Real exchange rates and foreign assets : three essays

Abstract

This thesis consists of three self-contained papers, which contribute to the debates surrounding global imbalances and financial globalization. The papers are unified by their featuring of foreign assets and real exchange rates (RERs) as the central themes. Following the introductory chapter, the first paper revisits the growth impact of RER distortions. The Washington Consensus emphasizes the economic costs of RER misalignment. However, a sizable recent empirical literature finds that undervalued RERs help countries achieve faster economic growth. The study shows that these findings are driven by inappropriate homogeneity assumptions imposed on long-run RER behavior across countries and/or misspecification of the growth equation. When these problems are redressed, the empirical results for a sample of 63 developing countries over the period 1970-2007 suggest that misalignment of the RER, in either direction from the level consistent with external and internal equilibrium reduces economic growth. However, deviations from Balassa-Samuelson adjusted purchasing power parity do not seem to affect growth. The RER should thus be consistent with external and internal balance, irrespective of the purchasing power parity benchmark. The second paper is motivated by the popular view that the surge in China's foreign exchange reserves is due to a distortionary exchange rate policy aimed at keeping the RER undervalued in order to support export-led growth. It undertakes an in-depth empirical investigation to quantify how much "mercantilist" and "precautionary" motives have contributed to the reserve build-up in China during the period 1998Q4-2011Q4. A substantial problem is that theory is consistent with employing two vastly differing approaches to defining and estimating the role of mercantilist reserve accumulation. A priori, either method could generate misleading results. The study shows, however, that the distinction between the two approaches is immaterial in China's case. The results suggest that mercantilism accounts for less than 10 percent of the reserve accumulation. Precautionary motives and other factors seem to be the dominant determinants of the surge in China's international reserves. The third paper studies the macroeconomic impact of valuation effects (changes in net external assets of a country arising from movements in exchange rates or asset returns). In theory, valuation effects are an important channel of international risk sharing through their facilitation of external adjustment. However, the effects can also be economically destabilizing in the presence of frictions in the international financial system. Despite the growing significance of valuation effects in an era of financial globalization, the nature and extent of their macroeconomic effect has not yet been systematically examined, especially in relation to emerging market economies (EMEs). The study examines the macroeconomic impact of valuation effects for 53 countries over 1980-2010. Valuation effects seem to operate as a risk sharing channel in high income countries. For EMEs the results depend on how valuation effects correlate with domestic consumption growth. There is weak evidence that valuation effects act as a risk sharing channel only if the correlation is negative, and are destabilizing otherwise. In the latter case, the welfare loss may well exceed one percent of permanent consumption.