April 08, 2007	Sunday	Rabi-ul-Awwal 19, 2007

WASHINGTON, April 7: Changes in real exchange rates can play a helpful role alongside the rebalancing of demand in the adjustment of global imbalances, says an IMF report released with its semi-annual World Economic Outlook.

The report notes that a real depreciation of the US dollar and real appreciations of currencies of countries with current account surpluses could facilitate the narrowing of imbalances by reducing the output costs that may otherwise occur during the adjustment period because of demand shifts.

The US trade balance may be more responsive to real exchange rate movements than often assumed, the report adds.

The report points out that responsiveness of trade to changes in the real exchange rate is greater the more flexible the economy.

According to the IMF, movements of real exchange rates can help smooth the rebalancing of demand involved in the narrowing of external imbalances.

An analysis of 42 episodes of large and sustained reversals of current account deficits over the past 40 years suggests that advanced economies have experienced less of a reduction in GDP growth when their currencies experienced a relatively large depreciation.

In addition to movements in real exchange rates, domestic policies matter for external adjustment. In particular, historical evidence suggests that increases in saving rates and strong fiscal consolidation in deficit countries have allowed investment and growth rates to be better sustained during the adjustment period.

For both advanced and emerging market countries, reversals of external surpluses have tended to involve real appreciations of their currencies. Moreover, the narrowing of surplus positions has generally been accompanied by a pickup in domestic demand, associated with more expansionary monetary and fiscal policies.

The US trade balance may be more responsive to changes in the real value of the US dollar than often assumed. Standard empirical trade models tend to underestimate US trade volume responses to real exchange rates as they fail to account for large differences in response across sectors, and for the degree to which imports embody domestically produced intermediate products.

Moreover, long-run US trade price elasticities have tended to increase over time, reflecting greater competition among firms in an increasingly globalised economy.

Specifically, the report finds that a real US dollar depreciation of less than 10 per cent could bring about a one per cent of GDP narrowing in the US trade deficit. This compares to estimates commonly found in the economics literature that a 10–20 per cent real dollar depreciation would be needed for such a reduction in the trade deficit.

The IMF report said any slowdown in the US economy can exert spillovers in both advanced and developing countries, especially to those with strong trade ties to the United States.