Front Matter

Front Matter

Charalambos Tsangarides, Carlo Cottarelli, Gian Milesi-Ferretti, and Atish Ghosh
Published Date:
September 2008
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    Exchange Rate Analysis in Support of IMF Surveillance

    A Collection of Empirical Studies

    Carlo Cottarelli

    Atish R. Ghosh

    Gian Maria Milesi-Ferretti

    Charalambos Tsangarides



    © 2008 International Monetary Fund

    Production: IMF, Multimedia Services Division, Creative Services Cover Design: Atish R. Ghosh (concept), Andrew Sylvester (execution)

    Figures: Andrew Sylvester

    Composition: Julio R. Prego

    Cataloging-in-Publication Data

    Exchange rate analysis in support of IMF surveillance: a collection of empirical studies / Carlo Cottarelli … [et al.], editors—Washington, DC: International Monetary Fund, 2008.

      • p. cm.

    • Includes bibliographical references.

    • ISBN 9781589067288

    1. Foreign exchange rates. 2. International Monetary Fund. I. Cottarelli, Carlo. II. International Monetary Fund. HG3851 .E934 2008

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    The following conventions are used in this publication:

    • In tables, a blank cell indicates “not applicable”; n.a. indicates “not available”; and 0 or 0.0 indicates “zero” or “negligible.” Minor discrepancies between sums of constituent figures and totals are due to rounding.

    • An en dash (–) between years or months (for example, 2005–2006or January-June) indicates the years or months covered, including the beginning and ending years or months; a slash or virgule (/) between years or months (for example, 2005/06) indicates a fiscal or financial year.

    As used in this publication, the term “country” does not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.


    Exchange rate issues have been at the core of the IMF’s mandate since its establishment. During the post–World War II Bretton Woods system, changes in exchange rate parities exceeding 10 percent required “the concurrence of the Fund.” Following the collapse of that system in the early 1970s, the Second Amendment of the IMF Articles of Agreement called on the Fund to oversee “the international monetary system” as well as its members’ economic policies, with the objective of ensuring “orderly exchange arrangements and to promote a stable system of exchange rates” (Article IV, following the Second Amendment). Thus, exchange rate issues remain central to IMF “surveillance,” the technical term used to describe this oversight activity, as they have been since the IMF’s inception.

    Reflecting the pressures of a globalizing economy, IMF member countries have again underscored that exchange rate analysis is critical to IMF surveillance, and they have called on the institution to maintain a leading role in this area. The new Decision on Bilateral Surveillance over Members’ Policies approved by the IMF Executive Board in June 2007 sets the issue of “external stability” as the goal of Fund surveillance, while highlighting the centrality of judgments about exchange rate policies squarely at the center of the Fund’s surveillance mandate.1 In parallel, the IMF staff’s work on these issues has been fortified. A key step was the strengthening of the methodologies used by the IMF staff’s Consultative Group on Exchange Rate Issues (CGER) to produce mutually consistent estimates of equilibrium exchange rates for some 30 economies representing more than 90 percent of world GDP.2 More generally, Article IV consultations have increasingly focused on issues such as the assessment of exchange rate regimes, the evaluation of exchange rate levels, and the analysis of economic spillovers across countries. This book includes a sample of recent IMF staff papers on empirical exchange rate analysis in support of the Fund’s surveillance activity. It is only a small sample, but it is representative of the breadth and depth of coverage of these issues that is a hallmark of the IMF’s role in today’s global economy.

    John Lipsky

    First Deputy Managing Director

    International Monetary Fund


    Publishing a volume like this requires the help and contributions of many people. We would like to thank the authors of the various studies both for their careful research and for agreeing to have their papers included in the volume. In turn, these studies benefited from numerous comments received both from IMF colleagues and from audiences at various conferences and seminars. Special thanks are due to Olivia de Carolin, the administrative coordinator for the volume, and Sibabrata Das, who provided research assistance for the book’s publication. We would also like to express our deep appreciation of our editor, Michael Harrup, and of the IMF’s Editorial and Publications Division and Multimedia Services Division, for their help in editing, designing, and producing the volume.


    As is widely known, exchange rate analysis lies at the center of the IMF’s policy advice, program design, and surveillance mandate. What is perhaps less well known is the sheer variety and volume of exchange rate issues that IMF staff are called upon to analyze in various member countries, from the smallest to the largest, from the least economically developed to the most advanced, and from those whose currencies circulate only locally to those whose currencies are of global importance. Each year, IMF staff produce dozens of studies on exchange rate issues, some published by the IMF, others in various professional journals or books. It would be well beyond the scope of any single book or publication to include them all.

    The purpose of the present volume, therefore, is more modest: to give a flavor of the topics IMF staff typically examine under the broad rubric of exchange rate analysis. It is organized in three main parts: the determination and impact of the real exchange rate, assessing competitiveness and the equilibrium real exchange rate in specific countries or country groups, and considerations in the choice of exchange rate regime.

    Determination and Impact of the Real Exchange Rate

    The volume begins with a look by Paul Cashin and his coauthors in Chapter 1 at one of the main determinants of the real exchange rate in many developing countries, namely, commodity prices. Using a panel of some 58 developing countries over the period 1980–2002, these authors find strong evidence of cointegration between commodity prices and real exchange rates of commodity-dependent countries. The study has a number of important implications, both for modeling and analyzing real exchange rates—in which, obviously, inclusion of commodity prices is vital—and for policy recommendations, for example, on the choice of exchange rate regime.

    Next, Atish Ghosh and his coauthors focus in Chapter 2 on the impact of the exchange rate on trade balance adjustment in a panel of 46 emerging market countries over the period 1980–1980. Given how central is the effect of exchange rate movements on the trade balance, it is surprising that few academic papers study this question—though several look at exports or imports individually. An important innovation of the chapter is that it considers the impact of a change in the nominal exchange rate—under pegged exchange rates, the policy variable—and not just of the real exchange rate. Differentiating countries according to their main export (oil, non-oil commodities, and manufactures), Ghosh and his coauthors trace through the effects of an exchange rate movement on export and domestic prices and wages, export volumes, aggregate demand, and import volumes. Along the way, they derive the analog of the famous Marshall-Lerner condition for the case in which the country is large in its export market and the trade balance is measured in foreign currency (U.S. dollars). They find that this modified Marshall-Lerner condition holds: a depreciation of the exchange will improve the trade balance, and an appreciation will reduce a trade surplus, although the effects and dynamics are surprisingly complex.

    Returning to developing countries, in Chapter 3, Alessandro Prati and Thierry Tressel consider the impact of aid volatility on the real exchange rate and economic performance. They focus in particular on whether an aid-induced real appreciation can hurt the economy by discouraging manufacturing, and how well-designed macroeconomic policies can help offset such “Dutch disease” effects. With aid accounting for 5, 10, even 20 percent of GDP in some low-income countries, managing the effects of aid inflows—and, more pernicious, of aid volatility—is a policy challenge of vital importance. By definition, if aid is being absorbed by the recipient country, there must be a corresponding current account deficit. But volatility of aid—which translates into noisy movements of the real exchange rate—means confusing price signals for allocating resources in the economy, inefficiencies, and a loss of exports. This chapter provides much-needed guidance on the conduct of macroeconomic policies in these circumstances.

    The first section of the volume is rounded out by a study by Hamid Faruqee, in Chapter 4, of exchange rate pass-through in euro area countries. Using a vector autoregression, Faruqee estimates the impact of an exchange rate shock on various prices in the economy—factor, trade, wholesale, and retail—and calculates the pass-through. This chapter thus complements Chapter 2, but deals with advanced European rather than emerging market countries. Overall, Faruqee finds relatively low pass-through coefficients, implying the need for large exchange rate movements to make much of a dent in the trade balance.

    Assessing Competitiveness and the Equilibrium Real Exchange Rate in Specific Countries or Country Groups

    Perhaps the most common form of exchange rate analysis undertaken at the IMF concerns external competitiveness and assessments of whether the real exchange rate is in equilibrium—or either over- or undervalued, with studies focusing on single countries or, more broadly, on groups of countries. The standard approach—used in three of the four chapters in this section—is to estimate a long-run cointegrating relationship between the real exchange rate and various determinants. The actual real exchange rate is then compared to the fitted real exchange rate calculated at “equilibrium” values for the various determinants. There is both an art and a science to this. The science lies in undertaking the econometrics properly, finding time series that may be individually nonstationary but jointly forming a cointegrating vector with the real exchange rate. The art lies in choosing economically meaningful series to include in the analysis and—more difficult—deciding what constitute “equilibrium” values for these explanatory variables.

    Ronald MacDonald and Luca Ricci, in their study of South Africa in Chapter 5, model the real exchange rate as a function of interest rates, GDP, commodity prices (consistent with Cashin et al.’s finding in Chapter 1 that commodity prices play an important role in real exchange rate determination), trade openness, fiscal balance, and net foreign asset position. Next, in Chapter 6, Céline Allard and her coauthors estimate structural equations for exports and imports to explain differences in the external sector performance in euro area countries in response to movements of their common exchange rate. Then, in Chapter 7, Catriona Purfield models India’s equilibrium real exchange rate as a function of productivity differentials (relative to trading partners, to capture Balassa-Samuelson effects), trade openness, and net foreign asset position. Finally, Yasser Abdih and Charalambos Tsangarides in Chapter 8 examine real exchange rates in the WAEMU and CEMAC countries as functions of the terms of trade, government spending, productivity, and investment.

    For some of the variables examined in this section, specifying equilibrium values is straightforward. For others, such as the level of government spending or the fiscal balance, either the authorities’ policy intentions—as discussed, for example, during the Article IV process—or some estimate of a sustainable balance (for example, using the IMF’s debt sustainability framework) can provide useful benchmarks. For yet other variables, such as productivity differential, it is very difficult to choose long-run equilibrium values and possibly no easier than projecting the equilibrium real exchange rate itself. Faced with this challenge, the authors of this study adopt a variety of interesting and innovative approaches.

    Considerations in Choice of Exchange Rate Regime

    Each IMF member country is free to adopt the exchange rate regime of its choice. This does not mean, however, that IMF staff are not called upon to provide advice on the choice of exchange rate regime. Indeed, the freedom to choose has generated a huge demand for analysis on the appropriate choice of exchange rate regime.

    To this end, Aasim Husain proposes in Chapter 9 a “template” with which countries can assess the costs and benefits of different regimes according to their economic characteristics. He applies his template to Pakistan and Kazakhstan, explaining how their different economic characteristics affect the optimal regime choice.

    In Chapter 10, Enrica Detragiache and her coauthors take up a related, but slightly different, question, namely, when do countries exit from pegged regimes? A country may adopt an exchange rate peg “temporarily”—for example, pegging the exchange rate as part of an exchange-rate-based stabilization program, even though a pegged regime is not suitable for the country over the longer-term. When and how should it then exit the peg? The received wisdom—and common sense—suggests that countries should exit from a position of strength, that is, when exiting the peg is not likely to result in a disorderly depreciation of the exchange rate. Obviously, waiting for a currency crisis does not seem a great idea. Yet as Detragiache and her coauthors document, countries seldom take this advice and exit in a timely manner, and in about one-half of cases, they suffer a crisis in consequence.

    Indeed, as Grace Juhn and Paolo Mauro show in the final chapter in this volume, it is difficult to pin down systematically the determinants of countries’ choice of exchange rate regime. Juhn and Mauro survey the literature on regime choice and estimate their own multinomial logit regressions, relating regime choice to variables such as optimum currency area determinants, capital account openness, inflation, foreign exchange reserves, historical and institutional variables, and country size—finding only the last to be robustly related to whether a country chooses to float or peg its exchange rate.

    Juhn and Mauro’s chapter is a fitting piece on which to end this volume, because it underscores that much more work needs to be done—and will continue to be done at the IMF—to understand what drives exchange rates, how countries should choose their exchange rate regime, and what the implications of this choice are for their own economic performance and for the stability of the international monetary system. As the volume goes to press, such a study of countries’ choice of regime and the implications for the international monetary system is in fact underway at the IMF—yet another example of the centrality of exchange rate analysis to the IMF’s surveillance mandate.

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