Exchange Rate,Capital Control, and Industrial Policy

Filomeno S. Sta. Ana III

Action for Economic Reforms

Outline

• Exchange rate, institutions, and long-term growth

• Basic concepts

• Problems with currency overvaluation

• Policy preference for undervaluation

• The relevance of capital control

• Challenges

Exchange Rate and Institutions

• Quality of institutions is a determinant of long-term economic growth (see Dixit’s survey of literature, 2005).

• Skepticism on policy being a predictor of growth (e.g., Easterly, Rodrik)

• But policy can help shape or change institutions• For example, good tax policy and administration can change

behavior of taxpayers, making them comply to rules.• So is the case of exchange-rate policy: Incentives arising

from competitive or undervalued currency unleash entrepreneurship, productivity, innovation, and social cohesion.

Behavior of the exchange rate

• The difference between the rate of return on domestic assets (r) and the rate of return on foreign assets (R) is equal to the sum of the risk premium (z) and the expected rate of depreciation.

• Thus, we have this equation r-R= z + (E*-E)/E.

• Or: E=E*/(r-R-z + 1)

• when E* goes up, so does E (depreciation); when r > R increases, E decreases (appreciation). When z increases (note the minus sign before z), E likewise increases (depreciation).

Behavior of the exchange rate

• A bullish stock market or a boom in real property (an increase in r -R) attracts foreign currency inflow, thus contributing to currency appreciation.

• Political disturbances and uncertainty (an increase in z) discourage inflow and abet outflow, thus resulting in depreciation.

• Economic shocks or crises trigger massive capital flight, causing the currency to take a sharp plunge.

Is there a market-determined exchange rate?

• Policies have an impact on exchange rate--interest rate, taxation, public spending, labor policy, inflation targeting, signaling etc.--which influence market behavior on exchange rate.

Nominal rate vs. real exchange rate

• What matters is the real exchange rate--purchasing power parity (PPP)

• This is expressed as P= V x P*: Where P is the price of domestic goods, P* is the price of foreign goods, and V is the real exchange rate.

• The real exchange rate V is the ratio of P/P*. An increase in the price of domestic goods relative to foreign goods increases (depreciates) the real exchange rate.

Costs of overvaluation; benefits of undervaluation

• An overvalued currency is bad for growth but more to the point, an undervalued currency translates into higher long-term growth.

• Overvaluation: shifts incentives away from investments in exports, domestic industries, and non-traditional agriculture, thus likewise adversely affecting job creation.

• Undervaluation enhances relative profitability of tradable goods.

• For developing countries, undervaluation compensates for prevalence of institutional and market failures. Competitive price makes up for these failures.

Undervaluation as Growth Booster

• Rodrik: High undervaluation enhances growth; a 10 percent undervaluation translates into an increase in growth .026 percentage points. In China, a 10 percent undervaluation boosts growth by .086 percentage points!

• Undervaluation has a causal impact on growth. (Reverse does not apply.)

Necessity of Undervaluation

• Growth of tradables of developing countries is constrained by a) institutional or government failures and b) market/ coordination failures.

• Undervaluation compensates for these failures; e.g., tradables, more than non-tradables, suffer from market imperfections

Strategy of Undervaluation

• To reiterate, overvaluation is bad; a nominal exchange rate aligned to real exchange rate is insufficient; and undervaluation boosts growth.

• But a strategy of undervaluation is not easy to do. • Sterilizing inflows is costly; high opportunity

costs.• Taming of inflation; that is, depreciation rate >

inflation rate

Hence, the importance of Capital/Financial Control

• Sends the signal about the desired future exchange rate (increase E*).

• Or decrease r (rate of return on domestic assets)

• Thus driving up E (exchange rate).

• Nudge or redirect capital towards the real sector.

Challenges

• End of the period of export orientation, in light of the 2008-09 global economic shock.

• But undervaluation is not just about exports.• What matters is not export output but output

of tradables.• Import substitutes also benefit from

undervaluation.• Undervaluation serves the whole real sector.

Challenges

• Global imbalances contributing to global recession (thought not a principal factor) will make undervaluation undesirable from the perspective of macroeconomic stability.

• But what options are available to developing countries, if the tool of undervaluation is taken away from them?

Undervaluation is a form of industrial policy

• Price competitiveness; substitute for tariff.• Undervaluation strategy became the first option

because of the constriction of space for a wide range of industrial policy tools.

• To address the tension between global macro objectives and developing countries’ growth and development objectives, it will be necessary to relax the global rules (e.g., WTO rules) that discourage the use of industrial policy.

State capacity

• Neoliberals frown upon managing exchange rate and having industrial policy for developing countries, arguing that the costs are too high.

• Their argument: Regulatory capture by vested interests especially when the state is soft or weak.

Market failure versus state failure (The Fabella line)

• How to maximize public welfare, when market failure is prevalent (e.g. financial markets)?

• Market failure occurs when un-intervened social outcome W* is inferior to a feasible desired social outcome W** (W** > W*).

• Realizing W** requires state or institutional intervention, but such intervention will entail some kind of transactions cost or C(m).

Market failure versus state failure

• If the transaction costs are too high, to the point of negating W**, (in other words, state failure), it does not make sense to have intervention (“rein back the state”).

• To quote Fabella: “A market that the relevant state cannot improve upon is not a market failure.”

Response to the Fabella line

• As applied to capital/financial markets, W** > C(m) + W*. In other words, the gains from output, incomes and employment arising from capital/financial regulation far outweigh the costs of corruption and rent seeking and the inferior gains from the status quo.

• In other words, a level of predictable corruption and rent-seeking can be tolerated.

• But at the same time, we need to strategically address the C(m) or strengthening state’s capacity as enabler and regulator. This is in the main a political, institutional agenda, preferably done by winning political power.