Avoiding overvaluation of the currency has been one of the most monitored factors in economic growth. Easterly (2005) noted that large over-valuations have an adverse effect on growth. Overvalued exchange rates are associated with results that are damaging to economic growth like shortages of foreign currency, rent-seeking and corruption, unsustainably large current account deficits, balance-of-payments crises, and stop-and-go macroeconomic cycles.
This paper argues that as overvaluation hurts growth, undervaluation facilitates it especially in developing countries. An increase in undervaluation boosts economic growth just as well as a decrease in overvaluation. For China, for example, the rapid increase in economic growth starting in the second half or the 1970s and the 1990s is very closely tracked by the increase in the undervaluation index. This is similar to India, Uganda and Tanzania. On the other hand, the economic slowdown of South Korea and Taiwan in recent years was associated with growing overvaluation or reduced undervaluation. On the other hand, the Mexico case is an exception in that the relationship of growth and undervaluation turned out to be positive as periods of capital inflows were associated with consumption-led growth booms and currency appreciation.
Undervaluation and growth: the evidence
To conduct an empirical analysis, the following time-varying index of real exchange rate undervaluation based on Penn World Tables data on price levels was set:
lnRERit = ln(XRATit/PPPit)
where XRAT = exchange rates, PPP = PPP conversion factors, i = country, t = time. When RER>1, the value of the currency is lower than is indicated by the PPP
This captures the relative price of tradables to non-tradables, adjusting for the Balassa-Samuelson effect. RER was regressed on per-capita GDP. By adjusting for the Balassa-Samuelson effect, it is observed that when incomes rise by 10%, real exchange rates appreciate by 2.4%. The final index is taken by taking the difference between the actual RER and the Balassa-Samuelson-adjusted rate. It takes the relative price of tradables to non-tradables into account and it is adjusted for the fact that richer countries have higher relative prices of non-tradables.
The baseline panel evidence
After assessing the relationship between undervaluation and growth was estimated, results show that the two have a systematic positive relationship (undervaluation is associated with a contemporaneous growth boost) and that the growth impact of undervaluation depends on a country’s level of development. The results are tested for robustness for outliers, different real exchange rate measures and additional covariates. A cross-section regression was also run and it was found that the central finding on undervaluation is robust.
Causality is hard to establish because most governments pursue policies that affect the real exchange rate. The real exchange rate may respond to such policies and other shocks. However, it is still argued that the causality runs from undervaluation to growth (but the converse is not true).
By looking at cross-national evidence – at countries that have experienced notable growth – it was observed that countries that managed to engineer economic growth were supported by undervalued currencies. Using standard panel regressions, undervaluation was observed to work its positive impact on the share of tradables in the economy. Also, using two-stage panel growth regressions, the effects of real exchange rate on growth operate through the associated changes in the size of tradables. Hence, developing countries that find ways of increasing the relative profitability of their tradables are able to achieve higher growth.
The importance of the real exchange rate
Two theories are presented to determine the precise mechanism through which an increase in the relative price of tradables increases growth.
1. Tradables are "special" because they suffer disproportionately from the institutional weakness and contracting incompleteness that characterize low-income environments.
This argument focuses on the weaknesses in the contracting environment. Poor institutions keep incomes low and create low private appropriability of returns to investments. Empirical studies have shown that such problems are more severe in tradables than in non-tradables as: 1) lower quality institutions are associated with smaller ratios of trade to GDP; 2) more institution-intensive tradables are prone to larger effects; and 3) institutional weakness interacts with contract-intensity of goods to play a role in determining comparative advantage.
2. Tradable are "special" because they suffer disproportionately from the market failures that block structural transformation and economic diversification.
This view focuses on market failures[1] in modern, industrial production. Such market failures are arguably more pronounced in the tradables sector where economic development and new lines of production (those needed to increase economy-wide productivity than in traditional ones) are encouraged. First best policy would consist of identifying distinct market failures and applying the appropriate remedies. As tradables are affected disproportionately by pre-existing distortions, real exchange rate depreciations can be good for growth; undervaluation in effect becomes a substitute for industrial policy.
Model of real exchange rates and growth
A simple growth model is developed in which tradable and non-tradable sectors both suffer from economic distortion. When the distortion in tradables is larger, the size of the tradable sector is too small in equilibrium. A policy that can induce a real exchange rate depreciation would promote growth.
Sustained real exchange rate depreciations increase the profitability of investing in tradables, and act in second-best fashion to alleviate the economic cost of these distortions. That is why episodes of undervaluation are strongly associated with higher economic growth. This is similar to the conclusion of Prasad, Rajan, and Subramanian (2007). Fast-growing developing countries have tended to run current account surpluses rather than deficits. This contradicts the view that developing countries are limited by external finance, and with the presumption that capital inflows add to domestic saving and enable more rapid growth. They also noted that capital inflows appreciate the real exchange rate and impede growth through reduced investment incentives in manufactures.
Quantitative estimates reveal that an undervaluation of 20% produces a growth boost of 0.4 percentage points. The promotion of growth depends on the size of the gaps between social marginal products in tradable and non-tradable sectors. These gaps may be large since there is a long tradition of dualism in developing countries which takes the continuance of large differentials between marginal products in the advanced parts of the economy and marginal products elsewhere as the essence of underdevelopment.
The model demonstrates that changes in relative prices can induce growth and that real exchange rate is a policy variable. Freund and Pierola (2008) suggested that currency undervaluations is important because it compels producers from developing countries to enter new products and new markets, and that seems to be the primary mechanism through which they generate export surges.
Governments have a variety of instruments to influence the real exchange rate level. Maintaining a more depreciated real exchange rate requires higher saving relative to investment, or lower expenditures relative to income. This can be achieved through a surplus via a fiscal policy, incomes policy (redistribution of income to high savers through real wage compression), saving policy (compulsory saving schemes and pension reform), capital-account management (taxation of capital account inflows, liberalization of capital outflows), or currency intervention (building up foreign exchange reserves).
There is some systematic evidence[2] showing how policy choices affect real exchange rate and undervaluation. When a measure of undervaluation (UNDERVAL) is regressed on variables of terms of trade, government consumption, capital account liberalization, and a set of dummy variables it is observed that positive terms-of-trade shocks affect undervaluation negatively. Meanwhile, increases in government consumption and policies that liberalize the capital account cause the real exchange rate to appreciate.
Opening up the capital account invites inflows and causes the real exchange rate to appreciate. The results of the exchange-rate regimes dummies relative to fixed-rate regimes suggest that actively managed regimes like crawling pegs or managed floats produce currencies that are more undervalued than fixed rate regimes. Periods where the currency is in free fall are found to be good while a pure float does not generate significant levels of undervaluation. It was further detected that high saving facilitates undervaluation while the reverse is true for FDI investments. Also, the level of inflation is strongly associated with currency undervaluation. All these show that policy choices suggested by economic logic do matter.
Maintaining high real exchange rates triggers a surplus or a smaller deficit on the current account. If all developing countries follow the outlined strategy, advanced countries would have to put up with the corresponding deficits. Moreover, when some developing countries follow this strategy while others do not, the latter will incur a larger growth penalty as their traded sector shrinks even further under the weight of competition.
Eliminating the institutional and market failures would eradicate policy dilemmas. However, this is not plausible as recommending this strategy is like telling developing countries that the way to get rich is to get rich. Instead of subsidizing indirectly through the real exchange rate, a more practical approach might be to subsidize tradables production directly. Note that a depreciated real exchange rate is equivalent to a production subsidy plus a consumption tax on tradables. Production subsidy of tradables achieves the first without the second; it avoids the spillovers to other countries. This supports exports and imports simultaneously and therefore need not come with a trade surplus.
Fine-tuning production subsidies to address perceived distortions would require a complex industrial policy, with all the attendant informational and rent-seeking difficulties. Also, the strategy would come into conflict with existing WTO rules that prohibit export subsidies. With these constraints, it appears that there is no easy alternative to exchange-rate policy.
Source:
Rodrik, Dani, “The Real Exchange Rate and Economic Growth” Harvard University (September 2008).
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