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December 2, 2007

"The Value of Being Undervalued"

Dani Rodrik on exchange rate policy for developing countries:

The Value of Being Undervalued, by Dani Rodrik, Project Syndicate: 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. ...

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. ...

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. ...

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..., 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 ... 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.

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