where α is the share of internationally traded goods in the CPI, ρ is the rate of change of the traded goods prices, ρn is the rate of change of the of nontraded goods relative to the traded goods.

Substituting Eq. (16.3) the augmented inflation into a dynamic version of the terms of trade Eq. (16.2):

But we also know that Eq. (16.1) also holds. Substituting that equation into the previous equation we obtain:

The terms of trade, Eq. (16.4′), measure the relative price changes among nontraded products in different localities.

Rearranging the terms in Eq. (16.4) yields another interesting way of interpreting the different relationships among the variables. It yields a broader equation for the nominal exchange rate:

How the inflation rate differential affects the nominal exchange rate has already been discussed. In a world where there are no transportation costs and goods and factors are perfectly mobile, arbitrage will insure that there are no profits opportunities. That will only be the case if the dollar price of every commodity is the same across the world. That is the PPP proposition.

The terms of trade effects are somewhat different. An improvement in the terms of trade in one country means that the nontraded good can now buy more of the traded commodity. The terms of trade have two distinct effects in the country. One is a net wealth effect that leads to an increase in the aggregate demand for goods and services. The other, terms of trade effect, are that an improving terms of trade means that the rate of return of producing the nontraded commodity rises.

As a result of the increased rates of return, capital and other factors will be attracted from the traded sectors both at home, as well as the rest of the world. As factors of production move from the traded sector, the global traded goods production both at home and abroad tends to decline. The increased domestic demand and decline in domestic production of the traded good means that the country’s trade balance will decline. The increased domestic demand for the traded good combined with the increase in demand from the rest of the world means an increase in the world’s aggregate demand, and the world price for the current consumption of traded goods vis-a-vis the future will unambiguously increase. That will induce a common effect on output across the different economies. World income and the various national productions of the traded goods will tend to rise by the same proportion.

The increase in the global demand for the traded goods will attract resources form the nontraded sectors in the rest of the world. The end result being that the rising price of the traded goods will induce a common effect on all the countries’ GDPs. However, the story with the nontraded sector is a bit different. The rates of return in the nontraded sector will rise above that of the traded goods. In the other country, the opposite will happen; the rate of return will rise by less than that of the traded sector.

Notice that, we have assumed here an initial aggregate demand shock that increases local demand. If instead, we had assumed an aggregate supply shock that increases local supply, effect on the trade balance would be different. Yet even under these circumstances, we would expect the country with the aggregate supply shift to improve its growth rate and profitability relative to the rest of the world. Hence, we would expect the stock market to improve its relative performance.

In conclusion, the terms of trade effect result in:

The argument commonly made by the pundits and some policymakers is that a weaker currency will make the country’s imports more expensive, while making their exports cheaper. If that is the case, it means that the country will import less and export more; thereby the currency devaluation will result in an improvement in the trade balance.

Implicitly, this argument assumes that a monetary devaluation alters the terms of trade in an adverse manner. Unfortunately, the logic of the argument is incorrect. Let’s go back and concede that devaluation may initially make the devaluing country’s imports more expensive and its exports cheaper. Let’s call the devaluing country’s imports M, and the devaluing country’s exports X. This way we may be able to keep track of the rest of the world’s demand for the two goods.

As the devaluation made the price of M more expensive, the rest of the world will now consume less of the more expensive commodity and more of the now less expensive commodity, X.

The sum of the devaluing country’s demand and the rest of the world’s demand gives us the worldwide demand for both X and M. The demand for M will decline in both the devaluing country, as well as in the rest of the world. In contrast, the demand for good X will increase in both the devaluing country and the rest of the world. The decline in the global excess demand will result in a lower price for M, while the global excess supply will result in a higher price of X.

Recall that M is nothing more than the devaluing country’s imports (our proxy for the rest of the world’s price), while X is the price of exports (our proxy for the devaluing country’s price level). Simply put, the devaluing country’s inflation rate will rise relative to the rest of the world. We contend that if money is a veil, the inflation rate differential will completely offset the impact of the devaluation on the terms of trade. Therefore, a monetary devaluation will have no lasting real effect on the economy. The only lasting effect will be a higher price level.

As discussed in Eq. (16.5), there are two drivers of the foreign exchange value of the dollar. The first one is the inflation rate differential. The higher the foreign inflation rate relative to the United States, the stronger the US dollar will be. The second one is the terms of trade. The more a US consumer basket buys of the foreign consumer basket, the stronger the US dollar will be. The rate of change in the foreign exchange value of the dollar consists of the net of these two effects, the real (i.e., changes in the terms of trade) and the monetary (i.e., inflation rate differential).

Now we will discuss how to apportion each of these sources of nominal exchange rate fluctuations. Fortunately, the solution to the problem is readily available. The Federal Reserve Bank of Saint Louis publishes an index of the foreign exchange value of the dollar against major trading partners. In turn international organizations such as the IMF, World Bank, and the OECD publish estimate of the country’s economic statistics. Currently we chose to use the OECD data. Most of the data also published the GDP deflator in domestic currency for each of the countries. The ratio of the price deflators’ measure the monetary effects and combined with the foreign exchange value of the currency once can calculate the terms of trade or real exchange rate.

Fig. 16.1 provides us a visual representation of the nominal exchange rate and alternative measures of the Real exchange value of the dollar. A casual inspection of Fig. 16.1 shows that the two series are different. Also, the various relationships implied here provide us with some interesting insight. The first one is that if each country’s central bank adopted a domestic price rule that kept the local inflation at zero, then the inflation rates in each country would remain at zero at all times. If the inflation rates are the same across countries, then the inflation rate differential would be zero at all times. Eq. (16.5) shows that when the inflation rates are the same across countries, the fluctuations in the terms of trade and exchange rates will match each other. In contract, when the terms of trade remain unchanged, the only source of exchange rate fluctuations would be the inflation rate differential. Again Eq. (16.5) shows that is the case.

Using this result one can then argue that the differences between the terms of trade and the foreign exchange value of the dollar in Fig. 16.1 would be the cumulative result of the inflation rate differential across the countries ex-the terms of trade. We contend that this differential is in fact the result of monetary policy. Hence, this may provide us with a solution to the signal extraction signal regarding the fluctuations in the nominal exchange rate. We can now decompose the fluctuations in to those caused by the terms of trade and those caused by the monetary rate induced inflation rate differentials. Fig. 16.1 shows the two components of the nominal exchange rate: the two sources of nominal exchange rate fluctuations.

Under the price rule, the bulk of the exchange rate fluctuations will be real or fiscal policy shocks, which are the same variables that impact the terms of trade. Hence, under a domestic price rule scenario, we expect the two variables (the nominal exchange rate and the terms of trade) to move together. That is effectively what we find in the data. This we interpret as a validation of this insight or hypothesis derived for our framework. The price rule makes the signal extraction problem a trivial one. However, under alternative monetary arrangements, the distinction between the terms of trade and monetary shocks will not be an easy one to disentangle.

An important insight derived from all this is that, we can rule out monetary shocks as the source of the exchange rate fluctuations under a price rule. The two real exchange rates inverted versus shown in Fig. 16.1 are intended to capture the full exchange rate cycle caused by the different policy shocks. We can then focus our attention on the real shocks that may impact the terms of trade. Taking a US-centric view of the world, we know that President Reagan lowered US tax rates to 50% from 70%, leaving the after-tax income of a dollar taxed at the highest rate yielding 30 cents on the dollar prior to the tax rate cuts and 50 cents on the dollar after the tax rate cuts. That is a 66% increase in the after-tax income. Not surprisingly, the rate cut produced an increase in asset valuation and a capital inflow. Both contributed to a dollar appreciation over and above the inflation rate differential, that is, terms of trade effect. The fact that it took several years for the dollar to peak even though the tax rate cuts were fully preannounced is consistent with our views that there are significant adjustment costs faced by the economy and the markets. During 1995–2001 time period, the dollar and terms of trade appreciated. That period coincided with the Republicans taking over Congress, the Clinton triangulation, and the Maestro’s finest performance. The 1986–88 and 2002–04 time periods coincided with the transition to new tax rates.

Using the information presented in Fig. 16.1, we identified cycles where the exchange rate and or terms of trade, rose, fell, or stayed flat. The dates for the exchange rate cycles are reported in Table 16.1, while the dates for the terms of trade cycles are reported in Table 16.2.

As already mentioned, it is our view that under a domestic price rule, the nominal exchange rate and the terms of trade will move together. However, when the price rule is not strictly adhered to, then monetary disturbances, according to our framework, will have an impact on the nominal exchange rate and no impact on the terms of trade. Thus, we contend that a failure of the two variables to move together is the result of monetary actions. Looking at the data reported in Tables 16.1 and 16.2, it appears that during the years 1990, 1996, and 2011–13 the two variables did not move in unison.

In 1990, President Bush went back on his pledge not to raise taxes. 1996 was when triangulation was in full swing and Alan Greenspan is credited with identifying the surge in productivity that began around that time. During both years, the Fed was led by Alan Greenspan, whose Fed attempted to anticipate and accommodate aggregated demand shocks. The Bush administration argued that leading up to the election, the Greenspan Fed was too tight and that may have delayed the economic recovery and cost President Bush his reelection. Mr. Greenspan was clearly correct on the productivity surge and as a result his accommodation was the appropriate one. However, he was certainly wrong on Y2K. Yet looking back, adding the Fed’s response in the aftermath of 1987, Greenspan’s accommodations were more often right than wrong. In 2010, in part because of the weakness of the recovery, the Bernanke Fed announced a second round of quantitative easing.

The possibilities: The previous discussion suggests that there are four different possibilities about the joint performance of the nominal exchange rate and terms of trade. Two cases involve the nominal exchange rate and terms of trade moving in the same direction (both variables appreciate or depreciate. Then there is the outcome when the two variables move in the opposite direction. In one case, the exchange rate appreciates, while the terms of trade depreciate. The other case is when the exchange rate depreciates, while the terms of trade depreciate.

We have calculated the performance of several macroeconomic indicators during the rising and falling cycles for the nominal exchange rate and terms of trade, as well as the four-possible combination for the joint outcomes of terms of trade and exchange rate fluctuations. As mentioned under a domestic price rule, the real effects will be the only potential disturbances to the overall equilibrium. The real shocks will induce a common movement between the nominal exchange rate and the terms of trade.

The more interesting case is one where the two variables move in opposite directions. These latter cases may allow us to separate and get a sense of the relative impact the monetary effects and or the real effects on the terms of trade and nominal exchange rate.

Table 16.3 summarizes the impact of the monetary and real disturbances on the relative growth rates, stock returns, inflation rate differential, as well as the changes in the terms of trade as a percent of GDP. As we assume that money is a veil, we expect monetary policy to be neutral and thus have no effect on the real variables of the economy. In contrast, those who believe that a devaluation can alter the terms of trade should ignore the first two columns in Table 16.3 and focus solely on the last two columns, irrespective of whether the economic disturbance in question is a monetary or real one.

Table 16.4 reports the performance the developed economies ex-the EMU and the emerging economies relative to the US economy [1]. Notice that we only report the nominal exchange rate cycles and the combined cycles. The terms of trade cycles are not reported because that information is mostly redundant. One can infer or derive most of the results of the terms of trade cycles form the information at hand. For that reason as well as an easier visual representation we decided not to directly report the terms of trade information in Table 16.4.

Looking at the information presented, we find that as one moves from the column reporting the average performance during periods when the foreign currencies depreciate relative to the dollar, column 1, and compare them to the results produced by the periods during which the foreign currencies appreciate relative to the dollar, for both the developed and emerging countries the results point to:

All of these results are consistent with the terms of trade effect on these variables as reported in Table 16.3. The results are reassuring to both the terms of trade view of the world as well as to those who believe that a devaluation alters the, that is, improves, the terms of trade.

One interesting result reported in the first two columns of Table 16.4 is the differences in relative inflation; these do not follow the same pattern as the other variables. Later on, we will discuss these results in greater detail.

Moving on to the right side of the table, columns 3 and 4 report the average performance of the different variables when both the nominal exchange rate and terms of trade provide the same signal. Column 3 reports the results for when both variables decline, while column 4 the results when both variables appreciate. As one compares the results in the two columns, we find the outcome consistent with those reported previously. The variables behave as predicted by the terms of trade effect, see Table 16.3, columns 3 and 4.

In some ways, the two periods when the exchange rate and terms of trade produce different signals should be the most interesting. Periods when the two variables move in opposite direction and thus could yield some interesting information that may allow us to disentangle the effects of the terms of trade and those of a monetary devaluation. Unfortunately there are only three episodes that encompass only 4 years. We feel that the number of cycles are too few and their duration too short. Simply put the sample is too small and the events are not sustained enough to allow us to identify significant differences that may help identify the differential effect of the terms of trade and exchange rate fluctuations on the economy. For that reason we will exclude these observations from the sample and compare them to the complete sample. However, in so far as we exclude these observations, the issue as to whether there are significant differences between the terms of trade and the nominal exchange rates will be left for another day.

Now, on to an interpretation of the inflation rate differentials results, we have argued and shown that under a domestic price rule, the inflation rate differential will not change unless there is a change in the price rule inflation target. We also know and can argue that most of the developed world during this time moved toward a domestic price rule around a 2% domestic inflation target range. If every country was on the price rule and was successful, there will be no inflation rate differential. If, in contrast, the inflation targets were different across countries, but fixed and did not change, then the inflation rate differential would also be constant. In that case, we have shown that the domestic inflation will rise and the differential would reflect a terms of trade effect. That is the case as we compare columns 1 and 2 and columns 3 and 4 for the developed economies relative inflation rate. This result provides a clear signal.

It is the emerging markets inflation rate differential during the different periods that produces a conflicting signal. Notice during the cycles in which both the nominal exchange rate and terms of trade move in the same direction, that is, both appreciate or both depreciate at the same time, the inflation rate differential rises as nominal exchange rate and terms of trade appreciate. Again, it is a result consistent with the terms of trade effect. Yet during period in which the nominal exchange rate appreciates and the fluctuations in the terms of trade are not accounted, columns 1 and 2, the inflation rate differential decreases as the exchange rate appreciates. This result is consistent with the view that the nominal exchange rate fluctuations are the result of monetary disturbances, in which case we should expect the PPP results.

In many ways this result is quite intriguing. One can argue that the PPP type scenario for the nominal exchange rate is much more representative of the relative performance of the inflation rate differential between the emerging markets and the United States. First, the emerging markets have not adopted a domestic price rule. Earlier in the period they adopted an international price rule or, simply put, a fixed exchange rate system. Yet we know that these systems were abandoned by most emerging markets as a result of several financial crises. The first one that comes to mind is that of the Latin Pumas, initiated by Mexico’s devaluation in December of 1994. Then we had the Asian Tigers crisis with the Thai Blood Baht in 1997 and capped by the Russian crisis in 1998. In short, all regions of the emerging markets experienced a financial crisis followed by large and abrupt devaluations that decoupled their exchange rates after which they were allowed to float freely.

The large devaluations may be quite useful in providing information that may allow us to disentangle the terms of trade and exchange rate effects. The numbers are consistent with the PPP interpretation. As we compare columns 1 and 2, we find that the average inflation rate declines as the nominal exchange rate appreciates. These results provide support for a terms of trade effect and a monetary effect on the relative inflation. The issue is how can we separate the two sets of results and link them to the country’s monetary policy? We sort of did that already when we argued that the developed world followed a domestic price rule and the emerging market did not. This is very useful for it allows an investor or portfolio strategist to take a short cut in interpreting the whole data set and this way get a quicker sense of the market and economic developments, a useful piece of information in the design of a successful portfolio strategy. But can we say more than that? Can we support our views empirically?

While the numbers are consistent with this interpretation, we have to keep in mind that the sample where the nominal exchange rate and terms of trade move in the opposite direction was deemed to be too small. Hence, we have to take the results with a grain of salt. Nevertheless, they are encouraging in so far as they hold the promise that focusing on periods when these two variables move in different direction is the path to finding a way to separate these two effects.

The Mexican trade balance as a percent of GDP did improve in the aftermath of the devaluation, just as the proponents of devaluation argue. Yet we also find that the real GDP growth rate declined, the inflation rate accelerated and the stock market continued to underperform. Not a pretty picture and perhaps too high a price for Trade balance improving devaluation.

The economic situation clearly deteriorated. The proponents of devaluations have a tough time with the event. If the devaluation does in fact makes the local country products cheaper, the increased exports should have a multiplier effect and thereby result in higher output. Also with the economy contracting, why did the domestic prices rise? Arguing that things would have been much worse had not the currency been devaluated is not an acceptable defense. Instead, we have a very simple interpretation of the events. A monetary devaluation should have no impact on real variables, yet the PPP framework suggests that the devaluation results in a higher inflation rate. It does.

Normally a devaluation is not an isolated policy. Usually it is accompanied by capital controls, other restrictions, as well as austerity measures that have a real impact on the economy. As a result of the companion policies, incentives to produce decline, the economy contracts, and the terms of trade weaken, thereby resulting in an improvement in the balance of trade. Finally, the contraction also means that the rates of returns to producing nontraded goods decline and that produces a decline in the country rates of return relative its trading partners. The stock market underperforms and capital flows out as a result. This is a nice parsimonious explanation consistent with the view that terms of trade effects mostly impacting the real economy and the devaluations mostly impact the nominal variables.

The data reported in bottom of Table 16.5 is also consistent with a regional contagion. The reason for the contagion may differ. Some may argue that because the economies in the region pursue similar policies, similar behavior is also expected. Another way to say the same thing is that they may be considered near substitutes of each other and as investors sour on the policies in one country, it is more than likely that they will do so for similar economies.

Although not reflected in this data, there is an important point we want to make here is. The volatility in the exchange rate ended in 1996, when the Mexican authorities adopted a new monetary operating procedure that guaranteed the convertibility of the pesos at the margin. Under the new procedure, the Mexican central bank only printed new money to match increases in the central bank‘s international reserves. The new Mexican policy effectively insured the central bank would only create the money necessary for the economy to function. Any excess creation resulted in a loss of international reserves and a reduction in the domestic monetary base. Similarly, any liquidity shortage created a capital inflow that resulted in a corresponding increase in international reserves and an equal amount of domestic money being created. To enable investors to keep tabs on how the bank is meeting these restrictions, the bank published its international reserve holdings on a weekly basis. These steps helped Mexico weather the Thai devaluation reasonably well. Its stock market outperformed, the economy recovered and Mexico was able to repay the United States emergency assistance loan ahead of schedule.

The emerging market nations in the Southeast Asia region suffered currency pressures of their own. Contagion was the order of the day. Looking at the bottom of Table 16.6, there is clear evidence of contagion. On average, the other countries in the region also felt the ill effects of the devaluation more so than the other emerging countries, and regions such as Latin America, Emerging Europe, Middle East, and Africa. Shortly after the Thai action, the Philippine peso was forced to float, Indonesia widened its trading band, the Malaysian Ringgit suffered a small devaluation, and even the Singapore dollar, considered the region’s strongest currency, was shaken. The degree to which each of these emerging nation’s felt the Thai currency shock was largely dependent on the organization of its monetary system.

The predictable comparisons to the Mexican peso crisis in 1994 surfaced immediately in the press. And since the float, analysis has shown some interesting comparisons. Analysts at the International Monetary Fund and the World Bank concluded that Thailand’s problems, while the most severe in the region, were not as likely to be as long lasting as Mexico’s—primarily because of the region’s above average growth. That growth, however, had been largely the result of the region’s commitment to strong currencies.

The press has said the Thai correction was inevitable. The product of an overly strong currency was choking net exports. And advocates of the move have said that by floating (devaluing) the baht, Thailand’s competitiveness in the global economy improved. At the time, we argued that while this may be the case when applied strictly to the terms of trade, when speaking of the nominal rate, this model is flawed [2].

Failing to differentiate between nominal and real exchange rates produces faulty economic analysis, and has been at the center of numerous currency troubles for decades. Following a set of policy recommendations which fail to distinguish the two can lead to deepening economic hardship. A change in a country’s real exchange rate or terms of trade has real impact on other nation’s economies. In fact, the relationship between the real exchange rate and the trade balance and capital flows is exactly as described in the press. An appreciating real exchange rate is associated with a deteriorating trade balance and improving capital flows. Quite simply, the terms of trade reflect the real economy, while the nominal rate reflects relative inflation rates across countries. While a currency devaluation may give a brief boost to competitiveness, its impact on a nation’s real economy is considerably less certain. Generally, a nation’s competitiveness is not enhanced by the devaluation itself, but by the growth-oriented, sound monetary policies that emerge in response to devaluation’s most painful product: inflation.

The anatomy of the crisis is worth reviewing. The region has been beset by speculative currency attacks that have transpired for a number of reasons. But basically under a peg or fixed exchange rate system, such attacks are one-sided bets, a kind of “heads I win, tails I don’t lose” proposition. Speculators bet against the currency. If the currency folded, they would win big. If the currency withstands the assault, speculators lose only transaction costs. If they have sufficient resources, they might even force the country’s currency to fold. True, speculators may inflict considerable damage to emerging nations’ economies. But speculators don’t deserve all the blame. They didn’t set up the game. Central banks set it up and all that the speculators did was play to win.

To understand the Thai crisis, many analysts were drawing a parallel with the 1994 Mexican peso crisis. Such a perspective offers useful insights. The most important of which is that, just as was the case in Asia, Mexico didn’t have an independent central bank guaranteeing the convertibility of its currency at the time of its devaluation. By all accounts, the Mexican government used some of its international reserves during the capital-inflow phase to finance government spending. This left the central bank inadequately prepared to defend the peso against a speculative attack. The same mistake was made by the Asian Tigers’ central banks. The exception in the region was Hong Kong and its currency board.

Our view then, and still is, was that the Southeast Asia crisis was unnecessary and could have been avoided. We base our arguments on the experiences of Hong Kong in the aftermath of these crisis. Around the time, there was an attack on the Hong Kong dollar that underscored a number of issues in international finance and monetary policy. Foreign exchange speculators sensed that Hong Kong may have been ripe for an attack that would result in an unhinging of Hong Kong’s currency from the US dollar. The assault tested the will of the Hong Kong monetary authorities. The peg or fixed exchange rate system had been under siege ever since the Asian Tigers unhinged their currencies from the dollar. The question at the time was whether Hong would Kong prevail.

Repeating ourselves, we have argued that a fixed-exchange rate system sets up a one-sided bet for speculators in the currency game. These currency “gamblers” have much to win if they bet correctly against a currency, and have little to lose (transaction costs) if they guess wrong. This cost-benefit asymmetry encourages speculative attacks. We have further argued that the success of the speculative game depends on the nature of the exchange rate arrangement. If the central bank fixes the exchange rate by employing a currency band, it could, under certain conditions, end up guaranteeing the convertibility of its entire money supply. In contrast, if a nation uses a currency board to direct policy, as Hong Kong does, only the monetary base is guaranteed (the currency board alters the base in direct relation to international reserve holdings). It’s easily seen that the currency band system is guaranteed to fail a large speculative attack. The amount of international reserves held by the domestic central bank would never be enough to insure the full convertibility of its money supply (M1, M2, etc.). Therefore, if the attack is large enough, the country will fold, as Argentina did.

However, under a currency board that has stuck to its 100% international reserve backing of the monetary base, authorities will always have enough reserves to survive the attack. This is not to say that the currency board country doesn’t pay a price. The capital outflow occasioned by the speculative attack produces a massive credit crunch that affects the nation’s real economy. Viewed this way, it’s easy to see that speculators can inflict pain on an economy that uses a currency board.

This produces the second component of the speculative attack: to short the local stock market. This way the speculators set up what they believed was a win-win speculative position or a free lunch. The way the saw it, it the country did not devalue, the credit crunch and capital outflow would produce a stock market decline, and they win. In contrast, if the country devalued, they also win. What is the central bank of monetary authorities to do? Again, Hong Kong is the poster child for the proper response. They used their reserves to counter the speculative attack. They bought stocks and prevented the market decline that speculators were looking for. Eventually the carrying costs of the short became too high, the speculators gave up, closed their position, and the Hong Kong monetary authorities won. Once the crisis was over, the HK monetary authorities reversed their stock holding and returned to a normal backing of the HK dollar. The Hong Kong experiences demonstrate to us that the Latin Pumas and Asian Tigers crisis were unnecessary. It’s important to note, however, that argument also explains why currency board nations see their economies rebound more quickly after a speculative attack than noncurrency board nations.

In the case of the emerging markets, the data reported in Tables 16.5 and 16.6 show that it is unfortunate that the global markets tend not to distinguish between the good emerging markets and all the others. In effect, international investors punish the sinners and the virtuous equally. The good countries suffer unnecessarily. The investment implications are quite clear: watch the region’s capital flows. If the capital flow is positive for the nation in question and the real exchange rate or terms of trade appreciates, investors need not worry about the organization of the nation’s monetary system. In these countries, the stock markets—particularly in the nontraded and interest-sensitive sectors—will perform quite nicely. However, the instant the capital flow reverses, even if the economic fundamentals appear sound, the organization of the monetary system matters a great deal. In these nations, look at the international reserve coverage of the monetary base. If it is inadequate, that is, less than 100%, make sure your investment is partially hedged or predominately in the traded sector, where goods are generally “dollarized.” If a currency run materializes, the traded sector will be the least affected.

The devaluation was supposed to free these countries from the burden of a fixed-exchange rate system and, according to street lore, would also improve their competitive position. What the devaluation produced was higher inflation, and Russia was no exception (Table 16.7). Prior to the devaluation, these countries had private borrowing in the international markets, the currency depreciation—to the extent it was not accompanied by a corresponding domestic asset appreciation—resulted in additional capital-adequacy problems for the banks. Problem loans proliferated, and to meet the capital ratios either new capital had to be found (an unlikely possibility) or loan activity had to be curtailed. These countries were in the unenviable position of facing a credit crunch and high inflation caused in large part by the devaluation. For example, in Indonesia the interest rate for one-month paper was about 70%.

Again, the experience of the Latin American countries during the Tequila Effect is quite instructive. The Mexican experience is closer to that of the Asian countries. For almost a year, Mexican inflation kept rising despite a contracting money supply. The devaluation had reduced demand for pesos so much that the government could not arrest the peso expansion fast enough to halt the currency slide. It was not until the operating procedures at the central banks were changed—prohibiting creation of additional pesos without the backing of international reserves—that things started to improve. The policy served Mexico well, the exchange rate stabilized at around 7.6 pesos to the dollar, the inflation rate declined to single-digit rates, and the Mexican stock market recovered.

Clearly, Mexico fared much better than the Asian Tigers during their flu-Contagion episode. But, across the board, fixed-exchange rate countries did not experience the same difficulties as those countries that floated or to the same degree. The Mexican experience should have been the blueprint for countries that have devalued or let their exchange rate rise. As they have obligations in foreign currencies, the depreciation causes capital adequacy problems. This, in turn, leads to a credit crunch. The currency depreciation leads to higher inflation. In short, a financial collapse will invariably occur. Recovery did not begin until the inflation rate was controlled and the capital adequacy issue was addressed.

Given the experiences of Mexico, it is clear now that the Asian countries and Russia were as far along as Mexico was in the aftermath of the Tequila Effect. The Russian story was even worse. Russia started from a much weaker economic situation, having never really found its footing with a sustained period of growth under free-market economics. Furthermore, the Russian banks bought everything they could—as long as it was on margin. Influence peddling and cronyism also abounded. Not surprisingly, as the country’s economic policies failed and asset values declined, the banks were unable to meet their obligations.

The capital outflow occasioned by the confidence crisis in the region leads to a reduction in international reserves. As the reserves make up the country’s monetary base, the outflow will lead to a reduction in the domestic money supply. Given the magnitude of the money multiplier, there will be a magnified reduction in both the quantity of money circulating in the economy and in domestic credit creation. If the financial markets are not well developed (and they were not in those countries), the banking system was the major source of credit. (The other sources would be the emerging stock market and foreign borrowing). The credit reduction led to a credit crunch, the severity of which depended on the ability of the other two sources of credit to fill the void. In a time of crisis, the stock market was not the vehicle to fill the void—there were few IPO’s or nongovernment foreign borrowing. Thus, skyrocketing interest rates would be the order of the day. All of this would result in a rising inflation, slower real GDP growth, a declining stock market in absolute and relative rates of return. Table 16.7 indicates that is precisely what happened to Russia. Again, going back to the basic framework, the performance of the Russian economy during the crisis and its aftermath, it fits our views that the devaluations mostly influences nominal variables with the terms of trade impact the real sectors of the economy. Finally, if there is a lesson for the emerging economies is that Hong Kong was a clear example to emulate.

The essence of our insight is simple. We contend that as the global economy expanded, in particular China, it increased the demand for agricultural commodities and minerals used in the production of goods and services. There are two mechanisms to eliminate excess demand. One is price increases and the other is higher output. How much of each takes place depends on the aggregate demand and supply elasticity of the commodities in question. The lower the supply elasticity, the higher the price increase will be. The higher the supply elasticity, the greater the output response will be. The higher price would result in additional profits for the producers and the higher output would produce higher employment.

The commodity price increase also has a clear macro effect. An increase in the commodity prices means that every unit of nontraded goods now acquires more internationally traded goods than before. This implies that the real rate of return of domestically located assets increases relative to the rest of the world, and so will domestic asset values. In an attempt to arbitrage the higher rates, investors will flock to the local economy. The country will experience an inflow of capital as a result of the increased rate of return. A decline in commodity prices will have the opposite effect. It will result in a lower rate of return for domestic assets. The relationship between the commodity prices and the performance of the domestic stock market relative to the global economy will be a positive one.

Table 16.8 reports the performance of selected variables for three commodities producing and exporting countries relative to the corresponding performance of these variables in our universe of developed economies. Table 16.9 reports a similar table, but this time the countries selected are all emerging economies and their performance is measured relative to the emerging economies in our universe. A careful analysis of the two tables yields some empirical regularities. For the commodity-producing developed countries, the trade balance worsens while the stock returns performance improves. The inflation rate also rises and the real GDP improves more often than not. The end of the commodity super cycle also points to a reversal of the relative performance. The one exception has been the trade balance, which continued to deteriorate.

Some of the same cyclical effects are also evident for the emerging economies. The relative inflation rate and relative stock returns tend to rise in relative terms as during the super cycle and then either decline or reduce the rate of appreciation as the cycle ended. For the other variables, it is hard to discern which one dominates, the cyclical relative performance or an apparent secular trend. However, excluding the secular trend, the relative performance during the cycles is in line with the developed market.

We have argued that during a price rule period, the inflation rate measures the terms of trade effects. We have also argued that monetary variables will have little or no impact on the real variables. We do not expect to find a systematic relationship between the nominal exchange rate and the real variables, which appears to be the case. In contrast, most of the counters results are in line with the terms of trade effects identified by our framework.

We loved the parallel and agree with the earlier mentioned statement, but where we part company with Professor Taylor is in the conclusion that he makes. We do not believe that the floating of the yuan is such a bullish event. On the contrary, we believe that it will have effects similar to those of the Bretton Woods demise. Among other things, the unhinging of the dollar from gold produced a loss of confidence in the US currency and economy and in a very short order experienced double-digit inflation. We believe that China could follow a similar path.

Before we make our arguments let’s review China’s experience. Table 16.10 summarizes the performance of different economic indicators prior to the fixing of the exchange, during the peg and the first 2 years of the so-called floating period. The first row illustrates what we already knew. Prior to the peg, China’s exchange rate was depreciating relative to the US dollar at a double-digit rate. The peg produced a result similar to the experience of other countries and economic unions that have adopted a fixed exchange rate, the peg induced a convergence of the underlying Chinese inflation rate to that of the country it was pegging its currency to (the US dollar). Since the abandonment of the peg, the managed float has resulted in a slightly higher depreciation rate. It takes more yuan to acquire a US dollar.

The second row shows that contrary to expectation of policy makers, the unhinging did not result in a deterioration of the trade balance. In fact, the trade balance as a percent of GDP improved. The data shows that relative real GDP growth rate was lower during the peg than during the floating periods. The same is true for the underlying inflation rate. Not much can be surmised about the relative stock returns, all we can say is that over time the relative performance had been steadily improving.

Table 16.11 shows the performance of the Chinese economy relative to the developed world, the emerging markets and the Asian Pacific emerging market region. The patters are basically the same. The trade balance improves as the peg is removed; the relative GDP growth and inflation rates are lower during the peg while the relative performance of the stock market trends up over time.

Now we focus on the effect of unhinging from the US dollar. Let’s see and determine what is being lost as China dismantles the system. First, by fixing the exchange rate to the US dollar, the Chinese central bank effectively is importing US monetary policy. Under a fixed exchange rate, absent changes in the terms of trade, arbitrage insures that the price of traded goods converges across countries. The underlying inflation rate in the countries fixing the exchange rate converges to that of the Unites States, the reserve currency country, but there is more to this story. The beginning quote also states that the other Asian countries are quasi fixed to the Yuan. It follows that we have a series of exchange rate/inflation linkages: the Asian countries to China and China to the United States. In the end, the United States is the sole determinant of the underlying inflation rate. Looking back over the past decade, the Chinese and Asia could not have chosen a better anchor than the United States and Sir Alan.

The Yuan had been pegged to the dollar for more than 10 years. Critics complain that it was artificially weak, which gave Chinese exports an unfair advantage. Presumably, the move to float the exchange rate will appease the United States and will stop the move to impose a 27.5% tariff on Chinese goods.

The exchange rate manipulation argument is a flawed one. It assumes domestic price rigidities, which leaves the exchange rate as the only mechanism for affecting the terms of trade (i.e., the price of imports in terms of exports). Under this assumption, it is easy to see why some people advocate a currency revaluation. A currency appreciation will make the Chinese goods more expensive in terms of the US goods. But what if prices in the aggregate are reasonably flexible? Then attempts to maintain an artificially low or fixed exchange rate will be offset by the changes in the domestic price levels. A differential inflation will be observed and the country for which the terms of trade are appreciating will exhibit a lower inflation rate. That is precisely what happened in China. Prior to the fixing of the exchange rate, China’s inflation rate was much higher than that of the United States. In the aftermath of the fixing of the exchange rate, the Chinese inflation converged to that of the United States and in the years prior to the unhinging it had been slightly lower than the US inflation. This is exactly what the price flexibility hypothesis predicted. Also, if the price level adjusts to reflect the terms of trade, exchange rate manipulations will not affect the terms of trade; they will only affect the country’s differential inflation rate.

A very important point is that when the exchange rate system is fixed, the domestic prices adjust to reflect the changes in the terms of trade. Deliberate changes in the exchange rate are not needed to bring about changes in the terms of trade. The impact of deliberate changes in the exchange rate will only produce an increase in the inflation rate differential. The reverse is also true as China showed. A peg will produce a convergence of the inflation rate to that of the reserve currency country.

The Chinese central bank engineered a sharp drop in Yuan market interest rates by flooding the banking system with cash. The move is seen by some as aimed at reducing the demand for the Yuan and to keep it from strengthening. Yet we know what the long-term impact of excess domestic money creation is, either a balance of payment deficit and/or domestic inflation. Neither of these two outcomes bodes well for China. It was quite recently that people used to talk about China having such a large amount of international reserves, close to 4 trillion dollars, that it could pursue an independent monetary policy. The United States thought the same thing during the Bretton Woods years. Both countries have learned a lesson. The United States had to close the gold window because it was losing reserves at too rapid a pace. The same thing recently happened to China when it lost close to 700 billion dollars in a short span of time.

The move by the Chinese to a managed float of its currency was hailed as one that will allow China to modernize its financial system. The liberalization would allow for the development of currency derivative products, or so the advocates of the float say. However, once one thinks about it, it is a silly argument. The derivatives, such as forwards and swaps, are designed to protect companies from adverse swings in currency exchange rates. Isn’t that precisely what the fixed rate delivered? The need for these derivative products exists now because of the uncertainty introduced by the floating exchange rate system. To make matters worse, we know that the derivatives are tough to regulate. We also know that the Chinese government will not give up its right to regulate and manipulate the market as it wishes. We believe that the new exchange rate system has resulted in a more distorted Chinese economy where the true market signals will be more difficult to discern.

The unhinging of the Yuan allows the inflation rate to diverge across countries for reason other than the terms of trade. The inflation rate differentials become a major source of exchange rate movements. But more than that, the expectations of the spikes in the underlying inflation rate leads investors to attempt to avoid the inflation spikes either through derivative product or through pure and direct currency substitutions (i.e., domestic money holders’ shift out of the local currency into the foreign currencies). In short, the currency substitution adds another source of demand shifts that if managed incorrectly by the central bank could lead to explosive inflationary bouts with little or no apparent domestic money growth or in a command and control economy it will result in additional regulations, capital controls etc. The central bank response is not known for certain in the economy and its actions may trigger a different response in the demand for money, which if not anticipated will lead to fluctuations in the underlying inflation rate. It is even worse in the case of a nonreserve currency; there will be substitutions on the demand side. The unhinging of the exchange rates leads to more instability of the demand for money and greater volatility in the exchange rate. Also, people do not know with precision the intervention rule with regards to the reference basket of currencies. The forecasting errors on the part of the private sector or the central bank may, under some circumstances, lead to perverse responses that inevitably lead to runs on the currency and spikes on the underlying inflation.

The lack of a fixed exchange rate discipline will now free the central bank to pursue goals other than fixing the exchange rate (i.e., importing the US inflation rate). Although we think Sir Alan was the best central banker of his generation, we would be remiss if we don’t mention that many of the US financial crises have coincided with Sir Alan departing from the price rule. If the Chinese central banker is not as good as Sir Alan, what makes the Chinese think they can do better? Remember that the United States went through a decade of high inflation that at times reached double-digit rates in the aftermath of the dismantling of Bretton Woods.