Research Roundup

Highlighting some interesting research that I’ve come across recently, and worth a read (excerpts/abstracts):

1. Dealing with Volatile Capital Flows - “How have emerging-market countries dealt with capital flow volatility in the current crisis? What is the appropriate level of reserves for emerging-market countries? How can international crisis-lending and liquidity-provision arrangements be improved? What role can financial regulation and capital controls play in dealing with volatile capital flows? Olivier Jeanne discusses these and other important questions that are useful to keep in mind when thinking about the reform of international liquidity provision for emerging-market countries to deal with volatile capital flows.”
   
   I’ve talked about the dangers of unregulated capital flows before (here and more extensively here), and this new article just reinforces my view that open capital accounts aren’t necessarily beneficial for economic development.
   
   Jeanne, Olivier, "Dealing with Volatile Capital Flows", Peterson Institute for International Economics, Policy Brief 10-18, July 2010
   
   
2. Estimates of Fundamental Equilibrium Exchange Rates, May 2010 - "The fundamental question explored is what pattern of exchange rates is consistent with satisfactory medium-term evolution of the world economy, interpreted as achieving those objectives while maintaining internal balance in each country...The big disequilibrium in the pattern of exchange rates remains the undervaluation of the renminbi and the overvaluation of the dollar. The size of this disequilibrium is, however, less than previously estimated (now 15 percent on an effective basis and 24 percent bilaterally with respect to the dollar), due to the decline in the IMF's estimate of China's prospective current account surplus."
   
   Cline and Williamson update their estimates of the real effective exchange rate against the USD for a range of countries, and find some pretty significant changes from last year. Their methodology suggests that the MYR should be at RM2.52 to the USD, up from 2.63 last year. I covered their previous research, and what I think is wrong with it, here. Read this post for an alternative view.
   
   Cline, William R., and John Williamson, "Estimates of Fundamental Equilibrium Exchange Rates, May 2010", Peterson Institute for International Economics, Policy Brief 10-15, June 2010
   
   
3. Do Consumer Price Subsidies Really Improve Nutrition? - Many developing countries use food-price subsidies or price controls to improve the nutrition of the poor. However, subsidizing goods on which households spend a high proportion of their budget can create large wealth effects. Consumers may then substitute towards foods with higher non-nutritional attributes (e.g., taste), but lower nutritional content per unit of currency, weakening or perhaps even reversing the intended impact of the subsidy. We analyze data from a randomized program of large price subsidies for poor households in two provinces of China and find no evidence that the subsidies improved nutrition. In fact, it may have had a negative impact for some households.
   
   Another example of subsidies and market distortions creating perverse incentives, though with a different approach (and implications) than that which I tried to show.
   
   Jensen, Robert T., and Nolan H. Miller, "Do Consumer Price Subsidies Really Improve Nutrition?", NBER Working Paper No. 16102, June 2010
   
   
4. Calling Recessions in Real Time - "This paper surveys efforts to automate the dating of business cycle turning points. Doing this on a real time, out-of-sample basis is a bigger challenge than many academics might presume due to factors such as data revisions and changes in economic relationships over time. The paper stresses the value of both simulated real-time analysis-- looking at what the inference of a proposed model would have been using data as they were actually released at the time-- and actual real-time analysis, in which a researcher stakes his or her reputation on publicly using the model to generate out-of-sample, real-time predictions. The immediate publication capabilities of the internet make the latter a realistic option for researchers today, and many are taking advantage of it. The paper reviews a number of approaches to dating business cycle turning points and emphasizes the fundamental trade-off between parsimony-- trying to keep the model as simple and robust as possible-- and making full use of available information. Different approaches have different advantages, and the paper concludes that there may be gains from combining the best features of several different approaches."
   
   Prof Hamilton is one of the two bloggers behind Econbrowser, which is one of my favourite reads. And he isn’t afraid to put his research to the test either – you can find his recession indicator index on the Econbrowser frontpage, complete with emoticon (details here and here).
   
   James D. Hamilton, "Calling Recessions in Real Time", NBER Working Paper No. 16162, July 2010
   
   
5. Moving Holiday Effects Adjustment for Malaysian Economic Time Series - The dates of holidays such as Eid-ul Fitr, Eid-ul Adha, Chinese New Year and Deepavali vary from one year to the next and non-fixed date can affect time series data. The moving holidays need to be taken into consideration in the seasonal adjustment process to avoid misleading interpretations on the seasonally adjusted and trend estimates. Hence, by removing the moving holiday effect, the important features of economic series, such as the turning points can be easily identified. Seasonally adjusted data also allows meaningful comparisons to be made over a shorter time frame and it also reflects real economic movements. Currently, there are various methods applied for seasonal adjustment such as the X-12 ARIMA. However, these methods can only be used to adjust for the North American Easter effect and there is no such method which can deal with holiday effects in Malaysia such as Eid-ul Fitr, Eid-ul Adha, Chinese New Year and Deepavali. Due to these limitations, this paper proposes a procedure for seasonal adjustment of moving holiday effects in Malaysian economic time series data called SEAM (Seasonal Adjustment for Malaysia). The procedure involves estimating the irregular components using the X-12 ARIMA program and subsequently removing the moving holiday effects using a regression method. Three types of regressors namely, REG1 (using one weight variable), REG2 (using two weight variables) and REG3 (using three weight variables) are proposed in this study to measure the Eid-ul Fitr, Chinese New Year and Deepavali effects. Overall, it is found that SEAM is an effective method in removing the Malaysian moving holiday effects.
   
   Data in most advanced economies is seasonally adjusted i.e. smoothened to take out seasonal effects from holidays, structural peaks and troughs in consumption and production (and thus demand and supply), and other "regular" shocks to data. But Malaysian data is not seasonally adjusted, which is a failing I've tried to remedy in part through this blog. While doing some research on the subject, I stumbled on this paper, which explains how to account for Malaysian specific holidays that aren't included in standard statistical seasonal adjustment programs – since these holidays aren’t specific to any date in the standard Georgian calendar, you can introduce bias into seasonally adjusted series. The procedure outlined isn't earth-shatteringly new from my reading, but since it is known and available, I'm somewhat nonplussed that DOS still hasn't applied seasonal adjustment to Malaysian data. So what about it, DOS?
   
   Update: Hah! Seems I spoke too soon. I just checked the revised external trade data for May which has just come out on the DOS website, and Table 17 includes seasonally adjusted data for exports and imports. I await with bated breath for seasonal adjustment to be applied to the rest of Malaysian time series.
   
   Norhayati Shuja, Mohd Alias Lazim and Yap Bee Wah, "Moving Holiday Effects Adjustment for Malaysian Economic Time Series", Journal of the Department of Statistics Malaysia, Volume 1 2007 (Warning: pdf link)

Currencies and Current Account Adjustments Part II

I did a post about six months ago on an article in VoxEU (link) that evaluated exchange rate imbalances between the USD and Asian currencies, which suggested that the MYR was as much as 1/3 too low against the USD. I criticised the paper on both methodological and procedural grounds.

Now another article on VoxEU is also basically challenging the findings of that article (excerpts):

On the renminbi and economic convergence

“Many economists agree that the build-up and maintenance of international imbalances, with their accompanying capital flows, contributed to the overleveraging of finance and underpricing of risk. How to rebalance then? Many observers are increasingly emphasising that China should let its exchange rate appreciate.

For example, Cline and Williamson (2009) have recently estimated “fundamental equilibrium exchange rates” compatible with moderating external imbalances. They estimate that the required renminbi appreciation is more than 20% in real effective terms and 40% relative to the dollar. Ferguson and Schularick (2009) point to the manufacturing wage unit-costs to estimate the degree of undervaluation of the renminbi relative to the dollar and come up with the figure of 30% and 50%. Finally, the Bank of China’s continuous intervention in the foreign exchange market also suggests that the renminbi would appreciate significantly if let loose; this intervention has accumulated $2.3 trillion of foreign exchange reserves.

…

To be sure, poor-country currencies are normally undervalued in terms of purchasing power parity with rich countries. In fact, poorer countries do have undervalued exchange rates (due to the Balassa-Samuelson effect), and convergence will imply considerable correction of that undervaluation. Services (and wages) are cheap in poor countries and expensive in rich countries, while prices for internationally traded goods are roughly equalised in a common currency. When the productivity in traded goods rises (while productivity growth for haircuts and other services are very limited), more income is generated and spent on services. The price ratio of non-traded to traded goods will rise. In other words, the real exchange rate will appreciate. Hence, part of the undervaluation ascribed to China’s and other currencies results from market forces that make non-traded goods relatively cheap in poor countries, rather than from deliberate currency manipulation by China’s authorities.

While growing and converging fast, China is still poor. Its per capita income in 2008 was 6.2% of the US’s at market rates and 12.8% at PPP-adjusted rates, according to World Development Indicator data. Figure 1 relates the log of real per capita GDP as a fraction of the US level and the deviations of current market exchange rates per US dollar from PPP rates for the year 2008. It shows strong support for the Balassa-Samuelson effect and suggests a well-determined elasticity (0.2) by which the undervaluation of the currency will be eroded during the catch-up toward the US per capita income level. Real exchange rates can thus be expected to appreciate as economies grow, approaching PPP exchange rates as economies converge with US living standards, as posited by the Balassa-Samuelson effect.

Figure 1. Income convergence and exchange rates appreciation

To gauge a converging country’s degree of undervaluation, the appropriate yardstick cannot be purchasing power parity; it should rather be the regression (over 145 countries) that provides the best fit for the Balassa-Samuelson effect. While the renminbi was undervalued by 60% in PPP terms, it was merely undervalued by 12%, if the regression fitted value for China’s per capita income level is compared to the current value in 2008. Note that India and South Africa (which had a current account deficit) were more undervalued than China by that Balassa-Samuelson benchmark, by 16% and 20%, respectively, in 2008. The currencies of Brazil and Russia were appropriately valued, i.e. close to the regression line.”

My kind of guy! Have a read through - there's some interesting policy conclusions as well.

Currencies and Current Account Adjustments

A recent article by Cline & Williamson (2009)* on VoxEU.org investigates the state of play in terms of global currency misalignments, particularly against the USD. The results aren’t too surprising:

“The main counterpart to the overvalued dollar is the undervaluation of the Chinese renminbi, along with a few of the smaller Asian currencies…Our analysis is one more piece of evidence that the major macroeconomic imbalance in the world today stems from China’s exchange-rate policy.”

For the MYR, Cline and Williamson suggest an undervaluation of 17.7% in the real effective exchange rate, and 33.2% against the USD, with a medium term target rate of RM2.63. That’s a substantial movement for MYR, and will have a pretty massive impact on Malaysia’s external demand as well as the current account.

The modeling framework takes its cue from Williamson’s earlier work, which substantially helped launch non-purchasing power parity (PPP) based assessments of exchange rate valuations more than twenty years ago.

Some background is in order here. I’ve posted on these alternative models before, but the model used in this article is a variant of what’s called the Fundamental Equilibrium Exchange Rate (FEER) approach (aka Macroeconomic Balance approach), which uses a medium term current account target as a measure of a currency’s misalignment. Using an elasticity model, the extent of under or over valuation can then be calculated as the movement in the exchange rate required to bring the current account from its forecast level to the model’s target level over the medium term.

As you can imagine, I’m going to pick a few holes in this argument:

1. FEER models have a normative component – the target rate is selected by the researcher (admittedly based on global historical norms), rather than that inherent to each economy. In other words, the extent of misalignment derives directly from what the researcher considers a “sustainable” current account surplus/deficit. For instance, Williamson’s early work used a 2% band rather than the 3% used in the article - a tighter band implies a greater required adjustment. Since the current account covers both trade in goods and services as well as income flows, applying one number to all countries (or even one country at different points of time) isn’t obviously logical. The article attempts to account for this by incorporating a net foreign assets measure where required (essentially replacing a flow variable with a long-term stock variable), but the same critique applies.

2. Secondly, FEER models assume that all adjustments are made solely through exchange rates, which of course isn’t necessarily true. Demand and supply shocks, terms of trade shocks, secular changes in consumer preferences, productivity improvements, changes in portfolio holdings – all can have an impact on the current account without necessarily impacting the exchange rate at all.

3. FEER models don’t incorporate dynamics, which describes the interrelationship between the model variables across time. In short, you know your destination but you have no idea how to get there.

Lastly, I have a procedural criticism – the REERs used as reference points for the article are taken from the IMF International Financial Statistics Database. To my knowledge, the trade weights on these were last changed in 2006 based on averaged trade data from 1999-2001 (and thus accounting for the introduction of the Euro).
Ordinarily, I’d have no problem with this as trade weights rarely evolve much in any given 5-10 year span.

In this case however, I think the IMF REER indexes from about 2003 onwards are flawed – the emergence of China has had such far reaching effects on trade patterns that substantial changes in trade weights are warranted. That in turn implies that movements in the IMF REER indexes are too biased towards the G3 currencies, and not enough to emerging markets.

The effective difference doesn’t amount to a lot in an absolute sense – a few points at most on the index scale – but those few points do matter in terms of determining the threshold for possible policy action, and would matter even more if emerging market currencies were more volatile against the USD. In this case, the difference tends to support the article’s primary thesis of USD overvaluation against many Asian currencies.

To illustrate, here’s how the trade weights for the top 5 currencies in my own calculated MYR indexes have evolved during the same period:



Note that there are three different groupings: the EUR has been relatively stable; JPY, SGD and especially USD have been declining; and CNY has been steadily rising, with a big jump in 2003. The IMF static weights for these currencies for MYR are 14%, 15%, 6% (lumping SGD with all other ASEAN currencies), 24% and 5%; the latest weights for mine are 11.2%, 13.5%, 13.2%, 12.8%, and 13.7%. So there have been some pretty big changes in terms of which currencies are more important within a multilateral trade framework.

To illustrate the difference, here’s a comparison of the different indexes:




So, do I believe that MYR is that much undervalued? No, for a few reasons, not least of which are the flaws in the modeling framework I’ve pointed out above. But since this post is getting over long, I’ll save that for later.

*"Equilibrium exchange rates", William R. Cline & John Williamson