Exchange Rate Regimes and

competitiveness
The case of Greece


Dimitris Routos









Trade and Economic Integration in Eastern
and South-Eastern Europe

Exchange rate Regimes & Competitiveness - Routos 2

CONTENTS

Abstract 3
Introduction 4
Exchange rate regime and competitiveness 5
The case of Greece 7
Conclusions 15
References 16

















Exchange rate Regimes & Competitiveness - Routos 3



ABSTRACT
The optimal choice of an exchange rate regime is often connected with inflation
expectations, output growth, and economic integration. The impact of the
exchange rate regime on the competitiveness of a country, although
controversial, is considered to be a major factor in this respect. The case of
Greece is portrayed as an example regarding the consequences of either a
floating exchange rate regime or a fixed one, on the competitiveness of the
country towards its trading partners and the rest of the world. The adoption of
the Euro as Greeces national currency, affected its ability to intervene through
monetary measures in order to fix the balance of trade disequilibria, and
deteriorated its export performance during the last decade.
















Exchange rate Regimes & Competitiveness - Routos 4

INTRODUCTION
Exchange rate regimes can be categorized in three major groups: a) fixed or pegged
exchange rate regimes, where a currency's value is fixed against the value of another single
currency or to a basket of other currencies, or to another measure of value, such as gold, b)
flexible or floating exchange rate regimes, where the value of a currency against other
currencies is determined by the market forces of supply and demand, and c) managed
floating exchange rate regimes, that are hybrids of fixed and floating exchange rate regimes.
The choice of an exchange rate regime is directly associated with country-specific
characteristics. Three competing approaches in the relevant literature explain the choice of
an exchange rate regime and underline those characteristics: The optimal currency area
(OCA), the financial view, and the political view. According to the OCA theory, the choice of
the exchange rate regime is related with the countrys size, trade links, openness, and the
kind of shocks that the country is vulnerable to. The financial view is concentrated on the
consequences of international financial integration, while the political view interprets the
choice of an exchange rate regime as a buffer in the absence of nominal and institutional
credibility.
1

The concept of competitiveness as applied to economies has no clear or agreed definition
among scholars. Still less is there any consensus regarding the factors that contribute to
national competitiveness. Nevertheless improving a nations competitiveness is frequently
presented as a central goal of economic policy and in this respect the following definition by
OECD (OECD, Technology and the Economy: the Key Relationships, 1992) can describe the
outlines of the term: "Competitiveness may be defined as the degree to which, under open
market conditions, a country can produce goods and services that meet the test of foreign
competition while simultaneously maintaining and expanding domestic real income". What
would be the characteristics of a competitive economy are described in the EU report
European Competitiveness Report (2000) as follows: An economy is competitive if its
population can enjoy high and rising standards of living and high employment on a
sustainable basis. More precisely, the level of economic activity should not cause an
unsustainable external balance of the economy nor should it compromise the welfare of
future generations.
The impact of the exchange rate regime on competitiveness and economic development of a
country was extensively debated during the last fifty years. One general understanding is
that the nominal depreciation of the currency of a country with a floating exchange rate
supports its competitiveness in the short-term by making its exports cheaper. However
there are other factors that can neutralize the short-term effects of a nominal depreciation
such as, rise in the prices of imported goods, inflation pressures, wages and inflation
expectations. These factors are playing a decisive role in small open economies, with limited

1
Levy-Yeyati Eduardo, Sturzenegger Federico, and Reggio Iliana (2009), On the Endogeneity of Exchange Rate
Regimes, European Economic Review V. 54 No. 5 (2010) pp. 659677.
Exchange rate Regimes & Competitiveness - Routos 5

opportunities for implementing autonomous monetary policies. Therefore in the medium
term the nominal depreciation of the currency does not lead to a sustainable improvement
of competitiveness.
2
In this respect McKinnon (1963) argued that a floating exchange rate
regime is desirable if a nations exports are limited to one or few goods, while a pegged
regime is chosen if tradable goods represent a large proportion in a nations GDP.

EXCHANGE RATE REGIME and COMPETITIVENESS
Earlier studies on the difference between floating and pegged exchange rate regimes are
based on the external shocks, and the OCA theory. More recent approaches focus on the
trade-off between flexibility and credibility, or the economic performance and currency
crisis.
In the classical literature the choice is portrayed as either completely fixed exchange rate, or
fully flexible. The general approach of the classical literature is that the prices of the
commodities are relatively sticky regarding exchange rates, thus shocks to the economy lead
to fluctuations in the economic activity. Major contributors to the classical exchange rate
literature are among others Friedman (1953), Fleming (1962), Mundell (1961, 1963),
McKinnon (1963), and Kenen (1969). Friedman argued that in the presence of sticky prices,
floating exchange rates would insulate the economy from foreign shocks, by allowing
relative prices to adjust faster. Mundell (1963), explored the role of capital mobility in the
choice of exchange rate regimes. Under this approach, the choice between fixed and floating
depends on the sources of shocks in an economy, whether they are real or nominal, and the
degree of capital mobility. In an open economy with high degree of capital mobility a
floating exchange rate provides insulation against real shocks, such as a change in the
demand for exports or in the terms of trade, because under a floating rate system the
exchange rate can adjust quickly and restores equilibrium, rather than requiring price level
changes. On the other hand, a fixed exchange rate is desirable in the case of nominal shocks
such as a shift in money demand, because money supply automatically adjust to changes in
money demand without interest rate changes or price level changes (Mundell, 1963;
Fleming, 1962). The assumption in Mundell Fleming framework is that capital mobility
implies international arbitrage across countries in the form of uncovered interest parity. And
the conclusion is that it is impossible to achieve simultaneously the three domestic goals:
exchange rate stabilization, capital market integration and independent monetary policy,
known as the impossible trinity. Also Mundell (1961) stressed the fundamentals of the
optimal currency theory (OCA), defining the characteristics of areas in which it is optimal to
adopt a single currency. The OCA approach weights out the trade and welfare gains from a
stable exchange rate against the benefits of exchange rate flexibility as a shock absorber in
the presence of nominal rigidities. According to OCA theory, the advantages of fixed
exchange rates increase with the degree of economic integration among countries.

2
See: Rose A. (1999); Klein M. & Shambaugh J.(2006); Adam C.& Cobham D. (2007).
Exchange rate Regimes & Competitiveness - Routos 6

McKinnon (1963) focused on the criterion of the openness of an economy. He argued that
economic size and openness of an economy are the fundamentals for OCA theory, and that
small and open economies tend to adopt fixed exchange rate regimes than large and
relatively close economies. Also Kenen (1969) argued that product diversification in trade,
should be considered as a major determinant of whether a country should adopt a fixed
exchange rate regime, or not. He also argues that countries with very concentrated
production structures are more likely to adopt flexible exchange rates than countries with
diversified production.
Inflation and growth play an important role on a governments choice of exchange rate
regimes. Recent literature has attempted to explain the impact of exchange rate regimes on
economic performance. Ghosh et al. (1997) examine the effects of the exchange rate regime
on inflation and economic growth. Their results suggest that both the level and variability on
inflation is lower under fixed exchange rates than floating ones. Levy-Yeyati and
Sturzenegger (2001) demonstrate that developing countries with pegged regimes are
associated with lower inflation than developing countries under floating rates, but pegged
regimes are associated with slower growth. Rogoff et al. (2003) study the link between
exchange rate regimes and economic performance and according to their results, for
countries at a relatively early stage of financial development and integration, fixed regimes
appear to offer anti-inflation credibility gain without compromising growth objectives. On
the contrary, flexible exchange rate regimes seem to offer higher growth without any cost to
credibility for developed countries that are not in a currency union. Obstfeld and Taylor
(2002) link the evolution of exchange rate regimes to the various phases of financial
globalization, based on this impossible trinity argument. They argue that, while capital
mobility prevailed at a time when monetary policy was subordinated to exchange rate
stability (as in the gold standard), as soon as countries attempted to use monetary policy to
revive their economies during WWI, they had to impose controls to curtail capital
movements.
Another approach in modern literature has studied the use of the exchange rate as a
nominal anchor to reduce inflation. In particular, Giavazzi and Pagano (1988) argue that
governments with a preference for low inflation but facing low institutional credibility, in
order to convince the public of their commitment to nominal stability, may chose a peg as a
policy crutch to tame inflationary expectations. They also argue that countries with a poor
institutional track record may be more eager to rely on fixed exchange rate arrangements as
a second best solution to a commitment problem. As the argument goes, weak governments
that are more vulnerable to expansionary pressures (i.e., pressures from interest groups
with the power to extract fiscal transfers), may choose to use a peg as a buffer against these
pressures.
The variety of definitions regarding competitiveness not only among scholars but also
between national and international organizations dealing with its measurement,
demonstrates the ambiguity of the term. Prominent academics decline even its use as an
indicator of nations international performance and called it a dangerous obsession; it has
Exchange rate Regimes & Competitiveness - Routos 7

been also characterized as vague and ill-measured concept, while some argue that it is
productivity that matters for a nations international advantage, and not competitiveness.
3

Nevertheless as the rhetoric for competitiveness has become predominant among opinion
leaders throughout the world, arguments in favor of competitiveness as an indicator of
national competitive success are pervasive in the academic literature. Labor costs, interest
rates, exchange rates and economies of scale are considered to be the most influential
determinants of competitiveness. In terms of preconditions for the achievement of a
nations competitive advantage, four attributes are playing a decisive role: a) Factor
conditions, that is the nations position in factors of production, such as skilled labor or
infrastructure, necessary to compete in a given industry, b) Demand conditions, that is the
nature of home-market demand for products or services, c) Related and supporting
industries, that is the presence or absence in the nation of supply industries that are
internationally competitive, and d) Firm strategy, structure and rivalry, that is the conditions
in the nation governing how companies are created, organized, and managed, as well as the
nature of domestic rivalry.
4

The ideal indicator for measuring competitiveness has been a controversial issue among
scholars for more than a decade. Real Effective Exchange Rates (REER), and Unit Labor Costs
(ULC), are used more frequently for this purpose. Nevertheless other indicators such as
relative export prices are also used for competitiveness measurement.
5

THE CASE of GREECE
The options for choosing an exchange rate regime after WW II, were mainly determined for
Greece by international developments, particularly the choices of Western European
countries and the subsequent priorities of the political and economic leadership of the
country. Immediately after the war, the allied countries with the initiative of USA and the UK
established a new international monetary order, focusing on the dollar, with which other
currencies were pegged. This system, known as the monetary system of Bretton Woods,
managed to ensure international monetary stability for almost two decades. Greece
participated in this system in 1953. After the collapse of the Bretton Woods system in 1971,
Greece chose in line with other Western European countries a floating exchange rate
regime, up to 1997. Since 1998 Greece participated in ERM I and ERM II, while since January
1
st
2002 adopted the Euro as its national currency.
The period of the Bretton Woods system was for Greece a period of stability regarding
exchange rate fluctuations and the Drachma remained pegged with the US Dollar with its
initial rate 1 USD=30 drachmas (it must be noted that drachma devaluated 50% against the
US dollar, just before the participation of Greece in the Bretton Woods system). This

3
See: Krugman P. (1994); Thompson R. (2003).
4
Porter Michael (1990), The Competitive Advantage of Nations, Harvard Business Review, MarchApril 1990,
pp.73-91.
5
Ca Zorzi Michele, Schnatz Bernd (2007), Explaining and Forecasting Euro Area Exports- Which Competitiveness
Indicator Performs Best?, ECB Working Paper Series, No 833, November 2007.
Exchange rate Regimes & Competitiveness - Routos 8

remarkable stability was mainly derived from the fact that after the civil war of 1944-1949,
there were no pressures from any credible political opposition towards the alteration of the
economic and political goals of the elites. The adoption of the floating exchange rate regime
in Greece was simultaneous with the first oil crisis. Upon the announcement of the end of
the gold standard (end of the Bretton Woods system, August 1971), drachma remained in a
fixed parity with the US dollar (1 USD=30 drachmas), despite the fact that other Western
European countries created a new monetary mechanism known as the snake in the tunnel,
which allowed major European currencies to fluctuate 2,25% relatively the US dollar. Due
to the fact that the US dollar devaluated against the European currencies, Greece managed
to improve its current account balance as Greek tradable goods became cheaper compared
with those of its European trade partners. On the other hand, Greek economy suffered from
high rates of imported inflation, as imported goods became more expensive, and of course
due to the oil crisis effects. Therefore the fixed parity of drachma with the US dollar lasted
up to October 1973, when it started to fluctuate freely against all currencies after a 10%
revaluation. Since then and up to 1998, drachma entered in a period of continuous sliding
against major currencies, in an attempt to neutralize the negative consequences from huge
differences in the level of inflation in comparison with the European trade partners of
Greece.
6
In table 1 the de jure drachma devaluations are depicted.

DRACHMA DEVALUATIONS (and a revaluation)

1953 50% against USD (1USD = 30.000 GRD from 1USD = 15.000 GRD).
1983 15,5% against major currencies.


1985 15% against major currencies.


1998 12,3% against ECU. Drachmas participation in ERM. 1 ECU = 357 GRD.
1999 Drachma participates in ERM II. 1 = 353,11 GRD.


2000 3,5% revaluation against the Euro. 1 = 340,75 GRD.


Table 1
Devaluations of the Greek drachma were used extensively during the 80s and 90s, as a tool
for fixing the disequilibria in the balance of trade. In the period April 1981 December
2000, drachma devaluated (either de jure or de facto) against the US dollar and the
German mark, 714% and 709% respectively (figure 1).

6
. (2006), :
..., unpublished.
Exchange rate Regimes & Competitiveness - Routos 9


Source: Federal Reserve Bank of St. Louis, own calculations Figure 1
The main policy objective of the devaluation, apart from taming imported inflation, is to
improve the balance of payments performances through external competitiveness allowing
the nominal exchange rate to depreciate. The price ratio of tradable to non-tradable is a
method, which generally measures the internal competitiveness). Domestic price level has
substantial influence on RER. Increasing of domestic price level at a higher rate relative to
foreign price levels directly affects the RER in terms of appreciation of domestic currency in
real terms eroding the external competitiveness. Nominal devaluation in turn leads to
increase in the domestic price level (Hinkle and Montiel, 1999). As stated earlier, the main
objective of the devaluation or depreciation is to gain external competitiveness and balance
of payments improvement in an economy. Under this scenario the policy makers should face
certain dilemma in terms of increasing price level and eroding competitiveness under a
single policy variable if the pass-through of exchange rate is substantial (figure 2).
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Exchange rate Regimes & Competitiveness - Routos 10


Figure 2
The competitiveness of the Greek economy remained weak after WW II, regardless the
adoption of a floating or a fixed exchange rate regime. An indication of this argument is
shown in table 2. Greek exports as a percentage of GDP, never exceeded 25% on average for
various periods with different exchange rate arrangements.

Source: EU AMECO Database, Own Calculations Table 2
Measuring competitiveness of the Greek economy is an inherently difficult issue. Estimates
can differ, depending on whether competitiveness is measured on the basis of relative prices
or relative unit labor costs, on whether one uses nominal or real unit labor costs, on which
countries one compares Greece with and, finally, on the relative weight of each country in
the index. In addition to that measurement of competitiveness must be focused on the
export sector, i.e. tradable goods and services, not the whole economy, since a large part of
goods and services produced in the Greek economy are non-tradable due to the fact that
the Greek public sector is quite large. REERs for Greece either UCL based or CPI based, as
well nominal ULCs are presented in table 3. The differences occurred are due to different
methodologies and different base years.
Exchange Rate
Devaluation/Revaluation
Depreciation/Appreciation
Improvement/Deterioration of
Competitiveness
Exchange Rate Pass-Through on
Domestic Prices
Banance of Payments Results
EXPORTS as % of GDP
1953 1971 Bretton Woods. 10,48% (1960-1971 )
1972 1987 Free Floating. 19,12%
1988 1997 Hard drachma policy. 18,36%
1998 2001 Participation in ERM and ERM II. 23,27%
2002 2012 Participation in the Euro zone. 23,06%
Exchange rate Regimes & Competitiveness - Routos 11


Source: Eurostat Ameco database, Bank of Greece Table 3
The following analysis will be based on the CPI based REERs produced by Bank of Greece
because CPI based REERs are demonstrating in relative accuracy the competitive advantages
or disadvantages of the Greek economy. In order to quantify the competitiveness of the
Greek economy, the structure of the economy (proportion in GDP of the primary, secondary,
and tertiary sectors) must be taken into account. According to EU statistics the relative
numbers are 7%, 23,9% and 69%.
7
Moreover, it must be taken into account that exporters of
goods often face different competitors than exporters of services such as the tourist
industry. For example, Germany is one of the biggest export markets of Greek goods and
Greek exporters of industrial goods face fierce competition from German producers.
However, Germany is not a competitor for Greeces tourist industry because it offers winter
tourism, whereas Greece offers summer vacations. As a result, in measuring
competitiveness of Greek exports of industrial goods, Germany should have a large weight,

7
http://ec.europa.eu/agriculture/statistics/rural-development/2012/indicators_en.pdf
REERs and nominal ULCs
REER (ULC
based)
2005=100*
BROAD
REER (CPI
based)
2000=100**
EU REER (CPI
based)
2000=100***
NOMINAL
ULC ****
1995 101,3 N/A N/A 66,5
1996 100,9 N/A N/A 70,4
1997 100,6 N/A N/A 76,9
1998 100,3 N/A N/A 80,7
1999 99,5 N/A N/A 83,4
2000 98,0 100 100 85,0
2001 92,2 101,1 99,9 84,7
2002 98,9 103,7 101,5 93,3
2003 97,3 109,4 102,8 94,7
2004 98,6 111,5 103,7 96,8
2005 100 111,4 105,1 100
2006 97,4 112,2 106,3 98,9
2007 97,4 114 107,2 101,4
2008 97,6 116,8 108,1 106,6
2009 99,3 118,7 109,2 113,2
2010 99,2 118,1 112,6 113,1
2011 96,3 118,5 113 111,0
2012 88,2 114,6 112,1 104,1
* AMECO: REER, based on ULC (total economy)- Performance relative to the rest of 36 industrial countries: double
**BOG: REER Broad CPI based index, includes the 28 main trading partners of Greece
***BOG: REER EU CPI based index includes the rest 16 Euro area countries
****AMECO: Nominal unit labour costs: total economy (Ratio of compensation per employee to real GDP per person
employed).
Exchange rate Regimes & Competitiveness - Routos 12

while in measuring competitiveness of Greek services, Germany should have a low (in fact
zero) one. The opposite holds for Spain, or Portugal, which have a low weight in Greeces
manufacturing exports but are at the same time some of Greeces major competitors in
tourist services. Greece is one of the major European tourist destinations and the tourist
sector is Greeces biggest export industry. In contrast to the goods exporters,
competitiveness of exporters of services such as tourism may depend more on prices of
services in Greece relative to competitor countries than on relative ULCs. A tourist in Greece
does not care so much about how much personnel is paid in a Greek hotel, but he definitely
cares about how much one week of his stay in Greece will cost him relative to one week in a
similar tourist resort in Spain or Portugal. Therefore CPI based REERs are considered better
indicators for measuring the competitiveness of the Greek economy.
Since the adoption of Euro as Greeces national currency, the ability of autonomous
monetary policy has been abolished. Consequently, the Greek authorities had not in their
possession any more, a useful tool in order to intervene in monetary terms for fixing
disequilibria in the balance of trade. The deterioration in the REER Index is shown in figure 3,
relatively to 28 main trading partners and the rest Euro area countries, for the period 2000-
2012. Since 2001 we observe an acute deterioration, especially towards the 28 main trading
partners, which continues up to 2009. From 2010 a gradual reversal is being observed.

Source: Bank of Greece, Bulletin of conjunctural indicators 148, Jan-Feb 2013 Figure 3
The sharp deterioration in the competitiveness of the Greek economy is also clearly depicted
in figures 4, 5 & 6. In figure 4 it can be noticed that while from 1996 till 2000, there is a
positive trend in Greek exports as a percentage of GDP relative to three core Eurozone
countries (Germany, Austria and the Netherlands), since 2000 there is a negative downturn
which is being reversed in 2003, when a stagnation period follows up to 2008.
100
102
104
106
108
110
112
114
116
118
120
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
CPI based REER INDEX (2000=100)
Broad index (28
main trading
partners)
EU17 Index (the rest
16 EA countries)
Exchange rate Regimes & Competitiveness - Routos 13


Source: EU AMECO Statistical Database Figure 4
In a comparison of the Greek exports as a percentage of GDP with three Eurozone periphery
countries (Spain, Italy and Portugal) in figure 5, the convergence noticed from 1993 till 2000,
is reversed in 2000, a more sharp decline is depicted through 2003, and a relative
deterioration from 2004 up to 2008.

Source: EU AMECO Statistical Database Figure 5
15,00%
25,00%
35,00%
45,00%
55,00%
65,00%
75,00%
85,00%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
EXPORTS as % of GDP
Germany Greece Netherlands Austria
15,00%
20,00%
25,00%
30,00%
35,00%
40,00%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
EXPORTS as % of GDP
Greece Spain Italy Portugal
Exchange rate Regimes & Competitiveness - Routos 14

Finally in figure 6 the comparison of the Greek exports as a percentage of GDP relative to the
27 European countries and the 17 Eurozone countries shows the convergence period from
1996 up to 2000, the negative trend from 2000 till 2003, and the stagnation period from
2004 until 2008.

Source: EU AMECO Statistical Database Figure 6
Since 2009, the Greek exports as a percentage of GDP, follow an upside trend similar to the
one experienced by the rest Eurozone and EU27 countries. This is a result of the
improvement in the CPI REERs as shown in figure 3.






15,00%
20,00%
25,00%
30,00%
35,00%
40,00%
45,00%
50,00%
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
EXPORTS as % of GDP
European Union (27 countries) Euro area (17 countries) Greece
Exchange rate Regimes & Competitiveness - Routos 15

CONCLUSIONS
The choice of an exchange rate regime affects the international competitiveness of a
country. Greece was suffering from chronic disequilibria in its balance of payments.
Devaluation of the drachma was a cure to its well lasting imbalances up to 2000. Greeces
entrance into the EMU was based rather on political than economic criteria. It was clearly
evident that Greece in 2001 was lacking behind the rest of the EMU countries in terms of
economic development and convergence. Although considerable improvement had been
recorded in various economic indicators in the years preceding the entrance to EMU,
alarming signals of structural problems in the Greek economy were present. Upon the
adoption of the Euro as its national currency, and the subsequent abolition of an
independent monetary policy, its competitiveness towards its trading partners both in the
EU, and internationally worsened. Although EMU joining decision was cheerfully celebrated
in Greece, it concealed the need for an incremental adjustment of the Greek economy in the
years following the accession, due to the fact that it was not adequately reformed, before
adopting the Euro as its national currency. Greek political and economic elites proved to be
incapable in imposing the needed reforms that would enable Greece to experience
sustainable growth along with fiscal discipline and social prosperity. The inability of the
Greek elites to impose these necessary reforms for the Greek economy and society is the
main cause for todays problems.












Exchange rate Regimes & Competitiveness - Routos 16

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