Undervaluation: a second-best solution for growth? – part I

In a chapter of Philippine Institutions: Growth and Prosperity for All (2010), Filomeno S. Sta. Ana III of Action for Economic Reforms makes the case for an undervaluation strategy for the Philippines. By this, he means not a specific nominal value for the exchange rate (a fixed regime) but rather a policy – led by the government, with central bank support – aiming at real depreciation of the peso, as measured by the real effective exchange rate.

He argues that this strategy would support export-led growth and help prevent costly balance of payments crises resulting from bouts of overvaluation. He notes that this is a “second-best” means of promoting growth, given that reform of institutions and markets – the “first-best solution” – will take a long time to be effective.

In this, he cites work by Harvard’s Dani Rodrik, which shows that real exchange rate undervaluation can have a positive and significant effect on growth for developing countries in general. Rodrik’s point that focusing only on institutions is like “telling developing countries that the way to get rich is to get rich” is well-taken.

Yet aside from Rodrik, there are other well-known economists who have made arguments along these lines. John Williamson, who coined the term “Washington Consensus”, also supports some undervaluation for developing countries, and also “intermediate exchange rate regimes” in between fixed and fully floating. Former Fed chairman Frederic Mishkin, who is cited several times in the paper for his 1997 paper with Bernanke, has pushed for a more flexible approach to inflation targeting – which could allow central banks to pursue an exchange rate goal alongside low inflation.

The experience of China and some others shows that undervaluation may be helpful for domestic growth and exchange rate stability – even during the crisis, when financial contagion and the impact on growth were relatively limited. Of course, this also relates to China’s closed capital account, and says nothing of spillover effects of the fixed exchange rate regime on other countries.

I appreciate Mr. Sta. Ana’s point that the government should adopt the strategy first to ensure consistency with the central bank. Policies like fiscal responsibility – through strengthened taxation and avoiding populist spending – and limiting foreign borrowing would be important. These would support the exchange rate policy and ensure the central bank and government are not pursuing incompatible goals. I have a couple of further thoughts on this line of argument, some critical, some supportive.

First, not every country can have an undervalued exchange rate. As the experience at both the global level and in Europe shows, there are two sides to every coin. Exchange rate regimes have been one factor in the massive global imbalances between China and the oil producers on the one hand, and the US and some others on the other. Persistently higher inflation rates in Greece, Spain and Ireland, combined with wage moderation in Germany, have led to huge imbalances within the euro area. The problem is generally larger on the side of deficit than of surplus countries.

Yet, if the Philippines has an undervalued exchange rate, and with it current account surpluses, and export growth, someone else must have an overvalued exchange rate, and hence current account deficits, and import growth. The exchange rate is a relative price between two currencies, and by definition not all countries can pursue undervaluation. There could be an argument that developing countries should be the beneficiaries of undervaluation, as growth is a clear policy priority – also for the developed world, which spends significant sums on development aid each year. After all, the relative impact (cost) for the global economy is likely much smaller and more broadly borne than the impact (benefit) for the Philippines. Yet someone else would have to bear the burden of overvaluation.

Second, this is precisely the sort of question that should be discussed multilaterally. Specifically the IMF would be the forum to bring this up. It is true that it is difficult for countries like the Philippines to get strong backing for a change in IMF policy (and policy advice) on their own. But it is the job of the IMF to serve as “the machinery for consultation and collaboration on international monetary problems” (Article I.i of the Articles of Agreement) and to “promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation” (Article I.iii).

The last point is very sensitive in practice, especially given the criticism of China’s exchange rate regime, and the considerable pressure from the US. The IMF has recently done new work and created a methodology to assess exchange rate misalignments as part of the External Balance Assessment. This allows policymakers to better understand external imbalances. But this applies only to imbalances in the big systemic economies, i.e. China, the US, UK, Euro area, Japan, and a number of larger advanced and emerging economies. A little bit of undervaluation in a developing country could probably be tolerated, if this is seen as support for a development strategy. Yet it should be presented and discussed multilaterally.

Third, there is an important link with other policy areas like capital account openness, due to the so-called impossible trinity. In the next column, we will look at implementation of an undervaluation strategy, and specifically the relationship with inflation targeting and capital account liberalization.

Jon Frost is an economist at De Nederlandsche Bank (DNB), the central bank of the Netherlands. The views expressed here are his own and do not necessarily reflect those of DNB.

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