How real exchange rate policy can promote economic growth

My new paper on real exchange rates and growth is now online. Here is the summary in abstractese:

I provide evidence that undervaluation (a high real exchange rate) stimulates economic growth. This is true particularly for developing countries, suggesting that tradable goods suffer disproportionately from the distortions that keep poor countries from converging. I present two categories of explanations as to why this may be so, focusing on (a) institutional/contractual weaknesses, and (b) market failures. A formal model elucidates the linkages between the level of the real exchange rate and the rate of economic growth.

The paper is still raw, so comments are appreciated.

Comments

[mohammad]

Dear Dr Rodrik
i read your interestng paper. can you send me your data that used for this paper. i want learn the process of your accounts.

[Nicholas Gruen]

Dani,

You are probably right that one reason why tradeables lose out in poorly governed countries is that they're more complex and poor governance imposes greater costs on activities in which there is a high degree of interdependence - unlike the barber shop.

I've only read your article quickly, so I hope I've not missed your raising the same point, but another possible thing to think about is that a traded sector activity - particularly in manufacturing - may be much riskier in a number of respects. It’s riskier on the downside because one is subject to competition from producers around the globe and to dumping from large firms and/or government policies around the world.

Secondly it has a big upside for the symmetrical reason that if you manage to get things right (whether by design or default) there may be a big payoff as your market is the world. This risk may be inadequately managed in capital markets. Also in the event of the tradeables firm getting very successful, this may make it a more satisfactory prospect for rent seeking from its government than the barber's shop. I guess you can add this possibility to your list of potential market failures.

[Neil LoBracco]

Dr. Rodrik,
On page 17:
Attract is misspelled as 'attrack'.
Unfortunately, that is the limit of my ability to critique the paper.

[Dan]

Hi,

How can you have both time- and country- specific dummies in your regression? Is it that for every time period, you have 5 observations (one for each year in the time period)? If so, that was unclear from the text. If not, it seems like you will have no basis for comparison (since for every country in every time period, you have 1 observation).

Also, I would really like to see more direct evidence that the devalued exchange rate is (exogenously) driving the growth. In particular, can you show that the growth that you attribute to the devaluation is coming from the tradables sector? I'd also like to see that non-tradables sector shrank relative to what it would have been had there not been a devaluation. That is, your theory says that exchange rate devaluation causes growth by diverting resources from non-tradables to tradables, where they are used more efficiently. The first half of that proposition is definitely verifiable; the second half may be as well, but that requires a whole bunch of messy TFP calculations (although as long as you have IO tables...)

I'm not super familiar with the literature on contract theory, but isn't contract failure or inadequate institutional support an instance of market imperfection? It certianly sufficies to ensure an underallocation of resources relative to the first-best case. Are you sure your first explanation doesn't just belong on the laundry list of market failures in section 3.2?

On the bottom of page 29, there is either a typo or a bit of mathematical notation I have never seen before.

[Andrzej]

Hello,

On page 2 in the sentence:
"But this relationship holds only for developing counties ..." I guess you meant "countries" not "counties". Unless there are still some developing counties in US or Canada.

Greetings from Toronto.

[Salih]

Dear Sir,
I would like to ask something related to Turkey bearing your Turkish backround in my mind. Over the last 4 years Turkish Lira have been overvalued while we have experienced high growth rates.What would be the implications of your proposal for Turkey which is a developing country. When i ask to Central Bank officials (people on the monetary board) in their letures about this so called overvaluation and concerns of the exporters on this they give me a simple answer. There is only one goal of the independent CB's all over the world. it is to protect the value and stability of the national currency against other currencies. So they keep interest rates at current levels in an attempt to catch their targeted inflation rates. What kind of path should Turkey follow?
i am a second year Economics major student in Turkey so i am not ready to grasp comlicated theories but a simple answer to make my mind would be very useful. i really appreciate you critical stance and am eager to follow your blog.
Regards.

[paine]

nice points
in your paper
not only on the more obvious north south effects
ie
chronic north trade gaps

but also
on the part/ whole
contradiction effects
of this policy on the
south itself

as one parts
growth step up
thru an export tilt
may create
a loser parts
growth slow down

nice question

how might trans nat corporations
make it work for them both ways
since they profit from both cheap south inports
and over priced
north exports

ie

too high and too low
works if you can "fire " from both directions
as only trans nats can

with some real exchanges rising as other south country real exchanges decline
it can be nice both ways

thinking pure south but with solidarity
obviously success is all relative
if its a state of hobbesian all agin all
i must out under you

then we all go lower then otherwise

we must agree to hold
a united regional
fair rate line
among ourselves
solely
aimed at mutual gains
in north markets

[Dani Rodrik]

Salih --

See my next post.

[paine]

salih

part one:

"There is only one goal of the independent CB's all over the world. it is to protect the value and stability of the national currency against other currencies."

part two:

" So they keep interest rates at current levels in an attempt to catch their targeted inflation rates. "

this is a non sequitor

obviously a rising lira
forex
is not a stable lira forex

the point this really implies

the turk cb
is into
internal price stability
these days
ie
inflation control

this pre empts
the use of monetary policy to hold down the value of the turk lira
for fear of its possible
run away price level
effect

[Nurhisham Hussein]

mohammad --

The data Prof Rodrik used is available here:

http://pwt.econ.upenn.edu/

Prof Rodrik --

While this may be a gross generalization and not really the thrust of your paper, would you say your conclusion would imply that choice of exchange rate regime would then be less important except as a means of achieving a state of undervaluation? From this perspective, it's harder to justify a peg to the Dollar - a managed float would be better.

My second comment is on your argument for market failure - I think the relative performance of Asia vis-a-vis other developing regions is that for the most part, undervaluation AND industrial policy were pursued not in substitution, but as complementary strategies. That's certainly true of my country (Malaysia), South Korea and Singapore, less so in the case of Thailand.

[gallagher]

An inductive thought about exchange rates, exports, and innovation. If you are maintaining an undervalued exchange rate as part of a comprehensive development policy where the build up of exporting firms is a key goal then you have to be sending a lot of the foreign exchange out of the country to maintain the undervaluation. Thus, NOT putting to much of that money into the domestic market to create demand and build infrastructure (read China's purchase of US bonds and so forth).

If you are also a "late industrializer" with in the short term only a comparative advantage in low-skilled labor then you are starting out as an assembler for many of the largest TNCs in the world (yes, still China). In the global electronics, automobile, and textiles' industries the profit margin for assembly is 2-4 percent of final sale price (yes, $40 bucks to be split between the owner and thousands of workers for a $1000 laptop). It seems that such an environment HAS to breed innovation. To make a real profit (and have the huge trade surplus that China has) you have to learn to ramp up scale--that means high quality products and a very high volume. Just a thought, but it seems to be the case--the contracts keep coming! So, part of an orchestrated DYNAMIC comparative advantage strategy where a nation is also doing R&D and is engaged in industrial policies, the nation can climb the ladder with such innovation and skills in hand (read Lenovo buying the IBM Think Pad and being able to run a full scale firm rather than just assembly).

So, what's this ramble say: at the bottom rung of the ladder in the face of oligopsony pricing in the supply chain you need to be able to produce high volume high quality reliable products quickly. An undervalued exchange rate opens the door for you but the nature of the markets and the small profits for assembly make you lean and mean. If the nation helps you build a ladder and you are lean and mean you can climb up. China has done this by combining undervalued exchange rates with selective industrial and FDI policy (and relatively very low wages). Mexico is failing at this because its tight monetary policy has created a persistently overvalued exchange rate and the government has failed to facilitate any industrial upgrading.

[Orhan Karaca]

Hi Prof Rodrik

Could you please give a list of rich and poor countries in your paper? Which period does the GDP per capita of 6000 dollars belong (mean, initial or final)?

[ines]

Dear Sir,
i am reading your interestng paper. Can you please send me the appendix that used for this paper. i want to understand the model but i find some difficultes.Thanks a lot dear professor .

[Forex Tracer]

Excellent post, thanks! Bookmarked your site for future reference.