depreciated in 2008-2009 than in past crises. Exceptions like Hungary, where homeowners had foolishly borrowed in seemingly cheap euros and Swiss francs, proved the rule.

Unfortunately, in the last five years, many emerging markets have reverted to borrowing in foreign currency. Though, for the most part, governments have continued the shift away from dollar debt, the corporate sector, as the Bank for International Settlements has warned, has been tempted by ultra-low interest rates.

The Chinese private sector may have the biggest problem. Much of its recent borrowing violates key tenets of hard-earned wisdom gained in past crises: it is foreign exchange-denominated, short-term, shadow-bank-intermediated, and housing-backed.

Even though the Fed has not yet started raising interest rates, the well-established US economic recovery and the prospect of monetary tightening have, over the last year, caused the dollar to appreciate sharply against most currencies, those of emerging markets and advanced countries alike. If the Fed tightens as early as the middle of this year, further dollar appreciation is likely. Those who have been playing with mismatches may be about to get burned.


Posted in Analysis, Budget, Exchange Rates, Financial Crisis, Financial Regulation, Fiscal Stimulus

The Non-Problem of Chinese Currency Manipulation

CAMBRIDGE – America’s two political parties rarely agree, but one thing that unites them is their anger about “currency manipulation,” especially by China. Perhaps spurred by the recent appreciation of the dollar and the first signs that it is eroding net exports, congressional Democrats and Republicans are once again considering legislation to counter what they view as unfair currency undervaluation. The proposed measures include countervailing duties against imports from offending countries, even though this would conflict with international trade rules.

This is the wrong approach. Even if one accepts that it is possible to identify currency manipulation, China no longer qualifies. Under recent conditions, if China allowed the renminbi to float freely, without intervention, it would be more likely to depreciate than rise against the dollar, making it harder for US producers to compete in international markets.

But there is a more fundamental point: From an economic viewpoint, currency manipulation or unfair undervaluation are exceedingly hard to pin down conceptually. The renminbi’s slight depreciation against the dollar in 2014 is not evidence of it; many other currencies, most notably the yen and the euro, depreciated by far more last year. As a result, the overall value of the renminbi was actually up slightly on an average basis.

The sine qua non of manipulation is currency-market intervention: selling the domestic currency and buying foreign currencies to keep the foreign-exchange value lower than it would otherwise be. To be sure, the People’s Bank of China (PBOC) did a lot of this over the last ten years. Capital inflows contributed to a large balance-of-payments surplus, and the authorities bought US dollars, thereby resisting upward pressure on the renminbi. The result was as an all-time record level of foreign exchange reserves, reaching $3.99 trillion by July 2014.

But the situation has recently changed. In 2014, China’s capital flows reversed direction, showing substantial net capital outflows. As a result, the overall balance of payments turned negative in the second half of the year, and the PBOC actually intervened to dampen the renminbi’s depreciation. Foreign-exchange reserves fell to $3.84 trillion by January 2015.

There is no reason to think that this recent trend will reverse in the near future. The downward pressure on the renminbi relative to the dollar reflects the US economy’s relatively strong recovery, which has prompted the Federal Reserve to end a long period of monetary easing, and China’s economic slowdown, which has prompted the PBOC to start a new period of monetary stimulus.

Similar economic fundamentals are also at work in other countries. Congressional proposals to include currency provisions in the Trans-Pacific Partnership, the mega-regional free-trade agreement currently in the final stage of negotiations, presumably target Japan (as China is not included in the TPP). Congress may also want to target the eurozone in coming negotiations on the Transatlantic Trade and Investment Partnership.

But it has been years since the Bank of Japan or the European Central Bank intervened in the foreign-exchange market. Indeed, at an unheralded G-7 ministers’ meeting two years ago, they agreed to a US Treasury proposal to refrain from unilateral foreign-exchange intervention. Those who charge Japan or the eurozone with pursuing currency wars have in mind the renewed monetary stimulus implied by their central banks’ recent quantitative easing programs. But, as the US government knows well, countries with faltering economies cannot be asked to refrain from lowering interest rates just because the likely effects include currency depreciation.

Indeed, it was the US that had to explain to the world that monetary stimulus is not currency manipulation when it undertook quantitative easing in 2010. At the time, Brazilian Finance Minister Guido Mantega coined the phrase “currency wars” and accused the US of being the main aggressor. In fact, the US has not intervened in a major way in the currency market to sell dollars since the coordinated interventions associated with the Plaza Accord in 1985.

Other criteria besides currency-market intervention are used to ascertain whether a currency is deliberately undervalued or, in the words of the International Monetary Fund’s Articles of Agreement, “manipulated” for “unfair competitive advantage.” One criterion is an inappropriately large trade or current-account surplus. Another is an inappropriately low real (inflation-adjusted) foreign-exchange value. But many countries have large trade surpluses or weak currencies. Usually it is difficult to say whether they are appropriate.

Ten years ago, the renminbi did seem to meet all of the criteria for undervaluation. But this is no longer the case. The renminbi’s real value rose from 2006 to 2013. The most recent purchasing power statistics show the currency to be in a range that is normal for a country with per capita real income of around $10,000.

By contrast, the criterion on which the US Congress focuses – the bilateral trade balance – is irrelevant to economists (and to the IMF rules). It is true that China’s bilateral trade surplus with the US is as big as ever. But China also runs bilateral deficits with Saudi Arabia, Australia, and other exporters of oil and minerals, and with South Korea, from which it imports components that go into its manufactured exports. Indeed, imported inputs account for roughly 95% of the value of a “Chinese” smartphone exported to the US; only 5% is Chinese value added. The point is that bilateral trade balances have little meaning.

Congress requires by law that the US Treasury report to it twice a year which countries are guilty of currency manipulation, with the bilateral trade balance specified as one of the criteria. But Congress should be careful what it wishes for. It would be ironic if China agreed to US demands to float the renminbi and the result was a depreciation that boosted its exporters’ international competitiveness.


Posted in Analysis, Budget, China, Dollar, Economic Development, Exchange Rates, Financial Crisis, Financial Regulation

The End of Republican Obstruction

CAMBRIDGE – What a difference two months make. When the Republican Party scored strong gains in last November’s US congressional elections, the universally accepted explanation was that voters were expressing their frustration with disappointing economic performance. Indeed, when Americans went to the polls, a substantial share thought that economic conditions were deteriorating; many held President Barack Obama responsible and voted against his Democratic Party.

Now, suddenly, everyone has discovered that the US economy is doing well – so well that Senate Majority Leader Mitch McConnell has switched from blaming Obama for a bad economy to demanding credit for a good one. Recent favorable economic data were, he claimed, the result of “the expectation of a Republican Congress.”

But the improvement in US economic performance began well before the November election. Indeed, it began well before September, when polls started to indicate that the Republicans were likely to do exceptionally well, taking control of the Senate and enlarging their majority in the House of Representatives.

The fact is, job growth was vigorous throughout 2014, averaging 246,000 per month – three million for the year – bringing the unemployment rate down to 5.6% in December 2014 (from 6.7% a year earlier). This represented an acceleration relative to the monthly average of 185,000 in 2011-2013, and it looks even better compared to the previous economic expansion of 2002-2007, when monthly job creation stood at 102,000. Indeed, the recent numbers recall the halcyon days of Bill Clinton’s presidency.

Similarly, GDP growth began to pick up in the spring of 2014, running above the rate of the preceding three years. Partly as a result of income growth, the US budget deficit last year was lower than forecast, at about 2.8% of GDP. This represents a record improvement relative to 2009, when the budget deficit amounted to nearly 10% of GDP.

The mystery, until recently, was why economic performance had been so weak. There were four types of explanations.

The first account relied on the view, most closely associated with the economists Carmen Reinhart and Kenneth Rogoff, that recovery from a recession takes longer if the cause was a crash in housing and financial markets. But this historical pattern is more a statement about the magnitude of the initial decline and the time needed to recover fully than a prediction about the annual rate of growth during the recovery phase.

The second explanation was that the slow recovery was part of a longer-term trend, attributable to secular stagnation or a dearth of important technological innovations. It is true that productivity growth and labor-force growth have slowed since 1975. Still, the economy should have been able to achieve a stronger recovery than the 2.1% growth rate recorded in 2011-2013.

The third interpretation for slow growth during these three years is that the depressed investment and long-term unemployment caused by the deep recession of 2008-2009 had taken a toll on the capital stock and the size and skills of the labor force.

But the fourth explanation seems the simplest: America’s dysfunctional fiscal politics in 2011-2013 – years that featured the “fiscal cliff,” debt-ceiling standoffs, flirtation with federal default, a government shutdown, and budget sequesters. One does not need to assume big Keynesian “multiplier effects” to conclude that the combined impact of these conflicts shaved at least one percentage point from growth each year, especially if one believes that the risk created by such behavior discourages firms from hiring or investing. (According to one measure, the 2011 debt-ceiling crisis and the 2013 government shutdown caused uncertainty comparable to that sparked by the September 2001 terrorist attacks and the 2008 collapse of Lehman Brothers.)

This explanation also accords with stronger US economic performance in 2014, which was the first year since the Republicans gained a House majority in November 2010 that dysfunctional fiscal policy did not actively impede economic recovery. Having borne the brunt of the blame for the government shutdown of October 2013, Republican leaders decided to stifle their more radical “Tea Party” members and refrain from similar dead-end showdowns in 2014.

One could have predicted that a year in which Congress stopped actively impeding economic recovery would be a year in which the pace of expansion in output and employment picked up. If the new Congress in 2015 refrains from standoffs, sequesters, and shutdowns, there is no reason why the economy cannot continue to do well.

Of course, shortcomings remain. Wage growth continues to be slow. Median household income has barely begun to recover, and is still well below its 2000 level. This is because most of the gains from economic recovery have gone to people at the top of the income distribution.

Indeed, of the various possible reasons why the electorate in 2014 did not perceive the economic recovery that was underway, the most plausible is that the typical American had not benefited from it. The irony is that rising inequality is usually thought to play to the Democrats’ electoral advantage.


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