Bi‐currency versus Single‐currency Targeting: Lessons from the Russian Experience

This paper examines how the 2005 shift in Russian exchange rate policy from US dollar (USD) single‐currency to USD–EUR (euro) bi‐currency targeting has impacted domestic interest rates. The finding show that this policy shift has disconnected Russian interest rates from US dollar‐denominated interest rates, while instead linking them to a synthetic interest rate composed of USD and EUR rates at the same proportion as that of these two currencies in the currency basket against which the ruble's exchange rate is set. The Russian experience shows that while the adoption of bi‐currency targeting may help ensure that domestic interest rates are less dependent on the monetary cycle of a single country, these rates are instead likely to reflect financial developments in all countries whose currencies are included in the currency basket. This insight is likely to be relevant for other countries that pursue basket‐targeting policies.     

One money, one market: the effect of common currencies on trade

A gravity model is used to assess the separate effects of exchange rate volatility and currency unions on international trade. The panel data, bilateral observations for five years during 1970–90 covering 186 countries, includes 300+ observations in which both countries use the same currency. I find a large positive effect of a currency union on international trade, and a small negative effect of exchange rate volatility, even after controlling for a host of features, including the endogenous nature of the exchange rate regime. These effects, statistically significant, imply that two countries sharing the same currency trade three times as much as they would with different currencies. Currency unions like the European EMU may thus lead to a large increase in international trade, with all that that entails.     

Currency Exposure to Downside Risk: Which Fundamentals Matter?

I study whether or not countries' macroeconomic characteristics are systematically related to their currencies' exposure to the downside market risk. I find that the currency downside risk is strongly associated with the local inflation rate, real interest rate and net foreign asset position. Currencies of countries with high inflation and real interest rates and negative net foreign asset position (debtor countries) are more exposed to the downside risk whereas currencies of countries with low inflation and real interest rates and positive net foreign asset position (creditor countries) exhibit “safe haven” properties. The local real interest rate has the highest explanatory power in accounting for the cross‐section of currency exposure to the downside risk. This suggests that the high currency exposure to the downside risk is a consequence of investments in high‐yield risky countries and flight from them in “hard times”.     

The drivers of foreign currency‐based banking in Central and Eastern Europe

Foreign currency (FX)‐based loans and deposits became very popular in Central and Eastern European countries (CEECs) over the 2000–2011 period. In this paper, I simultaneously examine the demand‐side (consumer‐related) and supply‐side (bank‐related) determinants of the quick spread of FX banking. I use a newly constructed dataset on FX and domestic currency loans, deposits and interest rates, covering 16 CEECs overtime. Local‐FX interest rate and market share spreads are: (1) lower in managed currency regimes; (2) strongly affected by the prevalence of FX funding, currency mismatch and FX banking restrictions, and (3) wider after economic crises.     

Currency restrictions,government transaction policies and currency exchange

Summary. We study how currency restrictions and government transaction policies affect the values of fiat currencies in a two country, divisible good, search model. We show that these policies can generate equilibria where both currencies circulate as medium of exchange and where currency exchange occurs between citizens of different countries. Restrictions on the internal use of foreign currency can cause the domestic currency to be relatively more valuable to domestic agents while taxes on domestic currency create an incentive for home agents to hold foreign currency. We demonstrate that some policies increase prices and lower welfare while others do the reverse. Received: September 5, 2001; revised version: March 1, 2002     

Costs and benefits of unilateral euroization in central eastern Europe

Countries unable or unwilling to join a monetary union can replicate most membership effects unilaterally through either a currency board or the formal replacement of domestic currency by that of the Union. Potential benefits include lower transaction costs, lower interest rates, and lower exposure to speculative attacks. Costs include initial reserves, inadequate response to asymmetric shocks, loss of seigniorage, no lender of last resort. Expected costs and benefits have probably been exaggerated. Net effects depend primarily on the degree of monetary, real, and institutional convergence. Positive net advantages will accrue to countries that are either already converging, or wish to use a single currency to speed up convergence — especially if small. There is no legal or economic justification for EU aversion to unilateral euroization in accession candidate countries. JEL classification: F33, F36, E58, P33.     

Banknotes And Economic Growth

Modern paper currency contributes little to productive investment. This shortcoming is not inherent to paper money. It stems from the fact that currency today is monopolistically supplied by public monetary authorities that are poor intermediaries. Commercial banknotes may, in contrast, support efficient intermediation, just as private bank deposits do. We demonstrate this advantage in an endogenous growth model, and use the model to simulate, for a sample of developing countries, steady‐state growth‐rate gains from various degrees of banknote deregulation. The simulated gains are generally large compared with those from conventional forms of financial liberalization.     

Fiscal,monetary policy and the conditional risk premium in short-term interest rate differentials: an application of Tobin's portfolio theory

This paper proposes a Multivariate-Arch in Mean model to analyze the potential channels through which domestic fiscal and monetary policy as well as changes in the international economic environment may affect interest rate differentials across countries. This technique is illustrated by analyzing the behavior of short-term interest rates in a number of European countries prior to the introduction of the common currency. The key feature of our results is that macroeconomic variables exert both a direct and indirect influence on the short-term interest rate differential. This indirect effect is captured through the conditional volatility of the differential, which is itself a statistically significant determinant of the level of the differential. This relationship is likely to be overlooked by more traditional models that focus solely on the first order moments of the process.     

Transmission of monetary policy and exchange rate shocks under foreign currency lending

This paper analyses the differences in reaction of domestic and foreign currency lending to monetary and exchange rate shocks, using a panel VAR model estimated for the three biggest Central and Eastern European countries (Poland, the Czech Republic and Hungary). Our results point toward a drop in domestic currency loans and an increase of foreign currency credit in reaction to monetary policy tightening in Poland and Hungary, suggesting that the presence of foreign currency debt weakens the transmission of monetary policy. A currency depreciation shock leads to an initial decline in foreign currency lending, but also in loans denominated in domestic currency as central banks react to a weaker exchange rate by increasing the interest rates. However, after several quarters, credit in foreign currency accelerates, indicating that borrowers start using it to substitute for depressed domestic currency lending.     

Hot Money Flows,Cycles in Primary Commodity Prices,and Financial Control in Developing Countries

Because the U.S. Federal Reserve’s monetary policy is at the center of the world dollar standard, it has a first-order impact on global financial stability. However, except during international crises, the Fed focuses on domestic American economic indicators and generally ignores collateral damage from its monetary policies on the rest of the world. Currently, ultra-low interest rates on short-term dollar assets ignite waves of hot money into Emerging Markets (EM) with convertible currencies. When each EM central bank intervenes to prevent its individual currency from appreciating, collectively they lose monetary control, inflate, and cause an upsurge in primary commodity prices internationally. These bubbles burst when some accident at the center, such as a banking crisis, causes a return of the hot money to the United States (and to other industrial countries) as commercial banks stop lending to foreign exchange speculators. World prices of primary products then collapse. African countries with exchange controls and less convertible currencies are not so attractive to currency speculators. Thus, they are less vulnerable than EM to the ebb and flow of hot money. However, African countries are more vulnerable to cycles in primary commodity prices because food is a greater proportion of their consumption, and—being less industrialized—they are more vulnerable to fluctuations in prices of their commodity exports. Supply-side shocks, such as a crop failure anywhere in the world, can affect the price of an individual commodity. But joint fluctuations in the prices of all primary products—minerals, energy, cereals, and so on—reflect monetary conditions in the world economy as determined by the ebb and flow of hot money from the United States, and increasingly from other industrial countries with near-zero interest rates.     

An analysis of East Asian currency area: Bayesian dynamic factor model approach

There has recently been an increasing interest in the establishment of a common currency area in East Asia in the aftermath of the East Asian financial crisis. In this article I examine the desirability and feasibility of forming a currency area in the region by checking the symmetry of shocks as an important criterion of the theory of Optimum Currency Area. I employ a dynamic factor model to decompose aggregate output into world, regional and country‐specific components and estimate the model using a Gibbs sampling simulation. Persistent properties of those components are examined and variance decomposition analysis is performed to investigate the role of each component in output variance. The European Monetary Union, with the successful launch of the euro, is the natural benchmark for comparison. Based on variance analysis, it is found that East Asian countries, on average, are less plausible candidates for a currency area than European counterparts. However, a subgroup of countries in East Asia is as qualified as those in Europe. Given the ongoing integration in East Asia, it is not premature to prepare for such a currency area in this region.     

Bond risk premia, macroeconomic fundamentals and the exchange rate

We propose a two-country no-arbitrage term-structure model to analyze the joint dynamics of bond yields, macroeconomic variables and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries and how the exchange rate is influenced by interest rates, macro-economic variables and time-varying bond risk premia.Estimating the model with US and German data, we find that time-varying bond risk premia account for a significant portion of the variability of the exchange rate: apparently, a currency tends to appreciate when investors expect large capital gains on long-term bonds denominated in that currency. A number of other novel empirical findings emerge.     

Bond risk premia,macroeconomic fundamentals and the exchange rate

We propose a two-country no-arbitrage term-structure model to analyze the joint dynamics of bond yields, macroeconomic variables and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries and how the exchange rate is influenced by interest rates, macro-economic variables and time-varying bond risk premia.Estimating the model with US and German data, we find that time-varying bond risk premia account for a significant portion of the variability of the exchange rate: apparently, a currency tends to appreciate when investors expect large capital gains on long-term bonds denominated in that currency. A number of other novel empirical findings emerge.     

The Effect of Monetary Policy on Exchange Rates during Currency Crises: the Role of Debt,Institutions, and Financial Openness*

This paper empirically examines the effect of monetary policy on exchange rates during currency crises. We find strong evidence that raising the interest rate: (i) has larger adverse balance sheet effects and is therefore less effective in countries with high domestic corporate short‐term debt; (ii) is more credible and therefore more effective in countries with high‐quality institutions; (iii) is more credible and therefore more effective in countries with high external debt; and (iv) is less effective in countries with high capital account openness. Our results support the idea that the effect of monetary policy depends on its impact on fundamentals, as well as its credibility, as suggested in the recent theoretical literature.     

Exchange rate regime,real misalignment and currency crises

Based on 69 sample countries, this paper examines the effect of macroeconomic fundamentals on real effective exchange rates (REER) in these sample countries. Using the misalignment of actual REER from its equilibrium level, we have estimated the factors explaining the extent of currency over- or under-valuation. Overall, we find that the higher the flexibility of the currency regime, the lower is the misalignment. The estimates are robust to different sub-samples of countries. We then explore the impact of such misalignment on the probability of a currency crisis in the next period, indicating the extent to which misalignment could be used as a leading indicator of a potential crisis. This paper thus makes a new contribution to the debate on the choice of exchange rate regime by bringing together real exchange rate misalignment and currency crisis literature.     

Financial Integration and EMU’s External Imbalances in a Two-Country OLG Model

The pronounced increase in external imbalances in the European Economic and Monetary Union (EMU) during the years running up to 2008 is traditionally explained by financial integration through the common currency. This paper examines in a one-good, two-country overlapping generations’ model, with production, capital accumulation and public debt, the effects of financial integration on the net foreign asset positions of initially low-interest and high-interest rate EMU countries. We find that a lower savings rate and government expenditure quota, together with a higher capital production share in the latter can in fact be transformed into the observed external imbalances when interest rates converge.     

New EU member states and the Euro: economic readiness,benefits and costs

All of the new EU member states (NMSs) have made a commitment to adopt the Euro. This essay considers the countries’ economic readiness to adopt the Euro as well as the economic benefits and costs of adoption. Paper applies a method suggested by Bayoumi and Eichengreen (1997) and finds that the changes of real effective exchange rates between the Euro area and the new EU member states follow the pattern predicted by the optimum currency area theory. This finding allows the construction of the readiness for adoption index for every NMS. The tangible benefits (for NMSs) of adoption are also examined in this essay. Analyses suggest that the costs of currency exchange and hedging against the uncertainty in foreign exchange markets account for about 0.08–0.012% of the countries’ GDP. In addition, countries that adopt the Euro might expect lower inflation and interest rates. This essay also examines the possible costs of adoption. These are in the forms of the lost ability to use monetary policy tools and set the level of seigniorage. Analysis suggests that many countries had given up their independence over monetary policy even before the accession to the EU. In addition, bigger NMSs have not used seigniorage as the source of fiscal income. However, they used exchange rate flexibility to depreciate their currencies during the recent crisis.     

Capital Inflows,Exchange Rate Flexibility and Credit Booms

Historically, capital flow bonanzas have often fueled sharp credit expansions in advanced and emerging market economies alike. Focusing primarily on emerging markets, this paper analyzes the impact of exchange rate flexibility on credit markets during periods of large capital inflows. It is shown that bank credit is larger and its composition tilts to foreign currency in economies with less flexible exchange rate regimes, and that these results are not explained entirely by the fact that the latter attract more capital inflows than economies with more flexible regimes. The findings thus suggest countries with less flexible exchange rate regimes may stand to benefit the most from regulatory policies that reduce banks' incentives to tap external markets and to lend/borrow in foreign currency; these policies include marginal reserve requirements on foreign lending, currency‐dependent liquidity requirements and higher capital requirement and/or dynamic provisioning on foreign exchange loans.     

Productivity Trends in Europe: Implications for Real Exchange Rates, Real Interest Rates, and Inflation

The paper examines a long–run (neoclassical) framework in which differences in productivity growth across sectors and countries lead to inflation differentials. In a currency union, these inflation differentials imply cross–country differentials in real interest rates. The authors estimate the likely size of these differentials for European Union countries, discuss the potential costs of persistent inflation differentials, and comment on the conflicts they may cause within Economic and Monetary Union (EMU). The analytical framework is a variant of the Balassa–Samuelson "productivity hypotheisis," which relates sectoral productivity trends to trends in the relative price of home goods.     

Assessing independent monetary policy in small, open and euroized countries: evidence from Western Balkan

This article approaches to the optimum currency area from the empirical side by investigating the costs of adoption of a single currency for small, open and euroized Western Balkan countries (WBC). Using several econometric techniques, this study attempts to answer three questions relevant for monetary integration of the WBC and similar transition countries: What are the constraints on an independent monetary policy? What is the need for operating an independent monetary policy? and What is the ability to conduct an independent monetary policy? The constraints on independent monetary policy in most of the WBC at this stage are relatively serious because of high levels of openness and euroization. They limit the ability of the central bank, which is oriented to price stability, to use the nominal exchange rate for achieving other goals (for example, output stabilization). Regarding the second question, the results from structural VAR framework suggest a low synchronization for supply and demand shocks between the WBC and the euro area, indicating potentially high costs of losing independent monetary policy. Furthermore, the results from Kalman filter technique inform that the shock convergence process is slow or absent in the WBC vis-à-vis the euro area. Regarding the last question, the results from cointegration and VAR analysis suggest that the ability to conduct an independent monetary policy, assessed by analyzing the interest rate channel as the most prominent transmission channel in the euro area, is relatively weak in the WBC.