Research & Policy Briefs From the World Bank Malaysia Hub No. 4, October 2016 Should We Fear Foreign Exchange Depreciation? Norman Loayza and Fabian Mendez-Ramos Moderate and gradual changes of the real exchange rate are beneficial for the economy to help it attain domestic and external equilibrium. They should not be feared. However, large and sharp devaluations can lead to insolvency and even systemic crisis. They should be prevented by macroprudential policies and by avoiding unsustainable fixed exchange rate regimes. Central bank intervention to avoid a secular depreciation is useless: it only leads to massive losses of foreign reserves. Foreign Exchange Rates: Trends, Consequences, and abruptly at the end of 2014 and beginning of 2015, making Policies resource-rich developing countries less attractive destinations for foreign investment. As result, the national currencies of many In the last few years, the majority of currencies around the world, emerging economies began a secular process of exchange rate both in developing and developed countries, have depreciated with depreciation (see figure 1). respect to the U.S. dollar. Governments, entrepreneurs, and house- holds are concerned because drastic depreciation of the national Not every country has followed the same trend, however. Within currency could lead to bankruptcy and even economic crisis. But are the group of developing countries, national currencies have followed diverging paths. To cite a few cases, since 2013, Turkey, Indonesia, these fears justified? And could there actually be benefits from Malaysia, and Mexico have experienced strong RER depreciations, currency depreciations? Peru’s RER has depreciated mildly, and China’s RER has remained This brief considers the main stylized facts on foreign exchange stable (see figure 2). The observed dispersion of real exchange rates, rates, with particular focus on developing countries; it examines the especially since the end of 2014, may reflect a general sense of reasons and evidence for both potentially negative and positive uncertainty in international financial markets and in particular effects of real exchange rate (RER) depreciation; and it discusses economies, but it may also represent differing paths of macroeco- whether policies can be effective in reversing depreciation or nomic adjustment to the international shocks that have occurred in mitigating its negative impact. recent years. The general pattern of appreciation, after 2009, followed by Stylized Facts depreciation, starting in 2013 and intensifying in 2014, can also be In the aftermath of the 2008–09 international financial crisis, many observed by looking at the annual growth of the real exchange rate developing countries experienced an appreciation of their curren- across different geographic regions and income categories (see cies, as financial flows were redirected to the— paradoxically—safer figure 3). Similarly, the contrasting behavior of these RER growth and higher-return possibilities offered in emerging economies. A rates, especially in 2015, reveals the diverging paths of real exchange rates across groups of countries. period of relative exchange rate stability around stronger currency values in these economies ensued until about 2013, when the Though substantial, the recent changes in exchange rates do not financial and economic panorama in the world changed. First, the match the abrupt currency collapses experienced in the last four United States and a few other developed economies—which had decades around the world. They were associated with insolvency been limping since the financial crisis—started to recover and attract and liquidity crisis, such as those related to the sovereign debt crisis financial flows back to them. Second, commodity prices declined in Latin America in the late 1970s and 1980s, the Mexican Tequila Figure 1. The Real Exchange Rate with Respect to the U.S. Dollar Has Depreciated in Most Countries, and Sharply so in Some Cases a. Developed countries b. Developing countries 150 150 140 140 130 130 RER index RER index 120 120 110 110 100 100 90 90 80 80 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Year Year 25th percentile 50th percentile 75th percentile Source: Haver Analytics monthly data and World Bank staff estimates. Note: The figure uses a complete monthly sample over the period January 2007–March 2016 for 72 countries. Aggregations use 2016–17 World Bank income definitions. The real exchange rate (RER) is a nominal exchange rate with respect to the U.S. Dollar adjusted for relative movements in national price or cost indicators of the home country and the United States. The real exchange rate index (RERI) is the ratio of the real exchange rate with respect to a base period. The figure uses January 2008 as the base period, such that RERt,to CPIIto,t RERI = 100. A decrease in the RERI denotes an appreciation.RERIt,to = RER to,to * 100; RERt,to = ERt CPII to,t,U S ; CPIIto,t,U S = CPI CPIto,tb CPIt,U S ; CPIIto,t = CPIt,tb , where to = base period; t = current to,U S period; tb = CPI original base period; CPIt,tb = consumer price index in period t with original base period tb; ERt = nominal exchange rate in period t. Affiliation: Development Research Group, the World Bank. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Global Knowledge & Research Hub in Malaysia Should We Fear Foreign Exchange Depreciation? Figure 2. Most Currencies Have Weakened with Respect to the U.S. Dollar, Especially Since 2013, While a Few Have Remained Stable 160 Euro Euro Tapering Oil Lehman crises crises quantitative price 150 collapse start peak easing crash 140 RER index 130 120 110 100 90 80 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan 2012 Jan 2013 Jan 2014 Jan 2015 Jan 2016 China Indonesia Mexico Malaysia Turkey Peru Source: Haver Analytics monthly data and World Bank staff estimates. Note: The figure uses January 2007–March 2016 monthly observations. Details about the construction of the RER index are presented in figure 1. A decrease in the RERI denotes an appreciation. Episodes: Lehman Brothers collapse = September 2008; start of the Europe’s sovereign debt crisis = January 2010–May 2010; Europe’s sovereign debt crisis peak = September 2011–November 2011; Federal Reserve announcement of gradual tapering of the quantitative easing program = May 22, 2013; oil-price crash = October 2014–January 2015. crisis in 1994–95, the East Asia crisis in the mid- to late-1990s, and increase their costs, often without a matching increase in their the great recession in 2009. Frankel and Rose (1996) define a revenues. Indeed, households, firms, and governments usually currency crash as a nominal depreciation of the currency vis-à-vis receive their income in national currency: for households, wages and the U.S. dollar of at least 30 percent. Using this definition, Valencia salaries; for firms, sales revenues; and for governments, income and and Laeven (2012) find 218 currency crashes from 1970 to 2011, of sales taxes. For them, a depreciation will likely have a negative which only 10 episodes occurred from 2008 to 2011, despite the impact on income and induce a substitution away from foreign latest international financial crisis and the great recession. goods and services and toward domestic ones. Moreover, for people and institutions that are indebted in Insolvency and Sharp Real Exchange Rate Depreciations foreign currency, a depreciation increases the real value of their A sudden and drastic depreciation of the national currency can debt. This may result in repayment difficulties, a deterioration of generate a chain of liquidity constraints and even insolvency at their balance sheet, and the risk of bankruptcy, unless they own different economic levels, from households to firms and govern- matching assets denominated in foreign currency (Glick and Hutchi- ments (Chang and Velasco 2000). These effects can be compounded son 2000; Gupta, Mishra, and Sahay 2007). as different sectors affect one another, decreasing consumption, It is worth emphasizing that these negative effects may occur restricting credit, increasing interest rates, and limiting investments. when depreciations are large and abrupt. Using a set of seven For the majority of agents in the economy that consume or use country currency crashes in the 1990s, Fallon and Lucas (2002) foreign products, a depreciation of the real exchange rate will observe negative effects on workers, finding a fall in real wages in the Figure 3. The Depreciation with Respect to the U.S. Dollar Has Generalized across Regions in Recent Years Real exchange rate index, year-to- year (YtY) growth rate -24 24 Source: Haver Analytics monthly data and World Bank staff estimates. Note: The figure is a heat map of annual (year-to- year, YtY) compound growth rates of the RERI indicator, as defined in figure 1. The quarterly regional growth rates are unweighted averages of country median values of monthly observations. A sample of 72 countries is used based on availability and world economic importance. 2016–17 World Bank income and regional definitions. Regional data is distributed in the following form: East Asia and Pacific (EAP) includes 6 countries; Europe and Central Asia (ECA) includes 13 countries; Latin America and the Caribbean (LAC) includes 9 economies; the Middle East and North Africa (MENA) includes 2 countries; South Asia (SAS) covers 2 countries; Sub-Saharan Africa (SSA) includes 6 economies; high-income countries (HICs) aggregates 34 countries. 2 Research & Policy Brief No.4 Figure 4. The Frequency of Currency, Banking, and Sovereign Debt Crisis Decreased Markedly in the 2000s, despite the Strong Interna- tional Shocks Experienced in the Second Half of the Decade 1970s 1980s 1990s 2000s 10 9.2 Annual average of crises 8 7.4 7.4 6 3.9 4.1 4 3.1 3 2.5 2.6 2.4 2 0.7 1 0.7 0.4 0.7 0.3 0 Currency crises Banking crises Sovereign debt crises Twin crises Source: Data from Valencia and Laeven 2012 and World Bank staff estimates. Note: A twin crisis is defined as the union of banking crisis in year t and currency crisis during [t - 1, t + 1], with sovereign debt crisis in period t and currency crisis in the interval [t - 1, t + 1]. manufacturing sector in all crises countries and quite severely in systemic crises. In the 1980s, currency crises were especially linked Indonesia (-44 percent), Turkey (-31.5 percent), and Mexico (-18.5 to sovereign debt crises, while in the 1990s currency crises occurred percent). The effect on firms seems to depend on their intrinsic in closer connection with banking crises. Importantly, the frequency characteristics. If they are importers, the effect will tend to be of these crises (both individual and “twin”) decreased markedly in negative; if they are exporters, the effect will tend to be positive. the 2000s, despite the strong international shocks experienced in Forbes (2002) studies the effects of currency crashes on firms by the second half of the decade. comparing 1,100 firms in 8 countries that had currency crashes and Currency crises and systemic crises are worrisome because they 48 countries that did not between 1996 and 2000. The estimates disrupt employment, induce poverty, and create uncertainty. suggest that firms in crisis countries have lower rates of capital Currency crisis are associated with negative effects on output growth and worse stock return performance after devaluations if growth, as well as on its components related to public and private they are capital intensive and if their cost of capital increases. consumption and investment. Using a panel data set from 1975 to Governments can also be negatively affected by sharp devalua- 1997 covering 24 emerging economies, Hutchison and Noy (2006) tions, but this depends on their exposure to foreign currency. Using find that after a currency crisis, GDP declines around 2–3 percent. a sample of 24 emerging markets from 1975 to 2002, Hutchison and However, the negative effect can be worsened if the currency crisis is Noy (2006) estimate that, after a currency crash, the budget deficit accompanied by a sudden stop of foreign investment and if it leads can increase by almost 1 percentage point and inflation by 2 percent- to a systemic financial crisis; in such cases, the cumulative effect is a age points on average, with larger impacts in more exposed 10–15 percent decline. For example, during the East Asia currency countries. crises in 1997, the Indonesian and the Thai economies contracted by 13 percent and 10 percent, respectively; and during the Argentina Systemic Crises and Currency Collapses currency crisis in 2002, output fell by 11 percent (Gupta, Mishra, and Sahay 2007). A sharp depreciation can cause more than isolated cases of illiquidity and insolvency. It can produce a systemic crisis if these instances of insolvency are closely connected, in a domino-like effect. A deprecia- Positive Effects of Real Exchange Rate Depreciation tion can produce a systemic crisis if it sufficiently affects the financial Do these risks associated with sharp depreciations imply that all system, which in many economies is the center of interconnection depreciations should be avoided? No, not at all. Gradual and moder- between businesses, consumers, and government (Gourinchas and ate depreciations (and appreciations) usually denote an orderly Obstfeld 2012). A financial system is vulnerable to a depreciation movement toward a new domestic and external equilibrium shock directly if its assets and liabilities are mismatched in terms of (Corsetti, Dedola, and Leduc 2010). A new equilibrium entails restor- currency of denomination, and indirectly if its debtors become ing potential employment and growth and resolving balance of insolvent. payments gaps when there are changes in fundamental factors (such as productivity growth and demographic changes) and shocks of Moreover, governments can be the source of a systemic crisis if various types (such as terms of trade, commodity prices, and global they are unprepared to absorb the depreciation shock and become financial crisis). Thus depreciations can help reduce trade deficits insolvent or strapped for liquidity (Reinhart and Rogoff 2011). and prompt domestic growth. Governments with high levels of foreign debt or with contingent liabilities on foreign exchange movements are particularly vulnerable In the face of exchange rate fluctuations, it should be kept in to a depreciation shock. Indeed, governments that provide explicit or mind that the real exchange rate is a relative price, whose flexibility implicit insurance against exchange rate fluctuations (by keeping a and movement is essential to avoid large imbalances and distortions fixed exchange rate or by providing price and profit guarantees in (Calvo, Izquierdo, and Mejía 2008: Asonuma and Trebesch 2016). To foreign exchange) are among the most vulnerable of all (Frankel obtain this flexibility, the exchange rate, as a national currency price, 2011; Ghosh, Qureshi, and Tsangarides 2013). can serve the function of coordinating a (very) large set of individual prices in both labor and output markets (Corsetti 2006). An exchange The empirical evidence suggests that currency crises are rate depreciation, for instance, can achieve the same objective as a sometimes related to banking crises and sovereign debt crises. Using reduction of domestic prices in a large variety of goods and services. a sample of 162 countries over the period 1970 to 2012, Valencia and Laeven (2012) identify a total of 432 currency, banking, or Flexible exchange rates are shock buffers and effective coordi- sovereign debt crises (see figure 4). Of them, 15 percent represent nating mechanisms, and both currency depreciations and apprecia- “twin crises” of currency collapse and either of the other two tions are just a reflection of such flexibility. Countries with flexible 3 Should We Fear Foreign Exchange Depreciation? exchange rates tend to adjust better to external or internal economic capital controls and central bank interventions as lender of last shocks. The flexible exchange rate regime allows a faster and more resort (Claessens, Ghosh, and Mihet 2013; Cerutti, Claessens, and sustainable recovery from trade and current account imbalances Laeven 2015). In addition, if adverse international conditions exacer- (Edwards and Yeyati 2005); from natural disasters like hurricanes, bate financial frictions, the central bank’s sale of foreign currency typhoons, and earthquakes (Ramcharan 2007); and from a variety of (held as international reserves) can be effective—albeit only in the shocks that produce internal and external imbalances (Edwards short run—in preventing negative real impacts and systemic crises 2004; Lane and Milesi-Ferretti 2012). Moreover, flexible exchange (Chang and Velasco 2016). rate regimes are less vulnerable to speculative attacks, especially as they become financially developed (Aghion and others 2009; Frankel Beyond these short-term crisis management measures, is there 2011; De Gregorio 2013). a role for central bank interventions to prop up the exchange rate? No, there is not. The evidence indicates clearly that there is no large Conclusion and the Role of Policy Interventions or long-lasting impact of foreign exchange interventions on the real exchange rate (Blanchard, Adler, and Carvalho Filho 2015). In the On balance, moderate and gradual depreciations and appreciations face of fundamental forces driving the exchange rate, “defending” of the real exchange rate are beneficial for the economy to help it the national currency does not prevent its depreciation and only attain domestic and external equilibrium. These are long-term leads to massive losses of foreign reserves. phenomena and a reflection of a healthy economy. It can be argued that the best policy in this case is to allow the exchange rate to move Although little can be done to avoid large external shocks, much in a flexible way, without undue interference by monetary or fiscal can be done to prevent crises. This starts by avoiding unsustainable authorities (World Bank 2013). policies. For exchange rate matters, the worst of these policies are A different situation occurs, however, when fluctuations in the keeping a fixed but misaligned exchange rate (sooner or later, it will real exchange rate are abrupt or highly volatile as a result of either a burst) and providing implicit or explicit insurance on undue or large and sudden shock or the unraveling of an unsustainable policy. excessive risk taking (by intervening against a clear exchange rate These real exchange fluctuations can cause insolvency for various trend, by subsidizing foreign exchange transactions, and by bailing economic agents (from households and firms to banks and govern- out financial institutions). These only invite speculative attacks, ments) and even systemic financial crises. They should be mitigated unwarranted risk taking, and losses of foreign reserves. 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