Reference no: EM132242552

With regards to current event analysis about Tariffs, summarized the following paragraphs;

The determinants of real exchange rate disrupting trade rules

There is a theoretical discussion on what are the variables behind the determination of long-run fundamentals. An older literature dates back to the work of Edwards (1987) and Dornbusch (1976). The first analyzes on the so-called Economy of Misalignment, its causes and consequences, and the second is a classic model of flexible exchange rates where monetary policy shocks cause variations beyond the long run fundamentals (PPP - Purchasing Power Parity). The works of Bilson (1979) and Mussa (1976) are also classics in the literature and include the so-called Monetary Approach to exchange rate. Under this approach, the exchange rate would be determined primarily due to the relative evolution of output and money supply across countries, assuming the continuing validity of purchasing power parity and uncovered interest parity (UIP), as well as a stable money demand in the countries. The work of Meese and Rogoff (1983) cast doubt on the explanatory power of this theory. Stein (1995) proposes the approach of the natural rate of exchange (NATREX). According to the author, the equilibrium exchange rate is the one that equals the level of savings to the level of investment generated by the economic fundamentals. A more recent discussion in the misalignment literature is presented by Williamson (1994). The concept of equilibrium exchange rate is the one that allows the country to maintain a determined deficit or surplus (seen as sustainable) in the current account. This is the Fundamental Real Exchange Rate Approach - FRER. Another more recent reference to this approach is Cline (2008). Cline and Williamson (2010, 2011, 2012), are calculating FRERs for many countries and publishing the results site of the Peterson Institute. One problem with this approach has to do with the subjectivity included in choosing the target level of current accounts. Moreover, this kind of approach focuses exclusively on flows and not on stocks. Faruqee (1995) tries to incorporate issues related to the evolution of stocks and builds an economic model which allows an interaction between flows and stocks. In this way, he shows that there must be a stable relationship between real exchange rate and the net external position of liabilities between residents and nonresidents. This is the Behavioral Real Exchange Rate Approach (BRER). Alberola, Cervero et al. (1999) developed an empirical exercise to estimate exchange rate misalignment using fundamentals suggested by Faruqee. Kubota (2009) builds an economic model where the representative agent maximizes the inter-temporal consumption and accumulates capital. Under this model, the real exchange rate is also a function of terms of trade, net external position, and relative productivity of tradable and non-tradable sectors. This is the approach used by FGV in its estimation of misalignments.

This methodology seeks to reduce the existing degree of subjectivity in the estimation of exchange rate misalignment by connecting the real exchange rate to a set of fundamentals obtained from some theoretical model and decompose the actual real exchange rate series and the fundamentals in transitory and permanent components, using time series econometric techniques.

The issue of exchange rate misalignments is flooding newspapers as currency wars menace is leading to trade wars. This discussion is being held not only at the G 20 but also at the IMF and at the WTO. Now it is finding its way into the negotiations of the mega-blocks of preferential trade agreements led by the US and the EU.  

The real problem is how the significance and persistence of these misalignments are distorting not only trade rules but also financial rules. In other words, whether exchange rate misalignments are affecting the objectives of trade and financial policies and neutralizing the efficiency of their instruments.  

In terms of trade, for the last seventy years, countries constructed an international forum the GATT, latter the WTO to negotiate rules to enhance transparency and predictability for international trade. The main objective of the GATT and WTO is to liberalize international trade and to establish a binding regulatory framework for all its members, where conflicts could be settled at the “juridical-diplomatic tribunal” of the organization.

The origin of the problem can be traced back to the creation of the Bretton Woods System in the 1940´s with the functional distinction between the GATT and the IMF. The GATT was created to be responsible only for trade and the IMF for exchange rates and balance of payments practices. At the time, the system worked under the dollar and gold standard regime. However, even after the implosion of this system, only the IMF was adapted to face different exchange rate regimes. The GATT and the WTO remained silent and paralyzed facing this revolution, pretending that the trade system could survive this tectonic shift.

With the advent of China in the international arena, as a new economic power and the world’s biggest exporter of goods, and its influence on the currency of almost all ASEAN area countries, the exchange rate issue has been globalized and is affecting directly the international trade policy of all trade partners. For the WTO, the only rule linking trade and exchange rate, since 1948, has been GATT Article XV. It states that: “Contracting parties shall not, by exchange action, frustrate the intent of the provisions of this Agreement, nor, by trade action, the intent of the provisions of the Articles of Agreement of the International Monetary Fund”.

No member has ever had the initiative to contest the practice of another member under this article. To solve the issue, several proposals for the use of trade remedies, such as anti-dumping and countervailing measures to offset the exchange rate effects have been discussed (. But again, no member has so far applied them as an instrument to neutralize the use of exchange rates as unfair trade, although some discuss it in the US.

Considering the extent and persistence of the last couple of years’ exchange rate misalignments, and their effects on trade, the pressure is mounting for the negotiation of some kind of solution. Discussions were held in the G-20, the IMF, and the WTO, but nothing has yet been achieved.  

If the exchange rate is a new issue for lawyers, it is an old one for economists. It is worth noting that the concept of currency antidumping was already proposed by Australia to be included in the Draft of the Havana Charter as it is shown on the Report of the Drafting Committee of the Preparatory Committee of the United Nations Conference on Trade and Employment (UN ECOSOC, E/PC/T/34 of March 5th, 1947). This proposal attempted to include four kinds of dumping: price, freight, currency and social dumping. Nowadays, economists are consolidating considerable academic production, indicating the extent of the problem. There are different methodologies to calculate the equilibrium exchange rates and the exchange rate misalignments of the main currencies: the purchasing power parity, the equilibrium of the current account, the equilibrium of stocks of net foreign assets and liabilities of a country, or the exchange rate based on the unit of labor costs.

These studies present a great variety of results because they have different objectives. For the WTO, the perfect accuracy of the exchange rates misalignment estimates is not relevant. The main point is to find out a threshold, a limit of a band of fluctuation, from where trade policy instruments become ineffective. This happens when the impacts of exchange rates nullify the efficacy of the rules negotiated in the trading system over the last six decades.

The FGV Observatory on Exchange Rate has presented in this paper the impacts of exchange rates on tariffs. It is currently analyzing their effects on trade remedies, such as anti-dumping and countervailing measures, conceived to protect countries from unfair trade, and safeguard measures, which deal with import surges considered to be fair. The preliminary results are alarming and will be published in the near future.

The analysis of preferential rules of origin, a core issue for all bilateral and regional trade agreements, which are widely spreading nowadays, would also be providential. It would be relevant to analyze how exchange rate misalignments would affect not only the objective to eliminate all tariff barriers among the parts as also the concept of the rules of origin based on value added. Another relevant question to be studied would be the effects of misalignments on the already implemented Quota Free and Duty-Free Initiative. Are the desired zero barriers being really achieved?