The Value of Being Undervalued

The Value of Being Undervalued

Dani Rodrik

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.

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4 respostas a The Value of Being Undervalued

  1. panaxginseng diz:

    IMF surveillance role: fundamentally misaligned?
    News|Bretton Woods Project|5th October 2007|update 57|url
    Shortly after IMF members agreed to a new bilateral surveillance framework on exchange rates in June it was undermined by the US and criticised by civil society. Now the US wants the Fund to start regulating sovereign wealth funds.

    After the reform of the surveillance framework (see Update 56) the Chinese central bank issued angry statements decrying Fund interference in Chinese economic policy. But the first blows actually fell on the US, as the Fund’s annual economic report on the US economy released in August declared the dollar overvalued. The report mimicked language in the surveillance decision which said that “fundamental exchange rate misalignment” would prompt thorough review by the IMF.

    The next day, a US Treasury official in testimony before US Congress publicly rejected the idea of determining the proper exchange rate for a currency. The official, Mark Sobel, was arguing against proposed US legislation that would punish China for its ‘undervalued’ currency: “While exchange rate models yield valuable insights, there is no reliable or precise method for estimating the proper value of an economy’s foreign exchange rate or measuring accurately a currency’s undervaluation.” Similar reservations about the concept of fundamental exchange rate misalignment have long been expressed by developing countries, most recently in IMF board discussion on how to implement the the recommendations of the Independent Evaluation Offiice report on the IMF’s exchange rate surveillance.

    Michael Mussa, chief economist at the Fund from 1991 to 2001 and now a fellow at Washington-based think tank The Peterson Institute thought it unwise of the US to cast doubt on currency valuations: “The US Treasury has cut the legs from under the IMF before it even started the race. This was foolish and unnecessary when they could have just said nothing.” Adam Lerrick, a professor at Carnegie Mellon University and fellow at the neoliberal think tank American Enterprise Institute, said: “The US criticism will certainly weaken the authority of the Fund to comment on China’s currency. The Chinese are likely to argue that the Fund is wrong about their currency, too, and point out that even the U.S. doesn’t trust the Fund’s views.”

    Some civil society critics of the Fund might be heartened that the Fund’s new surveillance framework is being undermined. Aldo Caliari of Washington-based NGO Center of Concern felt that the new framework would impinge on developing country policy space because it “reduces the policy space needed for developing countries to successfully grow using a trade and export-led model”. He continues: “It should be underscored that the growth of export revenue leads to current account surpluses, which will put pressure on the exchange rate to appreciate. Thus, the type of ‘sustained’ and ‘stable’ exchange rate required for the success of the export-based development strategy is going to require a degree of government exchange rate and monetary policy intervention.”

    Jan Kregel, a professor of finance at the Levy Economics Institute of Bard College, faulted the new decision for being too in line with the interests of private sector financiers in the industrialised countries: “Since 1973 the IMF changed its role from being a sole lender of last resort to one of providing good housekeeping seals of approval for country policies to convince private investors to remain or increase lending to a country. By definition the policies then were conditioned by the requirements of the private lenders rather than the countries. The new surveillance measures are just another step on the path to which the IMF will no longer be a lending institution but one that ensures countries apply policies that satisfy the requirements of international private lenders rather than national interests.”

    What to do about sovereign wealth funds?
    Still, the US is proposing yet another expansion of mission for the IMF: regulating sovereign wealth funds. These funds are investment vehicles established by countries with large foreign currency reserves, such as oil exporters and most recently China. With an increasing number of countries building up large precautionary reserves because they do not want to rely on the IMF in times of financial crisis, sovereign wealth funds are becoming a popular way to for these countries to earn higher returns than they would get from the standard method of holding reserves, buying US Treasury bonds.

    The funds invest in public and private companies, including those in other countries.The US and European countries are worried that such funds could be acquiring strategically important assets in industrialised countries, such as ports or utility companies, and might act on geopolitical motives rather than economic ones.

    US Treasury official Clay Lowry proposed in a speech in June, “I believe that the IMF and World Bank could take a very useful step by developing best practices for sovereign wealth funds, perhaps through a joint task force.” Lowry highlighted the risks sovereign wealth funds posed to financial market stability and emphasised that the solution is greater transparency and clearer management guidelines. He also invoked the risks that sovereign wealth fund activity in industrialised countries might provoke reactions of financial protectionism.

    While recognising the risks to stability stemming from a lack of transparency, and comparing these risks to those posed by hedge funds, in September the IMF’s chief economist Simon Johnson rejected the need for quick action by the Fund. “What should the IMF do about this situation? There’s certainly no need for dramatic action. For one thing, the situation involves sensitive issues of national sovereignty. For another, at their current level of $3 trillion, sovereign funds aren’t a pressing issue.”

  2. panaxginseng diz:

    No comment? This was posted here on November 6, and now, December 13, you say you go no comments? C’mon, have your 2 cents…

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