The Exchange Rate as a ‘Veil’

(Dan here…Biagio Bossone will be joining contributors to Angry Bear.  Here is his first post for AB concerning the impact of exchange rates)

by Biagio Bossone      (Biagio BOSSONE is an Italian national,  currently advises the World Bank Group/IMF 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.)

The Exchange Rate as a ‘Veil’

A few years back, Antonio Fatas challenged the 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, arguing that where countries run large persistent current account deficits, sudden stops of capital could be contractionary even under floating rates. The issue was at the center of a lively controversy, yet is has remained unresolved. Coming to a closure on it requires considering that the effectiveness of exchange rates as an adjustment mechanism must be seen in relation to the role that financial markets play in the context of a given country. This is what this post sets out to do, after reviewing the terms of the controversy.

The controversy

Various views were expressed on the issue. Andrew Rose noted that the magnitude of the business cycle had not varied significantly between inflation targeters and hard fixers over the period since 2007, and concluded that the ‘insulation’ power of different exchange rate regimes is in fact similar. Paul Krugman countered that a decline in the capital account caused by a sudden stop must be matched by a rise in the current account, and noted that the mechanism to produce such adjustment varies with the underlying exchange rate regime: it works though import compression under fixed rates, while it works through depreciation and export growth under floating rates. As a consequence, a shock that is contractionary under fixed rates (or a monetary union) is expansionary under floating rates.

Kenneth Rogoff remarked that outcomes are sensitive to long-term debt sustainability and future inflation. A country with its own currency has indeed the ability to escape a debt crisis through seigniorage and inflation, but this works only to the extent that inflation is not priced in. In fact, as Giancarlo Corsetti and Luca Dedola pointed out, the historical record indicates that outright default on public debt denominated in domestic currency is far from rare, including in countries where the authorities control the ‘printing press’: the moment investors anticipate inflationary financing, interest rates rise and reduce the gains from debt monetization up to the point of undermining its effectiveness altogether.

Interestingly, Brad DeLong claimed that in a sudden stop the central bank can credibly commit to persistently keeping the short-term safe nominal interest rate at zero (swapping out cash and pulling in bonds ad libitum), yet such policy would have no effects on the economy’s real equilibrium if, on the relevant margin, government-printed cash were to become as unsatisfactory an asset as government bonds: under similar circumstances, people would not want to dump government bonds for cash and foreign securities; they would dump both government bonds and cash for foreign securities. Economic chaos would be such that foreigners would be unwilling to trade their own currencies for domestic goods and services or assets (e.g., domestically-located property). However, as DeLong also noted, for this scenario to hold there should be an extraordinary degree of dysfunction, not just a reduction in market views of the long-term fundamental value of the currency.

More recent research in this area has produced inconclusive evidence, with some works suggesting that the choice of exchange rate regime may not matter and others concluding that countries with floating exchange rates have better shock absorbing capacity than countries with pegged exchange rates, even if they cannot attain full insulation of their economies.

In fact, the question should be posed differently.

When (and for whom) exchange rates do not matter

DeLong suggests that the insulating power of, and the degree of policy independence granted by, floating exchange rates vary with the economic circumstances that characterize each economy. There are countries where monetary policy loses its ability to affect domestic real interest rates and where exchange-rate depreciation no longer yields expansionary effects. In DeLong’s view, these countries are those with very large foreign currency-denominated debts and those already near the edge of hyperinflation. Considering the role that financial markets play in judging (and determining) the sustainability of national public liabilities (both money and debt), the list of country types suggested by DeLong should likely be broader.

To see this, consider that the price at which markets willingly absorb a country’s public liabilities reflects their perceived risk. Thus, in the case of a country suffering from weak credibility, a large and growing public debt would not only raise prospects of debt monetization; as DeLong explains, the related loss of market confidence would hit the domestic currency as well as the debt. For such a country, issuance of new debt denominated in the domestic currency – say, to finance full-employment policies – and the use of monetization to ensure low interest rates and guarantee debt servicing might trigger a sudden stop and capital flights whenever the markets would expect domestic liabilities to increasingly lose (internal and external) value in the future.

It may be argued that in as far as national debt is mostly held by residents, even the prospects of debt monetization should not raise concerns, since residents trust that their national money would continue to be used for domestic payments (including for taxes) and thus keep demanding it. However, this would not be sufficient to preserve the value of the domestic currency, since residents, too, factor into their expectations the anticipated future excess money creation and the associated risk of currency depreciation and inflation. In anticipation of unbounded liabilities growth (debt and/or money), on the relevant margin residents would start substituting both debt and money holdings for alternative financial and real assets (including foreign ones) as superior stores of value. In extreme circumstances, they might even replace the domestic currency with a foreign (more stable) one. Whether domestic residents would act more slowly and gradually than non-residents is a question of how much they would trust their own institutions and country policy framework under critical circumstances. However, if the country is fully financially integrated and domestic savings are intermediated by specialized institutions, differences between residents’ and non-residents’ behavior should not be significant.

Which model would support all this?

Krugman emphasizes the difficulty to produce a model where markets (or ‘bond vigilantes’, as he calls them) bear negative effects on countries adopting floating rates. In fact, models that build on the fundamental equilibrium exchange rate (FEER) approach, introduced by John Williamson’s, would have the structure to capture such effects. Defined as the real exchange rate that is consistent with both internal and external macroeconomic balance of a given country, the FEER would have to equalize, in present-value terms, the country’s current and future primary net export surpluses (deficits) to its initial net debt (asset) position (see Michael Burda and Charles Wyplosz for an excellent illustration of the long-run equilibrium exchange rate theory).

What usually goes unnoticed is that the FEER reflects the total net debt (asset) position of the country, which includes also the liabilities (assets) denominated in the domestic currency. In the case, for instance, of a country running a large domestic-denominated public debt, the FEER would (all else equal) have to be such as to generate, in present-value terms, the flow of future fiscal resources necessary to repay the debt. If the country were internationally financially integrated, market expectations on the evolution of its debt would affect the estimation of the FEER, and factors such as the credibility of the debt issuer and the underlying policy regime would become determinants of the FEER.

Take the case of the country above. Assume that markets consider its policy credibility to be weak and that its public liabilities (denominated in domestic currency) trade at a high-risk premium under a floating exchange rate regime. Assume also that the country commits to further expanding its public liabilities with a view to supporting domestic demand in a depression or secular stagnation environment so as to stabilize output and employment. A realist example might be a heavily indebted Eurozone country deciding to leave the euro, and redenominating its public debt liabilities in a new domestic currency. Under persistent expansion of public liabilities, the country policy authorities would soon be facing a dilemma:

• They may either be forced to set interest rates high enough to prevent the exchange rate from falling at levels that would make liabilities unsustainable.
• They may decide to print all the money needed to keep rates low and to guarantee debt servicing; this would expose the exchange rate to a risk of free fall and a drop in the real value of the (money and debt) liabilities.

Under the first option, the country would have to abandon its policy objective of stabilizing output and employment. Under the second option, the country would fail to achieve the objective anyway. For the purpose of this note, it is critical to observe that in ex-ante (equilibrium) terms, the two options must be equivalent from the creditors’ standpoint, for the expected losses from the risk of debt default (as compensated ex ante by higher interest rate premia) would equal the expected losses from debt repayments in a depreciating currency. Both options, as a consequence, would (ceteris paribus) carry the same probability of ending up in a sudden stop or capital flights: the exchange rate is a ‘veil’.

The exchange rate as a ‘veil’

The implications of the above discussion can be summarized as follows:

• If affected by lack of credibility, there is not much an economy can attain in terms of insulation from shocks and policy independence from adopting floating exchange rates.
• All countries face an intertemporal budget constraint, irrespective of whether they operate under floating or fixed exchange rates. Generally, a floating rate regime grants policymakers greater flexibility than a fixed rate regime; however, such flexibility varies inversely with the country’s credibility in the perception of financial markets.
• More specifically, the larger a country’s public liability position (both in domestic and foreign currency), the higher its vulnerability to changes in market expectations and the more binding the intertemporal budget constraint imposed by the markets on its policy choices.
• Finally, in the case of financially integrated economies suffering from credibility gaps, their vulnerability to changes in market expectations would be high irrespective of whether the liabilities are denominated in a foreign or domestic currency. Faced with a shock, the country would in both cases be exposed to the same risk of sudden stops and capital flights.

For these economies, the exchange rate is a ‘veil’ in that markets would detect the underling risks regardless of the exchange rate regime and the currency of denomination of the country’s public liabilities. As a consequence, floating rates would not insulate such economies from shocks, nor would they grant greater independence to their policy makers.