Financial dollarization and debt deflation under a currency board

In the late currency board years, Argentina faced a real exchange rate adjustment through price deflation amidst growing devaluation expectations. Using a firm-level panel database to analyze the incidence of these factors on the currency composition of private debt and on firms’ performance, we find that widespread debt dollarization showed no relationship with the firms’ production mix or the ever-changing probability of a nominal devaluation. While relative price changes favored export-oriented firms with the expected impact on sales, earnings and investment, increases in devaluation expectations elicited only a marginal differential response in investment from more financially dollarized firms. Our findings provide support to two criticisms faced by the Argentine currency board in recent years, namely, that by fueling beliefs in an implicit guarantee it stimulated across-the-board debt dollarization and that it could not fully isolate the economy from real shocks, as the feared balance sheet effect was replaced by a gradual but equally deleterious debt deflation effect.     

Currency mismatches and monetary policy: A tale of two equilibria

We develop a model of a small economy whose residents choose whether to borrow in domestic or foreign currency. The central bank, in turn, chooses fixed or flexible exchange rates, taking the currency denomination of debts as given. We characterize the simultaneous determination of portfolios and exchange rate regime. Both floating and fixed rates can occur as equilibrium outcomes. “Fear of floating” may emerge endogenously and in association with a currency mismatch in assets and liabilities. If equilibria with both fixed rates and floating rates coexist, the latter is Pareto superior. Lessons for current “de-dollarization” proposals are discussed.     

Exchange rate volatility and economic performance in Peru: a firm level analysis

This paper analyzes the impact of the exchange rate volatility on the performance of the Peruvian economy using financial information from 163 non-financial listed firms. We find evidence that, for firms holding dollar-denominated debt, investment decisions are negatively affected by real exchange rate depreciation. The reasons behind this result are: (i) the high degree of liability dollarization and currency mismatch that create the conditions for a balance sheet effect and a financial stress in the aftermath of a currency depreciation; (ii) the strong bank-lending channel that follows and reinforces the balance sheet effect; (iii) the domestic demand shrinkage that affects severely firms’ sales; and (iv) the relatively small and poorly diversified export sector.     

Export prices,selection into exporting and market size: Evidence from China and India

This paper empirically analyses the export pricing behaviour of Chinese and Indian exporters when there is selection into exporting. Previous exchange rate pass-through estimates that did not take selection into account could be biased if selection into exporting is correlated with pricing strategy. We use 6-digit product-level data across high- and low-income export destinations over the period 1994–2007 and assess a number of determinants of the degree of pass-through of exchange rates to export prices, such as the level of external demand, exporter’s wage cost, degree of competition in export markets, currency volatility and the direction of currency movements. We find systematic differences in the pricing strategies of Chinese and Indian exporters while uncovering a selection bias in exports to high-income markets, although the pricing of exports to low-income markets is independent of the decision to export. Export prices do not increase systematically with the destination market per capita income, and tend to be less sensitive in shipments to advanced nations. Export prices of India are sensitive to the volatility of the trade-weighted nominal effective exchange rate (NEER), indicating heterogeneity in prices to maintain competitiveness, but not in China as volatility is insignificant given a fixed currency system. It is also revealed that a country with a relatively flexible currency regime and arms-length trade such as India is more likely to exhibit incomplete pass-through, whereas a country with an inflexible currency system and involved in outward processing trade is more likely to have full pass-through as shown in the case of China.     

Fear of floating and domestic liability dollarization

Previous attempts to analyze the effect of liability dollarization on “fear of floating” have focused exclusively on the role played by foreign liabilities. Liability dollarization of the domestic banking system, however, poses a similar risk as dollar-denominated deposits and credit impose a source of currency risk on domestic banks and firms, respectively. Findings from a large cross-country sample indicate that domestic liability dollarization plays a central role in producing a “fear of floating” among emerging market countries and developing nations. This is an important result because domestic liability dollarization is more reversible than the dollarization of foreign liabilities, providing a reason for optimism that these countries can regain flexibility in the choice of exchange rate regime and overcome their “fear of floating”.     

Global monetary policy under a dollar standard

This paper derives an optimal monetary policy in a world with a dollar standard, defined as an environment in which all traded goods prices are set in US dollars, so that exchange rate pass-through into the US price level is zero. We show that the US is essentially indifferent to exchange rate volatility, while the rest of the world places a high weight on exchange rate volatility. In a Nash equilibrium of the monetary policy game, US preferences dominate; the equilibrium is identical to one where the US alone chooses world monetary policy. Despite this, we find surprisingly that the US loses from the dollar's role as an international currency, since the absence of exchange rate pass-through leads to inefficient expenditure allocations within the US. Finally, we derive the conditions for a dollar standard to exist.     

Exports versus multinational production under nominal uncertainty

This paper examines how nominal uncertainty affects the choice that firms face to serve a foreign market through exports or to produce abroad as a multinational. I develop a two-country, stochastic general equilibrium model in which firms make production and pricing decisions in advance, and I consider its implications for the relative attractiveness of exporting and multinational production. I find that when multinational sales are priced in the local currency while exports are priced in the producer currency, destination volatility benefits exporters: during a foreign nominal contraction, the foreign exchange rate appreciates, causing exports to be relatively cheaper. Exporters gain non-linearly through demand, making profit convex in prices. As foreign volatility rises, the model implies that the home country should serve the foreign country relatively more through exports. I take this implication to bilateral U.S. data, using inflation volatility as a proxy for nominal volatility. Using sectoral data on sales by majority-owned foreign affiliates matched with U.S. exports, I find that higher inflation volatility is associated with a significantly lower ratio of multinational sales to total foreign sales.     

Monetary policy in developing countries: lessons from Kenya

We estimate and then simulate a model of Kenyan economic development from 1965 to 1997 with two objectives in mind. The first is to demonstrate the degree of volatility of cyclical shocks that developing countries experience and to calculate the domestic nominal adjustments required by these shocks under both irrevocably fixed and free exchange rates.A comparison of these counterfactual nominal adjustments identifies the short-run implications for an economy of the choice of exchange rate regime. The second objective is to provide an estimate of the consequences for the economic development of Kenya of the lack of a coherent monetary order (excessive domestic credit expansion and overvalued exchange rate) throughout most of the period since 1965.A neoclassical convergence growth model based on Barro and Sala-i-Martin (1992) is employed and calibrated to represent the long-run growth path of real GDP in Kenya. A short-run four-sector CGE model is constructed that allows for cyclical movements of real GDP about the convergence growth path. The cyclical model focuses on the adjustment of the relative price of non-traded goods that is required to ensure short-run equilibrium in the non-traded goods sector. Given that terms of trade shocks dominated the macro environment of Kenya over the sample period, we find that a free exchange rate regime would have insulated the economy to a greater degree than an irrevocably fixed regime. In the growth decomposition exercise, we estimate that the two largest (and negative) influences on Kenyan economic growth were the decline in the external terms of trade from 100 in 1965 to an average of 79.5 over the 32-year time period, and the overvalued Kenyan shilling represented by a premium on the parallel market for foreign exchange. Overall, we estimate that the overvalued exchange rate reduced economic growth by an average of 0.47 per cent per annum over the 32 years.     

A theory of the currency denomination of international trade

The currency denomination of international trade has significant macroeconomic and policy implications. In this paper we solve for the optimal invoicing choice by integrating this microeconomic decision at the level of the firm into a general equilibrium open economy model. Strategic interactions between firms play a critical role. We find that the less competition firms face in foreign markets, as reflected in market share and product differentiation, the more likely they will price in their own currency. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.     

The exchange rate, employment and hours: What firm-level data say

Using a representative panel of manufacturing firms, we estimate the response of job and hours worked to currency swings, showing that it depends primarily on firms' exposure to foreign sales and their reliance on imported inputs. We also show that, for a given international exposure, the response to exchange rate fluctuations is magnified when firms exhibit a lower monopoly power and when they face foreign pressure in the domestic market through import penetration. The degree of substitutability between imported and other inputs and the distribution of workers by type introduce additional degrees of specificity in the employment sensitivity to exchange rate swings. Moreover, we show that episodes of entry and exit in the export market are associated with a heterogeneous employment response depending on the degree of external orientation when the switch of export status occurs.     

Endogenous exchange rate pass-through when nominal prices are set in advance

This paper develops a model of endogenous exchange rate pass-through within an open economy macroeconomic framework, where both pass-through and the exchange rate are simultaneously determined, and interact with one another. Pass-through is endogenous because firms choose the currency in which they set their export prices. There is a unique equilibrium rate of pass-through under the condition that exchange rate volatility rises as the degree of pass-through falls. We show that the relationship between exchange rate volatility and economic structure may be substantially affected by the presence of endogenous pass-through. Our key results show that pass-through is related to the relative stability of monetary policy. Countries with relatively low volatility of money growth will have relatively low rates of exchange rate pass-through, while countries with relatively high volatility of money growth will have relatively high pass-through rates.     

Debt composition and balance sheet effects of currency depreciation: a summary of the micro evidence

This paper surveys recent empirical evidence on the determinants of the currency composition of debt, and on the impact of exchange rate fluctuations on economic activity. It suggests that Latin American firms tend to partially match the composition of their debt with the currency composition of their income stream but the liability dollarization can reduce or possibly reverse the typical Mundell–Fleming result of expansionary devaluations.     

Financial dollarization

We present a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet. We show that minimum variance portfolio (MVP) allocations provide a natural benchmark to estimate the scope for dollarization of assets and liabilities (financial dollarization) as a function of macroeconomic uncertainty. Within this benchmark, we find that financial dollarization displays high persistence whenever the expected volatility of the inflation rate remains high in relation to that of the real exchange rate, even after price stabilization has been achieved. The empirical evidence confirms that MVP dollarization approximates financial dollarization closely for a broad sample of countries.     

Does US quantitative easing affect exchange rate pass‐through in China?

In this paper, we show theoretically and empirically that the US quantitative easing (QE ) policy results in lower exchange rate pass‐through into the destination prices of Chinese exporters. In addition, the more the exchange rate in the export destination appreciates than the Chinese yuan, the stronger this effect becomes. Our model combines various marginal effects of QE policy on the destinations of Chinese exporters and variable markups of export firms due to strategic complementarities. The model predicts that the impact of US QE policy on the pass‐through of Chinese exporters depends on its spillover on the exchange rate between China and the export destination of different firms. We provide strong support for the model predictions using Chinese firm‐product‐level data with information on export destinations. The baseline result and the heterogeneity we find in the response of exchange rate pass‐through of Chinese exporters to US QE policy remain robust to alternative measures of samples and controls.     

Into the Mussa puzzle: monetary policy regimes and the real exchange rate in a small open economy

Industrial countries moving from fixed to floating exchange rate regimes experience dramatic rises in the variability of the real exchange rate. This evidence, forcefully documented by Mussa [Nominal exchange regimes and the behavior of real exchange rates: evidence and implications. Carnegie-Rochester Conference Series on Public Policy 25 (1986) 117], is a puzzle because it is hard to reconcile with the assumption of flexible prices. This paper lays out a dynamic general equilibrium model of a small open economy that combines nominal price rigidity with a systematic behavior of monetary policy able to approximate a continuum of exchange rate regimes. A version of the model with complete exchange rate pass-through is broadly consistent with Mussa’s findings. Most importantly, this holds independently of the underlying source of fluctuations in the economy, stressing the role of the nominal exchange rate regime per se in affecting the variability of the real exchange rate. However, only a model featuring incomplete exchange rate pass-through can account for a broader range of exchange rate statistics. Finally there exist ranges of values for either the degree of openness or the elasticity of substitution between domestic and foreign goods for which the baseline model is also consistent with the empirical insensitivity of output volatility to the type of exchange rate regime, as documented by Baxter and Stockman [Journal of Monetary Economics 23 (1989) 377].     

固定汇率制度与浮动汇率制度下经济的自动稳定性

本文运用规范的开放宏观模型和比较静态分析方法,讨论了固定汇率制度或浮动汇率制度下、如果没有政策的干预,面对真实或名义瞬时冲击时的产出和物价的自动稳定性。分析表明,两种汇率制度下经济稳定表现与经济系统的结构参数有密切的关系,没有一个汇率制度在所有情形下都表现得最好。但对特定的发展中国家经济结构特征和外生冲击来源的可能性来说,相对于浮动汇率制度,固定汇率制度更利于经济的自动稳定。     

Exchange rate fluctuations,firm size,and export behavior: an empirical investigation

In this paper, we examine how changes in the exchange rate and its volatility affect the export behavior of manufacturing firms. We also investigate whether both exchange rate changes and exchange rate volatility affect firms of different sizes differently. Applying the two-step system generalized method of moment estimator on our data for a sample of 221 Pakistani manufacturing firms, we find that the real exchange rate depreciation has positive impacts, whereas the exchange rate volatility has negative impacts on firms’ exports. We also find that compared to large-sized firms, small- and medium-sized exporting firms are more likely to benefit from currency depreciations. Yet, regarding the effect of exchange rate volatility, we find that the adverse impact of exchange rate volatility is weaker for large-sized firms as compared to small- and medium-sized firms. Our findings confirm the presence of nonlinearity in export-deterring (favoring) effects of exchange rate volatility (depreciation) on exporting behavior depending on firm size. Pakistan should design and implement export-favoring preferential policies by emphasizing on real exchange rate stabilization and providing incentives to large firms to come into being. Small- and medium-sized enterprises should develop such export strategies that help reduce their size disadvantages, particularly in managing exchange rate risks.     

Exchange rate regimes, globalisation, and the cost of capital in emerging markets

This paper presents a multifactor asset pricing model for currency, bond, and stock returns for ten emerging markets to investigate the effect of the exchange rate regime on the cost of capital and the integration of emerging financial markets. Our results suggest that a fixed exchange rate regime system can help reduce the cost of capital in emerging markets by reducing the currency risk premia demanded by foreign investors.     

A STUDY OF THE DIVERSIFICATION OF CHINA'S FOREIGN RESERVES WITHIN A THREE‐COUNTRY STOCK‐FLOW CONSISTENT MODEL

The paper presents a three‐country stock‐flow consistent model, with one fixed exchange rate and two flexible exchange rates, in the tradition of portfolio balance models with imperfect asset substitutability. The model is applied to simulate the impact of the diversification of the foreign reserves of China, away from US dollars and towards euros. The simulation results show that China and the USA both benefit from diversification, while the Euroland economy slows down. An intriguing feature of the model is that it generates path dependence.     

Chinese trade price and Yuan's valuation

This paper studies how the major economic events would have affected Chinese yuan's nominal exchange rate against US dollar from 1989 to 2013. The traditional average treatment effect estimation methods cannot be used to consistently estimate yuan's pegged exchange rate. We develop a new estimation strategy by combining a novel panel data method (proposed by Hisao, Ching and Wan) and the purchasing power parity theory. Based on this new estimation strategy, we find that during the period of pegging to US dollar, Chinese yuan were undervalued. Before the 1997 Asian Financial Crisis, the pegged exchange rate regime starting from January 1994 made the yuan undervalued by 2.62%. China's accession to WTO caused yuan undervalued by 36.60%. After the reform of Chinese exchange rate policy in July 2005, the undervaluation of the yuan was reduced to only 0.76%. Yuan was undervalued again by 20.43% because of 2008 China's economy stimulus package. The policy reform in June 2010 made yuan overvalued by 14.40%. We conclude that Chinese fixed exchange rate policy indeed undervalued the yuan, especially after its accession to WTO. The recent reforms of Chinese exchange rate policy made progresses in re‐evaluating the yuan.