The role of exchange rate policies in economic development is still largely debated. There are two central and interconnected issues regarding exchange rate policies in the macroeconomic literature on emerging economies that relate to the links between exchange rates, the balance of payments and macro stability and growth:
The role that a competitive and stable exchange rate plays in facilitating economic diversification (Ocampo et al. 2009, Rodrik 2007, 2013, Stiglitz and Greenwald 2014). In this view, scaling up toward activities with higher technological content is the key to dynamic growth, and appropriate exchange rate policies can promote this. The East Asian experiences, first of the newly industrialising countries and most recently of China, are underscored as success stories of such diversification (Rodrik 1994, Lin 2018). This contrasts with the difficulty faced by a large number of natural-resource dependent economies in diversifying their production and export structures, attributed in part to the resulting appreciated exchange rate, and even the ‘premature de-industrialisation’ that several of them have faced (Rodrik 2016).The extent to which the exchange rate regime and capital account management help manage pro-cyclical swings in external financing to emerging and frontier economies as well as terms of trade fluctuations in commodity-exporting countries, and open or limit the space for counter-cyclical macroeconomic policies, thus affecting macroeconomic stability.
Both of these issues highlight the importance of exchange rate policies in open economies. In a recent paper (Guzman et al. 2018), we revisit those themes. Specifically, we analyse what role real exchange rate (RER) policies can play for fostering economic development, clarifying how optimal RER policies are dependent on the conditions under which they are implemented – including the available policy instruments at the time of their implementation. Even though the RER is an endogenous variable and not a direct policy instrument, we still speak of real exchange rate policies, understanding that these policies rely on the management of a set of actual policy instruments – including, of course, the interventions associated with the management of the nominalexchange rate.
Real exchange rate policies and economic development
We argue that in the presence of learning spillovers in at least some tradable sectors and the impossibility of subsidising these sectors directly, either because there are severe political economy problems, including risks of rent seeking that hinder an efficient allocation of subsidies, or there are international regulations that impede the implementation of subsidies – conditions that are common to developing economies – optimality entails competitive, stable, and effectively multiple RER policies. The optimal application of the available policy instruments leads in effect to different RER for sectors with diverse spillovers, while maintaining the formal commitment of members of the IMF to avoid multiple exchange rates.
Any policy that has the potential for reallocating the economy’s factors of production towards sectors with large learning spillovers could be welfare improving. Subsidies and transfers to such sectors constitute the first best policy response. But if these policies are not feasible, then there is a key role for RER policies as a second-best alternative.
Under those circumstances, a more competitive RER will increase the profitability of tradable sectors. However, an economy may have multiple tradable sectors, including some without learning spillovers. Therefore, as a means to channel the benefits of exchange rate policies to the right sectors – i.e. those with larger externalities – optimality requires taxing the sectors with no learning spillovers that receive the implicit subsidy generated by the competitive RER, while sectors with learning spillovers retain the associated policy benefits.1 The result is a system of effectively multiple exchange rates.
Not just the level of the exchange rate matters, but also its stability. This is especially important in developing countries where it is impossible or very costly to hedge exchange rate fluctuations, and where there are other imperfections in capital markets. Real exchange rate stability is essential for reducing the investment risks of the new tradable sectors.
Some caveats must be made in relation to these propositions. The first refers to the desirability for complementing RER policies with other traditional industrial policies. If the non-natural resources tradable sectors that these policies intend to expand do not have the other necessary conditions to emerge – access to technology and credit and to adequate infrastructure and human capital – the elasticity of aggregate supply to the RER will be low. Traditional industrial policies may be used to increase the elasticity of response to the exchange rate. One of those traditional policies is the provision of credit, with the use of national development banks – an instrument widely used by major developed countries (notably Germany and Japan) but also several emerging and developing countries (Griffith-Jones and Ocampo 2018). Investments in infrastructure, education, and R&D to enhance the competitiveness of the learning sectors would also contribute to that result.
The second caveat refers to the trade-offs that the implementation of these policies imposes on societies. A more ‘undervalued’ RER means higher prices of tradable goods and services in terms of the domestic currency. Therefore, following a policy of competitive RER is associated with lower purchasing power in terms of tradable goods today, with the objective of achieving higher purchasing power in the future. These trade-offs generate distributive effects: not all segments of society pay the same ‘price’ in the present for achieving faster economic growth, and it may not even be clear which segments will benefit in the future. Therefore, the implementation of competitive RER policies requires agreements among social actors that may be difficult to achieve.
A final caveat relates to the international implications of these policies. Adopting an active exchange rate policy may have negative externalities on other countries, especially if the country adopting such a policy is a large player in world trade. The expansion of its ‘learning sector’ may come at the expense of a contraction elsewhere. Also, if many emerging and developing countries adopted these policies, the joint effect would be more limited than if fewer economies did so, generating fallacy of composition effects.
Policy instruments for competitive real exchange rate policies
Capital account regulations and interventions in foreign exchange markets may be used as instruments for maintaining a competitive RER. Capital account policies – including all the policies that affect the private sector’s access to foreign capital – can have persistent effects on the RER (Jeanne 2012, Montecino 2018). They can be complemented in various ways with policies of intervention in foreign exchange markets and, in particular, with the accumulation of foreign exchange reserves. The experience of China illustrates the mechanisms at play. Between 2002 and 2008, the Chinese tradable sector experienced rapid growth; in absence of policy interventions, it would have led to an appreciation of the renminbi (due to the Balassa-Samuelson effect). But the appreciation pressures were resisted though capital account policies and a large accumulation of foreign exchange reserves.
Many countries prefer to place the weight on interventions in foreign exchange markets rather than using capital account regulations. Such interventions have indeed become prevalent in many emerging and developing countries, particularly after the emerging countries’ crisis that started in East Asia in 1997. A major result of this is that, in contrast to the mainstream view that prevailed in the 1990s, according to which only polar regimes were seen to be viable – hard pegs or freely floating exchange rates – in emerging and developing countries an intermediate regime, managedexchange rate flexibility, has become dominant (Ilzetzki et al. 2017).
Overall, the evidence suggests that best practice in open emerging economies subject to boom-bust cycles in external financing is the complementary use of traditional macroeconomic policies with interventions in foreign exchange markets and capital account regulations. Recent research has shown that these interventions are effective in stabilising the macroeconomy and promoting growth, overturning the earlier studies of the 1980s that had largely rejected the effectiveness of these interventions (Ocampo 2017: Chapter 4).
A variety of historical experiences support the claim that stable and competitive real exchange rate (SCRER) policies are good for economic development (Rodrik 2008, Razmi et al. 2012). We have argued that there are theoretical foundations for such an approach as an optimal policy strategy in the presence of certain constraints on the available set of policy instruments. The main argument against such interventions – that they represent interference in the free functioning of markets, which, in the absence of such intervention would ensure efficiency – misses two fundamental points:
every central bank intervention, including the setting of interest rates, affects the value of the exchange rate; this means, in fact, that there is no such thing as a ‘pure’ market exchange rate; and all economies, and especially developing and emerging markets, are rife with market imperfections, including learning and macroeconomic externalities.
Our analysis of the empirical evidence on the effectiveness of different policy instruments suggests that both foreign exchange interventions and capital account regulations can be effectively used for maintaining competitive exchange rates and for dampening the effects of boom-bust cycles in external financing and the terms of trade on the exchange rate, thereby promoting growth and stability.