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Exchange rate moves in a global economy: a central banking perspective

Speech by Gertrude Tumpel-Gugerell, Member of the Executive Board of the ECBFederal Reserve Bank of PhiladelphiaPhiladelphia, 3 December 2004


Ladies and Gentlemen,

Let me express first of all my gratitude to the organisers for the opportunity of being here to share with you some thoughts on such an important subject. The timing for this venue has turned out to be very wisely chosen indeed, with exchange rate developments just being back in the international debate.

In my short presentation I will not speak, for obvious reasons, about the present situation of exchange rates as regards the euro and the US dollar.

I will therefore touch upon the following issues:

  • First, I will briefly mention some of the challenges faced in understanding exchange rates. But I will also argue that we cannot abstain from analysing them,

  • Then I will shortly review the history of the monetary system in order to present the current system in perspective,

  • Third, I will try to elaborate on the question whether larger swings in the exchange rate matter for the real economy,

  • Furthermore, I will deal with the question of what might be the appropriate policy responses to exchange rate swings. There, I will emphasise in particular that the main policy objective is to preserve sound domestic economic fundamentals;

  • I will also refer to the monetary integration process of the new EU member states towards the euro area and their exchange rate arrangements;

  • Before concluding, I will shortly highlight some of the challenges that I see ahead.

The difficulties and importance of exchange rate economics

You will probably agree with me that the field of exchange rate economics, while a fascinating subject, often faces a certain degree of scepticism, both in academic and policy circles. Consensus seems hard to reach other than on negative statements. The common view is that exchange rate movements are difficult to predict and that random walk models generally have at least as good forecasting properties as standard macroeconomic models - even assuming ex-post knowledge of economic fundamentals.[1]

What is perhaps surprising is that this widespread scepticism about exchange rate economics does not halt numerous calls for policy responses every time a currency swings noticeably or does not move against another. This is a sign that, despite all the difficulties in understanding them, exchange rate movements are seen as important.

The price-competitiveness-channel is of course the most obvious transmission mechanism, as movements in the nominal effective exchange rate affect relative export prices with a subsequent impact on real exports.

There are, however, many other reasons why exchange rate changes are important:

  • They influence import and consumer price developments.

  • Larger and persistent swings affect the tradables and non-tradables production structure of the economy.

  • They are an important autonomous source of shocks that may have critical repercussions domestically and possible spillovers on other economies.

  • Exchange rate changes are also seen by some as an important adjustment mechanism for correcting external imbalances, although the relationship between both variables is far from being straightforward.[2]

  • Finally, according to some studies the volatility of the exchange rate may have an adverse impact on trade and the real economy in the long run.

The evolution of the international monetary system

It is worth noting that the international monetary system has generally evolved towards greater exchange rate flexibility between major currency pairs.

Historically, one can distinguish 5 main phases in which this has taken place. [3]

The gold standard imposed itself over the bimetallic standard (gold and silver) just after 1870 when the United States and other major European countries opted for this regime, which was already in use in Britain. This period, which is sometimes called the Gilded Age, was characterised by fixed exchange rates and gold convertibility of currencies. It ended when World War I broke out and most countries decided to restrict or abandon gold convertibility.

The interwar period was characterised by a progressive return to the gold standard with the aim of restoring financial discipline. The experience of the Great Depression, however, led many countries to see the system as faulty, with Britain and the Sterling bloc exiting in 1931 followed by the United States in 1937.

After a short period of exchange rate flexibility in the pre World War II period, a new phase was opened with the establishment of the Bretton Woods agreement in 1944, which led to all major industrialised countries operating a peg versus the dollar until 1971.

This phase was followed by what could be described as 'the trial and error' system of the 1970s followed by a more consistent move towards exchange rate flexibility in the course of the 1980s. During the 1990s preparation for the creation of a single currency in Europe led to the elimination of the exchange rate risk for 12 European countries so far.

This leads us to the system of today, characterised – with a few exceptions – by flexible exchange rates amongst the major currencies, accompanied by a system of international co-operation.

For the last 20 years the G7 has proven to be an effective forum where finance ministers and central bank governors can exchange views on a broad range of policy issues and can agree if appropriate, on specific policy messages, including, exceptionally, comments on foreign exchange market developments. Here, I refer for example to the G7 Communiqué agreed in Boca Raton in February 2004 and since then confirmed in subsequent meetings.

Another important element of the international system is of course the role played by the IMF in helping countries to design appropriate macroeconomic and exchange rate policies. This role, aimed mostly at crisis prevention, but also in some instances at crisis management, is of vital importance. Finally, an important element of novelty in the international monetary system has been the process of regionalisation for example in Europe – with the launch of the euro and the enlargement of the European Union - and in Asia, with the impetuous growth of intra-regional trade.[4]

Swings and exchange rate volatility – how much do they matter

The key but far from straightforward question is of course “how much” exchange rate movements matter. One may distinguish between effects taking place through the price-competitiveness-channel and those associated to market uncertainty. Focusing on the competitiveness channel, theory suggests that the size of the impact depends also on the structure of the economies, for example the degree of openness. Exchange rate movements have clearly a smaller impact on relatively closed economic areas than on small open economies. For example, exports of goods and services to countries outside the euro area accounted for about 19% of nominal GDP, which is considerably more than the respective figures for the United States (10%) and Japan (12%).

As regards the euro area, it is worth mentioning a fact that is often underestimated: the UK is the first trading partner of the euro area (with a share of approximately 17%), even ahead of the US (around 14%), while the share of the 10 new Member States in the euro area external trade is only marginally lower (11%) than the US share.

A wide variety of models help to gauge the impact of exchange rate movements on both prices and GDP and generally find evidence of a significant impact, albeit the range of available estimates is admittedly rather large. Finally with respect to exchange rate volatility, a number of studies tend to indicate that exchange rate volatility may have an important impact on trade in the long run.[5]

There are, however, some important dampening factors, which can reduce the immediate observable effects of sizeable exchange rate moves. In particular, firms are sometimes in the position to squeeze profit margins without immediately reacting to unfavourable exchange rates. This is indeed reflected in some “disconnect” occasionally observed in the euro area between exchange rate movements and export price developments. In some cases firms also extensively use hedging instruments as a form of insurance against excessive exchange rate fluctuations. Finally, multinational firms by operating simultaneously in multiple markets may find themselves in a better position than others when an exchange rate shock takes place. The persistence of shocks is, however, an important element, as hedging and profit squeezing are mostly viewed as effective responses in the short to medium run only.

Importance of regional integration

The European integration process, including the introduction of the euro, reduces the instability generated by shocks to the exchange rate at the national level. The introduction of a common currency and the mechanisms of exchange rate co-operation within an enlarged Europe are factors that should continue to reduce exchange rate volatility within Europe. Other things being equal this should tend to boost intra-European trade.

As I mentioned, a number of studies find support for the hypothesis of a negative relationship between trade and exchange rate volatility. An additional element to this analysis has been added by Rose,[6] arguing that a currency union has a positive impact on trade and potential output, which goes beyond the mere elimination of exchange rate volatility. While only an appropriate econometric analysis can disentangle the impact of exchange rate volatility from other factors, since 1999 extra-euro area trade has grown at a somewhat faster rate than intra-trade, which was, however, very dynamic as well. This may also reflect other important factors, as the relative cyclical position or globalisation and higher growth rates outside the euro zone.

Macroeconomic stability is the key response

It is my profound conviction that the best way to limit undesirable exchange rate instability and minimise global imbalances in a sustainable way is by ensuring sound domestic fundamentals. The notion of stability-oriented policies should be the guiding principle both at the country level but also, I believe, in framing the discussions between counterparts in the international monetary system. A monetary policy that is oriented towards price stability is ultimately conducive to exchange rate stability over a longer-term horizon. Sustainable medium-term fiscal policies are also conducive to balanced economic growth and ultimately helpful in avoiding the insurgence of imbalances also at the global level.

The common currency in Europe with its prerequisite of sound monetary and fiscal policies has helped many countries in Europe – euro area countries and new member states – to achieve better economic fundamentals.

Monetary integration in Europe: Exchange rate arrangements in the new member states and beyond

Let me now come to the monetary integration process in the enlarged European Union and the exchange rate regime related to it.

As you know, accession to the EU is only the beginning of the monetary integration process, which ends with the eventual adoption of the euro, as these countries have fully subscribed to the Maastricht Treaty without asking for an opting-out clause. The path towards euro adoption is embedded in a well-defined multilateral institutional framework and comprises a number of phases. The first phase for the new Member States is the period after EU accession and before joining the exchange rate mechanism (ERM II). This mechanism defines a regime characterised by fixed, but adjustable, exchange rates, with a central rate against the euro and a standard fluctuation band of (15 percent. The second phase is then the period of ERM II participation, which is destined to end with the adoption of the euro.

What is the framework in which monetary and exchange rate policy will evolve in the new Member States on their way to the eventual adoption of the euro? Upon accession and before ERM II entry, the new Member States are required to treat their exchange rate policies as a matter of common interest and pursue price stability as the primary objective of monetary policy. Yet, the full responsibility for monetary and exchange rate policy is still with the new Member States.

With respect to ERM II participation, there are no formal criteria to be met prior to the entry. Nevertheless, a successful and smooth participation in the mechanism requires that major policy adjustments – for example relating to a sound fiscal policy framework and price liberalisation – are undertaken before joining the mechanism. Depending on the monetary and exchange rate strategies in place, ERM II can help to orient macroeconomic policies towards stability and anchor inflation expectations.

Let me stress that joining the euro area is a far-reaching step for any country. To be able to join the euro area each country will be assessed on the basis of a deep and precise analysis of their performance with respect to the Maastricht convergence criteria. At the same time, it has to be ensured that the achievements in terms of nominal convergence are sustainable and can be maintained over the long term. So far the progress towards nominal convergence varies widely across the new Member States, which implies that the new Member States will join the euro area at different times. The examination of the countries’ performance relating to the convergence criteria is done in the “Convergence Reports”, which are regularly prepared by both the European Commission and the ECB.

The new Member Sates currently display a variety of exchange rate regimes, ranging from currency boards to free floating regimes. The wide diversity across the new Member States implies that the economic situations and strategies of countries will have to be assessed on a case-by-case basis, i.e. on their own individual merits and their particular situation. Given the different situations and strategies of the new Member States, it is clear that both the timing of ERM II entry and the preferred length of participation in the mechanism will differ across countries. As you know, four currencies have already entered the mechanism. Following the mutual agreement between the participating parties, three new Member States, namely Estonia, Lithuania and Slovenia, joined ERM II on 27 June 2004. The Danish crone already participated in the ERM II before.

After this round of enlargement the EU has new neighbour countries and countries which intend to strengthen their link to the European Union – and the euro. One needs to look beyond the boarders of today’s European Union. What are the exchange rate regimes there?

One can classify the regimes in place in four different groups:

  1. euro-based currency boards (Bosnia and Herzegovina and Bulgaria);

  2. pegs or managed floating with the euro as a reference currency (Croatia, FYR of Macedonia, Romania and Serbia); and,

  3. independent floating (Albania).

  4. Finally, there are two territories within Serbia and Montenegro, namely Kosovo and Montenegro where the monetary and exchange rate policy is determined by their unilateral euroisation.

Country specific circumstances have called for different choices of monetary and exchange rate policy and changing circumstances may have called for changes in the approaches to be followed. I will not expand on this issue further than to emphasise that regardless of the actual monetary and exchange rate framework chosen, it is crucial to consolidate a culture of price stability, supported by independent central banks.

The challenges ahead

What are the challenges ahead?

Several new challenges lie ahead, as the world is rapidly changing. The Asian countries – and in particular China and India – are all becoming important global players, accounting for an increasing share in world demand. Outsourcing is also a topical policy issue, both in developed and developing countries. It is generating opportunities but also fears, as competitiveness pressures increasingly pervade selected sectors of the economy.

There appears to be some evidence that, over the past few decades, capital mobility has increased to levels unseen since the gold standard.[7] New export markets have gathered importance and foreign direct investment flows are directed to emerging markets. The increased integration of financial markets, the opening of new export markets as well as the prospect of higher streams of income across countries generated by foreign direct investment may arguably affect the sustainability boundaries of current account deficits. In any case: Stability oriented policies remain the best safeguard both for developed and emerging markets.

Concluding remarks

Turning to my conclusions let me summarise briefly by saying that exchange rate economics is a fascinating, difficult, yet important subject.

The evolution of the international system has led us to the system we have today, characterised by flexible exchange rates, regional integration and occasional swings between currency pairs. In my view, the best policy advice one can give is to work on stability of macroeconomic fundamentals. This will, in turn, also have a smoothening effect on exchange rate developments.

The European example shows that there is more than one solution with respect to exchange rate regimes: even within the enlarged European Union the way of monetary integration is characterised by country specific choices of their exchange rate regimes. The overarching objective is, however, to achieve stability, measured against the Maastricht criteria, which need to be fulfilled in a sustainable way before adopting the euro.

The key challenges of the future are to increase the long-term growth prospects, make progress on financial market integration and continue stability oriented policies. On this, all major players have some home work to do.

  1. [1] See Meese, R. and K. Rogoff (1983), Empirical Exchange Rate Models of the Seventies: Do they Fit out of Sample?, Journal of International Economics, 14, 3-24 and Cheung Y. et al. (2003), Empirical Exchange Rate Models of the Ninenties: Are Any Fit to Survive?, NBER Working Papers, N. 9393.

  2. [2] See Obsfeld, M. and Rogoff, K., The Unsustainable US Current Account Position Revisited (2004), NBER Working Papers, N. 10869.

  3. [3] See Corden, W. M. (2002), Too Sensational: On the Choice of Exchange Rate Regimes, MIT Press, Chapter 2, for a more detailed discussion on the evolution of the international monetary system and further bibliographic references.

  4. [4] Dooley, M. and Folkerts-Landau D. (2003), An Essay on the Revisited Bretton Woods System, NBER Working Papers, N. 9971 argued that policies in Asia have “re-established the United States as the centre country in the Bretton Woods International Monetary System.”

  5. [5] For an empirical application to the euro area and review of the literature, see Anderton, B. and F. Skudelny (2001), Exchange Rate Volatility and Euro Area Imports, ECB Working Paper, N. 64.

  6. [6] See Rose A. (2000), One Money, One Market: Estimating The Effect of Common Currencies on Trade, Economic Policy, 15 (30), 7-46 and Rose, A. and E. van-Wincoop (2001), National Money as a Barrier to International Trade: The Real Case for a Currency Union, American Economic Review, 91 (2).

  7. [7] As pointed out by Mussa, M. et al. (2000), Exchange Rate Regimes in an Increasingly Integrated World Economy, IMF Occasional Paper, N.193: p. 1, “a comparison with the pre-World War I gold standard is complicated by the very high labour migration, which has not been approached in the recent era as well as strong cultural and political ties between the main lending country (the United Kingdom) and two of the largest recipients (Australia and Canada)”. For a comprehensive recent economic survey of international capital mobility since the late nineteenth century, see Obstfeld M. and Taylor, A. (2004), Global Capital Markets. Intergration, Crisis and Growth, Cambridge University Press.


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