Commodity peg to export price vs peg to import price

Jeff Frankel examined the impact of commodity price and menetary policy. He proposed to "Peg the Export Price" (PDF, HTML)
  • This idea is a much moderate version of a more exotic-sounding proposed monetary regime that I have written about elsewhere, called Peg the Export Price – or PEP, for short. I have proposed PEP explicitly for those countries that happen to be heavily specialized in the production of a particular mineral or agricultural export commodity. The proposal is to fix the price of that commodity in terms of domestic currency, or, equivalently, set the value of domestic currency in terms of that commodity. For example, African gold producers would peg their currency to gold – in effect returning to the long-abandoned gold standard. Canada and Australia would peg to wheat. Norway would peg to oil. Chile would peg to copper, and so forth. One can even think of exporters of manufactured goods that qualify: standardized semi-conductors (that is, commodity chips) are sufficiently important exports in Korea that one could imagine it pegging to the won to the price of chips.

    How would this work operationally? Conceptually, one can imagine the government holding reserves of gold or oil, and intervening whenever necessary to keep the price fixed in terms of local currency. Operationally, a more practical method would be for the central bank each day to announce an exchange rate vis-à-vis the dollar, following the rule that the day’s exchange rate target (dollars per local currency unit) moves precisely in proportion to the day’s price of gold or oil on the London market or New York market (dollars per commodity). Then the central bank could intervene via the foreign exchange market to achieve the day’s target. Either way, the effect would be to stabilize the price of the commodity in terms of local currency. Or perhaps, since these commodity prices are determined on world markets, a better way to express the same policy is stabilizing the price of local currency in terms of the commodity.11 The PEP proposal can be made more moderate, and more appropriate for diversified economies, in a number of ways.12 One is to interpret it as targeting a broad index of all export prices, rather than the price of only one or a few export commodities. This part of the paper proposes targeting just such an export price index. This moderate form of the proposal is abbreviated PEPI, for Peg the Export Price Index.13 The argument for the export targeting proposal, in any of its forms, can be stated succinctly: It delivers one of the main advantages that a simple exchange rate peg promises, namely a nominal anchor, while simultaneously delivering one of the main advantages that a floating regime promises, namely automatic adjustment in the face of fluctuations in the prices of the countries’ exports on world markets. Textbook theory says that when there is an adverse movement in the terms of trade, it is desirable to accommodate it via a depreciation of the currency. When the dollar price of exports rises, under PEP or PEPI the currency per force appreciates in terms of dollars. When the dollar price of exports falls, the currency depreciates in terms of dollars. Such accommodation of terms of trade shocks is precisely what is wanted. In recent currency crises, countries that suffered a sharp deterioration in their export markets were often eventually forced to give up their exchange rate targets and devalue anyway; but the adjustment was far more painful -- in terms of lost reserves, lost credibility, and lost output -- than if the depreciation had happened automatically.

    The desirability of accommodating terms of trade shocks is a particularly good way to summarize the attractiveness of export price targeting relative to the reigning champion, CPI targeting. Consider the two categories of adverse terms of trade shocks: a fall in the dollar price of the export in world markets and a rise in the dollar price of the import on world markets. In the first case, a fall in the export price, you want the local currency to depreciate against the dollar. As already noted, PEP or PEPI deliver that result automatically; CPI targeting does not. In the second case, a rise in the import price, the terms-of-trade criterion suggests that you again want the local currency to depreciate. Neither regime delivers that result. But CPI targeting actually has the implication that you tighten monetary policy so as to appreciate the currency against the dollar, by enough to prevent the local-currency price of imports from rising. This implication – reacting to an adverse terms of trade shock by appreciating the currency – seems perverse. It could be expected to exacerbate swings in the trade balance, and output.

A couple comments on Frankel's proposal
  • An anchor as Frankel proposed basically a controlled "free floating", i.e. taking a few of the most important market drivers and actively manage the "peg" accordingly, mimicing what free float would do, but excluding market drivers which are not in the 'recipe'. The effect is, the currency would appreciate when the demand for one's export is high and vice versa.
  • The benefit is that it provides a relatively objective measure for the exchange rate, so that speculation factors are partially excluded (speculators cans still indirectly bet on the underlying commodity, but that would be much less efficient as it impacts a lot more countries)
  • When the 'peg' is controlled, overshoot (such as 1997 Thai Baht) can be avoided
  • However, with every benefit it comes with a price. In this case, the anchoring and hence the unfriendliness/inconvenience for speculation would also mean that the currency regime would become "metastable" as market hedging is more difficult -- but this is a minor inconvenience as one can still speculate/hedge even on a fixed peg (e.g. non-deliverable forward for RMB)
  • That commodity price (or a basket of commodity index) is chosen as the proxy is simply because it is standardizable and tradable (and that it is a 'fundamental' price driver). There is no theoretical (only pratical/technical) hurdle to pegging to the price of T-shirts, furniture, computers or anything that sells in Walmart (and "made in China"). However, these are 'secondary products' and the prices are dirven by that of more fundamental cost drivers such as commodity, energya nd labor. In an ideal model one could take everything a country exports minus everything it imports. However, for an anchor only a selection is good enough (and at least better than the more arbitrary peg to USD or some currency basket).
Frankel also commented on the issue of "peg-to-import-price"
  • But for a country that is a net importer of oil, wheat, and other mineral and agricultural commodities, such a peg gives precisely the wrong answer in a year when the prices of these import commodities go up. Just when the domestic currency should be depreciating to accommodate an adverse movement in the terms of trade, it appreciates instead. Switzerland should not peg to oil, and Norway should not peg to wheat.
This deserves some discussions.

While Frankel made a generally good argument on the disadvantage of pegging to the import price, it is for a simple economy prior globalization. In today's world the matter seems to be a lot more complicated. For example, the oil and steel China imports are largely re-exported, both directly as products (hammers & nails, plastic toys) and indirectly (the machine and buildings that house the factories, and the power consumed by the manufacturers). Therefore, to determine whether an item (commodity in this case) should be present in the peg basket we should need to look at the overall export and import flow together.

If fact, peg-to-export may not be a good proxy to use for countries which re-export is a major component in its GDP. e.g. Singapore exports a lot of refined petroleum and petrochemical products. But it is unclear if Singaporean Dollar should be pegged to the price of petrochemical products for this reason. It would make more sense, if there is a system where Singapore's petrochemical industry would realize its value-added more or less unaffected by the short term fluctuation in oil price. This could be achieved if both the import price of its raw materials and export price of its products could somehow be linked. It could be achieved if Singapore Dollar is related to the price of oil and the petrochemical products it re-exports. Of course, Singapore has a lot more industries, and oil should only be one component of its basket. Moreover, Singapore is a small country, with signifcant value of its GDP in tertiary industry (IT, service, etc) the complexity for operating an elaborate commodity peg may not be as viable as a simple currency basket peg as it uses today.

For China, being a much large country, currency may present an new problem. Because its economy is so large that it affects the value of the currency it pegs onto. This is the main complain from the US. IMO China's currency reform is necessary not because of the trade imbalance. It is the responsibility of US itself to solve its imbalance problem. But China should not (unintentionally) prevent USD from depreciating against other currencies in the world through the RMB peg. Therefore, there are reasons for China to peg its currency to something other than other countries' currencies.

The most convenient choice, as Frankel proposed, the commodity peg. The commodities China can choose are 1) what it exports 2) what goes through in its process/re-export industry.

Since China today is a net importer for most commidities (both agricultural and industrial), (1) does not work. What China exports is actually semi-skilled labor, and China is the largest exporter of labor in the world. China is, therefore, the largest factor in determining the price of semi-skilled labor. Its currency rate affects the pricing of its primary export. Therefore, even if we can standardize the price of semi-skilled labor, it still does not qualify as a content of the RMB peg. Because, it is not independent enough to act as a measure for practical purpose, otherwise we are entering into a loop of circular formula.

As a result, we are left with only option (2). Therefore, if China is to peg its currency to a basket of commodities, the rationale will be to make the cost of its re-export transparent to its economy, or in other words, a currency that automatically hedges against the change in raw material costs. Following this rationale, the content and respective weight of the commodity basket can be determined.

Note: the implementation: Frankel offer some guideline in this paper. You can also see my earlier post on commodity basket.

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