The Value of Undervaluation

Laurence Go, who graduated summa cum laude from the University of the Philippines, is a researcher for Action for Economic Reforms. This piece was published in the December 5, 2011 edition of the BusinessWorld, pages S1/4 to S1/5.


Growth rates for the first, second and third quarters of 2011 were sluggish: 4.9 percent, 3.4 percent and 3.2, respectively.  With this disturbing performance, what can the government do to mitigate the detrimental effects of external factors and start fulfilling its promise of strong, sustainable and inclusive growth?

Economic theory dictates that competition lead to the best, i.e. efficient market outcomes. Can this be said in international settings—such as in foreign exchange markets where competitive exchange rates lead to optimal results?

Before making the case for competitive exchange rates, it is imperative to present some stylized facts. All else being equal, currency depreciation leads to cheaper exports and costlier imports. An appreciation has opposite effects: foreigners find the country’s products expensive, while domestic consumers pay less for imported products.

From a policy standpoint, exchange rates can be wielded to influence exports and imports, and hence, aggregate demand. Endowed with a gamut of policy instruments, governments can effectively use exchange rates to stimulate growth—but of course, not without consequences.

Undervaluation (or depreciation) is the process of fixing a rate lower than what it would be in a free market regime.While a large body of empirical research shows that more economists agree to overvaluation inducing lower growth, the opinion is not as unequivocal in the relationship that undervaluation spells higher growth. Despite this, recent strands of literature (following Dani Rodrik’s 2007 research) continue to show the virtuous circle that  results from undervaluation and growth.

Economists have varying theories as to how the relationship arises. Perhaps the most evident is the story of export-led growth: as the currency depreciates, a surge in manufacturing exports follows and this consequently boosts growth. Another view postulates that investors consider labor costs to be the most crucial difference among countries with contrasting attributes. A lower and competitive labor cost resulting from undervaluation leads to more profitable investments, paving the way for higher growth trajectories. Some economists however ascribe this growth to increased savings and capital accumulation arising from undervaluation. Still, others show that a depreciated exchange rate bolsters growth through learning by doing externalities in the tradables sector.

Nonetheless, it is Rodrik who makes the most compelling argument in all the undervaluation-growth literature. His study finds that for developing countries, high growth periods are associated with undervalued currencies. However, he notes that the case of undervaluation is not a mere export-led growth story.

Rodrik asserts,“Tradables suffer disproportionately from [institutional weaknesses and market failures], so that absent a compensating policy, developing economies devote too few of their resources to tradables. An increase in [the real exchange rate] can then act as a second-best mechanism for spurring tradables and for generating more rapid growth.Sustained real exchange rate depreciations…speed up structural change in the direction that promotes growth.”

Provided with all these results, two questions emerge: What should the Philippines do? Is it doing what it should?

Under any administration in the Philippines, the clamor for stronger and more inclusive growth has not eased. As a developing country, we are all aware of what should be done— improve institutions, invest in education, etc. However, we are all too aware that none of these are easy to do. Hence, a more pragmatic approach must be used to help boost growth in the Philippines.

The Philippines is a remittance-driven economy and is touted to have one of the world’s largest business process outsourcing industries. In addition, the Aquino administration sees tourism as a sustainable growth driver, which can curb the OFW phenomenon. But a strong peso can undermine the competitiveness of these sector— an unfortunate case of the “Dutch disease” phenomenon.

Fortunately, the current administration’s fiscal conservatism has provided the economy with sufficient fiscal space to undertake various policy interventions advantageous to growth. Except for growth per se, the Philippines currently enjoys stable and strong macroeconomic and fiscal indicators, which give room for adjustments in foreign exchange rate management.

However, opponents of undervaluation say that it leads to rampant inflation. Guided by the goal of inflation targeting, it seems that undervaluation runs counter to the BSP’s plan (see RA 7653). But one must not mistake the instrument (i.e. inflation rates) for the objective (i.e. growth), or the means for the end.

In fact, Rodrik has found that “the level of inflation does not have a strong association with undervaluation, indicating that undervaluation does not need to come at the cost of inflation.” Economist Vic Abola from the University of Asia and the Pacific supports this view by saying that in the Philippines, exchange rate depreciation has a trivial (almost negligible) effect on inflation.

Therefore, the Philippines—in gathering enough fiscal space—can eventually resort to at least a reduced and competitive appreciation (vis-à-vis its Asian neighbors, echoing Raul Fabella) or at most a controlled undervaluation of its currency (echoing Rodrik) to spur growth.

Just as competition leads to efficient outcomes in various economic spheres, so does a competitive exchange rate through undervaluation. Admittedly, exchange rate depreciation is by no means sufficient in ushering sustained and inclusive growth. However, it is a step forward in the right direction, especially for developing countries like the Philippines.

In supporting the case for competitive exchange rates, much can be gleaned from Rodrik’s view: “It is worth emphasizing once again that real-exchange rate policy is only second-best in the context of the economic distortions. Eliminating the institutional and market failures in question would do away with the policy dilemmas but recommending this strategy amounts to telling developing countries that the way to get rich is to get rich.” (Emphasis mine.)

Indeed, the “second-best” option can prove to be the best after all.

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