nep-ifn New Economics Papers
on International Finance
Issue of 2005‒07‒11
six papers chosen by
Yi-Nung Yang
Chung Yuan Christian University

  1. China's exchange rate policy: the case against abandoning the dollar PEG By Laurenceson,James; Qin,Fengming
  2. Identifying the effects of central bank intervention By Christopher J. Neely
  3. A Simple and Flexible Dynamic Approach to Foreign Direct Investment Growth: The Canada-United States Relationship in the Context of Free Trade. By Peter J. Buckley; Jeremy Clegg; Nicolas Forsans; Kevin T. Reilly
  5. Quo vadis Euro? By Enrique Alberola; Susana Garcia-Cervero; Humberto López; Angel Ubide

  1. By: Laurenceson,James; Qin,Fengming (Tilburg University, Center for Economic Research)
    Abstract: This paper critically evaluates the policy literature surrounding China's exchange rate regime. It first discusses several popularly raised contentions in relation to the dollar peg employed by China, which in fact are poorly grounded in evidence. These include notions that the RMB is clearly undervalued and that its value is a prominent cause of the U.S trade deficit. The paper then describes a consensus position that has emerged which argues that China should abandon the peg in favour of a flexible exchange rate regime. We see numerous weaknesses in this position but a few stand out. Moving to a flexible regime is far from the most proximate policy response to the problems that the consensus literature itself identifies in China's economy. Institutional realities that make moving to a flexible regime difficult also appear to have been seriously overlooked. The paper concludes by noting that in the longer term moving to a managed float may be in China's best interests - but for now the focus needs to be firmly in the area of domestic financial reform.
    JEL: E58 F31
    Date: 2005
  2. By: Christopher J. Neely
    Abstract: Most intervention studies have been silent on the assumed structure of the economic system*implicitly imposing implausible assumptions*despite the fact that inference depends crucially on such issues. This paper proposes to identify the cross-effects of intervention with the level and volatility of exchange rates using the likely timing of intervention, macroeconomic announcements as instruments and the nonlinear structure of the intervention reaction function. Proper identification of the effects of intervention indicates that it is moderately effective in changing the levels of exchange rates but has no significant effect on volatility. The paper also illustrates that such inference depends on paying careful attention to seemingly innocuous identification assumptions.
    Keywords: Foreign exchange ; Banks and banking, Central
    Date: 2005
  3. By: Peter J. Buckley (Leeds University Business School); Jeremy Clegg (Leeds University Business School); Nicolas Forsans (Leeds University Business School); Kevin T. Reilly (Leeds University Business School)
    Abstract: This paper asks a simple question: Did Wilfred Laurier’s dream of free trade with the United States, when it came to fruition in 1989, also impact on foreign direct investment (FDI) into Canada by US multinationals? This paper argues that the customary static econometric approach found in the FDI literature, along with the assumption that policy changes influence only the intercept term, are inadequate to address the question. Instead we introduce an innovative dynamic framework to support the testing of hypotheses on behavioural changes in the variables using a structural break framework. A key conclusion is that prior to signing the free trade agreement US FDI responded only to current growth in the Canadian economy, in a unitary fashion, and current exchange rate shifts. This can be described as a static relationship. The implementation of the free trade agreements between Canada and the USA increased the responsiveness of US FDI to growth in the Canadian economy by a factor greater than two. Furthermore, dynamics are found in the form of a lagged effect for changes in the growth in the Canadian economy and interest rate differentials. These conclusions challenge the dominant view, including that in official policy circles, that the free trade agreement had no impact on US firms’ FDI decisions in Canada. Note: Previous versions of this paper were entitled: “A Simple and Flexible Dynamic Approach to Foreign Direct Investment Growth: Did Canada Benefit From the Free Trade Agreements with the United States?”
    Keywords: Canada-United States, foreign direct investment, empirical relationship
    JEL: F3 F4
    Date: 2005–07–04
  4. By: Enrique Alberola (Banco de España); Luis Molina (Banco de España)
    Abstract: Fixing the exchange rate stabilises inflation and reduces monetary seignoriage, a key source of financing under the fiscal dominance hypothesis. However, the link between fixed exchange rate regimes and fiscal discipline in emerging markets has been found to be weak. This paper thoroughly reviews the issue through three venues. First, an alternative measure to gauge fiscal discipline –the so called shadow balance, inclusive of seignoriage revenues􀀐 is proposed, since the traditional one, the primary balance, does not convey monetary financing; notwithstanding this modification, no robust relation is found either. Second, we sustain and then prove the hypothesis that fixing the exchange rate may have offsetting effects on fiscal discipline through the relaxation of the fiscal constraint of the government. In particular fixing the exchange rate is expected to reduce the cost and burden of debt and to enhance the ability to obtain revenues through a higher level of activity. The empirical test of this hypothesis follows a two-stage approach. First, we test the impact of the fiscal constraints on discipline: as advocated, a higher fiscal burden induces higher discipline; higher activity does not clearly relax discipline, although expenditures grow and the burden of debt is shown to diminish. The second stage tests the impact of fixed regime on the considered determinants. Again, the relation between fixed regimes and the reduction of the burden is robust, but not so the impact of fixed regimes on the cycle. Third, we explore the dynamics related to the pegging of the exchange rate, uncovering that at its inception exchange rates trigger an expansion and reduce the debt burden. This final outcome does not only strengthen our hypothesis but illustrates how the peg sows the seeds of its own destruction, also at the fiscal level.
    Keywords: fiscal discipline, exchange rates, emerging markets
    JEL: F3 F4
    Date: 2005–07–07
  5. By: Enrique Alberola (Banco de España); Susana Garcia-Cervero (Deutsche Bank); Humberto López (World Bank); Angel Ubide (Tudor Investments)
    Abstract: This paper calculates the equilibrium exchange rates for the Euro and the rest of the G-7 currencies. Building on the methodology of Alberola et al., it is shown that the stock of net foreign assets and the evolution of productivity are the fundamentals underlying the behaviour of the real exchange rate. Panel cointegration techniques allow for the extraction, using an unobserved components methodology, of a time- varying equilibrium real exchange rate, and deviations from this equilibrium provide an estimate of the degree of multilateral misalignment. Finally, an algebraic transformation converts these multilateral equilibrium real rates into bilateral equilibrium nominal rates. The results uncover that the Euro was slightly undervalued by the start of Stage III of EMU and that, despite a faint fall of its fundamentals since then, the slide during 1999 has widened the misalignment above 10% against other main currencies.
    Keywords: equilibrium exchange rates, panel cointegration, Euro, G-7 currencies
    JEL: F3 F4
    Date: 2005–07–08
  6. By: Enrique Alberola (Banco de España)
    Abstract: Exchange rates in Latin America display a large volatility, constitute a central element of the policy strategies and their evolution have an important impact on financial stability due to the dollarization of liabilities which most countries exhibit. However, assessments on equilibrium exchange rates are scarce in the region. This paper aims at both filling this gap and analysing the impact of the adjustment of the exchange rates to equilibrium on financial stability. Building on the methodology of Alberola et al (1999,2002), we show that the stock of net foreign assets and the evolution of productivity are the fundamentals underlying the behavior of the real exchange rate. Using an unobserved components methodology in a cointegration framework, a time-varying equilibrium real exchange rate is derived, and deviations from this equilibrium provide an estimate of the degree of multilateral misalignment. The results uncover among other things the large overvaluation of the Argentinean peso in 2001, which was only partially explained by the estimated dollar overvaluation. The adjustment of exchange rates in 2002 corrected this and, to a lesser extent, other misalignments. The final part of the paper addresses the impact of liability dollarization on the adjustment of exchange rates. It is argued that the real exchange rate will tend to overshoot its equilibrium level, due to the need to foster higher current account surplus in the aftermath of depreciation to make up for to the increase in liabilities. An adjustment to account for this effect is performed on the previous results. This overshooting, when coupled with sudden stops of capitals, may help explaining the higher volatility of real exchange rates in the region.
    Keywords: Equilibrium Exchange Rates, Liabilities dollarization, Overshooting
    JEL: F31 F41 C23
    Date: 2005–07–08

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