by Biagio Bossone (Biagio BOSSONE is an Italian national, currently advises international financial organizations on financial sector development issues and technical assistance programs in several countries in Africa, Asia and the Pacific, Latin America, and Northern Africa and the Middle East. He is a consultant to private-sector organizations. He has taught at various universities in Italy.)
Macroeconomic policy and exchange rate regimes under global financial integration
I want to come back to the post I wrote recently on Angry Bear, regarding the power of exchange rates to insulate economies from shocks and to grant independence to economic policy action, with the purpose to derive some clear (and testable) propositions.
For the benefit of readers, let me explain that my previous post originated from Antonio Fatas’ challenge to conventional wisdom whereby sudden stops – or the abrupt reductions in net capital inflows caused by crisis confidence – are relevant only for countries with fixed exchange rates, whereas they are not much of a concern for countries that have their own currencies. An interesting yet non-conclusive controversy followed, with positions ranging from that expressed by Paul Krugman, who holds that the adjustment mechanism to a confidence crisis varies with the underlying exchange rate regime (i.e., it is contractionary under fixed rates and expansionary under floating) to Andrew Rose’s observation that the economic performance of ‘fixers’ versus ‘floaters’ has not been dissimilar since 2007, going through Brad DeLong’s claim that under extraordinary dysfunction (not just a change in market views of the long-term fundamental value of the currency), exchange-rate depreciation no longer yields expansionary effects.
In my post, I argued that the dysfunction need not be as extreme as DeLong claims, and that the effectiveness of floating rates depends ultimately on how financial markets evaluate the sustainability of an economy’s public liabilities (both money and debt) against its macro policy framework. As my arguments go, even with floating, a largely indebted and financially integrated country suffering from poor credibility in the eyes of the markets would find its policy space severely constrained by the need to protect its liabilities from the risk of future (internal and external) value losses, as determined by the market response to its policy stance. If the country was in recession or secular stagnation and intended to recover output and employment gaps through active demand management, markets might undermine the country’s good intentions and bring it back on its policy decisions, under the threat of sudden stops and capital flights. The exchange rate is, therefore, a ‘veil’: markets see the economy’s risks through it, and are indifferent to the underlying exchange rate regime.
The key variables determining the latitude of the policy space available to an economy wanting to exploit the ‘insulating’ and ‘independence’ power of floating exchange rates are: i) the economy’s stock of (debt and money) liabilities, ii) its level of credibility in the markets’ judgment (whether the judgment is right or wrong is another matter), and iii) its degree of integration in the global financial markets. Thus,
The policy space available to a country that is fully financially integrated into the global markets, and operates under a floating exchange rate regime, grows narrower with the economy’s stock of liabilities and is limited by the country’s market reputation as a debtor.
As I discuss below, this conclusion holds irrespective of the currency of denomination of the liabilities, and irrespective of whether the liabilities are held domestically or abroad. A number of equivalences can be established in this respect. They all rest on the following central assumption.
Full financial integration
The central assumption is that the national economy under consideration is fully integrated into the international financial markets. Barring factors that create domestic versus foreign market segmentations, there is no reason to expect systematically different market valuations of the economy’s liabilities and portfolio choices from residents versus nonresidents. Moreover, with no systematic differences in the way residents and nonresidents value the economy’s liabilities and manage portfolios, residents’ higher transaction demand for the domestic currency is no protection against the risk of currency depreciation if residents (as well as nonresidents) anticipate future excess money creation from the domestic monetary authorities: on the relevant margin, residents and nonresidents alike would substitute both domestic debt and money holdings for alternative assets (including foreign ones) that they would consider to be safer stores of value.
Finally, as regards the market valuation of the economy’s liabilities with respect to the currency of denomination, thinking in terms of expected losses shows that a rational investor should be indifferent to the currency in which debt liabilities are held. If the liabilities consist of public debt denominated in a foreign currency, the investor would face the risk of the country defaulting on its debt obligations at some point in the future, and would protect its investment by asking for a proportionate risk premium on the debt interest rate. If, on the other hand, the public debt was denominated in the domestic currency, the investor would be protected against the risk of default, since the issuer could always determine to monetize the debt by ‘printing’ money; yet the investor would be exposed to the risk of currency depreciation that would materialize as a market response to the prospects of unbounded deficit financing. Such eventuality would exact from the investor a loss on future debt repayments. In (ex-ante) equilibrium, the two options should be equivalent from the investor standpoint: the expected loss from the risk of debt default (as compensated ex ante by higher interest rate premia) would equal the expected loss from debt repayments taking place in depreciating money (a form of default of its own).
Both options would (ceteris paribus) carry the same probability of ending up in a sudden stop or capital flights. Symmetrically, the issuing country would be subject to the same intertemporal budget constrain under the two options, since the interest rate on the liabilities would have to adjust to the underlying risks facing the investors and would be equal under the two options. Furthermore, with full market integration, the interest rate on the liabilities would be the same whether the liabilities are held by residents or nonresidents. Generalizing:
In an integrated financial market, there is no ‘free lunch’ that either the investor or a country issuing liabilities would be systematically able to snatch by switching exchange rate regime.
Take a Eurozone country with a large public debt and a weak track record of monetary stability, deciding to leave the Eurosystem with a view to recovering monetary and full fiscal sovereignty. Assume the country introduces a new currency, redenominates its debt in the new currency (by invoking the lex monetae), and commits to financing the deficit with monetary expansion both to keep policy rates low enough to stimulate demand and to insure debt holders against the risk of default.
Would markets allow for such huge policy space? I strongly doubt it…
‘Modigliani-Miller’ applied to macro-economies?
The equivalences established above closely resemble the neutrality proposition associated with the Modigliani-Miller theorem for corporate finance, whereby, under condition of perfect competition, the value of a firm’s capital will be unaffected by the type of security used to finance the investment. Equivalently, if traded in an open competitive market, a liability must be the same liability (that is, it must carry identical value) independently of its form and the exchange rate regime under which it is issued and traded: as a ‘veil’, a floating exchange rate might not obscure that fact to rational investors both within and outside the country, provided they all operate in the same internationally financially integrated market space.
Obviously, we do not live in world of perfectly competitive markets, and any departure from a lean an clean ‘Modigliani-Miller’ type of paradigm (or any relaxation of its underpinning assumptions), would soften the equivalences above established. Yet, with all imperfections, not all people in the markets can be fooled all the times and – once again, assuming full financial integration – a country could not ground its policy framework on the expectation that domestic savers are any more willing than foreigners to accept losses on their public debt holdings, or that investors value the public debt differently if this is expressed in domestic or foreign currency.
As mentioned, the equivalences above established do not imply that all countries are subject to the same intertemporal resource constraint. This is, indeed, where country specificities – most notably their policy credibility and reputation as debtors in the view of the markets – come into play. Country specificities would be factored into by the markets and determine the ‘elasticity’ of each country’s intertemporal resource constraint and, hence, the latitude of the policy space available to the country under floating rates. This elasticity would ultimately be a function of the markets’ (right or wrong) judgment of the sustainability of the country’s liabilities and their (righto or wrong) judgment’s reflection on the market value of the liabilities. The resulting impact on the interest rates carried by the liabilities defines the space available to policymakers for active demand management.
Speculation or economic fundamentals?
As the discussion suggests, the equilibrium exchange rate (EER) of a country under floating becomes endogenous to the market reaction to the country’s policy stance. It crucially follows
The EER must incorporate – among its set of fundamentals – the value that markets attribute to the country’s liabilities, including equally the external and domestic liabilities.
As for illustration, even in the hypothetical case of a country’s public debt entirely held by residents and expressed in domestic currency, the market valuation of the debt would be a determinant of the EER, since the latter would need to be at the level where the economy generates (also through the external sector) the resources necessary to finance the budget and sustain the debt.
Finally, where financial stocks are of significant size, market expectations become a fundamental determinant of EERs: they do not only determine deviations of the actual exchange rates from their PPP (purchasing power parity) equilibrium level, they determine PPP itself!