Thorvaldur Gylfason Joint Vienna Institute/IMF Institute Course on Macroeconomic Management in Natural Resource-Rich Countries Vienna, 2-13 April 2012

Thorvaldur Gylfason

DUTCH DISEASE, VOLATILITY, AND EXCHANGE RATE REGIME IN RESOURCE-RICH COUNTRIES

Joint Vienna Institute/IMF InstituteCourse on Macroeconomic Management in

Natural Resource-Rich Countries Vienna, 2-13 April 2012

1. Real vs. nominal exchange rates

2. Exchange rate policy, welfare, and growth

3. Dutch disease, overvaluation, and volatility

4. Exchange rate regimes To float or not to float How many currencies?

OUTLINE

BACKGROUND: REAL VS. NOMINAL EXCHANGE RATES

1

*P

ePQ

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Increase in Q means real appreciation

e refers to

foreign currency

content of

domestic currency

Q = real exchange ratee = nominal exchange rateP = price level at homeP* = price level abroad

Devaluation or

depreciation of e

makes Q also

depreciate

unless P rises so

as to leave Q

unchanged

BACKGROUND: REAL VS. NOMINAL EXCHANGE RATES

*P

ePQ

THREE THOUGHT EXPERIMENTS

*P

ePQ

1. Suppose e fallsThen more rubles per dollar, so X rises, Z falls

2. Suppose P fallsThen X rises, Z falls

3. Suppose P* risesThen X rises, Z falls

Capture all three by supposing Q falls

Then X rises, Z falls

IMPORTANCE OF APPROPRIATE SIDE MEASURESRemember:

Devaluation needs to be accompanied by fiscal and monetary restraint to prevent prices from rising and thus eating up the benefits of devaluation

To work, nominal devaluation must result in real devaluation

*P

ePQ

Foreign exchange

Real exc

hang

e r

ate

Imports

Exports

2

Earnings from

exports of goods,

services, and capital

Payments for imports

of goods, services,

and capital

Equilibrium

EXCHANGE RATE POLICY AND WELFARE

Equilibrium between demand and supply in foreign exchange market establishesEquilibrium real exchange rateEquilibrium in balance of

paymentsBOP = X + Fx – Z – Fz

= X – Z + F = current account + capital

account = 0


X – Z = current account

F = capital and financial account

Foreign exchange

Real exc

hang

e r

ate

Imports

Exports


Overvaluation

Deficit

R R moves when e is fixed

Foreign exchange

Pri

ce o

f fo

reig

n e

xch

an

ge

Supply (exports)

Demand (imports)


Overvaluation

Deficit

Overvaluation works like a price ceiling

Appreciation of currency in real terms, either through inflation or nominal appreciation, leads to a loss of export competitiveness

In 1960s, Netherlands discovered natural resources (gas deposits)Currency (Dutch guilder) appreciated Exports of manufactures and services

suffered, but not for long Not unlike natural resource discoveries,

aid inflows could trigger the Dutch disease in receiving countries

3See my “Dutch Disease” in New Palgrave Dictionary of Economics Online

DUTCH DISEASE

http://www3.hi.is/~gylfason/Dutch%20Disease%20Palgravex.pdf

IMPACT OF AID ON REAL EXCHANGE RATE Review basic theory of Dutch disease in simple demand and supply model

Analytical literature uses complex two- or three sector modelsTradable manufacturesTradable resourcesNontradable services

DUTCH DISEASE: HOW OIL EXPORTS CROWD OUT NONOIL EXPORTS

Foreign exchange

Real exc

han

ge r

ate

Imports

Exports without oil

Exports with oil

A

C BOil discovery

leads to appreciation

, and reduces nonoil exports

Compositi

on of exports

matters

MIGRATION MITIGATES INCREASE IN REAL EXCHANGE RATE

Foreign exchange

Real exc

han

ge r

ate

Imports

Exports without oil

Exports with oil

A

C B Imports with immigration

D Immigrations

means more

income and imports

as well as

remittances abroad

TWO MAIN CHANNELS Spending effect

Increased income from booming natural resource sector boosts private and public spending, raising prices and output in non-tradables sector

In non-natural resource tradables sector (“manufacturing”), prices are fixed at world levels, profits are squeezed by rising wages, and increased demand is met out of rising imports

Resource movement effect Natural resource boom attracts capital and

labor away from rest of economyOutput declines in non-resource economy,

esp. in tradables, where prices are fixed at world levels

DECLINING MANUFACTURES, RISING CURRENCIES Both effects result in

Decrease in output share of non-natural resource tradables relative to non-tradables

Appreciation of real exchange rate So, decline of manufacturing and

appreciation of currencies in real terms tend to go hand in handExtensive theoretical literature behind this

resultWhat do the data say?Recent literature survey by Magud and Sosa

(2010) “When and Why Worry About Real Exchange Rate

Appreciation? The Missing Link between Dutch Disease and Growth,” WP/10/271

Dutch disease shocks Natural resources/capital inflows

0

5

10

15

20

25

30

35

40

45YesNo

Source: Magud and Sosa (2011)

Num

ber

of

case

s re

port

ed

0

5

10

15

20

25

30

35Yes

No

EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS I

Remittances Foreign aid

Appreciation Lower T/NT output

Lower growth

0

1

2

3

4

Yes

No

0

1

2

3

4

5

6

7

8Yes

No

Num

ber

of

case

s re

port

ed


EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS II

Empirical studies Theoretical studies

0

2

4

6

8

10

12

14Yes

No

0

5

10

15

20

25

30Yes

No

Num

ber

of

case

s re

port

ed


EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS III

EMPIRICAL EVIDENCE: LITERATURE REVIEW IN NUMBERS IV

Currency misalignments Exchange rate changes

Num

ber

of

case

s re

port

ed


Real overvaluation Real undervaluation0

5

10

15

20

25

30

YesNo

Real appreciation Real depreciation0

1

2

3

4

5

6

Yes

No

Does overvaluation reduce growth? Does

undervaluation?

SUMMARY OF RESULTS Dutch disease does exist

Resource booms make currencies appreciate

When currency appreciates in real terms, factors of production are reallocated and production switches away from manufacturing Exchange rate volatility hampers economic

growth (not shown here, will see later)Misalignment of real exchange rate from its

fundamental value also lowers growth Overvaluation is always bad for growth Evidence on the effect of undervaluation on

growth is inconclusive

DUTCH DISEASE Foreign exchange earnings are

converted into local currency and used to buy domestic goods

Fixed exchange rate regimeReserve inflow causes expansion of

money supply that leads to inflation and appreciation of domestic currency in real terms

Flexible exchange rate regimeIncrease in supply of foreign exchange

leads to nominal appreciation of currency, so real exchange rate also appreciates

M = D + R

Q = eP/P*

M = Money

D = Domestic

creditR = Reserves

DUTCH DISEASE: HOW FOREIGN AID CROWDS OUT EXPORTS

Foreign exchange

Real exc

han

ge r

ate

Imports

Exports without aid

Exports with aid

A

C B

Foreign aid

leads to appreciation

, and reduces exports (e.g., Zambia)

Trade vs.

aid

DUTCH DISEASE: HOW CAPITAL INFLOW CROWDS OUT EXPORTS

Foreign exchange

Real exc

han

ge r

ate

Imports

Exports without inflow

Exports with inflow

A

C B

Capital account

liberalization

leads to appreciation,

and sometimes

instability when

inflow stops or

reverses itself

Crises

NETHERLANDS: EXPORTS 1960-2010 (% OF GDP)

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

0

10

20

30

40

50

60

70

80

90

Nether-landsIcelandNorway

Volatility of commodity prices leads to volatility in exchange rates, export earnings, output, and employment

Volatility can be detrimental to investment and growth

Hence, natural-resource rich countries may be prone to sluggish investment and slow growth due to export price volatility

Likewise, high and volatile exchange rates tend to slow down investment and growth

DIFFERENT MANIFESTATIONS: VOLATILITY

WHICH INCOME STREAM WOULD YOU PREFER? (100 OVER 4 YEARS)

Uneven income stream Even income stream

Output volatility and economic growth 1960-2000

Inverse cross-country correlation between per capita growth and GDP volatility

GDP volatility is defined as the standard deviation of per capita growth

163 countries, 1960-2000

-8

-6

-4

-2

0

2

4

6

0 4 8 12 16 20

Volatility of GDP

Per

cap

ita g

row

th a

djus

ted

for

initi

al in

com

w (

% p

er y

ear)

VOLATILITY AND GROWTH

r = -0.47

Large inflows of foreign exchange earnings from a natural resource discovery can trigger a bout of Dutch disease

Real appreciation hurts competitiveness of exports and can thus undermine economic growthExports have played a pivotal role in

the economic development of many countries

An accumulation of “know-how” often takes place in the manufacturing export sector, which may confer positive external benefits on the rest of the economy

RISK OF DUTCH DISEASE

RISK OF DUTCH DISEASE Resource boom is likely to lead to

Dutch disease if It leads to high demand for nontradables

Trade restrictions may produce this outcome Recipient country uses aid to buy nontradables

(including social services) rather than importsProduction is at full capacity

Production of nontradables cannot be increased without raising wages in that sector

Resource rent is not used to build up infrastructure and relax supply constraints Including free mobility of labor across countries

Price and wage increases in nontradables sector lead to strong wage pressure in tradables sector

RISK OF DUTCH DISEASE The risk that resource boom

might have adverse impact on economy due to, e.g., oil-induced Dutch disease crucially depends on how resource rent is used in recipient countriesWe can identify four different cases based on how the rent is spent, and in which the macroeconomic implications of rent flows differArgument also applies to inflows of foreign aid

Spending can take several forms, with different macroeconomic implications:Case 1: Rent is saved by government Case 2: Rent is used to purchase

imported goods that would not have been purchased otherwise

Case 3: Rent is used to buy nontradables with infinitely elastic supply

Case 4: Rent is used to buy nontradables for which there are supply constraints

RISK OF DUTCH DISEASE

HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 1 Rent is saved by government

Rent inflow leads to accumulation of foreign exchange reserves in Central Bank … and, unlike increased rent that is spent,

is not allowed to enter the spending streamNo effect on money supplyNo inflationNo appreciation of currency

I.e., no increase in exchange rateNo risk of Dutch disease

Rent is used to purchase imported goods that would not have been purchased otherwiseImport purchases lead to transfer of

real resources from abroad, but not to increased spending at home

No effect on money supplyNo inflationNo appreciation of currencyNo risk of Dutch disease

HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: CASE 2

Rent is used to buy domestic nontradables with infinitely elastic supply due to underutilized resources (labor and capital) in economy Increased demand for nontradablesBecause some factors are unemployed,

greater demand leads to increased supply

This has a positive impact on production without increasing nontradables prices

No risk of Dutch disease


Rent is used to buy nontradables for which there are supply constraints, with all available resources already in use (e.g., social services)Increased demand for nontradablesIncreased prices for nontradablesShift of inputs away from tradables

(exports and import-competing goods and services) into nontradables

Real appreciation of the currencyDutch disease!


Monetary policy response determines if real appreciation of currency will take place through inflation or nominal appreciationIf foreign currency is used to increase

Central Bank reserves, increased spending on nontradables increases money supply and inflation, so currency appreciates in real terms

If Central Bank sterilizes impact on money supply of increased spending on nontradables by selling foreign exchange, currency appreciates in nominal, and real, terms


So, in either case,

currency appreciates in

real terms

To recapitulate, the risk of Dutch disease varies, and depends onHow rent is used (saved or spent) –

CASE 1The presence of a rent absorption

constraint – CASE 2The impact of rent on productivity in

the nontradables sector – CASE 3The existence of externalities in

nontradables sector affecting the rest of the economy – CASE 4

HOW RENT IS USED AND THE RISK OF DUTCH DISEASE: LESSONS

Rent inflow can give rise to Dutch disease when government uses the rent to purchase nontradables rather than imported goods and when there are constraints on increasing production in nontradables sector

The risk of Dutch disease is greater when rent is used in social sectors facing constraints on increasing their production due to resource scarcity (rent absorption constraint)


How can resource-rich countries avoid translating rent into Dutch disease? Save the rent and increase central

bank reserves (gross, not net) by not allowing the rent inflow to enter spending stream Recall the Hartwick rule

Use rent to purchase imported goodsBoost rent absorption capacity in

nontradables sector


Policymakers in resource-rich countries need to pay attention to potential early warning signals of, say, oil-induced Dutch disease such asTendency for wages and prices in

nontradables sector to increase Decline in profitability and sales of export

and import-competing industriesRapid relative rise of per capita GDP in

dollars Recall: Argument applies to sudden inflows of

foreign capital as well as natural resource booms

RISK OF DUTCH DISEASE: EARLY WARNING SIGNALS

The real exchange rate always floatsThrough nominal exchange rate

adjustment or price changeEven so, it matters how

countries set their nominal exchange rates because floating takes time

There is a wide spectrum of options, from absolutely fixed to completely flexible exchange rates

4EXCHANGE RATE REGIMES

EXCHANGE RATE REGIMESThere is a range of options

Monetary union or dollarizationMeans giving up your national

currency or sharing it with others (e.g., EMU, CFA, EAC)

Currency boardLegal commitment to exchange

domestic for foreign currency at a fixed rate

Fixed exchange rate (peg)Crawling pegManaged floatingPure floating

Currency union or dollarization Currency board

Peg Fixed Horizontal bands

Crawling peg Without bands With bands

Floating Managed

Independent

FIXED

FLEXIBLE

EXCHANGE RATE REGIMES

DollarizationUse another country’s currency as sole legal

tender

Currency unionShare same currency with other union

members

Currency boardLegally commit to exchange domestic

currency for specified foreign currency at fixed rate

Conventional (fixed) pegSingle currency pegCurrency basket peg

BASICALLY FIXED

Flexible pegFixed but readily adjusted

Crawling pegComplete

Compensate for past inflation

Allow for future inflation

PartialAimed at reducing inflation, but real appreciation results because of the lagged adjustment

Fixed but adjustable

INTERMEDIATE

Managed floatingManagement by sterilized

intervention I.e., by buying and selling foreign

exchangeManagement by interest rate

policy, i.e., monetary policy E.g., by using high interest rates to

attract capital inflows and thus lift the exchange rate of the currency

Pure floating

BASICALLY FLOATING

THE SCOURGE OF OVERVALUATION

Governments may try to keep the national currency overvaluedTo keep foreign exchange cheapTo have power to ration scarce

foreign exchangeTo make GDP look larger than it

isOther examples of price ceilings

Negative real interest ratesRent controls in cities

INFLATION AND OVERVALUATION

Inflation can result in an overvaluation of the national currencyRemember: Q = eP/P*

Suppose e adjusts to P with a lag

Then Q is directly proportional to inflation

Numerical example


Time

Real exchange rate

100

110

105 Average

Suppose inflation is 10% per year


Time

100

120

Real exchange rate

110 Average

Hence, increased

inflation lifts the

real exchange rate

as long as the

nominal exchange

rate adjusts with a

lag

Suppose inflation rises to 20%

HOW TO CORRECT OVERVALUATION

Under floatingDepreciation is automatic: e

movesBut depreciation may take time

Under a fixed exchange rate regimeDevaluation will lower e and

thereby also Q – provided inflation is kept under control

Does devaluation improve the current account?The Marshall-Lerner condition

FROM OVERVALUATION TO UNDERVALUATION If overvaluation of currency hurts

exports, undervaluation must by similar logic help exportsYet, as we saw, empirical evidence is mixed

Some countries – e.g., China – have kept their currencies undervalued to boost exports and contain importsUndervaluation as export promotion policy

Undervaluation leads to buildup of foreign exchange reservesReserve buildup raises some of the same

issues as natural resources booms

WHY WE HAVE FEWER CURRENCIES THAN COUNTRIES In view of the success of the EU

and the euro, economic and monetary unions appeal to many other countries with increasing force

Consider four categoriesExisting monetary unionsDe facto monetary unionsPlanned monetary unions Previous – failed! – monetary unions

EXISTING MONETARY UNIONS CFA franc

14 African countries CFP franc

3 Pacific island states East Caribbean dollar

8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize

winning development economist, adorns the $100 note

Euro, more recent16 EU countries plus 6 or 7 others

Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

DE FACTO MONETARY UNIONS Australian dollar

Australia plus 3 Pacific island states Indian rupee

India plus Bhutan (plus Nepal) New Zealand dollar

New Zealand plus 4 Pacific island states South African rand

South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe

Swiss franc Switzerland plus Liechtenstein

US dollar US plus Ecuador, El Salvador, Panama, and 6 others

PLANNED MONETARY UNIONS East African shilling (2009)

Burundi, Kenya, Rwanda, Tanzania, and Uganda

Eco (2009)Gambia, Ghana, Guinea, Nigeria, and Sierra

Leone (plus, perhaps, Liberia) Khaleeji (2010)

Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates

Other, more distant plansCaribbean, Southern Africa, South Asia,

South America, Eastern and Southern Africa, Africa

PREVIOUS MONETARY UNIONS Danish krone 1886-1939

Denmark and Iceland 1886-1939: 1 IKR = 1 DKR 2009: 2,500 IKR = 1 DKR (due to inflation in

Iceland) Scandinavian monetary union 1873-1914

Denmark, Norway, and Sweden East African shilling 1921-69

Kenya, Tanzania, Uganda, and 3 others Mauritius rupee

Mauritius and Seychelles 1870-1914 Southern African rand

South Africa and Botswana 1966-76 Many others

No significant

divergence of

prices or currency

rates following

separation

99.95%

CONFLICTING FORCES Centripetal tendency to join monetary

unions, thus reducing number of currencies To benefit from stable exchange rates at the

expense of monetary independence Centrifugal tendency to leave monetary

unions, thus increasing number of currencies To benefit from monetary independence

often, but not always, at the expense of exchange rate stability

With globalization, centripetal tendencies appear stronger than centrifugal ones

IMPOSSIBLE TRINITY

FREE CAPITAL MOVEMENTS

FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCE

MonetaryUnion (EU)

Free to choose

only two of three

options; must

sacrifice one of the

three

1

2

3

IMPOSSIBLE TRINITY


FIXEDEXCHANGE

RATE

MONETARYINDEPENDENCECapital controls

(China)

Free to choose

only two of three

options; must


three

1

2

3

IMPOSSIBLE TRINITY


FIXEDEXCHANGE

RATE


Flexible exchange rate (US, UK, Japan)

Free to choose

only two of three

options; must


three

1

2

3

IMPOSSIBLE TRINITY


FIXEDEXCHANGE

RATE


MonetaryUnion (EU)

Flexible exchange rate (US, UK, Japan)

Capital controls (China)

Free to choose

only two of three

options; must


three

1

2

3

FIX OR FLEX? If capital controls are ruled out in view of

the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), …

… then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates Cannot have both!

Either type of regime has advantages as well as disadvantages

Let’s quickly review main benefits and costs

Benefits Costs

Fixed exchange rates

Floating exchange rates

BENEFITS AND COSTS

Benefits Costs


Stability of trade and investmentLow inflation


BENEFITS AND COSTS

Benefits Costs



InefficiencyBOP deficitsSacrifice of monetary independence


BENEFITS AND COSTS

Benefits Costs





EfficiencyBOP equilibrium

BENEFITS AND COSTS

Benefits Costs





EfficiencyBOP equilibrium

Instability of trade and investmentInflation

BENEFITS AND COSTS

In view of benefits and costs, no single exchange rate regime is right for all countries at all times

The regime of choice depends on time and circumstance If inefficiency and slow growth due to

currency overvaluation are the main problem, floating rates can help

If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation

Ones both problems are under control, time may be ripe for monetary union

BENEFITS AND COSTS

What do countries do?

To eliminate high

inflation, need fixed

exchange rate for a

time

NATURAL RESOURCES, INFLATION, AND EXCHANGE RATES There is no evidence that countries with

abundant natural resources are more prone to inflation than other countriesThey tend to grow more slowly, yes, but

their inflation record is indistinguishable from others

Therefore, as far as inflation is concerned, choice between fixed and floating rates is essentially the same in natural-resource rich countries and elsewhereVolatility of export earnings in natural-

resource rich countries calls for flexibility – if not in exchange rate, then, e.g., in migration

Source: Annual Report on Exchange Arrangements and Exchange Restrictions database.

What countries actually do (Number of countries, April 2008)

(3)

(12)

(22)

(5) (2)(66)

(44) (40)

(76)

(84)

(10)

No national currency 6%Currency board 7%Conventional fixed rates

36%Intermediate pegs 5%Managed floating 24%Pure floating 22% 100%

46%

54%

There is a gradual tendency towards floating, from 10% of LDCs in 1975 to almost 50% today, followed by increased interest in fixed rates through economic and monetary unions

WHAT COUNTRIES ACTUALLY DO (2008, 182 COUNTRIES)

The End

These slides will be posted on

my website:

www.hi.is/~gylfason

Documents

Thorvaldur Gylfason Joint Vienna Institute/IMF Institute Course on Macroeconomic Management in Natural Resource-Rich Countries Vienna, 2-13 April 2012