Approaches to Assessing Currency Misalignment

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Approaches to Assessing Currency Misalignment

• Menzie D. Chinn
• UW-Madison NBER
• http//www.ssc.wisc.edu/mchinn

Presentation at Office of International
Affairs Department of the Treasury October 26,
2006
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Outline

• Caveats
• Methodologies
• Example China
• New Approaches
• Conclusion

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Key Point There Are Many Equilibrium Exch. Rates

• There is no way to get the equilibrium rate and
  hence misalignment
• The appropriate measure depends upon the
  conditions of the economy youre examining
• Different models will be relevant
• And different models will be consistent with
  different time horizons.

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Methodologies

• Relative PPP
• Absolute PPP/Deviations from Absolute PPP
• Productivity based models
• BEERs/Fair Value Models
• Macroeconomic Balance/FEERs/External or Basic
  Balance

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Relative PPP

• Assumes that relative price levels (measured by
  deflators, CPIs, or PPIs) adjusted by nominal
  exchange rates must be revert to some average
  level.
• Other deflators possible -- ULCs
• More flexible interpretations allow for reversion
  to trends.
• A long run goods arbitrage perspective

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Example US Dollar (in real terms)
Source DB, Exchange Rate Perspectives, October
2006.
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Example US Dollar (nom. terms)
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Example Korean Won (nom. terms)
Source Chinn, EMR (2000)
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Problems

• The relative PPP level must occur in the sample
  period.
• Only if the real exchange rate is stationary is
  the conditional mean invariant with respect to
  the sample.
• Related to the issue of whether the real rate is
  I(0), or price indices and the exchange rate are
  cointegrated with (1 -1 1) coefficients.

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Absolute PPP

• Absolute PPP requires the prices of bundles of
  goods are equalized in common currency terms.
• MacParity is a special case of absolute PPP.
• But Absolute PPP doesnt hold across countries of
  dissimilar incomes

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The Failure of Absolute PPP
Note Log price level log income/capita in
2000. Source Cheung, et al. (2006) WDI.
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Penn Effect and MacParity
Source Pakko and Pollard, FRB SL Review (2003).
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Productivity Based Models

• Balassa-Samuelson is the most prominent
• Higher productivity levels in tradable sector
  induces a stronger currency in real terms.
• Assumes PPP for traded goods.
• Perfect factor mobility w/in countries.
• Isnt the only relevant model in two good
  models, higher productivity may lead to a weaker
  real currency.
• Also a long run/long horizon model.

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Example China
Source Cheung, et al., FRB SF conference paper
(2005).
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BEER/DEER or Kitchen Sink

• Combination of Balassa-Samuelson, real interest
  differential (UIP with sticky prices),
  nontradables, and portfolio balance motivations
  (see Cheung, et al. (2005)).

Source F. Yilmaz and S. Jen, Morgan Stanley
(2001).

• Where does NFA come from? CA equals inverse of
  negative returns times NFA. See Lane and
  Milesi-Ferretti (2002).

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Macro Balance and Related Approaches

• Determine a normal level of current account
  balance or basic balance
• Basic balance is current account plus financial
  account (sometimes FDI flows).
• Using price elasticities, back out the
  equilibrium exchange rate.
• If an econometric approach is used to determine
  normal level of CA, then IMFs Macroeconomic
  Balance approach.

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In-Sample Fit for CA norms Korea Emerging
Asia
Source Chinn and Ito (2006)
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In-Sample Fit China
Source Chinn and Ito (2006)
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Complications

• Large prediction intervals for CA norms.
• What are the relevant trade elasticities?
• What are the conditioning variables (e.g., does
  one take budget deficits as given?)
• Details? See Isard, Faruqee, Kincaid, Fetherston
  (2001).
• FEER uses a normative assessment of equilibrium
  current account/basic balance.
• Looking at reserve accumulation is a variation on
  this approach.

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Many Equilm Rates China
GAO (August 2005)
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Relative PPP (I)
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Relative PPP (II)
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Absolute PPP and Uncertainty
Source Cheung et al. (2006)
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Recent Developments

• The role of net foreign assets, gross assets
• Measurement of the effective exchange rate

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Assets and Adjustment Gourinchas-Rey

• Propose a framework for NFA-ex rate movements
• Builds upon reversion to trend in NFA
• And an intertemporal budget constraint
• So a deficit can be closed by either the
  traditional trade channel (net exports), or
• Closed by revaluation effects
• NB depreciation works in same direction

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Normalized net exports/net assets

• Nxa is normalized so export weight is unity
• This means its measured in same units as
  exports.
• Interpretation nxa is (approx.) the age
  increase in exports necessary to restore ext.
  balance

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Econometrics

• First part component that fcasts future ret.
• Second component that fcasts nx growth
• Estimate using VAR

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Exchange Rate Adjustment
Gourinchas and Rey, International Financial
Adjustment (2005)
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Approximating G-R(in-sample)
Source authors calculations
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Measurement Divisia vs. geometric?
Source Thomas and Marquez (2006)
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References

• Cheung, Yin-Wong, Menzie Chinn and Eiji Fujii,
  2006, The Overvaluation of Renminbi
  Undervaluation, paper presented at the
  conference on Financial and Commercial
  Integration, SCCIE-JIMF conference, Santa Cruz
  (Sept.).
• http//sccie.ucsc.edu/webpages/conf/Cheung-Chinn.p
  df
• Cheung, Yin-Wong, Menzie Chinn and Antonio Garcia
  Pascual, 2005 Empirical Exchange Rate Models of
  the Nineties Are Any Fit to Survive? Journal of
  International Money and Finance 24 1150-1175.
• http//www.ssc.wisc.edu/mchinn/FXForecast.pdf
• Chinn, Menzie, 2000, Before the Fall Were East
  Asian Currencies Overvalued? Emerging Markets
  Review 1(2) (August 2000) 101-126.
  http//www.ssc.wisc.edu/mchinn/BeforetheFall_EMR.
  pdf
• GAO, 2005, International Trade Treasury
  Assessments Have Not Found Currency Manipulation,
  but Concerns about Exchange Rates Continue,
  Report GAO-05-351 (April).

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• Gourinchas, Pierre-Olivier and Helene Rey, 2005,
  International Financial Adjustment. NBER
  Working Paper No. 11155 (February).
• http//www.nber.org/w11155/
• Isard, Peter , Hamid Faruqee, G. Russell Kincaid,
  Martin Fetherston, 2001, Methodology for Current
  Account and Exchange Rate Assessments, IMF
  Occasional Paper No. 209.
• Lane, Philip and Gian Maria Milesi-Ferretti,
  2002, External Wealth, the Trade Balance, and
  the Real Exchange Rate, European Economic Review
  46 1049-71.
• Pakko, Michael R. and Patricia S. Pollard, 2003,
  Burgernomics A Big Mac Guide to Purchasing
  Power Parity, Review 85(6) Nov. 9-28.
• http//research.stlouisfed.org/publications/review
  /03/11/pakko.pdf