Exchange rate misalignment and economic growth: On the possible transmission channels for emerging economies

Abstract

Despite the large body of work that exists on the impact of exchange rate undervaluation on economic growth, only a mere literature focuses on the potential transmission mechanisms. There are authors who consider the size of the tradable sector as the operative channel through which undervaluation impacts economic growth. This is due to poor contracting environment and market failures that are prominent in the tradable sector as bad institutions “tax” tradables more than non-tradables. We look at this issue in this article for a set of emerging economies using annual data from 1970 to 2014. We find that the size of the tradable sector is indeed the operative channel through which undervaluation impacts growth. We have ruled out that bad institutions “tax” tradables more than non-tradables. Our results, robust to different undervaluation indexes, highlight instead the importance of total factor productivity surge induced by an undervaluation in increasing growth.

Keywords:

• equilibrium exchange rate
• exchange rate undervaluation
• economic growth
• total factor productivity
• transmission channel

PUBLIC INTEREST STATEMENT

We analyse the transmission channels through which weaker exchange rates impact economic growth for a set of emerging economies. We first find a positive relationship between these two variables. Indeed, weaker currencies tend to boost economic growth. This is due to their impact on the tradable sector as they make exporting firms competitive. Following that price incentive, productivity in the tradable sector increases compared to the non-tradable. The final result is an increase in the country’s output produced as a whole and economic growth.

Notes

1. The details of the exchange rate computation can be found in Tipoy et al. (2017b).

2. The TSLS strategy was also followed by Rodrik (2008). Although this system does not correspond to a fully fledged TSLS, we have preferred keeping, as Rodrik (2008), this acronym.

3. The following 21 countries have been identified as emerging economies: Brazil, Czech Republic, Hungary, Malaysia, Mexico, Poland, South Africa, Taiwan, Thailand, Turkey, Chile, China, Colombia, Egypt, India, Indonesia, Pakistan, Peru, Philippines, Russia and the United Arab Emirates. Due to data availability, we have restricted the study to a smaller set.

4. This article is a series of chapters from my PhD thesis. In previous articles, we have proven the existence of a positive relationship between misalignment of exchange rate and economic growth using panel smooth transition regression models. We therefore keep the estimation simple here.

5. The 1990 sub-sample is also used here as we have noted a certain synchronization from that year between the size of tradable and our misalignment index for most countries.

6. As in Rodrik (2009), we recognize that modern tradables are mainly industrial goods although some tradable services are becoming important.

7. As institutional quality will have low variability over time, we have also run a random effect. The estimates on IQ were still negative and statistically insignificant. The results are available upon request.

8. As in Guangjun and Sylwester (2010), we have replaced the current IQ_i,t variable with its 5-year lagged as institutional changes can have persistent influences. Here again we have found no significant relationship between IQ and relative size of tradables. The results are available upon request.

9. All variables used are five years averages unless otherwise specified.

10. Several specifications with various control variables were used. We found a significant and positive relationship between undervaluation and economic growth. The results are available upon request.

11. We test also a sub-sample starting in 1980. The estimates on IQ were not statistically significant.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Christian K. Tipoy

Dr Christian K. Tipoy is a lecturer at the University of KwaZulu-Natal. He holds a Ph.D. in economics from the University of Pretoria. He has several years of experience teaching macroeconomics and econometrics. His research focuses mainly on applied macroeconomics.

Marthinus C. Breitenbach

Marthinus (Martin) C. Breitenbach holds a Ph.D. in Economics from the University of Pretoria. He has been teaching Economics since 1990. He has authored and co-authored many publications. He has worked in Economic Development, Agricultural Economics and International Trade. His most recent collaborative work has been in exchange rate dynamics.

Mulatu F. Zerihun

Dr Zerihun is currently a Senior Lecturer at the Tshwane University of Technology (TUT). He holds a Doctor of Business Administration (DBA) from TUT and Ph.D. in economics from the University of Pretoria. His research endeavours have been focused on exploring developmental issues in Africa. He has authored/co-authored several research articles.