Overvalued Exchange Rate Research Articles

Effective Exchange Rates in Britain, 1920–1930

During the 1920s Britain's rate of economic growth lagged behind that of many other countries in the world economy. Much of the historical literature has attempted to explain this outcome in terms of the macroeconomic policy regime resulting from the return to a fixed exchange rate at the prewar gold standard parity in 1925.' Despite some agreement on the magnitude of overvaluation in 1925 and a consensus that the overvaluation was greater in 1920, the absence of consistent data has resulted in the co-existence of a number of views that are clearly contradictory. For example, David Greasley and Les Oxley argue that the sterling real exchange rate became overvalued mainly during World War I.2 Nicholas Dimsdale reports that the real effective exchange rate appreciated significantly over the period 1921-1925, whilst B. P. A. Andrews finds a real effective exchange rate peak in 1920, followed by a cycle of depreciation until 1922 and appreciation over 1922-1925.3 absence of agreed data means that we cannot seriously evaluate how the exchange rate overvaluation affected aspects of the British economy during the 1920s. main study of Britain's real effective exchange rate during the 1920s is John Redmond's The Sterling Overvaluation in 1925: A Multilateral Approach, which evaluates the degree of overvaluation in 1925 relative to 1913 from a purchasing power parity perspective. There are four main problems with Redmond's study that we wish to address here. First, Redmond uses a variety of weights (derived from trade data for 1925, 1928, and 1929) and finds that the effective exchange rate indices are not sensitive to the weights used. However, the volatility of exchange rates and prices during the transwar period means that the choice of weights does matter over that period. To deal with this we work with trade weights from 1920 and 1925.4 Secondly, Redmond used arithmetic averaging to derive the effective exchange rate index. In light of modern conventional practice, we work with geometric averaging.5 Thirdly, Redmond used consumer and wholesale price indices constructed by the League of Nations during the interwar period. There are some major discrepancies between the

Regulación del capital: A favor y en contra

La liberalización del mercado de capitales de los últimos veinte años ha traído consigo turbulencias bursátiles y monetarias que han afectado tanto a los países industrializados como a los países en desarrollo. Hasta hace poco se pensaba que este aspecto de la globalización era un coste que merecía la pena pagar para lograr una eficiente asignación de los recursos mundiales. Este análisis sobre el tema es de asequible lectura al tiempo que riguroso sobre las cuestiones más importantes de la economía internacional actual. En él se exponen los recientes acontecimientos acontecidos en Asia e Iberoamérica. Desde la crisis de la deuda iberoamericana, la prudencia fiscal y monetaria se ha convertido en la nueva ortodoxia de aquellos gobiernos que quieren recoger los beneficios procedentes de su participación en el nuevo mercado global. Estos sueños se vieron interrumpidos por la reciente turbulencia asiática que comenzó con las devaluaciones obligadas del Baht tailandés en julio de 1997. Lo que inicialmente se percibía como un correctivo del tipo de cambio sobrevalorado de un país menor, se transformó rápidamente en un huracán financiero que amenazó con engullir a las economías industrializadas. Hoy, la globalización se ha convertido en el enemigo de gobiernos tan dispares como los de Rusia y Malasia. Las crisis financieras que golpearon a Asia hace dieciséis meses han suscitado una vez más la cuestión de si es posible una razonable estabilidad económica en un mundo con mercados de capitales integrados.

What Undermines Aid's Impact on Growth?

We examine one of the most important and intriguing puzzles in economics: why it is so hard to find a robust effect of aid on the long-term growth of poor countries, even those with good policies. We look for a possible offset to the beneficial effects of aid, using a methodology that exploits both cross-country and within-country variation. We find that aid inflows have systematic adverse effects on a country`s competitiveness, as reflected in a decline in the share of labor intensive and tradable industries in the manufacturing sector. We find evidence suggesting that these effects stem from the real exchange rate overvaluation caused by aid inflows. By contrast, private-to-private flows like remittances do not seem to create these adverse effects. We offer an explanation why and conclude with a discussion of the policy implications of these findings.

What Undermines Aid's Impacton Growth?

We examine one of the most important and intriguing puzzles in economics: why it is so hard to find a robust effect of aid on the long-term growth of poor countries, even those with good policies. We look for a possible offset to the beneficial effects of aid, using a methodology that exploits both cross-country and within-country variation. We find that aid inflows have systematic adverse effects on a country's competitiveness, as reflected in a decline in the share of labor intensive and tradable industries in the manufacturing sector. We find evidence suggesting that these effects stem from the real exchange rate overvaluation caused by aid inflows. By contrast, private-to-private flows like remittances do not seem to create these adverse effects. We offer an explanation why and conclude with a discussion of the policy implications of these findings.

Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries

We test the hypothesis of a link between exchange rate policy and sovereign bonds. We analyze the effect of exchange rate policies on supply and credit spreads of sovereign bonds issued by developing countries. An exchange rate policy is captured by the de facto exchange rate regime and the real exchange rate misalignment. The main findings are: (1) real exchange rate overvaluation significantly increases sovereign bond issue probability and raises bond spreads; (2) spreads and the likelihood of issuing bonds depend on the exchange rate regime; (3) exchange rate misalignment under a hard peg significantly increases bond spreads; (4) in time of debt crises, exchange rate policy also greatly affects the sovereign bond market, especially through exchange rate overvaluation.

Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries

This paper empirically analyzes how exchange rate policy affects the issuance and pricing of international bonds for developing countries. We find that countries with less flexible exchange rate regimes pay higher sovereign bond spreads and are less likely to issue bonds. Quantitatively, changing a free-floating regime to a fixed regime decreases the likelihood of bond issuance by 4.6% and increases the bond spread by 1.3% on average. Furthermore, countries with real exchange rate overvaluation have higher bond spreads and higher bond issuance probabilities. Moreover, such positive effects of real exchange rate overvaluation tend to be magnified for countries with fixed exchange rate regimes. Our results suggest that choosing a less flexible exchange rate regime in general leads to higher borrowing costs for developing countries, especially when their currencies are overvalued.

Monetary policy in developing countries: lessons from Kenya

We estimate and then simulate a model of Kenyan economic development from 1965 to 1997 with two objectives in mind. The first is to demonstrate the degree of volatility of cyclical shocks that developing countries experience and to calculate the domestic nominal adjustments required by these shocks under both irrevocably fixed and free exchange rates.A comparison of these counterfactual nominal adjustments identifies the short-run implications for an economy of the choice of exchange rate regime. The second objective is to provide an estimate of the consequences for the economic development of Kenya of the lack of a coherent monetary order (excessive domestic credit expansion and overvalued exchange rate) throughout most of the period since 1965.A neoclassical convergence growth model based on Barro and Sala-i-Martin (1992) is employed and calibrated to represent the long-run growth path of real GDP in Kenya. A short-run four-sector CGE model is constructed that allows for cyclical movements of real GDP about the convergence growth path. The cyclical model focuses on the adjustment of the relative price of non-traded goods that is required to ensure short-run equilibrium in the non-traded goods sector. Given that terms of trade shocks dominated the macro environment of Kenya over the sample period, we find that a free exchange rate regime would have insulated the economy to a greater degree than an irrevocably fixed regime. In the growth decomposition exercise, we estimate that the two largest (and negative) influences on Kenyan economic growth were the decline in the external terms of trade from 100 in 1965 to an average of 79.5 over the 32-year time period, and the overvalued Kenyan shilling represented by a premium on the parallel market for foreign exchange. Overall, we estimate that the overvalued exchange rate reduced economic growth by an average of 0.47 per cent per annum over the 32 years.

International Financial Architecture and the Resolution of Financial Crises

Governor of the Bank of Canada. This is a slightly revised version of a speech given to the National Capital Branch of the Canadian Institute of International Affairs on 14 May 2002.THE PREAMBLE TO THE BANK OF CANADA ACT calls on the Bank to promote the economic and financial welfare of Canada. In this context, the Bank aims to foster good economic performance through monetary stability - that is to say, through low, stable, and predictable inflation. But no market economy can function properly unless it is also supported by an efficient and stable financial system. Sound financial institutions, a robust infrastructure, and well-functioning financial markets are necessary to facilitate transactions and to properly channel savings into investments.This is certainly true for Canada's domestic economy. But in today's interconnected world, it is equally true for the global economy. Recent experience has shown that world events can have serious repercussions on national financial markets, including ours, and indeed on our entire economy. The Mexican crisis of 1994-5 and the Asian and Russian crises of 1997-8 are cases in point. In both instances, Canada was sideswiped. And although the recent acute economic and social problems in Argentina have not resulted in widespread contagion, they have, nevertheless, had implications for Canadian banks operating in, or holding claims on, Argentina.So, Canadians have more than a passing interest in a healthy global financial environment. As the world becomes more and more integrated, sound macroeconomic policies and sound financial systems across all countries are becoming increasingly important.The episodes of financial stress that the world has experienced in recent years have revealed weaknesses in the foundation of the international financial architecture. To reduce the incidence and the impact of global financial disturbances, those problems have to be addressed, and that foundation has to be fortified.In the aftermath of the crises of the late 1990s, the international community acted to identify and to begin to deal with financial vulnerabilities.Canadians have been actively involved in this work. And the Bank of Canada has played its part. The Bank participates in several international forums where issues of financial stability are debated. And it works closely with others to strengthen the international financial architecture by developing frameworks for the prevention, management, and resolution of crises.While significant progress has been made, more needs to be done. But before discussing what needs to be done, a brief review of the lessons we have learned, or ought to have learned, from recent financial disturbances is in order.CRISIS PREVENTION - LESSONS AND PROGRESSWhat are some of the factors that led to the serious problems experienced by Mexico, a number of Southeast Asian countries, Russia, and, more recently, Argentina?In various combinations, there were large current account and fiscal deficits, heavy reliance on short-term borrowing, weak banking systems, poor risk management, overvalued exchange rates, and a lack of transparency in fiscal, monetary, and financial policies. Moreover, the presumption that the international community would come to the rescue if things turned sour appeared to offer some form of protection to borrowers and lenders in emerging markets. This presumption distorted market signals and encouraged over-borrowing and over-lending.So what has been done, and what can be done, to minimize the risks of future crises?A Sound Macroeconomic Policy FrameworkIt is now broadly recognized that sound and credible macroeconomic policies are the first line of defence against financial crises. As we know from our own experience in Canada, this means a fiscal policy focused on keeping public sector deficits and debts on a sustainable track and a monetary policy focused on keeping inflation low and stable. …

Impacts of price and exchange rate policies on pesticide use in the Philippines

Pesticide prices can influence producer decisions to apply pesticides as opposed to nonchemical means of pest control. Those prices are in turn influenced by price and exchange rate policies. The effective rate of protection for nine pesticides commonly applied to vegetables in the Philippines was calculated to determine whether government policies are creating incentives or disincentives to adopt more integrated pest management methods. Calculations found that direct price policies, primarily through an import tariff, tax pesticide use while an overvalued exchange rate subsidizes pesticide use. The net effect is a 6 to 8% pesticide subsidy. This subsidy results in economic surplus gains to vegetable producers and consumers when negative externalities associated with pesticide use are not accounted for. However, recent analysis of human health effects of pesticide use on rice in the Philippines demonstrates that these externalities can be substantial.

The Measurement of Real Effective Exchange Rates: A Survey and Applications to East Asia

The theoretical bases for different definitions of the real exchange rate are discussed. Alternative means of calculating exchange rates are presented. Some of the empirical characteristics of these series are examined in the context of several Pacific Rim countries. The use of real effective exchange rates is presented in several context, including (i) evaluating exchange rate overvaluation, (ii) relating real exchange rates to productivity differentials, (iii) estimating the relative price responsiveness of trade flows, and (iv) assessing the impact of competitive devaluation.

Exchange Rate Arrangements in the Americas: Lessons from East Asia?

Even before a consensus had developed about the lessons from the East Asian crises, events in Brazil and Russia added grist to the policy analysts' mill. In this welter of conflicting interpretations, it is difficult to settle on an appropriate set of responses, in part because there is no common view on what precipitated these events. In this paper, I set forth an integrated reading of the theory and empirical literature on financial crises and exchange rate regimes. These messages are then applied to the question of the optimal exchange rate and monetary arrangements for the emerging economies of the Americas. The key points that flow from this analysis are the following. First, recent financial crises not interpreted as the inevitable outcome of globalization, but rather the consequence of private agents exploiting either explicit or implicit government guarantees to insure private liabilities. These liabilities could take the form of officially guaranteed bank debt (as in the 1980s) or insolvent banks and dollar-denominated corporate debt (the 1990s). Second, while fixed exchange rate regimes do not cause all such financial crises, they may exacerbate them, to the extent that they make government guarantees more explicit. This is especially true because our knowledge of the equilibrium exchange rate - in real time - is very limited. Third, currency boards and dollarization might mitigate the likelihood of currency crises, but they cannot provide inoculation against financial crises, unless the Federal Reserve Board is willing to take on the role of regulator and lender of last resort. Furthermore, such fix regimes are likely to impose heavy costs upon the economies in question since the economies of the region do not constitute an optimal currency area. Thus, the lesson I take from recent experiences in the global capital is that, except for the most pathologically managed economies, freely floating exchange rates are often the best route to take. The caveat is not a trivial one. If, for instance, Brazil is unable to bring its budget deficit somewhat in line, then dollarization that imposes a hard constraint upon its fiscal system might be beneficial on net. Whether this option would be politically feasible is a question I leave to those better equipped to answer this question. The article is structured in the following manner. Section 2 contains a discussion of the major features of recent financial crises. Section 3 will address the issue of exchange rate overvaluation, while the subsequent section forwards some thoughts on the desirability of hardfixes of the exchange rate. Concluding remarks follow.

A guide to the constitutional structures and electoral systems of east, south and southeast Asia

In 1997 an economic crisis swept through much of Asia. In addition to the various proximal causes of the crises, e.g. overvalued exchange rates, lax banking regulations, etc., political structures have received much attention. Some claim that problems in countries’ political structures set the stage for the crisis. Others argue that governments’ responses to the crisis were helped or hindered by existing political institutions. However, research on the consequences of Asian political institutions is hampered by a lack of basic information on the different constitutional and electoral frameworks around the region. This article is an attempt to help fill this void by providing a description of the constitutional structures and electoral systems of 17 Asian-Pacific countries since 1945.

Vulnerability to a Currency Crisis: Lessons from the Asian Experience

Are currency crises caused by manias and panics in financial markets, or by unsustainable deteriorations in domestic macroeconomic conditions? This question is explored in the context of the recent Asian currency crisis. The theoretical concept of vulnerability is used to identify three early‐warning indicators of susceptibility to a currency crisis: rapid accumulation of mobile capital; domestic lending booms; and overvalued exchange rates. It is shown that the crisis and noncrisis countries of Asia may be distinguished empirically, using these indicators, over the decade preceding the crisis. This exercise provides convincing evidence that the crisis emanated largely from domestic macroeconomic conditions.

Are the Central and Eastern European Transition Countries Still Vulnerable to a Financial Crisis? Results from the Signals Approach

The aim of paper is to analyse the vulnerability of the Central and Eastern European accession countries to the EU as well as that of Turkey and Russia to a financial crisis. Our methodology is an extension of the signals approach. We develop a composite indicator to measure the evolutin of of the risk potential in each country. Our findings show that crises in Central and Eastern Europe are caused by much the usual suspects s in others emerging markets. In particular an overvalued exchange rate. Weak exports and dwindling currency reserves have good precictive power for assessing crisis vulnerabilities. Keywords: F31, F47, financial crises, vulnerability indicator, Central and Eastern Europe

The impact of terms of trade and real exchange rate volatility on investment and growth in sub-Saharan Africa

Specialization in primary product exports reduces growth, but why? Adverse trends in, and the high variance of, primary product prices are possible explanations. The impact on investment and growth of the level and volatility of the terms of trade and the real effective exchange rate is estimated for a panel of 14 sub-Saharan African countries over 1980–1995. Growth is negatively affected by terms of trade instability, and investment by real exchange rate instability. Both growth and investment increase when the terms of trade improve and real exchange rate overvaluation is eliminated.

Flight Capital as a Portfolio Choice

The authors examine flight capital in the context of portfolio choice. They estimate the stock of flight capital held abroad and compare it with the stock of real (nonfinancial) capital held within each country. For 51 countries they construct estimates (as of 1990) of private domestic capital and flight capital - which combined add up to domestic wealth. There are large regional differences in the proportion of private wealth that is held abroad, ranging from 3 percent in South Asia to 39 percent in Africa. They explain differences in portfolio choice in terms of the capital to labor ratio, indebtedness, exchange rate distortions, and risk ratings - all proxies for differences in the risk-adjusted rate of return on capital. They then apply the results to four policy questions in which private portfolio choices are potentially important: the effect of the East Asian crisis on domestic capital outflows; spillovers; the effect of HIPC debt relief on capital repatriation; and why Africa has so much of its private wealth outside the continent. Their conclusions: 1) The four most severely affected East Asian countries will eventually lose about $250 billion in domestic wealth as a result of the deterioration in risk between March 1997 and September 1998. 2) They found some support for a spillover model. 3) The effect of the HIPC debt relief initiative on capital repatriation will vary massively between HIPC-eligible countries. 4) Africa has by far the lowest capital per worker, which makes massive capital flight from Africa all the more distinctive. Three variables explain capital flight in Africa: exchange rate overvaluation, adverse investor risk ratings, and high indebtedness.

Overcoming Crises Resulting from Adherence to the Washington Consensus: Lessons From the Republic of Korea and Brazil

Considering the recent experiences of both the Republic of Korea and Brazil, the following lessons should be underscored. (1) Brazil's (and Latin America's) liberalisation policies approved by the Washington Consensus, and especially the inflation control programmes based on overvalued exchange rates, placed the region's economies in a vulnerable position. (2)The Republic of Korea's experience with liberalisation in the mid-1990s was much more superficial and shorter. However, in terms of its rapid and short-term external indebtedness, the country was quite imprudent. (3) The Republic of Korea's spectacular reversion in its external current account deficit during 1998 clearly underscores the importance of having large national business groups that are sufficiently competitive, industrially and technoogically, to react quickly to national policies and decisions. In Brazil, the financial, industrial, and technological weakness of large national business groups, explains, to a large degree, the difficulty of overcoming the balance of payments crisis, despite the reduced inflationary impact of the maxi-devaluation in the exchange rate.

Singapore and the Asian Economic Crisis: An Assessment of Policy Responses

Singapore seems to have weathered the financial storm of East Asia better than most in the region. Yet it was not spared from contagion. Economic growth slowed from 7.8 per cent in 1997 to 1.5 per cent in 1998. The declining regional demand for Singapore's exports due to contraction in the crisis economies and loss of competitiveness in the face of competitive devaluations posed new challenges for Singapore which had to adopt policies to combat the crisis. This article examines the effects of proposed policies using a computable general equilibrium model. We find that the wage reduction and devaluation policies are more promising than domestic demand stimulation. I. Introduction Singapore seems to have weathered the financial storm of East Asia better than most in the region. Yet it was not spared from contagion. Economic growth slowed from 7.8 per cent in 1997 to 1.5 per cent in 1998. The crisis impacted different sectors unevenly. Sectors such as commerce, transport, tourism, and financial services, which have large regional exposures, were badly hit. The declining regional demand for exports and the challenge of maintaining international competitiveness despite competitive devaluations mean that Singapore had to adopt effective policy responses. This paper uses a computable general equilibrium (CGE) model to simulate the effects of policies adopted by Singapore. Section II is a brief discussion of the Asian crisis and its implications for Singapore. Section III reviews Singapore's policy responses to the crisis. Section IV presents the results. Section V concludes. II. The Asian Crisis and Its Implications for Singapore The Asian crisis began as an exchange rate crisis in Thailand and spread quickly to the Philippines and Indonesia, and then to Malaysia. This led to financial crises which, in turn, produced severe downturns in real economic activity in these, and other, countries. While a full discussion of the causes, propagation channels, and effects are beyond our scope,1 some points need to be made to show how, and to what extent, Singapore was caught up in the crisis. We focus on Thailand, the first domino. An overvalued exchange rate pegged to the US$,2 declining exports,3 and a growing current account deficit made Thailand vulnerable to a speculative exchange rate attack. The falling yen and an effective depreciation of about 10 per cent of the yuan4 contributed to reduced export competitiveness. The resulting devaluation triggered a financial crisis. Substantial capital inflows, about 6 per cent of GDP, had fuelled price bubbles in real estate and the stock market. Although these bubbles peaked at the end of 1993, by the end of 1997 share prices fell to about 29 per cent of their 1995 levels while the property company share index fell to 10 per cent of its 1995 level (Edison, Luangaram and Miller 1998, p. 4). In addition, relatively high domestic interest rates and the pegged exchange rate led to increases in foreign short-term borrowing5 that was largely unhedged. As the exchange rate fell, financial institutions suffered large capital losses as the value of their foreign denominated debt increased. These losses were magnified since most bank lending was backed by collateral, particularly real estate. Financial system solvency, already impaired, was further damaged as the value of the banks' collateral collapsed6 and non-performing loans increased. New domestic credit dried up, as did foreign credit with capital outflows of about 2 per cent of GDP. Otherwise viable firms were unable to finance working capital and new investment, leading to widespread bankruptcies and sharp declines in aggregate demand and real output.7 Financial system weaknesses (including implicit government guarantees against risk, inadequate monitoring, and supervision) prevented the devaluation from stimulating the economy as exporting firms were unable to take advantage of their increased price competitiveness (Montes and Popov 1999). …

The Time Profile of the Cost Structure in Pakistan’s Manufacturing Sector

The manufacturing sector of Pakistan has at times played the role of the leading sector of the economy. The successful experience of planned growth in the 1960s owes much to the special attention paid to the growth of manufacturing sector. Policies like the export bonus scheme, tax-holidays, subsidised import of capital, easy and subsidised loans and over-valued exchange rate, resulted in a substantial growth in the sector. However, with over-protection of the sector, nationalisation of some of the major industries in the 1970s and, later-on, over-employment in the nationalised industries, the performance of the sector started to deteriorate gradually. It is now widely believed that many of the manufacturing industries in Pakistan have become inefficient because they have not been exposed to competitive environment due to protective and distortionary policies.

The political economy of exchange rate policy in Brazil: an empirical assessment

This paper investigates whether political economy factors contribute to explain the exchange rate policy in Brazil from 1964 to 1997. An analytical framework presents the tradeoff between the positive effect of a depreciated exchange rate on the balance of payments and its negative effect on inflation as driving force affecting exchange rate policy. The exchange rate policy resulting from this tradeoff depends on the political environment. We test our hypotheses by modeling the exchange rate disequilibrium level as a Markov switching model with time varying transition probabilities, and the influence of political economy variables on the transition probabilities is tested. The results support partially the predictions of our analytical framework. According to our statistical results there is an election cycle: the probability of having an overvalued exchange rate is higher in the months preceding elections, while the probability of having an undervalued exchange rate is higher in the months succeeding elections.