Exchange Rates. Figure ExR.1 In real-effective terms developing currencies have been much less volatile than viz-à-viz the US dollar

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1 Global Economic Prospects June 2012 Exchange Rates in early 2012 when the (partial) relaxation of tensions in high-income Europe and the stabilization of global financial markets resulted in falling investors risk aversion. As a result, during the first two months of 2012, the tradeweighted real effective exchange rates of,, and appreciated by 5 percent or more, while higher international commodity prices boosted the currencies of commodity exporters including Chile, Colombia and Mexico. With resumption of Euro Area uncertainties since early May and flight of private capital to safer US financial assets and weakening of commodity prices for commodity Recent developments In the year to the first week of June, the US dollar strengthened from 1.44 to 1.25 per euro, with the bulk of the appreciation occurring post July 2011 as the nominal (and real) trade weighted US dollar appreciated by 6 percent, largely reflecting the US dollar s safe-haven status at the onset of the Euro Area crisis and the flight to quality that ensued. To a large extent, these developments have also been mirrored in emerging market currencies as developments in the US dollar continues to be a major determinant of both the value and volatility of emerging market currencies. But it is important to realize that in spite of the US dollar s safe haven status, the average real trade weighted emerging market currency has been less volatile than the real US dollar trade weighted exchange rate almost percent of the time over the last 10 years (figure ExR.1).1 Figure ExR.2 Generalized appreciation of US dollar relative to emerging market currencies Inverted local currency/us$, Index, Jan. 1, 2012= Even so, and despite the improvement in developing countries relative macroeconomic fundamentals vis-à-vis the U.S., some of the larger emerging currencies still came under significant pressure at the onset of the Euro Area debt crisis in the second half of Likewise, partly because of the liquidity generated by very loose monetary policy in high-income countries several large financially-open emerging market countries experienced a a surge in foreign capital Malaysia Feb-12 Mar-12 Apr-12 May-12 Jun-12 Source: IMF International Financial Statistics, Datastream and World Bank. Figure ExR.1 In real-effective terms developing currencies have been much less volatile than viz-à-viz the US dollar Inverted USD exchange rates, index average 2005= Real-effective exchange rate, index average = Jan Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-05 Jan-06 Source: IMF International Financial Statistics, J.P. Morgan, and World Bank. 29 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

2 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Global Economic Prospects June 2012 exporting developing countries the US dollar again experienced a generalized appreciation with respect to emerging market currencies (figure ExR.2). Although central bank intervention in foreign exchange markets briefly halted the slide in the ian real in late May, other emerging market currencies showed signs of appreciation in early June, encouraged by expectations of coordinated official actions to deal with the ailing Spanish banking sector, reduction in borrowing costs in, and possibility of further stimulus measures. Moreover, partly as a consequence of the broader appreciation of the US dollar, developing countries currencies measured against a wider range of currencies have depreciated less than against the US dollar in recent months. While cyclical factors have played a role, to a large extent the appreciation of the currencies of many of the larger middle-income countries during the last decade has reflected long-term fundamental factors including large changes in commodity prices, productivity differentials and in some cases domestic policy. Exchange rates over the medium-term Developing countries real exchange rates have appreciated since 2003, with return to trend following crisis In general, developing countries average tradeweighted real effective exchange rates have been appreciating more or less steadily since 2003, even as high income countries real exchange rates depreciated (figure ExR.3). The average GDP weighted real exchange rate of developing countries (excluding ) appreciated by a cumulative 25.7 percent (26.7 percent) between 2003 and the first quarter of 2012, or by about 2.6 percent (2.7 percent) annually, in spite of significant real depreciations during the Lehman crisis in 2008 and during the Euro Area sovereign debt crisis in late In general, the positive trend in developing countries currencies since 2003 reflects a faster pace of growth and higher rate of productivity Figure ExR.3 Developing countries' real exchange rates appreciated between 2003 and 2011 Real effective exchange rate, average (Jan. 2003=) Developing Developing excl. High-income Linear (Developing) Linear (Developing excl. ) Linear (High-income) Source: IMF International Financial Statistics, J. P. Morgan, and World Bank. increases compared with high income countries. Developing countries average annual real GDP growth accelerated from 3.8 percent during to 6.4 percent over In the same two periods, high income countries average growth declined from 2.8 percent to 1.6 percent. Furthermore, developing countries total factor productivity (TFP) rose 2.2 percent annually on average during this period, more than double the rate of increase for high income countries. Other factors at play include improved macroeconomic management in many developing countries, high commodity prices (in commodity exporting countries), and sustained inflows of private capital and remittances in several middle- and low-income countries. Importantly, the strong appreciation of developing country currencies after the Lehman crisis in 2008 mainly reflects a return to pre-crisis levels and trend appreciation in line with underlying fundamentals rather than a significant deviation from earlier trends. Rising commodity prices until April supported commodity exporting currencies Most commodity exporting countries have experienced (often significant) gains in their terms of trade as commodity prices rose sharply over the past decade. These improvements have 30

3 Figure ExR.4 Real exchange rates of commodity exporters appreciated as their terms of trade improved with increase in international commodity prices up until April Colombia Index (Jan 2005=) Index (Jan 2005=) Index (Jan 2005=) Index (Jan 2005=) 220 Nigeria Index (Jan 2005=) Index (Jan 2005=) [left] Mexico Index (Jan 2005=) Index (Jan 2005=) 75 Index (Jan 2005=) Index (Jan 2005=) Index (Jan 2005=) Index (Jan 2005=) Source: IMF International Financial Statistics, J. P. Morgan, and World Bank. been reflected to varying degrees in real exchange rates depending on the extent to which the authorities have allowed the nominal exchange rate to appreciate (or depreciate) in response to international commodity price shocks. For instance, s flexible exchange rate regime has allowed the real exchange rate to move closely with its terms of trade, with the nominal exchange rate acting as the economy s main shock absorber and automatic stabilizer. This phenomenon was also observed to a more or lesser extent in other oil and commodity exporting countries such as, Colombia, Nigeria, Mexico and (figure ExR.4). Notwithstanding their access to commodity resources, exchange rates in these countries are not only exposed to volatile commodity markets, but this currency volatility is often exaggerated by commodity related capital flows particularly for the larger, more open middle income commodity exporters. For instance, after experiencing a steep depreciation in the second half of 2011, s trade weighted real exchange rate appreciated 5.2 percent between December 2011 and February 2012 due to the combined effect of high commodity prices and a surge in capital inflows. But measures to stem the currency appreciation, including extension of taxes on cross-border borrowing by local firms to shorter-maturity loans, resulted in a substantial nominal and real depreciation. Real exchange rates of commodity exporters with a significant manufacturing export sector have also been influenced by developments in trade partner countries. Mexico s trade-weighted real effective exchange rate depreciated steeply during the Euro Area debt crisis in late 2011 similar to that of other financially integrated emerging markets; but it then appreciated 7.6 percent in the first quarter of 2012 as strengthening demand and better employment 31

4 outturns in the U.S., its largest trade partner, translated into improved domestic prospects. There is a widely held perception that the exchange rates of many commodity exporting countries are extremely volatile. However, these currencies are merely reflecting the underlying volatility of commodity prices. Although adverse exchange rate movements (and volatility) are often painful to domestic industry in these countries, the (volatile) exchange rates often act as an automatic shock absorber and stabilizer. Capital flows are an important driver of short-term movements in emerging market currencies Capital flows continue to be a driver of shortterm movements in nominal and real exchange rates. The rapid withdrawal of foreign capital during the Euro Area sovereign debt crisis in the second half of 2011 from several emerging markets (including from some commodity exporters) appears to have contributed to a steep depreciation of their currencies, but the resumption of capital inflows contributed to appreciation of emerging market currencies, including those of,, and in the first quarter of Permanent increases in the underlying capital inflows (such as capital inflows responding to faster potential growth) to a developing country are likely to result in currency appreciation and vice versa. Apart from a once-off adjustment to the new equilibrium capital inflows, this should not raise currency volatility. When capital flows are relatively permanent in nature and are likely to contribute to increasing productivity and longer-term growth, there is little rationale for policymakers to intervene or restrict these flows. However, when these inflows are more related to speculative hot money flows, the flows can be disruptive. Such hot money inflows can potentially erode competitiveness, albeit temporarily, and could give rise to credit and asset price booms. Rapid withdrawals of such flows and the resulting nominal depreciation can increase the burden of foreign currency debt on sovereign and corporate balance sheets (Ostry and others 2011). To the extent that shorter-term currency movements are driven by (identifiable) speculative capital flows that are temporary in nature, there could be a rationale for leaning against the wind. Some forms of controls on foreign currency capital inflows or outflows and other prudential regulations may be justified in the shorter-term to reduce excessive exchange rate volatility and to provide space for domestic manufacturers to adjust to a changing economic environment. There is a risk, however, that such short-term measures may become sticky, and over time introduce distortions in production and capital allocation decisions, thereby hurting longer-term growth prospects. Capital flow management measures should therefore be reviewed regularly, and capital controls should be adapted or reversed as destabilizing pressures abate (G ). In particular, capital flow management measures should not be used to avoid or unduly delay necessary adjustments in the economy. Commodity importing countries real exchange rates depreciated as commodity prices rose up until April Several net oil- and commodity-importing countries experienced terms of trade losses and real exchange rate depreciation as the increase in imported commodities prices outpaced manufacturing export prices. Real currency depreciation appears to have been more pronounced in countries with relatively weaker current account positions which were more exposed to foreign capital, such as and (figure ExR.5). Currencies of several net oil-importing Sub-Saharan African and South Asian countries have faced depreciation pressures due to a combination of rising burden of energy imports amid strong economic growth. For instance, Bangladesh and Pakistan have faced current account pressures and nominal depreciation due to a rising import bill from high international prices of crude oil imports and relatively weak export growth. 32

5 Figure ExR.5 Terms of trade losses and real exchange rate depreciation in and Index (Jan 2005=) Index (Jan 2005=) Figure ExR.6 Oil- and commodity-importing developing countries experienced larger real depreciation during recent crises Real effective exchange rate appreciation (%) Index (Jan 2005=) Index (Jan 2005=) Developing oil-importers Real effective exchange rate appreciation (%) 4 2 July-Dec 2008 July-Dec 2011 Developing oil-exporters 0 Sources: IMF International Financial Statistics, J. P. Morgan, and World Bank. Net oil and commodity importing developing countries as a group experienced significantly larger depreciations during recent crises compared to oil exporters. The GDP-weighted average real exchange rate of oil importing countries excluding depreciated 12.2 percent during the Lehman crisis in the second half of 2008 and 6.1 percent during the Euro Area debt crisis in the second half of 2011, compared to 3.2 percent and 1.4 percent declines, respectively, for oil exporting developing countries (figure ExR.6). Even as commodity exporters gained from high prices up until April 2012, oil and commodity importing developing countries, in particular those that are relatively open to foreign capital and have weaker current account positions, have faced renewed depreciation pressures with resumption of Euro Area tensions Other developing July-Dec 2008 July-Dec 2011 Commodity-rich developing Note: Charts exclude Sources: IMF International Financial Statistics, J. P. Morgan, and World Bank. Prospects for developing countries exchange rates Developing countries currencies are likely to appreciate in the longer term, but remain under pressure in the near term Exchange rates are extremely difficult to forecast over the short run. However, in the longer term, as discussed earlier with a relatively weak growth outlook in high income countries, continuation of improvement in developing countries fundamentals, superior growth and total factor productivity differentials developing countries real appreciation is expected to continue, albeit at a slower rate. The discussion above suggests that the future path of developing countries currencies will 33

6 depend on capital flows, commodity prices, and most importantly, relative productivity increases. Some developing countries currencies benefited from falling risk aversion and a surge in capital inflows in early 2012, partly reversing earlier depreciation, as loose monetary policies and lower relative yields in high income countries generated renewed interest in emerging market assets. Going forward, however, developing countries currencies could come under even greater pressure if current Euro Area tensions escalate and private capital flows become more volatile; if the pace of European banking sector deleveraging accelerates (see Finance Annex); and if the US dollar continues to appreciate with respect to emerging market currencies given its safe haven status. Commodity exporting countries currencies gained from high international prices in early 2012, but weakening global demand and the resulting lower commodity prices are leading to depreciation pressures. On the other hand, commodity importers among developing countries could also face worsening trade and current account positions if weak global demand keeps manufacturing exports below the longer term trend. Moreover, renewed geopolitical tensions in the Strait of Hormuz could result in a spike in crude oil prices, further exacerbating strains on oil importing countries. Current account and trade balances of developing regions have deteriorated in recent years (figure ExR.7), in large measure due to the decline in East Asia and Pacific region s current account surplus. s surplus fell from over 10 percent of GDP in 2007 to 2.8 percent in 2011, reflecting weakening export demand and a shift towards domestic sources of growth, which has resulted in imports growing faster than exports. In other developing regions, however, widening trade deficits and deteriorating current account balances, especially in commodity- and oil-importing countries, suggest that developing countries exchange rates are likely to remain under strain. International reserves expressed as share of merchandise imports fell in 76 percent of middle-income developing countries between Figure ExR.7 Current account surpluses have fallen and deficits widened in developing regions Current account balance as a share of developing countries' GDP, Percent EAP excl. Europe & Central Asia Latin America & Caribbean Middle East & N. Africa South Asia Sub-Saharan Africa Source: World Bank. Figure ExR.8 Reserve cover has fallen in more than 75 percent of middle-income developing countries since January 2010 Percent change in international reserves in months of mechandise imports Angola Philippines Lebanon Mexico Algeria Peru Chile Malaysia Honduras Paraguay Albania Moldova, Rep. Romania Zambia Pakistan Dominican Republic Mauritius Azerbaijan Thailand Bolivia Jamaica Colombia Nicaragua Guatemala Lithuania Morocco Sri Lanka n Federation Vietnam Armenia Kazakhstan Ukraine Gabon Ghana Yemen, Rep. Cameroon Argentina Latvia Nigeria Jordan Ecuador Venezuela, RB Egypt, Arab Rep. % Increase between Jan and MRV Note: MRV = Most recent value Source: IMF International Financial Statistics and World Bank. 34

7 January 2010 and the most recent available date in 2012, by 26 percent on average (figure ExR.8). Reduced international reserves available for meeting short term obligations can increase vulnerability of developing countries to external shocks, in particular if external financing conditions were to deteriorate further and capital flows retreat. policies. Working Paper 17363, NBER: Cambridge MA. Williamson, J Exchange Rate Economics. Open Economy Review, Vol. 20, pp In the longer term, real exchange rates of developing countries are likely to revert to the upward trend. Developing countries will need to learn to live with real currency appreciation and instead focus on maintaining favorable productivity trends and competitiveness. Developing countries with relatively good growth prospects will need to adapt to gradual real appreciation over the foreseeable future. Notes 1. Using 12-month rolling standard deviations, the average real trade weighted developing country exchange rate had a lower volatility than the same measure for the US dollar 68.8 percent of the time. References De Mello, L., P.C. Padoan, and L. Rousová (2011). The Growth Effects of Current Account Reversals: The Role of Macroeconomic Policies. OECD Working Paper 871, OECD: Paris G G20 Coherent Conclusions for the Management of Capital Flows Drawing on Country Experiences. Adopted at G20 Summit, Cannes, November 3-4, Ricci, L.A., G.M. Milesi-Ferretti, and J. Lee Real Exchange Rates and Fundamentals: A Cross-Country Perspective. IMF Working Paper 08/13, International Monetary Fund: Washington DC. Qureshi, M. S., J. D. Ostry, A. R. Ghosh and M. Chamon Managing capital inflows: The role of capital controls and prudential 35