This paper is an econometric investigation of the determinants of the real value of the South African rand over the period 1984-2007. The results show a relatively good fit. As always with exchange rate equations, there is substantial weight on the lagged exchange rate, which can be attributed to a momentum component. Nevertheless, economic fundamentals are significant and important. This is especially true of an index of the real prices of South African mineral commodities, which even drives out real income as a significant determinant. An implication is that the 2003-2006 real appreciation of the rand can be attributed to the Dutch Disease. In other respects, the rand behaves like currencies of industrialized countries with well-developed financial markets. In particular, high South African interest rates raise international demand for the rand and lead to real appreciation, controlling also for a forward-looking measure of expected inflation and a measure of default risk or country risk.
Fixed and flexible exchange rates each have advantages, and a country has the right to choose the regime suited to its circumstances. Nevertheless, several arguments support the view that the de facto dollar peg may now have outlived its usefulness for China. (i) Although foreign exchange reserves are a useful shield against currency crises, by now China's current level is fully adequate, and US treasury securities do not pay a high return. (ii) It may become increasingly difficult to sterilize the inflow over time. (iii) Although external balance could be achieved by expenditure reduction, e.g. by raising interest rates, the existence of two policy goals (external balance and internal balance) in general requires the use of two independent policy instruments (e.g. the real exchange rate and the interest rate). (iv) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. (v) The experience of other emerging markets points toward exiting from a peg when times are good and the currency is strong, rather than waiting until times are bad and the currency is under attack. (vi) From a longer-run perspective, prices of goods and services in China are low—not just low relative to the US (0.23), but also low by the standards of a Balassa–Samuelson relationship estimated across countries (which predicts 0.36). In this specific sense, the yuan was undervalued by ∼35 percent in 2000, and is by at least as much as that today. The study finds that, typically across countries, such gaps are corrected halfway, on average, over the subsequent decade. These six arguments for increased exchange rate flexibility need not imply a free float. China is a good counter-example to the popular “corners hypothesis” prohibition on intermediate exchange rate regimes. However, the specific changes announced by the Chinese authorities in July 2005 have not yet resulted in a de facto abandonment of the dollar peg.
The most obvious explanation for the large and widening US current account deficit is the high budget deficit and low national saving. But a variety of clever economists have come up with 8 other, more sanguine, explanations: (1) the siblings are not twins, (2) investment boom, (3) low US private savings, (4) global savings glut, (5) "It's a big world," (6) valuation effects will pay for it, (7) "Intermediation rents . . . pay for the trade deficits," and (8) China's development strategy entails accumulating unlimited dollars. The impressive paper by Caballero, Farhis, and Gourinchas falls under category (7). Their theoretical model is innovative and interesting, and has the virtue of being able to explain the current account deficit together with the anomalously low long-term interest rates during 2001-2005. The basic idea is that fast growth in emerging markets coupled with their inability to generate local store of value instruments increases their demand for saving instruments from the developed countries. More growth potential in the United States than in Europe means that a larger share of global saving flows to US assets. Ultimately, however, I am not sure that it is the correct explanation, or a reason to consider the deficits sustainable, any more than the others. Their hypothesized collapse in the desirability of emerging market assets and stagnant growth in Europe and Japan fit the 1990s fairly well. But they don't fit 2003-2006 as well, which is the puzzle period, that is, the period that featured the record US current account deficits coinciding with low long-term interest rates. Emerging markets have had a high capacity during 2003-06 to generate assets that others want. More persuasive is the hypothesis that the US continues to exploit the exorbitant privilege under which others accumulate dollars as reserves, but that this exclusive position of the dollar will not necessarily continue forever.
To update an old statistic: a political leader in a developing country is almost twice as likely to lose office in the six months following a currency crash as otherwise. This difference, which is highly significant statistically, holds regardless of whether the devaluation takes place in the context of an IMF program. Why are devaluations so costly? Many of the currency crises of the last 10 years have been associated with output loss. Is this, as alleged, because of excessive reliance on raising the interest rate as a policy response? More likely it is because of contractionary effects of devaluation. There are various possible contractionary effects of devaluation, but it is appropriate that the balance sheet effect receives the most emphasis. Pass-through from exchange rate changes to import prices in developing countries is not the problem: this coefficient fell in the 1990s, as a look at some narrowly defined products shows. Rather, balance sheets are the problem. How can countries mitigate the fall in output resulting from the balance sheet effect in crises? In the shorter term, adjusting promptly after inflows cease is better than procrastinating by shifting to short-term dollar debt, which raises the costliness of the devaluation when it finally comes. In the longer term, greater openness to trade reduces vulnerability to both sudden stops and currency crashes.