International Monetary Economic-Group ASG-ECON1270 PDF

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International Monetary Economics(ECON1270)Final AssignmentGroup ProjectLecturer: Phan Minh HoaClass: Friday 9 am – 11 amStudent Names & IDs:Nguyen Thu Huyen - SNguyen Thi Nhat Anh – SNguyen Giang Chau – 3653040Le Thu Ha – STa Mai Khanh – SPart A. Exchange Rate and Trade BalanceFigure 1. India Tr...

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International Monetary Economics (ECON1270)

Final Assignment Group Project Lecturer: Phan Minh Hoa Class: Friday 9 am – 11 am

Student Names & IDs: Nguyen Thu Huyen - S3575663 Nguyen Thi Nhat Anh – S3757073 Nguyen Giang Chau – 3653040 Le Thu Ha – S3749473 Ta Mai Khanh – S3870994

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Part A. Exchange Rate and Trade Balance

Figure 1. India Trade Balance and Real Effective Exchange Rate (1994-2020) (Source: World Bank n.d. & FRED n.d) According to Hayes (2021), REER is the indicator for external competitiveness of currency in a nation, which is determined by the weighted average of home currency against a basket of other major currencies after inflation differential adjustment. Overall, although India experienced a slightly upward trend in real effective exchange rate, it has remained around the benchmark (=100) during the examined period which indicates India still had ability to keep its external competitiveness. Especially, REER since 2015 were less fluctuated around 100 due to the decline and stability in inflation differentials between India and most trading partners, which was the result of flexible inflation targeting (FIT) framework in this country. In terms of balance trade, in 2013-2014, while REER surged to 89 indicating that Indian exports were cheaper while imports became pricey, the trade deficit was improved by 32% correspondly due to attractive exports goods.

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Figure 2. India real exchange rate and trade balance (1981-2020) (Source: World Bank n.d. & FRED n.d) From the graph above, the India trade balance and IDR/USD real exchange rate moved toward the opposite direction most of the period of 40 years from 1981 to 2020. According to Catao (2021), RER is determined by the ratio of price level abroad over your country in order to evaluate the level of price change and two currencies' relative value. The real exchange rate line in the graph experienced a downward trend, indicating that the price in India goods has been becoming relatively cheaper than the products in America. Although high inflation, high interest rate in India relative to US, floating exchange rate system and political uncertainties were main reasons for Rupee depreciation over 40 years; INR/USD stabilized since 2013 due to the change in policy which implemented by economist Raghuram Rajan, setting inflation as primary target for interest rate predictability and FX stability (Sharma et al, 2019). Regarding trade balance, besides RER, there are some other factors influencing India's balance of trade. This country experienced the largest trade deficit in 2012 with over 136 billions dollars - 22 times larger since the economic liberalisation programme in 1991 due to large import in gold and oil. In 2017-2018, India trade deficit was the widest it has been since 2012 as imports surged while exports only increased moderately because of short-term concerns like the disruption made by GST implementation to longer-terms concerns like losing competitive edge in textiles and agriculture export categories. Besides, the surges in oil price owing to the Iran Sanction and Venezuela crisis boosted the value of imports significantly while the exports of main products as gems, textile and jewelry sluggish led to the widening of the trade deficit (Dugal, 2018). Furthermore, despite being country redundant in many natural resources, Indian usage was blocked by these resources foreign sellers through NGOS and envitalists, which forced this country to import resources, leaving the trade deficit up (Behera and Yadav 2019). Correlation calculation and J-curved evidence The correlation between India trade balance and RER is -0.054, indicating the negative relationship; in other words, real exchange rate of INR/USD implemented a negative effect on India net trade balance. The inverse movement except for the periods from 2012 to 2016, along with negative correlation indicate the evidence of J-curve in India. According to Bahmani-Oskooee and Ratha (2004), J-curved refers to time lag since trade balance has a 3

tendency to respond slowly to the RER change. Country trade deficit will worsen initially after currency depreciation and reverse after that, forming a pattern of letter J. Specifically, although domestic currency depreciation increases the price of imported goods; both traded quantify and prices are determined and fixed even in the next period, citizen consumption patterns need time to be adjusted, while they do not want pricey imported goods. Hence, the supplier domestically needs time for new domestic demand adjustment, that creates the inelasticity in price for both exports and imports. As a result, we can indicate that a rise in the price of imports will worsen the trade balance.

Figure 3: Graph illustrates J-curved However, as mentioned by Petrovic and Matic (2010), this effect will counterbalance the decline in import volume because of the decline in quantity demanded for pricey imported goods. The total spending on imports will fall while export volume rises because they become more attractive to foreigners in terms of price. As a result, trade balance will be improved in the long run. The adjusted demand quantity for imports and exports presented that they become more elastic. For the case in India, we can see that the J-curve pattern is the most clear in the period from 1988 to 1996; while the Rupee depreciated against USD for 8 years. Meanwhile, the trade deficit improved for 3 years but it was followed by the decrease afterward. The J-curved evidence can be observed most of the time except for the period since 2012 due to foreign exchange stability target policy in India.

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Part B. Trilemma and Exchange Rate Regime Currency Crisis 1998 is our selected crisis that Russia suffered from during the last three decades. The World Bank data analysis showed that the exchange rate in Russia from 1988 to 1998 did not show a strong upward trend (Figure 4). This was due to the fixed exchange rate regime and tourist exchange rate also formulated, setting 10 times depreciated than the official exchange rate since early 1989 for liberalizing the exchange and trade system after the breakup of Soviet Union (Koen, Meyermans & Donovan 1994). From mid-1992, multiple exchange rate regimes were formulated by Russian governments with introduction of exchange rate unification in terms of reforming the economy during high inflation period, followed by large-scale domestic prices’ liberalization which resulted in gradual ruble appreciation (Goldberg 1993). Due to increasing concern about the impact of domestic inflationary anticipations, CBR established an exchange rate band from mid-1995, allowing market exchange rate to be freely volatile (Balino, Hoelscher & Hoarder 1997). From 1998 onwards, the government debt crisis triggered CBR formulating a controlled floating exchange rate which was largely market-driven til 2005 with reduced limited capital control regulations, resulting in steadily appreciating rouble with consistent CBR’s intervention to maintain the rouble’s appreciation (Bank of Russia n.d). We will further examine underlying causes and the overall story of the 1998 crisis as well as Russia’s economic condition during that time.

Figure 4. The Russia’s Exchange Rate from 1998 to 2008 5

(Source: World Bank.nd) According to the Federal Reserve Bank, the Currency Crisis in Russia began on August 17, 1998 – November 15, 1998. The reasons triggering the crisis are the pegged exchange regime, government deficit and debt and monetary ineffectiveness (Chiodo & Owyang 2002). During the economic reform period from the fall of the Soviet Union, Russia recorded its first year (1997) achieving positive growth (0.8%) and was capable of paying foreign debts that subsequently enhanced the country's credit ratings, permitting Rusia borrow less expensively. However, increasing debt payment (17%) from 1997 with low tax collection and soaring crude oil prices are key drivers deteriorating fiscal deficit and Asian Crisis (mid-1997) has made CBR losing around $6 billion in reserves, while foreign holders of current government bills signed forward contracts to exchange rubles for other currencies, allowing CBR implemented pegged exchange regime to prevent reserve loss. Additionally, Asian crisis and political reform by 35-year-old Sergey Kiriyenko eroded investors’ confidence regarding currency stability with strong expectation of ruble devaluation, leading to over 75% loss of stock market (Figure 5). Meanwhile, Russian governments were also incapable of selling sufficient bonds to refinance the upcoming debt due to shortage of household deposits in 1998 (decreased by 22.5 billion). Given governmental unstoppable efforts including increased lending rates or formulated anti-crisis strategies collaborated with the West and IMF, authorities formulated floating exchange rates which deprecated the rubble, thereby defaulting on its debt, Russia had entered the darkest period in the process of consolidating the economy.

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Figure 5. The Russian Stock Market (Source: IMF n.d) In November 1998, the Russian government introduced a managed floating exchange rate, while implementing short-term stabilization policy (1999-2003) with the resurgence of oil prices, which ameliorated Russia’s fiscal accounts from rise and accumulation of extremely large international reserves. Therefore, the ruble experienced remarkable appreciation from 1999 and with import substitution effect after the devaluation from rising commodity prices, fiscal policies, leading to first state budget surplus in 2000.

Foreign Exchange Market & Money Market Implementation Despite achieving better credit rating during six years of economic reform after the fall of the Soviet Union, Asian crisis in 1997 and political reform by 35-year-old Sergey Kiriyenko eroded investors’ confidence regarding currency stability with strong future expectation of ruble devaluation (Chiodo & Owyang 2002).

According to the above diagrams, strong expectation of ruble depreciation would increase E0 up to E1, shifting the exchange rate curve upward. This will increase the interest rate (R*) to the right due to the fact that if interest rate still remains with higher expected return for foreign currency deposit and increasing asset demand for foreign currency deposit, central bank needs to sell the reserve to meet excess demand, defending the exchange rate. This will 7

subsequently decrease the money supply (M1 to M2), indicating the contractionary monetary policy implemented which exerts a negative impact on the output, while E1 moves to E2, ultimately maintaining at E0. The second case when the Central bank does not have sufficient reserves, they are obliged to formulate a floating exchange rate regime. In response, the CBR used $1 billion of Russia’s low foreign reserves to defend its domestic currency while increasing lending rate to 50%. However, the Central Bank’s reserves were depleted for debt repayments and it was incapable of defending ruble, leading the Russian government to float the exchange rate and devalue the ruble (Chiodo & Owyang 2002).

Russia’s macroeconomic options before and after the crisis Before 1998 Exchange rate After a 6-year course of Russia’s economic rehabilitation from the collapse of the Soviet Union, privatization and macroeconomic stabilization had undergone certain success. Since mid-1995, the Russian government had implemented an exchange rate corridor system, entering a 3-year period of the pegged exchange rate (Dabrowki, Paczyński & Rawdanowicz 2002). This was due to CBR soaringly concerned about the effect on domestic inflationary anticipations of wide exchange rate volatilities, setting the 4,600 per US dollar as exchange rate midpoint between July-December 1996 with a fixed band width of 6.5% on either side. Moreover, the boom of asset market associated with surging stock and bond prices during 1995-1997 derived from significantly ambitious monetary stabilization programs, compressing inflation more quickly and with high dollarization, thereby disinflation was relied on exchange rate (Suppel 2003). Capital movement In the 1995Q2, strong intervention of CBR had increased international reserves to prevent an appreciation of the ruble owing to renewed foreign capital inflows. However, several external shocks occurred in late 1997 including plummet of Dow Jones Industrial Average point (October 27), East Asian crisis and collapse of global oil prices (December 1997) had fueled international investors’ risk aversion while forming particular misgivings about Emerging Market currencies and debt. Capital outflows exerted a severe pressure on the ruble exchange rate but the CBR was capable of managing with fixed exchange rate. During 1996-1997, Russian authorities began negotiations to reschedule the payment of foreign debt stemming 8

from the former Soviet Union to restore investor confidence (Chiodo & Owyang 2002). However, Russia did not witness such capital mobility since international capital inflows, including foreign direct investments (FDIs) occupied a mere portion of Russian capital inflows (average 0.4% of GDP from 1995–1997), non-liberalization of FDI transactions have been strictly limited in terms of devaluing ruble with different program adopted for capital liberalization while the net current external liabilities considerably increased before the 1998 crisis (Ketenci 2014). Monetary policy The hard inflationary period had forced Russian governments into stabilization efforts regarding price stability as a generally advocated ultimate goal of monetary policy. The target was to decrease the monetary financing of the state deficit, limiting refinancing, and developing proper monetary instruments. Specifically, monetary authorities had created quantitative limits on domestic lending to government and commercial as well as central banks of other nations, aiming to deteriorate the expansion of base money (currency outside the CBR and required reserves) and rouble broad money (M2), pertaining to programmes agreed with the International Monetary Fund. Moreover, other instruments include lending programmes which provided credits to particular regions and state corporations, credit controlling expansion, and a positive discount rate offered an efficient way for liquidity injection in the money market, while controlling inflation rate (Rytilä 2002). After 1998: Exchange rate The post currency crisis 1998 had led the Russian Central Bank to abandon the adjustable pegged exchange rate policy and float the ruble freely in November 1998, formulating exchange rate policy under the managed floating rate regime which the central bank still intervened to facilitate gradual nominal depreciation along with gradual real appreciation (Figure 6). Exchange rate dynamics were primarily market-driven and enabled official reserves to be reconstructed after oil prices revived. The exchange rate policy was introduced and tightly managed til 2005 to avoid excessive volatility in rouble exchange rate that might pose risks to macroeconomic and financial stability, while rebuilding trust in the country's financial system after the crisis and dampening the impact of fluctuating commodity prices on the economy (Treisman 2004). 9

Figure 6. Rouble Exchange Rate and Bank of Russia FX Intervention (Source: Central Bank of Russia) From 2005 onwards, as the ruble experienced steady appreciation due to increasing world oil prices, the CBR had implemented a dual-currency basket as the operational measure for its exchange rate policy, aiming to smooth the fluctuation of the ruble's exchange rate against other currencies, maintaining the basket’s value dynamics in accordance with changes in the rouble's nominal effective exchange rate (Central Bank of the Russian Federation n.d). Capital movement The short-term stabilization policy (1999-2003) was the spike of economic growth derived from the 1998 devaluation and with the resurgence of oil prices, which ameliorated Russia’s fiscal accounts while allowing accumulation of extremely large international reserves (over $50 billion in gross foreign reserves) accounting for 90% of 2002 imports (Treisman 2004). Meanwhile, the bank also eased capital controls with respect to managed floating exchange rate regime, whereas the liberalization of FDP transaction also gradually eased with gradual restrictive removal of non-resident portfolio investments which marked a move from an authorisation-based system to flow controls from 2004 onwards (Ketenci 2014). From 2006, new foreign exchange law was formulated, being focused on progressive liberalization of capital movements. Monetary policy With the managed floating exchange rate regime which was usually considered to have taken precedence over the inflation target, Russia had followed a comparatively accommodative monetary policy. The persistently significant current account surplus usually pushed the 10

exchange rate which the Central Bank attempted to prevent its exchange rate appreciation target from purchasing foreign reserves, thereby eroding the competitiveness of the nonnatural resources sectors while increasing potential inflationary pressures (Souza 2007).

The Trilemma Index and evolvement of country’s position According to Impossible Trinity, CBR had implemented a tighter monetary stance which was a significant change in macroeconomic policy in 1995 to promote the nation’s economy and achieve internal stability after the collapse of the Soviet Union in 1991 (IMF 1999). The new law was officially approved in April 1995, offering this institution independence in formulation of monetary policy while prohibiting direct credit to authorities which established the introduction of pegged exchange rate in June 1995. Russia had achieved an exchange rate stability and monetary independence, whereas sacrificing freedom of financial flows to deal with financial instability combined with hyperinflation between 1992-94 and persistently high inflation 1995-98, resulting in dollarisation (Central Bank of the Russian Federation n.d). However, concerning post-1998, CBR’s measures targeted to achieving a managed floating regime with foreign exchange interventions outweighed other instruments that CBR had to manage the money supply and interest rate level. Therefore, Russia had relatively limited capabilities to adopt the interest rate channel of monetary policy to impact the financial markets, given liquidity and price were freely influenced by external factors with higher degree compared to Bank’s monetary policy with eased capital controls (Bank of Russia n.d). Overall, Russia did not violate the trilemma constraints. From 1995-1997, the nation stood at the ground corner position, which is not the exact corner of a certain degree of fixed exchange rate, monetary autonomy with strict limitation of financial integration. From 1998 onwards, with increasing commodity prices and international reserves, Russia pursued freedom of financial flows facilitating capital mobility with exchange rate stability whereas comparatively forgoing monetary independence.

Russia’s Capital Mobility & Effects of Monetary Policy under IS LM BP Model Capital Mobility in Russia - Assumption & Explanation In recent years, Russia has become a politically stable, economic and financial country, and has stood firm as a democratic country with an expansion of market-based interactions. 11

However, the issue related to capital mobility in Russia was viewed as extremely relevant for financial integration and was an important part of Russia’s policy. According to CBR, foreign direct investment (FDI), foreign portfolio investments are considered ‘good cholesterol’ which are freely allowed into the country, while ‘bad cholesterol’ including foreign loans or related flows are also freely permitted. Therefore, we assume that Russia enables mobile capital flow and floating exchange rate. IS LM BP Model & Model Prediction in Reality Since Russia had suffered from a currency crisis caused by plummeting oil prices with national involvement in conflict with U...