The paramount policy dilemma that emerging markets face nowadays is this: on the one hand, sustained economic growth requires a competitive (read “undervalued”) currency. On the other hand, any good news is immediately followed by currency appreciation, making the task of remaining competitive that much harder.
So, you finally passed that crucial piece of legislation? Your fiscally responsible political party just won the election? Or your commodity exports hit the jackpot? Good for you! But the currency appreciation that follows will likely set off an unsustainable consumption boom, wreak havoc with your export sector, create unemployment, and sap your growth potential. Success brings its reward in the form of immediate punishment!
In response, central banks may intervene in currency markets to prevent appreciation, at the cost of accumulating low-yield foreign reserves and diverting themselves from their primary goal of price stability. This is the strategy followed by countries such as China and Argentina.
Or the central bank lets the markets go where they will, at the cost of drawing the ire of business, labor, the rest of the government, and, in fact, practically everyone except financial types. This is the strategy pursued by countries such as Turkey and South Africa, which have adopted more conventional “inflation targeting” regimes.
The first strategy is problematic because it is unsustainable. The second is undesirable because it buys stability at the cost of growth.
The importance of a competitive currency for economic growth is undeniable. Virtually every instance of sustained high growth has been accompanied by a significantly depreciated real exchange rate. This is as true of South Korea and Taiwan in the 1960’s and 1970’s, as it is of Argentina today. Chile made its transition to high growth in the 1980’s on the back of a large depreciation. Since the 1990’s, both China and India have received a huge boost from their undervalued currencies.
These are just some of the better-known examples. Looking at the experience of more than 100 countries, I have found in my research that each 10% undervaluation adds 0.3 percentage points to growth.
Currency undervaluation is such a potent instrument for growth for the simple reason that it creates incentives for the economy’s growth-promoting sectors. It increases the profitability of manufacturing and non-traditional agricultural sectors, which are the activities with both the highest level of labor productivity and with the most rapid rates of productivity increase.
An undervalued currency enables an economy to integrate into the world economy on the basis of strong export performance. It stimulates production (and hence employment), unlike overvaluation, which stimulates consumption.
So what should policymakers do? First, it is important to realize that a strong and overly volatile currency is not just the central bank’s problem to fix. While the central bank bears a good part of the responsibility, it needs support from other parts of the government, most notably from the finance ministry. Maintaining a competitive currency requires a rise in domestic saving relative to investment, or a reduction in national expenditure relative to income. Otherwise, the competitiveness gains would be offset by rising inflation.
This means that the fiscal authorities have a big responsibility: to target a structural fiscal surplus that is high enough to generate the space needed for real exchange rate depreciation. This may not be popular, especially in an economic downturn. But no one has the right to complain about the central bank’s “high-interest rate, appreciated currency” policy when fiscal policy remains too lax for interest rates to be reduced without risking price stability.
There are other instruments available for increasing domestic saving and reducing consumption besides the fiscal balance. Government policies can target private saving directly, by creating incentives for saving through appropriate tax and pension policies. Even more importantly, policies can discourage foreign-borrowing-led consumption booms by taxing capital inflows (Chilean-style) or increasing financial intermediaries’ liquidity requirements. There is little to be gained from letting hot money flow into an economy freely.
With such policies in place, the comfort zone for central banks is enlarged sufficiently to loosen monetary policy. Equally important, the central bank needs to signal to the public that it now cares about the real exchange rate, because it is important to exports, jobs, and sustainable growth.
This can be done without announcing a specific target level for the exchange rate. There is huge room to maneuver between the extremes of targeting a specific level of the real exchange rate and disowning any interest in the real exchange rate. The central bank does need to have a view, updated over time, about the exchange rate’s appropriate range, and it should signal when it thinks the currency is moving in the wrong direction.
Once the monetary rules of the game incorporate the real exchange rate, and assuming that fiscal policy remains supportive, investors can look forward to a less volatile and more competitive currency. This will mean more investment in tradable industries, more employment overall, and faster growth.
You will know you have succeeded when the United States’ Treasury Secretary comes knocking on your door saying that you are guilty of manipulating your currency.
Dani Rodrik is Professor of Political Economy, John F. Kennedy School of Government, Harvard University.
Copyright: Project Syndicate, 2007.