Managing real exchange rate for economic growth: Empirical evidences from developing countries

Abstract

This article analyses macroeconomic policies capable of influencing the long-run real exchange rate (RER). In this vein, it identifies economic policy tools that can devalue RER, covering a theoretical issue neglected by the economic literature, which argues that competitive exchange rate enhances growth. After discussing the “Trilemma,” we identify those variables that could affect RER without constraining monetary policy or exchange rate regime choice. In what follows, we model the probability of achieving an undervalued (small or large) RER for a sample of 14 developing countries from 1980 to 2010 (30 years) by applying econometric techniques for discrete choice and censored data. Afterwards, we compare the results for Latin American nations with Asian ones. They suggest that competitive exchange rate requires different approaches depending on the region. Moreover, Latin American countries need to take on additional policies so that interventions in the foreign exchange market become effective.

Keywords:

• Competitive exchange rate
• exchange rate management
• exchange rate policy

Notes

1 Kregel (2004) and Palma (2012) argued that growth strategies based on external finance are harmful for developing countries, because they increase financial fragility (Minskyan approach) and exposes countries to massive liquidity of financial markets (according to Kindleberger).

2 Following Frenkel and Taylor (2006), the “Trilemma” does not hold. Even under free capital mobility, the monetary authority can buy and sell bonds in domestic and foreign markets, or even take on monetary control policies, which regulate money supply regardless other forces that drive the exchange rate.

3 First, CB buy dollars, selling domestic currency. Then, the monetary base and international reserves rise. At the same time, CB sell domestic bonds, returning the monetary base and the interest rate to the initial value.

4 The Brazilian experience between 1994 and 1998 illustrates this issue. The difference between the interest rate paid by the public debt and the income earned from international reserves discloses the high costs of sterilization. In addition, since the growth rate of public revenue was much smaller than the interest rate paid by the public debt, sterilization policy sustainability was undermined (see Palma 2012).

5 According to the authors, oil producing countries and countries with important privatization programs are examples of cases where the latter correction matters.

6 We use this alternative index to verify the effect of intervention in the exchange rate market. The first index Interv.exrate is more careful insofar it considers only international reserves accumulation above monetary aggregate growth.

7 The Asian countries are China (CHN), Hong Kong (HKG), South Korea (KOR), Indonesia (IDN), Malaysia (MYS), and Singapore (SGP). The Latin American countries are Argentina (ARG), Brazil (BRA), Chile (CHL), Mexico (MEX), Peru (PER), Venezuela (VEN), and Colombia (COL).

8 The proxy variable to RER is the inverse of pl_gdpo (Price Level of Output-side real GDP at current PPPs in mil. 2005US$) from Penn World Table 8.1.

9 This variable is from Penn World Table 8.1 (rgdpo/pop).

10 Underval is in logarithmic form. For robustness check purposes, we will use Macdonald and Vieira’s (2012) index of undervaluation.

11 Censored regression can be put into one of two categories. In the first case there is a variable with quantitative meaning, y*, and we are interested in the population regression, $E(y^{\mathrm{*}}\parallel x)$. However, y* is not observable for part of the population. A second kind of application of censored regressions is where the dependent variable, y, is an observable outcome, which takes on the value zero with positive probability but it is a continuous random variable over strictly positive values. This is an example of corner solution outcome. In such cases, we are interested in features of the distribution of y given x, sucha as $E(y\parallel x)$ and $P(y=0\parallel x)$ (Wooldridge 2002).

12 See Wooldridge (2002), Greene (2003) and Baltagi (2005).

13 A one-unit increase corresponds near 25% of Chinn-Ito index.