Friday, June 19, 2009

Currencies and Current Account Adjustments

A recent article by Cline & Williamson (2009)* on investigates the state of play in terms of global currency misalignments, particularly against the USD. The results aren’t too surprising:

“The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies…Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.”

For the MYR, Cline and Williamson suggest an undervaluation of 17.7% in the real effective exchange rate, and 33.2% against the USD, with a medium term target rate of RM2.63. That’s a substantial movement for MYR, and will have a pretty massive impact on Malaysia’s external demand as well as the current account.

The modeling framework takes its cue from Williamson’s earlier work, which substantially helped launch non-purchasing power parity (PPP) based assessments of exchange rate valuations more than twenty years ago.

Some background is in order here. I’ve posted on these alternative models before, but the model used in this article is a variant of what’s called the Fundamental Equilibrium Exchange Rate (FEER) approach (aka Macroeconomic Balance approach), which uses a medium term current account target as a measure of a currency’s misalignment. Using an elasticity model, the extent of under or over valuation can then be calculated as the movement in the exchange rate required to bring the current account from its forecast level to the model’s target level over the medium term.

As you can imagine, I’m going to pick a few holes in this argument:

1. FEER models have a normative component – the target rate is selected by the researcher (admittedly based on global historical norms), rather than that inherent to each economy. In other words, the extent of misalignment derives directly from what the researcher considers a “sustainable” current account surplus/deficit. For instance, Williamson’s early work used a 2% band rather than the 3% used in the article - a tighter band implies a greater required adjustment. Since the current account covers both trade in goods and services as well as income flows, applying one number to all countries (or even one country at different points of time) isn’t obviously logical. The article attempts to account for this by incorporating a net foreign assets measure where required (essentially replacing a flow variable with a long-term stock variable), but the same critique applies.

2. Secondly, FEER models assume that all adjustments are made solely through exchange rates, which of course isn’t necessarily true. Demand and supply shocks, terms of trade shocks, secular changes in consumer preferences, productivity improvements, changes in portfolio holdings – all can have an impact on the current account without necessarily impacting the exchange rate at all.

3. FEER models don’t incorporate dynamics, which describes the interrelationship between the model variables across time. In short, you know your destination but you have no idea how to get there.

Lastly, I have a procedural criticism – the REERs used as reference points for the article are taken from the IMF International Financial Statistics Database. To my knowledge, the trade weights on these were last changed in 2006 based on averaged trade data from 1999-2001 (and thus accounting for the introduction of the Euro).
Ordinarily, I’d have no problem with this as trade weights rarely evolve much in any given 5-10 year span.

In this case however, I think the IMF REER indexes from about 2003 onwards are flawed – the emergence of China has had such far reaching effects on trade patterns that substantial changes in trade weights are warranted. That in turn implies that movements in the IMF REER indexes are too biased towards the G3 currencies, and not enough to emerging markets.

The effective difference doesn’t amount to a lot in an absolute sense – a few points at most on the index scale – but those few points do matter in terms of determining the threshold for possible policy action, and would matter even more if emerging market currencies were more volatile against the USD. In this case, the difference tends to support the article’s primary thesis of USD overvaluation against many Asian currencies.

To illustrate, here’s how the trade weights for the top 5 currencies in my own calculated MYR indexes have evolved during the same period:

Note that there are three different groupings: the EUR has been relatively stable; JPY, SGD and especially USD have been declining; and CNY has been steadily rising, with a big jump in 2003. The IMF static weights for these currencies for MYR are 14%, 15%, 6% (lumping SGD with all other ASEAN currencies), 24% and 5%; the latest weights for mine are 11.2%, 13.5%, 13.2%, 12.8%, and 13.7%. So there have been some pretty big changes in terms of which currencies are more important within a multilateral trade framework.

To illustrate the difference, here’s a comparison of the different indexes:

So, do I believe that MYR is that much undervalued? No, for a few reasons, not least of which are the flaws in the modeling framework I’ve pointed out above. But since this post is getting over long, I’ll save that for later.

*"Equilibrium exchange rates", William R. Cline & John Williamson

1 comment:

  1. hishamh,

    Your estimate of RM2.63 to the USD looks reasonable to me.

    For those of us who were working in the late 1980s and early 1990s, we were happy with RM2.70 (that has always been in my mind to be the eqilibrium rate) before the short-term capital flows raised it to RM2.50.

    The aberrant was the outflow which pushed it down to RM4.80. But before the currency speculators could unwind, the adjustment was killed at RM3.80.

    The current dirty float is a serious defect in the economy, as it artificially tries to boost the economy - but prevented it from going further up the value chain.

    If you can do further work on it, I shall be happy to learn from it.