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 longterm 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 nontradables, 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 rentseeking 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.