External Stability, Real Exchange Rate Adjustment, and the Exchange Rate Regime 1

Transcription

1 Preliminary and incomplee Please do no quoe wihou permission Exernal Sabiliy, Real Exchange Rae Adjusmen, and he Exchange Rae Regime 1 Olivier Gervais Bank of Canada Larry Schembri Bank of Canada Lena Suchanek Bank of Canada July 29 Absrac Unsusainably large global curren accoun imbalances are widely seen as an imporan conribuing facor o he ongoing financial crisis and global recession. The lack of significan and imely exchange rae adjusmen has allowed hese imbalances o increase and persis. The purpose of his paper is o explore wo relaed hypoheses: (i) ha real exchange rae flexibiliy and adjusmen is criical o mainaining exernal sabiliy and (ii) ha a flexible nominal exchange rae faciliaes real exchange rae adjusmen and he mainenance of exernal sabiliy, if domesic wages and prices are sicky. Based on an even sudy analysis for a large se of emerging marke economies over he period, we find ha real exchange rae adjusmen has conribued significanly o curren accoun adjusmens. However, adjusmen of curren accoun deficis in counries wih fixed exchange rae regime does ypically no occur hrough he classical adjusmen process, bu as a consequence of exchange rae crises, where he nominal exchange rae is forced o adjus and he coss in erms of foregone GDP growh is high. Vecor error correcion resuls suppor our finding in he even sudy; namely ha he long run relaionship beween he curren accoun and he real exchange rae is consisen wih heory. JEL classificaion codes: F31, F32, F41 1 We would like o hank Wei Dong, Sharon Kozicki, Michael Francis, Rober Lavigne, Jeannine Baillu and he paricipans of he CEA conference 29 for helpful commens, and Firas Abu-Sneneh for excellen research assisance. The views in his paper are solely our responsibiliy and should no be inerpreed as reflecing he views of he Bank of Cananda. lsuchanek@bankofcanada.ca

2 1 Inroducion Unsusainably large global curren accoun (CA) imbalances are widely seen as an imporan conribuing facor o he ongoing financial crisis and he lack of exchange rae adjusmen o hese imbalances is viewed as being parly responsible. 2 This concern abou global imbalances helped insigae he reform of IMF surveillance aciviies ha resuled in he recen 27 Decision on Surveillance (IMF 27). In his Decision, he IMF made he mainenance of exernal sabiliy he focus of is surveillance aciviies over members exchange rae, fiscal, moneary and financial secor policies. The IMF refers o exernal sabiliy as a balance of paymens posiion ha does no, and is no likely o, give rise o disrupive exchange rae movemens. The concep of exernal sabiliy encompasses boh he curren and he capial accouns of he balance of paymens because CA imbalances may no cause disrupive exchange rae movemens if hey are complemened by susainable capial inflows or ouflows. In pracice, however, he focus is primarily on CA imbalances and real exchange rae (RER) misalignmen, because here is a well documened heoreical relaionship beween hem. However, he fear of labeling member counry s exchange raes as misaligned in Aricle IV repors has hampered he effecive implemenaion of he 27 Surveillance Decision. Lavigne and Schembri (29) argue ha he focus of IMF surveillance over exchange raes should, insead, be on permiing imely and effecive RER adjusmen o ensure ha CA imbalances are resored o susainable levels. Theories of exernal adjusmen in open economies (e.g., Obsfeld and Rogoff, 1995) mainain ha smooh adjusmen o exernal imbalances can be mos easily obained via RER adjusmen, raher han via income/oupu/expendiure adjusmen. Relaive price movemens cause expendiure o swich beween domesic and foreign-produced goods and can ake place while he economy is operaing a close-o-full employmen. In conras, income and expendiure adjusmen have proven o be much more disrupive. In heory, marke-driven RER adjusmen will occur in response o a CA imbalance eiher via money supply and price level movemens under a fixed nominal exchange rae (i.e., he classical adjusmen process) or via movemens in a flexible nominal exchange rae (i.e., he [Meade-] Friedman adjusmen process). Friedman (1953) and Borda (25) mainain ha because of he nominal sickiness of domesic wages and prices, a flexible exchange rae can faciliae RER adjusmen. Numerous examples exis of he high cos of he classical adjusmen process: he UK s reurn o he gold sandard in 1926, he Wes German boom of he 196s, and he Argenine experience wih a currency board in he 199s. In pracice, recen examples of he classical adjusmen process are rare. Counries wih a fixed nominal exchange rae and CA surpluses ypically frusrae he RER adjusmen process by serilizing he impac on he domesic money supply. In counries wih a defici, RER adjusmen under a fixed exchange rae ofen occurs as a consequence of an exchange crisis in which he nominal rae is forced o adjus and economic aciviy is severely disruped. The purpose of his paper is o explore wo relaed hypoheses: 2 For example, he IMF wries in he People s Republic of China: Saff Repor for he 26 Aricle IV Consulaion : From a global perspecive, exchange rae flexibiliy... would also help conribue o an orderly process for resolving global CA imbalances. In addiion, Garcίa-Herrero e Koivu (27) find ha a more flexible nominal exchange rae would favour he adjusmen of he rade balance. Page 2 of 32

3 1. ha RER flexibiliy and adjusmen is criical o mainaining exernal sabiliy (main hypohesis) and 2. ha a flexible nominal exchange rae faciliaes RER adjusmen and he mainenance of exernal sabiliy because nominal wages and prices are sicky (corollary hypohesis). From a policy perspecive, addressing hese hypoheses and quesions is imporan because hey speak direcly o exchange rae policy and he choice of exchange rae regimes. Firs, does a relaively flexible RER promoe an adjusmen of CA imbalances? 3 And second, if so, does a flexible exchange rae regime increase RER flexibiliy and hus enhance smooher adjusmen? Alhough he exising lieraure has ended o focus on he second of our wo hypoheses, ha is, he choice of he nominal exchange rae regime, we believe i is imporan o examine he firs hypohesis, ha is, he criical role of he RER in he adjusmen process, especially for emerging marke economies (EMEs). To examine hese quesions and hypoheses we adop wo complemenary empirical mehodologies. We firs examine he role of RER adjusmens during periods of CA adjusmens using an even sudy for 21 EMEs and he G-7 from , following he mehodology of Freund and Warnock (25). We also examine CA surplus reversals, and spli he sample ino crisis vs. non-crisis periods, and in fixed vs. floaing exchange rae regimes. To our knowledge, he quesion of exchange rae regimes has no been addressed in he even sudy lieraure and his approach yields ineresing resuls. Our empirical findings are consisen wih he wo hypoheses. Firs, we find ha periods of CA reversals from defici o surplus have been associaed wih sizeable RER depreciaions. Moreover, he larger is he CA reversal, he larger is he depreciaion. Second, here seems o be a radeoff beween he adjusmen ha comes via he RER and ha hrough GDP. Pu differenly, if he RER can no adjus (poenially due o a fixed nominal exchange rae or slow adjusmen of relaive price levels), oupu/income have o ake on a larger burden of he adjusmen. Third, he adjusmen is more painful in erms of oupu loss for counries ha had a fixed exchange rae regime a he ime of he reversal, and he RER depreciaes by more. Our resuls sugges ha faser adjusmen of exernal imbalances comes hrough a more flexible nominal ER, or, more dramaically, an exchange rae crisis. Given ha a crisis implies a much higher cos in erms of los oupu because of financial disrupion, his resul suggess ha a flexible ER allows a more rapid bu orderly adjusmen of he CA, which is consisen wih our second hypohesis. We hen examine he dynamic ineracion of he CA, he RER, foreign and domesic income for he same sample of EMEs using vecor error correcion echniques. To our knowledge, here have been no aemps in lieraure o examine he long run relaionship beween he CA and he RER for EMEs. We find ha here exiss a long run equilibrium coinegraion relaionship beween he CA and he RER, which is consisen wih heory. The resuls moreover suppor our firs hypohesis ha he RER is an imporan facor in deermining he movemen of he CA. 3 We measure exernal imbalances by he level of he CA. The lieraure has proposed alernaive measures, such as he level of exernal deb o GDP, foreign asses, or reserves in erms of impor monhs. Adjusmen capaciy has been measured by he change in impors following a shock (Igbar and Erbas, 1997) and he firs order auocorrelaion of he CA (Cheung and Lai, 27). Page 3 of 32

4 The paper proceeds as follows. Secion 2 provides some heoreical background and a brief lieraure review. Secion 3 inroduces he even sudy analysis and presens resuls. Secion 4 specifies he VECM, and presens esimaion resuls and analysis. Secion 5 concludes. 2 Theoreical Background and Lieraure Review The heory surrounding adjusmen o CA imbalances in open economies has a long hisory, saring mos noably wih he price-specific-flow adjusmen mechanism under he gold sandard developed by David Hume in he 18h cenury. Since hen here have been many developmens including he work of Viner (1937), Meade (1951), Friedman (1953), Mundell (1962) Dornbusch (1976), and Branson (1983), leading up o he Redux model of Obsfeld and Rogoff (1995). In all of hese models, he RER moves o faciliae adjusmen o a CA imbalance, regardless of wheher he nominal exchange rae regime is permanenly fixed, flexible or inermediae. For example, following a shock o exernal demand ha creaes a CA surplus, he RER will appreciae eiher hrough nominal exchange rae appreciaion or hrough a rise in domesic inflaion, hus reducing compeiiveness and reducing expors, while favoring impors. Thus, he main channel hrough which RER helps bring abou CA adjusmen is hrough a relaive price change ha causes an expendiure-swiching effec capured by he IS curve in he variaions of he radiional Fleming-Mundell model. 4 The expendiure-swiching mechanism reains is validiy in he Obsfeld and Rogoff (1995) model provided ha nominal prices are fixed in he producer counry and he exchange rae pass-hrough is complee. 5 Milon Friedman (1953) argued in favor of flexible exchange rae regimes, based on he fac ha, in a world wih sicky prices, he nominal exchange rae would adjus in response o exernal real shocks and hus help insulae he domesic economy. Friedman noed ha in a world wih sicky prices he speed a which relaive prices adjus depends crucially on he exchange rae regime. Since hen, a number of heories have confirmed his original inuiion and i has become one of he leas dispued argumens in favor of flexible exchange rae regimes (see Dornbusch (198) for direc descendans of he open economy Mundell Fleming models wih sicky prices; see Obsfeld and Rogoff (1996) and Corsei and Peseni (21) for dynamic general equilibrium models wih nominal sickiness.) In he Mundell-Fleming-Dornbusch model, floaing exchange raes are superior o fixed exchange raes when real shocks are he dominan source of disurbance o he economy. 6 Wih a real shock, domesic goods money prices have o bear he enire burden of downward adjusmen. Because hese are sicky, he economy reaches is new long-run equilibrium only gradually. The opposie is rue for floaing exchange rae regimes: following a real shock, he 4 For some empirical evidence and evoluion of he expendiure swiching effec, see Dong (29). 5 Noe ha he J-curve implies ha here migh be an iniial deerioraion of he CA following a real depreciaion because he Marshall-Lerner condiion may no hold in he shor run. A real depreciaion iniially causes impors o be more expensive and expors less expensive, and, if volumes are predeermined, will reduce he CA. Afer a while, hough, he volume of expors will sar o rise because of heir lower more compeiive prices, causing he demand for expors o pick up and domesic consumers o swich heir expendiure o domesic producs and away from expensive impored goods and services. Evenually, he CA should rise. 6 See Obsfeld and Rogoff (1996) Page 4 of 32

5 adjusmen o a new equilibrium is immediae, reached by an appreciaion of he nominal exchange rae, which eliminaes he need for a change in he nominal price level. In conras, if money or asse demand shocks dominae, hen hey would be fully and auomaically eliminaed by foreign exchange rae inervenion under a fixed exchange rae regime, hus leaving he real economy unaffeced. An empirical implicaion of hese heories is ha he adjusmen of exernal imbalances across exchange rae regimes should differ. In paricular, regimes ha allow for faser movemens in he RER should allow a more rapid adjusmen o exernal imbalances such as large CA deficis. Under a flexible regime, he RER and relaive prices can adjus immediaely hrough changes in he nominal exchange rae, while under fixed regimes he adjusmen occurs a he rae permied by he nominal sickiness, which is usually much slower and ofen more painful in erms of los employmen and oupu or much higher inflaion (Dornbusch, 198). Therefore, flexible regimes should allow quicker relaive price adjusmens and hus a faser resoluion of CA imbalances. Alhough heoreical models are based on RERs, here is limied evidence on our firs hypohesis. Few researchers explore he link beween RER movemens and he adjusmen of real variables. 7 Arghyrou and Chorareas (28) address he quesion of CA adjusmen and he role of he RER using a vecor error correcion model. In paricular, he auhors focus on he diverging CAs of he individual euro area counries, he dynamics of CA adjusmen, and he role of he RER. They find ha he RER has a subsanial effec on CA adjusmen, bu ha relaionship is subjec o nonlinear effecs. Freund and Warnock (25) use an even sudy approach o examine episodes of CA adjusmen in indusrial counries. They firs deermine periods of CA defici reversals using crieria in Freund (2), and hen examine he behavior of key variables during he reversal. Among oher resuls, hey find ha CA adjusmen ends o be associaed wih slow income growh and a real depreciaion. Wih respec o he second hypohesis, he lieraure has suggesed mehods o classify exchange rae regimes (e.g. Reinhar and Rogoff, 24, and Levy-Yeyai and Surzenegger, 25) 8 and he imporance of exchange rae regimes for exernal sabiliy. Chinn and Wei (28), for insance, examine he imporance of he nominal exchange rae regime for he adjusmen process of he CA and find here is no robus relaionship beween he exchange rae regime and he rae of CA reversion. 9 In paricular, hey do no find a srong monoonic relaionship beween flexibiliy of a nominal exchange regime and he speed of convergence in RERs. However, hese conclusions are somewha misleading because hey assume ha 7 One excepion is Lee and Chinn (22). The auhors use srucural VARs o analyze he behavior of he RER, he CA, and oher variables following emporary and permanen shocks. They find ha emporary shocks play a larger role in explaining variaions in he CA, whereas permanen shocks play a larger role in explaining RER variaion. However, he auhors ignore he fac ha mos of heir variables are inegraed of order 1, and ha coinegraion is likely o bias heir VAR resuls 8 Reinhar and Rogoff (24), for insance, quesion he IMF classificaion and develop a sysem of reclassifying hisorical exchange rae regimes, employing monhly daa on marke-deermined parallel exchange raes. Levy- Yeyai and Surzenegger (22) consruc a de faco classificaion based on daa on exchange raes and inernaional reserves. 9 The auhors use he resuls of Reinhar and Rogoff (24) o deermine he imporance of he exchange rae regime for he adjusmen process of he CA. Page 5 of 32

6 speedier adjusmen is, in all cases, associaed wih less cosly adjusmen. In pracice, CA adjusmen under fixed exchange rae regimes does no occur via he classical adjusmen process, bu mos ofen counries running CA deficis adjus hrough exchange rae crises or forced devaluaions, which are associaed wih large employmen and oupu losses. Moreover, heir reduced form regressions mask a large endogeneiy problem and omi imporan conrol variables, including he degree of wages and price flexibiliy and frequency and impac of exchange rae crises. Broda (22) empirically assesses he Friedman hypohesis ha a flexible nominal exchange rae will help insulae domesic oupu o exernal real shocks. He analyzes he responses of real GDP, RERs, and prices o erms of rade shocks and finds ha responses are significanly differen across exchange rae regimes. He finds ha counries wih more flexible regimes end o have smaller real GDP losses and immediae large real depreciaions. In conras, counries wih fixed regimes experience large and significan declines in real GDP, and he RER depreciaes slowly by means of a fall in prices. 1 In heir sudy of small open economies in Europe, Choudhri and Kochin (198) conend ha here were hree differen currency experiences during he Grea Depression hose of he Gold Bloc lead by France (i.e., he Neherlands, Belgium, Ialy, and Poland), ha of Scandinavian counries ha were iniially on he gold sandard, bu hen allowed heir currency o adjus during he Depression, and ha of Spain which followed a floaing exchange rae. They show ha he Spanish oupu and prices remained largely unaffeced compared o counries following he gold sandard during he Depression. Deflaion was more significan in Scandinavian counries han Spain (floaing raes), bu smaller han ha of counries under he gold sandard (fixed raes). Wih regards o oupu, negaive oupu effecs were more severe in gold sandard counries han in Scandinavian counries. 3 Empirical Mehodology To sudy he relaionship beween he CA and he RER, we firs look a simple correlaions. Then, following Freund and Warnock (25), we use an even sudy approach o assess he behavior of he RER in periods of CA reversions. Lasly, we use VECMs o examine he role of RER flexibiliy in CA adjusmen. 3.1 Daa and descripive saisics We use daa on he RER, CA, and a number of conrol variables from a variey of sources. 11 Mos daa is quarerly. 12 If only yearly daa are available for a cerain ime period, we linearly inerpolae missing quarerly daa for RER and he CA. We use he real effecive exchange rae (REER) which is defined as he weighed average of he indexed bilaeral exchange raes (rade 1 Few auhors even argue ha he nominal exchange rae regime does no maer a all. For insance, Helpman (1981) 11 Curren accoun daa comes from he World Bank, he IIF and he IMF. Real exchange rae is aken from he IMF, he IIF and he BIS, while GDP is from he IMF and he OECD. 12 Quarerly daa for he CA and he governmen balance has been seasonally adjused. Page 6 of 32

7 weighed wih main rading parners), adjused by relaive consumer prices. 13 The RER is indexed o 1 for 21:4, and an increase in he RER corresponds o a real appreciaion. Daa availabiliy reduces our pool o 21 EMEs; from 1975 o For comparison purposes, we also include G7 counries for which a larger daa sample is available. Consisen wih our heoreical priors, CA reversals have generally been associaed wih large exchange rae movemens. For insance, Argenina s CA reversal from a defici of abou 3% in 21Q1 o a surplus of 1% by he end of 22 was accompanied by a RER depreciaion of 6%. Likewise, he deerioraion of Mexico s CA from a surplus of abou 1.5% in 1987 o a defici of 6% in 23 was accompanied by a RER appreciaion of 78%. Table 1 shows ha he correlaions beween curren accoun, real exchange rae, oupu, and he governmen balance across he hree samples, EMEs, G7, and oal. In all samples, he correlaion of he RER wih he CA is negaive implying ha an appreciaion is generally associaed wih a deerioraion of he CA. This resul is also consisen wih findings in he CA crisis lieraure. 15 The correlaion is more pronounced for EMEs we inerpre he low correlaion in G7 counries o he fac ha G7 counries CA migh be deermined o a larger exen by oher variables. The heoreical link beween GDP growh and he CA is no unambiguous. In simple open economy models (e.g. Mundell-Fleming), an increase in income is associaed wih higher spending on impored goods, and hus a deerioraion of he CA. We should hus expec a negaive sign, however, his is only rue for G7 counries. For robusness, we also look a some conrol variables ha have been used in he lieraure on CA deerminaion. The governmen balance is posiively correlaed wih he CA implying ha a fiscal expansion (i.e. a deerioraion of he budge balance) could lead o higher ineres raes and in he presence of capial inflows an appreciaion of he domesic currency may occur which increases he CA defici (win defici hypohesis). 16 Char 1 plos volailiy of he CA vs. volailiy of he RER here seems o be a posiive relaionship beween he flexibiliy of he RER and he variabiliy of he CA, suggesing some evidence for our firs hypohesis. To address he quesion wheher RER flexibiliy is associaed wih nominal exchange rae flexibiliy, we plo volailiy of boh in Char 2. Nominal exchange rae flexibiliy seems o be associaed, o a reasonable degree, wih RER flexibiliy. However, he correlaion beween he wo ranges from -.58 in Turkey o.99 in Malaysia. A negaive correlaion beween he nominal exchange rae and RER movemens implies ha nominal exchange rae movemens are no rading closely differences in inflaion raes as relaive purchasing power pariy would sugges Even sudy approach As menioned above, heory suggess ha CA improvemens are associaed wih a RER depreciaion, and CA deerioraion wih RER appreciaion. To examine he validiy of his hypohesis empirically, we firs apply Freund and Warnock s (25) even sudy o our broader se of EMEs. This kind of analysis is no new for insance, Algieri and Bracke (27) apply 13 For simpliciy, we will coninue denoing he real exchange rae by RER, referring o he REER. 14 The sample period is smaller for some counries due o missing daa. 15 See Algieri and Bracke (27) for empirical evidence using an even sudy. 16 Also, a fiscal expansion can lead o higher oupu and hus higher impors which increases he curren accoun defici. 17 This is coheren wih heoreical findings of Mussa (1982). Page 7 of 32

8 Freund and Warnock s mehodology o a larger se of counries, including some EMEs. However, we exend his exercise here for our se of counries o yield new insighs abou he role of RER adjusmen for CA adjusmens for differen groups of EMEs. An imporan conribuion of our analysis is ha we disinguish beween crisis and non crisis periods, and beween fixed exchange rae regimes and floaing regimes a he ime of he reversal. Moreover, we also analyze CA surplus, as well as defici, reversals. We hen evaluae he behavior of oupu growh and RER movemens, he wo main conribuors o CA adjusmen according o he exising lieraure (see Algieri and Bracke, 27, for a summary) in periods of CA reversion. In a firs sep, we deermine CA reversal periods for our sample. The crieria for a CA reversal are: 1) The CA defici (surplus)-gdp raio exceeds wo percen before he reversal. 2) The average defici (surplus)-gdp raio is reduced by a leas wo percenage poins over hree years (from he minimum o he cenered hree year average). 3) The CA defici (surplus)-gdp raio is reduced by a leas one hird. 4) The maximum defici (surplus)-gdp raio in he five years afer he reversal is no larger han he minimum in he hree years before he reversal. The firs hree crieria ensure ha only large CA reversals are capured, whereas he fourh ensures ha he reversal was susained, i.e. he change in he daa was no only due o some heighened volailiy CA defici reversals Using hese crieria on daa for our se of EME counries from , we idenify 55 episodes of CA defici adjusmen in 21 counries, which are lised in Table 2. Char 3 documens he paern of adjusmen across he CA, he RER, and GDP growh, wih even ime corresponding o he year he CA balance is mos negaive. 18 For comparison, we also examine G7 counries (Char 4). On average, he CA defici sood a -6.5% of GDP a he ime of reversal (a -3.9% for G7 counries), which is very close o he average repored by Freund and Warnock (25), alhough heir sample only includes indusrialized counries. In our sample, here is considerable variaion across episodes, ranging from relaively small deficis (e.g. Argenina wih 2% in 198) o over 13% in Ecuador in During hese periods, he CA improved by an average of 6 percenage poins wihin he 3 years following he sar of he reversal. In he majoriy of cases, paerns of real GDP growh and he RER movemens are consisen wih heory and oher findings of he lieraure: in 7% of he cases, he RER depreciaed in he 18 Ideally, we would like o use domesic demand insead of GDP, because in heory, i is domesic demand ha maers for impor demand and hus he CA. We use domesic demand daa where available and find ha he paern is similar o GDP (i.e. domesic demand increases during CA surplus reversals and decreases during CA defici reversals). However, daa consrains reduce he sample o 14 counries (for CA deficis) and 9 counries (for CA surpluses), which resuls in somewha volaile averages. Moreover, a spli ino fixers/floaers or crisis/non-crisis would reduce he sample size considerably. Page 8 of 32

9 hree years following he sar of he CA defici reversal. On average (for all idenified periods), he RER depreciaed by abou 9%. However, in all 55 cases, counries experienced a oal depreciaion 19 of, on average, 33%. These resuls provide ample proof ha CA defici reversals in EMEs have been accompanied by a sizeable currency depreciaion. This resul is consisen wih findings in he lieraure, alhough he adjusmen of he RER for EMEs seems o be more pronounced. Freund (25) for insance finds ha, in indusrialized counries, CA defici reversals are accompanied by a real depreciaion of abou 1 o 2 percen. Moreover, here seems o be a posiive correlaion beween he size of he CA reversal (wihin 3 years) and he size of he oal depreciaion in ha period (Char 5). Furher, in 7% of episodes, CA defici reversals have been accompanied by a decrease in real GDP growh, by an average of 1.6 percenage poins. 2 The fall seems o be in line wih previous findings (Algieri and Bracke, 27), and is consisen wih heoreical priors. We examine wheher here is evidence of a rade off beween adjusmen hough GDP or hrough depreciaion. Freund and Warnock (25) argue ha, resriced exchange rae adjusmen leads o lower income growh during CA recovery. In paricular, income growh is forced o accommodae CA adjusmen precisely because RER depreciaion is no sufficienly large o faciliae he needed adjusmen. Indeed, we also find an inverse correlaion beween he exen of exchange rae adjusmen and he slowdown in GDP growh (Char 6). There is a clear radeoff: adjusmen comes hrough eiher RER movemens or GDP growh. If exchange raes movemens are limied, he CA posiion worsens furher and he GDP reducion is more exreme. Thus RER flexibiliy is criical o low-cos (in erms of oupu cos) CA adjusmen. Mos of he counries in our sample have experienced currency and/or deb crises; hese may magnify he resuls. 21 We herefore spli he sample ino crisis (26) and non-crisis (32) periods (Char 7). 22 No surprisingly, during crisis periods, he CA revers faser and by more (7.9 pp wihin 3 years), and is accompanied by a much sronger currency depreciaion (15% in 3 years, and 34% over he period as a whole). Also, GDP conracs subsanially more during crisis periods (2.54 pp) and hus, i is no he mos efficien mean of adjusing exernal imbalances. To yield insigh on our second hypohesis, we spli he sample of CA defici reversals ino floaing and fixed exchange rae regimes a he ime of he reversal. To classify episodes, we use he classificaion compiled by Levy-Yeyai and Surzenegger (25) for he specific counries a he ime of he CA reversal. For robusness, we also use he Reinhard and Rogoff (24) classificaion. These classificaions are beer able o capure de faco ER regimes compared o de jure regime classificaion such as in he IMF s official ER classificaion, published annually in is Annual Repor on Exchange Arrangemens and Exchange 19 Toal depreciaion is defined as he percenage change beween he maximum value of he RER in he hree years leading up o he reversal minus he minimum value of he RER in he hree years following he reversal. 2 Noe ha his is no he case for G7 counries. 21 Noe ha he periods deermined in able 2 and 3 include crisis periods as well as periods of normal reversion of CA imbalances. 22 To deermine crisis periods, we have o rely on several sudies o deermine crisis periods for all counries in our sample: Frankel and Cavallo (24) and Kaminsky (23), Calvo and Reinhar (2), and Calvo, Izquierdo, and Mejía (24). Crisis periods deermined in differen papers for he same counry overlap significanly. Page 9 of 32

10 Resricions. 23 Some ineresing resuls emerge (Char 8): Firs, CA reversals occur earlier in counries wih fixed ER regimes, a a CA defici o GDP raio of 5.2% compared o 6.5% for floaers. Despie he deeper rough, he adjusmen of he CA in floaing ER regimes occurs sooner, suggesing ha flexible ER regimes allow for faser resoluion of exernal imbalances. Second, a significan RER depreciaion precedes CA reversal in fixed exchange rae regimes, wih coninuing sizeable depreciaions during he reversal. This suggess ha despie he fixed nominal rae, adjusmen has o come hrough he RER in mos cases hrough a crisis and he collapse of he fixed ER regime. In his case, he adjusmen hrough he RER is larger han in he case for floaers. And mos imporanly, he cos in erms of GDP is significanly greaer in counries wih fixed exchange rae regimes: GDP drops from an average of 8.2% wo quarers before he reversal o -.2% a year afer he reversal, compared o a drop from 5.8 o.7% in floaing regimes. This implies ha adjusmen of exernal imbalances is more painful if here is limied nominal ER flexibiliy. The resuls suppor our second hypohesis ha more flexible ER regimes faciliae he mainenance of exernal sabiliy hrough a rapid adjusmen of exernal imbalances. Moreover, counries wih fixed exchange rae regimes only allow CA adjusmen hrough large depreciaion and large losses in GDP growh, hus hrough much more painful adjusmen. Using he Reinhard and Rogoff (24) classificaion, he resuls differ somewha, bu he basic conclusions sill hold. The CA akes much longer o rever in counries wih fixed regimes, suggesing ha floaing raes faciliae a more rapid adjusmen. Also, he average CA defici is much larger a he ime of he reversal (7% vs. 4% for floaers), suggesing ha fixers reard he momen of adjusmen. The RER depreciaes more, by around 1% wihin 6 quarers in floaing regimes, whereas he RER remains fla during he reversal for fixers. However, adjusmen sill akes place hrough he RER, bu only in he hird year of he CA adjusmen (his downwards shif is driven by a number of currency crises). The difference in he adjusmen hrough GDP growh is no as dramaic as in he Levy-Yeyai and Surzenegger classificaion CA surplus reversals Using he above menioned crieria we deermine 3 CA surplus reversal periods (Table 3). The resuls are broadly symmeric o he analysis of CA defici reversals. For comparison, we add G7 counries (Char 4). On average, he surplus was 7.8% (a 4.1% in G7 counries) and fell by 8.9pp wihin 3 years (Char 3). During hese periods, he CA improved by an average of 6.2 percenage poins wihin he 3 years following he sar of he episode. Again, here is considerable variaion across episodes, ranging from relaively small surpluses (e.g. Bolivia wih 2% in 199Q4) o 2% in Russia in 22Q2. Wihin 3 years following he peak, he RER appreciaed in 8% of he cases. The average appreciaion (including all periods) was large: 2% on average. Noe ha he appreciaion is smaller for G7 counries. In all episodes, he RER appreciaed in he 6 years around he reversal, by an average of 64%. Again, hese resuls provide ample evidence for our firs hypohesis (ha CA adjusmens are faciliaed by RER movemens), and ha RER movemens 23 For a discussion of de faco and de jure exchange rae regime classificaion, please refer o Bailliu, Lafrance and Perraul (23). Page 1 of 32

11 are quie large. Consisen wih heory, GDP growh increased during hese periods (in EMEs, in 8% of all periods, as well as in G7 counries), by an average of 1.7pp (average over all periods). We can again spli our sample ino counries ha followed a fixed exchange rae regime a he ime of he reversal, and hose ha le heir currency floa (Char 9). 24 On average, CA surpluses sar o rever earlier in floaing regimes (a 7% of GDP compared o 9% for fixers), suggesing ha fixed ER regime counries reard he adjusmen of he CA. The major conribuing facor o CA reversion in fixed ER regime counries is rapid oupu growh suggesing ha nominal ER rigidiy impedes an adjusmen hrough he RER. As for floaers, boh RER appreciaion and GDP growh conribue o he adjusmen process. The resuls seem o again provide some evidence for our second hypohesis: he RER does no adjus in fixed ER regimes; he adjusmen has hus o come hrough GDP growh, and o a much larger exen han for floaers. 25 The even sudy has provided some insigh ino he characerisics of CA surplus and defici reversals. However, a deficiency of his approach is ha i does no fully capure he empirical relaionship beween hese variables overime, bu only over discree episodes. This is why we now urn o ime series analysis. 3.3 Vecor Error Correcion Model approach To analyze he long run relaionship beween he CA and he RER, we use a VECM approach. Since, he series are inegraed, he VECM allows he esimaion of a coinegraing relaionship wihou imposing a causal relaionship beween wo endogenous variables. The main advanage of a VECM specificaion in he conex of our research is ha i allows empirical esimaion of he long run relaionship beween he CA and he RER, as well as o deermine he reversion speed of he CA. 26 A second advanage of he VEC model framework is ha i allows feedback effecs beween he variables Noe ha he sample size for his able is very small (4 fixed ER regimes and 1 floaing ER regimes), and drawing conclusions should be reaed wih respecive cauion. 25 The main conclusions sill hold when using he Reinhard and Rogoff (24) classificaion (Char 13). : The CA revers laer and slower, suggesing some suppor for he hypohesis ha floaing regimes faciliae earlier and more rapid adjusmen of imbalances. Accordingly, he adjusmen ha occurs hrough RER appreciaion is larger under floaing regimes. However, he adjusmen hrough GDP is larger in floaing regime counries, which is inconsisen wih he findings above and wih heory. However, his sample only includes hree counries and could be nonrepresenaive. 26 An alernaive measure of he adjusmen speed of he CA could be he size of he mean revering coefficien (e.g. Chinn and Wei 28). However, he auoregressive coefficien on he CA migh be influenced by he number of differen shocks ha a counry experiences and herefore seems o fail o disinguish beween rapid adjusmens ha resul from flexible policies as opposed o low persisence which resuls from he absence of shocks. 27 Noe ha a reduced form regression would esimae he effec of a depreciaion of he exchange rae on he CA, CA given by he parial derivaive. The VECM allows o capure feedback effecs, represened by he oal REER dca derivaive. dreer Page 11 of 32

12 3.3.1 Inegraion and coinegraion A firs sep is o es for he saionariy of he individual variables. In his paper, we apply he sandard Augmened Dickey-Fuller es o deermine he level of inegraion. The resuls rejec he hypohesis ha he series are saionary, hereby implying ha he variables are, in general, I (1). In Bolivia, China, and Israel he RER is saionary. The presence of uni roos leads us o es for coinegraion. We use boh he λ-max and he Trace saisic o deermine he number of coinegraion relaionships. In 11 ou of 22 cases we find evidence for one coinegraion relaionship. The observaion ha he CA and he RER do no coinegrae for a number of counries can be explained by several facors. Firs, for some counries, his migh be due o he omied variable problem, an issue which we address in secion Second, he CA and RER migh no adjus as expeced in heory because policies impede an adjusmen of eiher variable. For insance, in counries wih fixed exchange regimes and sicky and/or regulaed prices, he RER is likely o be inflexible, and herefore would adjus very slowly, if a all, o is long run equilibrium value. Policy inervenion is he likely explanaion of he finding of no co-inegraion beween China s CA and RER. Similarly, we find no coinegraion for Malaysia, India, and Thailand, all of which heavily inervene in heir currency markes. Serilizaion policies hinder CA adjusmen, as hese policies do no allow a full adjusmen of heir RER. 28 Given our heoreical priors, we accep he evidence of one coinegraing vecor for all our counries Specifying a Vecor Error Correcion Model (VECM) We now specify a vecor error correcion model (VECM). A VECM has coinegraing relaions buil ino he specificaion so ha i resrics he long-run behavior of he endogenous variables o converge o heir coinegraing relaionships while allowing for shor-run adjusmen dynamics. Given ha he daa are quarerly, he VECM is specified wih wo lags of each variable as follows: Equaion CA = α CA +, i= 1 i= 1 ( CA 1 β RER 1 ) + λ1, i CA i + λ2, i RER i ε1 2 2 RER = α RER ( CA 1 β RER 1 ) + λ3, i RER i + λ4, i CA i + ε1,. i= 1 i= 1 β specifies he long-run equilibrium relaionship beween he CA and he RER, whereas α CA and α RER measure he speed of adjusmen of he CA and he RER, respecively. In he long run, he CA should reurn o he level compaible wih he level of he RER: CA = β RER We use a wo equaions VECM in order o avoid endogeneiy problems arising from he link beween RER and CA. 29 Theory predics ha β should be negaive. Table 6 gives he esimaed 28 See Lavigne (28) Serilized Inervenion in Emerging-Marke Economies: Trends, Coss, and Risks, Bank of Canada Discussion Paper Arghyrou and Chorareas (28) use a similar VECM mehod o assess real exchange raes and curren accouns dynamics. Page 12 of 32

13 coinegraing vecors for he counries, normalized on CA. 3 The shor-erm variaions in he CA can be more or less persisen depending upon he value of α CA. For insance, a value of α CA near will lead o very persisen adjusmen dynamics Resuls We firs examine he long-run relaionship beween he CA and he RER. The CA and he RER are negaively coinegraed for 18 ou of 22 cases (Table 6), and hus he esimaed value of β has he expeced sign in mos cases. In paricular, he β coefficien on he RER is highly saisically significan in 13 ou of 18 cases. The resuls provide some evidence for he negaive long erm relaion beween he CA and he RER, and hus suppor our hypohesis ha RER movemens are associaed wih CA adjusmen. The resul is moreover consisen wih findings by Arghyrou and Chorareas (28), alhough hese auhors only consider European counries. This resul holds despie he fac ha our sample includes periods of crisis ; hence, he esimaed negaive coefficien represen he adjusmen of he CA ha akes place hrough RER depreciaion, wheher i is as a resul of financial crisis or hrough a smooh adjusmen. There is a wide dispersion in he size of he coefficien: i ranges from.6 Brazil o.41 in Malaysia. In few cases, he sign of he coefficien is counerinuiive: for insance, for China, he long erm relaion beween he RER and he CA is posiive and saisically significan which migh be aribued o serilizaion policies menioned above. This finding migh also capure imporan aspecs of China s developmen sraegy of expor-led growh. The lack of significance of he long run parameer for some counries migh be aribued o he fac ha he RER on is own may no fully explain he reversion of he CA such as in Mexico. The inclusion of addiional variables may help provide a more complee explanaion (see nex secion). Moreover, here migh be a lag in he rade volume adjusmen in response o a change in exchange rae, as indicaed by he J-curve, suggesing ha he conemporaneous relaionship beween he RER and he CA is small, bu ha he RER affecs he CA over ime. We now urn o he shor run dynamics of our regression. Deviaions from he CI relaionship can be correced hrough he adjusmen of he CA, and/or he adjusmen of he RER. We concenrae here only on he speed of adjusmen of he CA, α CA : 31 I is negaive and saisically significan in 2 ou of 22 counries, indicaing ha he CA responds significanly o he pas deviaions (Table 6). For he remaining wo cases (Russia and China), he coefficien is no saisically significan. The fac ha he coefficien is saisically significan also implies ha he RER Granger causes he CA in he long run, supporing our firs hypohesis Given ha he order of he variables in he VECM does no maer, we pu he CA firs, meaning ha he coefficien on in he coinegraing vecor on he CA is The error-correcion erm in he RER equaion, αrer, is no saisically significan for half of he counries, and even posiive in some cases, meaning ha here is lile evidence for an adjusmen of he REER owards is longerm equilibrium value. This implies ha for mos counries, i is he CA ha adjuss o he long run equilibrium, whereas he REER is he rend variable. 32 Engle and Granger (1987) demonsrae ha he resuls from he VECM model in Equaion 1 can be used o es causaion from he RER o he CA (ha is, he RER does no Granger-cause he CA if all λ 2,i and α CA = ). Besides, he VECM approach allows o disinguish beween shor-run and long-run Granger-causaliy. Long-run Granger causaliy can be evaluaed by esing wheher he coefficien of he error-correcion erm (i.e. α CA ) is saisically differen from zero by a -es. The shor run Granger causaliy can be evaluaed by esing wheher he Page 13 of 32

14 The adjusmen speed also varies considerably across counries, ranging from.5 in Bolivia o.295 in Korea. An α of.136 for Argenina, for insance, suggess ha 13.6% of he difference beween he equilibrium and observed CA is eliminaed wihin one quarer. This corresponds o a half life of he CA of 4.74 quarers, or one year and 2 monh. The average adjusmen speed of.134 is comparable o he resuls of Arghyrou and Chorareas (28), who find an average CA adjusmen speed of.18 for 11 European counries, ranging from.58 in France o.49 in Greece. The inerpreaion of he size of his coefficien is no sraighforward. Ignoring crisis periods, a higher adjusmen speed would imply ha a counry adjuss rapidly o exernal imbalances. However, he adjusmen of exernal imbalances can, in many cases, occur as a resul of exchange rae crises. Therefore, he resul ha he CA adjuss rapidly migh be driven by he fac ha hese counries experienced CA crises wih rapid movemens in he RER and he CA (such as in he case of Korea). For oher counries he adjusmen speed of he CA is quie low. This observaion could have several possible explanaions. Firs, some counries have limied nominal exchange rae flexibiliy. Thus, he absence of nominal exchange rae adjusmen may be depriving he counry from a poen channel of CA adjusmen. For hese counries, adjusmen has o come hrough increased rade compeiveness by reducing relaive uni labor coss and prices. If prices are rigid in he shor run, convergence of he CA has o come hrough oher variables han he RER, such as oupu/income levels. These counries may face significan CA imbalances in he even of demand shocks. Second, we may aribue slow reversion of he CA o he fac ha he CA adjuss hrough oher variables no aken accoun, which are more imporan in he reversion of he CA han he RER. The adjusmen speed of he CA does no seem o be posiively correlaed wih he flexibiliy of he de faco exchange rae regime. We compare he esimaed error correcion coefficiens wih he exchange rae classificaion developed by Levy-Yeyai and Surzenegger (25) (Char 11). 33 Whereas Korea s CA adjuss fairly quickly according o he esimaed error correcion coefficien, Levy-Yeyai and Surzenegger classify his counry as inermediae over he esimaion horizon. On he oher hand, CA adjusmen speed in Turkey is relaively slow when esimaed by he error correcion erm, alhough i has been classified as a floaer for almos he whole sample period. This difference poenially arises from he fac ha he esimaed coefficien α CA does no disinguish rapid adjusmen hrough crises or via a flexible nominal and real exchange rae. Moreover, for some counries, he RER migh no be he mos imporan conribuing facor o CA adjusmen, wih oher facors such as domesic GDP playing an imporan role Accouning for income growh differenials 34 Theoreically, income growh differenials across counries should play an imporan role in he deerminaion of he CA. On he empirical side, Arghyrou and Chorareas (28) esimae he coinegraing relaionship beween he CA, he RER, and income growh differences. esimaed coefficiens on lagged values of RER in equaion 1 are joinly saisically significan. However, we are ineresed in he long run behaviour here and hus concenrae on he shor run Granger causaliy es. 33 The degree of ER flexibiliy for a counry is capured by aking he average score over he esimaion period of he Levy-Yeyai and Surzenegger classificaion. 34 The lieraure has suggesed a lis of variables ha could be coinegraed wih he RER. We es for he budge balance (cf. Afonso and Raul, 28), erms of rade, and accoun for periods of crises using dummy variables. Page 14 of 32

15 Following Arghyrou and Chorareas (28), we use G7 naional income as a proxy for foreign income. This measure cerainly raises some concerns, as G7 naional income migh be beer suied as a variable of foreign demand for some counries more han ohers. However, we hink ha i allows a preliminary assessmen of he imporance of foreign demand. We find ha he GDP, GDP* (foreign demand, i.e. G7 income), CA and he RER are coinegraed in 18 ou of 21 counries (he excepions being Brazil, Russia, and Thailand). 35 In some cases, we can now find a coinegraion relaionship where here was none before. This suggess ha he level of income growh is an imporan deerminan of CA reversion in hese counries. Given our heoreical priors, we impose one coinegraion vecor in he VECM. 36 Regarding he esimaed coinegraing vecors (Table 7), in 13 ou of 21 EMEs, he coefficiens on domesic naional income have he expeced sign and are saisically significan in mos of hese cases. 37 Evidence on he imporance of foreign income is less eviden: only in 12 ou of 21 cases, he variable has he expeced sign, of which only 7 are saisically significan. Ineresingly, wih he excepion of Souh Africa, he absolue values of he coefficiens of GDP and GDP* are lower han hose of he RER, which is opposie o Arghyrou and Chorareas (28) findings. This finding suggess ha for he EMEs under analysis, RERs have been playing a more prominen role han relaive incomes in long-run CA deerminaion, whereas for European counries, relaive incomes seemed o have had a bigger impac on CA deerminaion. This resul is moreover somewha consisen wih he findings in he even sudy analysis, which suggess ha he currency depreciaes more significanly in EMEs han in indusrialized counries in order o faciliae CA adjusmen. 4 Conclusion The lack of exchange rae adjusmen is widely seen as an imporan conribuing facor o unsusainably large global CA imbalances. In his paper we explore wo relaed hypoheses: (i) ha RER flexibiliy and adjusmen is criical o mainaining exernal sabiliy (main hypohesis) and (ii) ha a flexible nominal exchange rae faciliaes RER adjusmen and he mainenance of exernal sabiliy (corollary hypohesis). We adop wo complemenary empirical mehodologies. Using an even sudy analysis for a large se of EMEs over he period, we find ample evidence in favor of our firs hypohesis: RER adjusmen is criical o reducing CA imbalances and mainaining exernal sabiliy. CA revisions are accompanied by large RER movemens, regardless of he exchange rae regime. However, he crucial disincion becomes how counries adjus o large CA deficis - he adjusmen may come hrough an orderly process of gradual RER depreciaion, or, hrough a crisis. Second, we find evidence for our second hypohesis ha a flexible nominal ER faciliaes RER adjusmen and he mainenance of exernal sabiliy. We find ha 1) he 35 Tes resuls are no shown in order o save space. 36 Noe ha he log of GDP is saionary. However, Hansen and Juselius (1995) have noed ha no all individual variables included in he CI regression need be I (1). To find coinegraion, beween non-saionary variables, only wo of he variables have o be I(1). The sysem of variables should be chosen because of heir economic relevance, and no merely for heir ime series properies. 37 The coinegraing relaion coefficien on he RER remains relaively robus in mos cases wih respec o he specificaion wih wo variables. Page 15 of 32

16 adjusmen is more painful in erms of oupu loss in crisis periods and for counries ha had a fixed exchange rae regime a he ime of he reversal, 2) he RER depreciaes by more in crisis periods and for counries wih fixed exchange rae regimes, and 3) he CA revers faser in crises and for floaing regimes. Our vecor error correcion modeling confirms ha he negaive relaionship beween he RER and he CA holds in he long run. The resul is consisen wih our firs hypohesis ha CA adjusmen is correlaed wih RER movemens, regardless of he ER regime. Moreover, deviaions from he long run relaionships are imporan deerminans of CA reversion. In sum, our findings suppor recen argumens ha EMEs should permi heir RERs o adjus o exernal imbalances by eschewing effors o serilize he impac of hese imbalances on he domesic money supply and on domesic prices and wages. EMEs should also allow more nominal exchange rae flexibiliy in order o promoe adjusmen o exernal imbalances, hus avoiding crises and large coss in erms of oupu. Going forward, i would be ineresing o separaely idenify he conribuion of nominal exchange rae and price adjusmen o RER flexibiliy, and hus CA reversion. Second, i would be ineresing o es for srucural breaks in he esimaed coinegraion relaionships o accoun for he fac ha esimaed coefficiens change pre- and pos-crisis, or before and afer a counry changes nominal exchange rae regime. 38 References Afonso, Anónio and Chrisophe Raul. 28. Budgeary and Exernal Imbalances Relaionship A Panel Daa Diagnosic. ECB Working Paper No. 961 / November 28 Algieri, Bernardina and Thierry Bracke. 27. Paerns of CA Adjusmen Insighs from Pas Experience. European Cenral Bank Working Paper Series No 762 / June 27 Arghyrou, Michael G. and Georgios Chorareas. 28. CA Imbalances and Real Exchange Raes in he Euro Area. Review of inernaional economics 9(5) Bailliu, Jeannine, Rober Lafrance and Jean-Francois Perraul. 23. "Does Exchange Rae Policy Maer for Growh?" Inernaional Finance, Winer 23, 6 (3), p Broda, Chrisian. 24. Terms of Trade and Exchange Rae Regimes in Developing Counries Journal of Inernaional Economics Calderon, Cesar Auguso, Albero Chong and Norman V Loayza. 22. Deerminans of CA Deficis in Developing Counries. In: Conribuions o Macroeconomics Volume 2, Issue 1 22 Aricle 2. Calvo, Guillermo A. and Carmen M. Reinhar. 22. Fixing for your Life. NBER Working Paper Fujii (22) sudies a relaed quesion on PPP and argues ha long run parameers in he coinegraion relaion do no change, bu ha he adjusmen speed of some Asian counries changed afer he respecive crisis. Page 16 of 32