Money and Banking

Lecture X: Exchange Rate Regime Choice, Exchange Rate Forecast, andRMB Internationalization

Guoxiong ZHANG, Ph.D.

Shanghai Jiao Tong University, Antai

November 20th, 2018

Source: http://www.dailymirror.lk

Road Map

Exchange rate regime choicehistorical experienceChina’s perspective

Exchange rate forecastexchange rate forecast modelsexchange rate forecast performance

Gold Standard

Before World War I, the world economy operated under the goldstandard: currency of most countries was convertible directly into goldat fixed rates.

Disadvantage of this gold standard: can not have active monetarypolicy.

The world economy grows faster than the speed of gold production,caused deflation;Huge amount of gold discovered in South America caused inflation.

Bretton Woods System

After World War II, US became the world leader and USD became theonly reserve currency, and therefore Bretton Woods System wascreated in 1944:

All the other countries’ currency has a fixed exchange rate with USD;One USD has a fixed value of 1

35ounce of gold.

In 1971, US unilaterally devaluated dollar to one dollar equals 142

ounce of gold;

In 1973, US terminated convertibility of the US dollar to gold and letother countries to choose their own exchange rate with dollar.

Classification of Exchange Rate Regime

Textbook classification:fixed (Hong Kong, etc.)managed float (China, etc.)float (most other countries)

IMF classification:floatingsoft peg (managed float)hard peg (currency board)others?dollarization?

Map of Exchange Rate Regimes

Optimal Exchange Rate Regime

How to choose exchange rate regime that suits the country the besthas been an evolving theme:

before 1990s, most countries, especially developing and transitioneconomies prefer fixed exchange rate regime;in 1990s, several countries with fixed exchange rate regime suffer fromserious capital crisis and therefore shifted to more float exchange rateregimes;around 2000, bipolar exchange rate regime (either free float or hard peg)became popular until Argentina’s currency crisis in 2002;after every financial crisis (2001 IT bubble, 2007-2009 financial crisis),more countries tend to abandon float exchange rate regime (fear to float)

Benefits from a Fixed Exchange Rate Regime

A series of studies by IMF (1999 - 2009) do find empirical evidencethat a fixed exchange rate regime may benefits developing countries:

Pegged exchange rate regimes are associated with the best in ationperformanceGrowth performance is best under intermediate exchange rateregimes?those that maintain relatively rigid exchange rates but do notformally peg to a single anchor currency.Countries in a monetary union have deeper trade links.

Downsides of a Fixed Exchange Rate Regime

These studies also find downsides of a fixed or intermediate exchangerate regime may hurt a developing economy:

a fixed or intermediate exchange rate regime severely constrains the useof other macroeconomic policies (both monetary policy and fiscalpolicy);a fixed or intermediate exchange rate regime has greater susceptibility tocurrency and financial crises, such as debt crises, a sudden stop incapital inflows, or banking crisesa fixed or intermediate exchange rate regime impedes timely externaladjustment

Exchange Rate of RMB

Exchange Rate Regime of RMB

Before 1994, RMB is officially pegged to dollar (between 1985 and1993, dual exchange rates);

In 1994, RMB started managed-float with USD as the only referencecurrency: market exchange rate can fluctuate within a narrow bandaround the official benchmark rate;

Started in 2005, RMB use a basket of currencies as reference;

Band width: 0.3% in 2005, 0.5% in 2007, 1% in 2012 and 2% in 2014.

In August 2015, two major reforms were initiated:use last trading-day’s close rate as reference for the official benchmarkrate;reduce USD’s weight in the basket of reference currency.

Future Perspective of the Exchange Rate Regime of RMB

The direction of renminbi exchange rate reform is irreversible.China will continue to enhance exchange rate flexibility, and in thenear future, China is going to increase the floating band of therenminbi even further, letting market supply and demand play thefundamental role in exchange rate formation. China will alsoreduce central bank intervention, enhance the self-rebalancingcapability of foreign exchange market, and improve the self-pricingand risk management capabilities of the financial institutions.

-Yi, Gang (2013)

Exchange Rate Forecast Models

It is well known that exchange rates are very difficult to predict usingeconomic models

Meese and Rogoff puzzle: a simple random walk model without anyeconomic meaning can generate better exchange rate forecasts thaneconomic models.

Nevertheless it is important to understand the forecast models used byeconomists.

Older models (before 1990s): uncovered interest rate parity model,purchasing power parity model.Newer models (after 1990s): sticky price model, productivity differentialmodel, composite model

Random Walk Model

St = St−1 + εt,

where E(εt) = 0, var(εt) <∞ and corr(εi, εj) = 0 for ∀i 6= j.

USD-Euro Exchange Rate, Level

Source: https://fred.stlouisfed.org/series/DEXUSEU

USD-Euro Exchange Rate, Change

Source: https://fred.stlouisfed.org/series/DEXUSEU

USD-Euro Exchange Rate, Autocorrelation

Source: https://fred.stlouisfed.org/series/DEXUSEU

Purchasing Power Parity Model

st = α+ pt + ut,

where st = log(St), pt is the log of CPI,pt = pt,i − pt,j , and ut is an errorterm.

Uncovered Interest Rate Parity Model

st+k = st + it,k + ut,

where it,k is the interest rate of maturity k at time t.

Sticky Price Model

st = α+ β1mt + β2yt + β3 it + β4πt + ut,

where mt is log money supply, yt is log real GDP, it is nominal interestrate, πt is inflation rate, and again · denotes country differential.

Productivity Differential Model

st = α+ β1mt + β2yt + β3 it + β4zt + ut,

where zt is country productivity (TFP).

Composition Model

st = α+ pt + β1ωt + β2rt + β3 ˆg dt + β4 ˆTOT t + β4 ˆNFAt + ut,

where ωt is the price of non-tradables, rt is the real interest rate, g dt is theGDP over government debt ratio, TOT t is terms-of-trade (real exchangerate), and NFAt is net foreign asset holding.

Forecast Performance

We assess the forecast performance of these models by comparing itsforecast MSE with the one of the random walk model:

MSE =T∑

t=1

(st − st)2.

Forecast Performance

Table 1

The MSE ratios from the dollar-based exchange rates

Specification Horizon Sample 1: 1987q2e2000q4 Sample 2: 1983q1e2000q4

PPP S-P IRP PROD COMP PPP S-P IRP PROD COMP

Panel A: BP/$

ECM 1 4.165 1.047 1.008 0.995 1.085 5.678 1.050 1.046 1.042 1.049

0.003 0.409 0.883 0.897 0.208 0.031 0.310 0.318 0.303 0.448

4 1.750 1.127 1.092 1.017 1.099 1.612 1.142 1.123 1.085 1.127

0.199 0.503 0.620 0.802 0.253 0.224 0.171 0.310 0.237 0.225

20 0.782 1.809 1.342 1.095 1.340 0.632 1.457 0.841 1.545 2.179

0.536 0.014 0.240 0.411 0.168 0.156 0.071 0.518 0.092 0.057

FD 1 1.041 1.006 1.191 1.086 1.079 1.023

0.434 0.940 0.217 0.135 0.337 0.901

4 1.120 1.124 1.881 1.250 1.455 1.448

0.315 0.524 0.001 0.149 0.176 0.351

20 1.891 2.531 6.953 3.223 5.557 6.015

0.177 0.021 0.000 0.195 0.019 0.001

Panel B: CAN$/$

ECM 1 32.205 1.054 1.090 1.148 1.278 31.982 1.056 1.092 1.041 1.337

0.008 0.127 0.048 0.062 0.016 0.001 0.279 0.022 0.552 0.004

4 6.504 1.102 1.172 1.182 1.603 6.947 1.116 1.170 1.017 1.754

0.016 0.181 0.452 0.157 0.118 0.004 0.334 0.359 0.929 0.018

20 1.569 0.939 0.865 1.090 1.760 1.171 1.062 0.813 1.097 1.623

0.000 0.574 0.760 0.308 0.002 0.093 0.727 0.607 0.318 0.000

FD 1 1.100 1.115 0.614 1.101 1.171 0.666

0.179 0.138 0.109 0.257 0.047 0.151

4 1.137 1.160 0.899 1.196 1.269 1.143

0.461 0.341 0.798 0.347 0.192 0.704

20 0.515 0.504 1.924 1.892 2.004 2.289

0.193 0.182 0.006 0.182 0.143 0.204

Panel C: DM/$

ECM 1 6.357 1.059 1.030 1.041 0.995 11.173 1.105 1.029 0.997 0.911

0.006 0.464 0.295 0.574 0.955 0.005 0.416 0.364 0.961 0.206

4 2.301 1.080 1.136 1.080 1.116 2.675 1.104 1.063 0.949 0.898

0.016 0.444 0.069 0.282 0.642 0.007 0.599 0.485 0.626 0.558

20 0.649 1.047 0.596 1.131 2.137 0.411 1.771 0.895 1.260 0.633

0.363 0.637 0.167 0.141 0.216 0.248 0.212 0.656 0.039 0.202

FD 1 1.268 1.324 0.555 1.123 1.196 0.694

0.052 0.106 0.001 0.017 0.084 0.020

4 1.402 1.607 0.844 1.077 1.281 1.151

0.024 0.030 0.571 0.452 0.009 0.612

20 1.814 1.927 2.522 1.723 1.964 3.975

0.175 0.114 0.140 0.246 0.121 0.003

Panel D: SF/$

ECM 1 7.595 1.074 1.051 1.024 . 8.694 0.995 1.050 1.052 .

0.001 0.187 0.138 0.515 . 0.000 0.906 0.141 0.581 .

4 2.537 1.269 1.183 1.184 . 2.106 1.002 1.122 1.136 .

0.014 0.015 0.059 0.367 . 0.003 0.982 0.248 0.149 .

(continued on next page)

1159Y.-W. Cheung et al. / Journal of International Money and Finance 24 (2005) 1150e1175

Benefits of Being an International Currency

There are several benefits to be an international currency

Convenience for the country’s residents

More business for the country’s banks and other financial institutions

Seigniorage

Political power and prestige

“Safety premium” and risk diversification if becoming a reservecurrency

Costs of Being an International Currency

There are also costs to be an international currency

Larger fluctuations in demand for the currency

An increase in the average demand for the currency (appreciation hurtsexport)

Burden of responsibility

Internationalization of RMB

Offshore RMB bond market (dim sum) was created at Hong Kong in2007

Many countries have signed cross-border trade RMB settlementagreement since 2008

Off-shore RMB market was created at Hong Kong in 2009

RMB has been able to flow freely between Shanghai Free Trade Zone,non-resident onshore account and offshore account since 2013

RMB successfully joint the SDR of IMF

Fundamental Determinants of Currency Status

The currency of a country that has a large share in internationaloutput, trade, and finance has a big natural advantage

Capital and money markets in the home country must be not onlyopen and free of controls, but also deep and well-developed

Confidence in the value of the currency.

network externalitiesinertia: small changes in the determinants will not producecorresponding changes in the reserve currency numbers, at least not inthe short runeconomies of scope: one is more likely to use a given currency in his orher transactions if everyone else is doing so

Reserve Currency

Source: Frankle (2011)

Internationalization of Deutsche Mark in the 1970s-1980s

Through 1950s to 1960s, a rising U.S. balance of payment deficits anddeclining ratio of U.S. gold reserves to dollar liabilities brought intoquestion the long-term prospects for the dollar

President Richard Nixon took the dollar entirely off gold in 1971 andthe fixed exchange rate system definitively ended in 1973

Deutsche Mark became attractive while dollar became weaker

Nevertheless, the mark continued to gain status throughout the 1980s.

It was a side effect of the growing size of the German economy(especially trade) and the impeccable reputation that the Bundesbankhad established for keeping the mark strong in value

Deutsche Mark lost its share largely due to the fact that Germany waspaving the way for Euro

Internationalization of Japanese Yen in the 1980s

For the same reason as Germany, Japan has always reluctant tointernationalization of Japanese Yen

The U.S. motive in pushing for internationalization of the yen was atheory that it would lead to appreciation and help U.S. exporters

International use of the yen continued gradually to rise in the 1980sdespite reluctance of the Japanese government

In the mid-1990s, official policy at last shifted firmly in favor ofinternationalization

reducing exchange rate risk for domestic firms,facilitating business for Japanese banks and other financial institutionspromoting Japan as a financial center

Ironically the share of Yen in the World’s reserve currency actuallystarted to decline in mid-1990s

Prospect of RMB Internationalization: Size of China

Source: Frankle (2011)

Prospect of RMB Internationalization: Financial Openness

Source: Frankle (2011)