Rethinking Exchange Rate Competitiveness

2.2: Rethinking Exchange Rate Competitiveness
CHAPTER 2.2                           Most governments care about the real exchange rate of
                                      their currency, that is, the value of prices (or wages) relative
                                      to world values, when translated into a common currency.
Rethinking Exchange Rate              For example, a high real exchange rate makes imports
                                      cheap relative to domestically produced goods.This is
Competitiveness                       good not only for consumers, but for importers of foreign
                                      intermediate goods, such as capital equipment. But by the
KENNETH ROGOFF,1 Harvard University   same token, a richly valued currency presents problems for
                                      exporters, whose goods become less competitive in global
                                      markets. Do the needs of exporters necessarily trump the
                                      interests of importers? If so, can macroeconomic policy do
                                      anything about it? Does export competitiveness depend
                                      mainly on microeconomic factors? These are fundamental
                                      and difficult questions, and the answers have never been as
                                      simple as some observers might have us believe.
                                            In this short essay, I will try to explain some of the
                                      theoretical and practical problems in identifying severe
                                      exchange rate misalignments.This is particularly relevant,
                                      now that the vast majority of countries in the world have
                                      substantially unified their exchange rate systems, such that
                                      one can no longer simply point to a large black market
                                      exchange rate premium as a compelling sign of exchange
                                      rate misalignment.
                                            Identifying situations of extreme real exchange rate
                                      under- or overvaluation used to be a lot simpler back in
                                      the not-so-distant past, when currency controls were ram-
                                      pant, often resulting in large discrepancies between the           99
                                      officially sanctioned exchange rate and the underground
                                      black (parallel) exchange rate. Indeed, such practices were
                                      the norm throughout most of the developing world until
                                      the past decade, with black market premia of 50 to 100
                                      percent surprisingly common, especially in Africa, Latin
                                      America and, more recently, the CIS countries. A relatively
                                      unusual recent example is Myanmar where, at the begin-
                                      ning of 2003, the (active) black market price of foreign
                                      currency—in terms of domestic currency—exceeded the
                                      official rate by over 700 percent! Not surprisingly, with
                                      such pronounced market-based evidence of overvaluation,
                                      it is not difficult to find corroborating macroeconomic
                                      evidence, such as the fact that the county was experienc-
                                      ing high inflation with little offsetting exchange rate
                                      adjustment. (Myanmar’s premium was hardly the modern
                                      record; the premium in pre-2002 Iraq was reported to be
                                      over 6,000 percent (see Reinhart and Rogoff, 2003)).
                                            In principle, the black market premium, in and of
                                      itself, is not necessarily representative of underlying eco-
                                      nomic forces either, and can reflect many other factors,
                                      such as the severity of punishments for violating currency
                                      controls. In practice, however, large premia turn out to be
                                      very good indicators of underlying pressures, and strong
                                      predictors of the size and direction of future exchange rate
                                      movements (see Reinhart and Rogoff, 2003). Moreover, it
                                      was not the developing countries that invented the idea of
                                      using draconian exchange rate controls as a method of
2.2: Rethinking Exchange Rate Competitiveness

                                                 intervening into foreign trade.The same phenomenon              unit labor costs. I will concentrate on real exchange rate
                                                 plagued much of Europe for some 20 years after World            measures because we have by far the best and most com-
                                                 War II.                                                         prehensive data available, while unit labor costs are only
                                                       Obviously, if governments are setting official            available on a comparable basis for a relatively select group
                                                 exchange rates for their currencies far above observable        of mostly richer countries. Also, many of the basic issues
                                                 market-determined rates, the spread constitutes prima           are the same, regardless of which metric one chooses.
                                                 facie evidence of exchange rate overvaluation, even if an
                                                 exact measurement is still difficult.Today, however, these      Measuring the real exchange rate relative to trend
                                                 black and white cases of exchange rate misalignment are         One problem with comparing real exchange rates is that
                                                 rarer than they used to be. Instead, analysts interested in     different countries typically use different weights in con-
                                                 assessing exchange rate misalignments are generally forced      structing their consumer (or producer) price indices.Thus,
                                                 to rely more on other factors, such as comparisons of           comparisons of overall price levels are immediately cloud-
                                                 labor and product costs in different countries, and on trade    ed by the fact that we are often comparing apples and
                                                 imbalances. Unfortunately, each of these approaches poses       oranges. I will set this problem aside for the moment, not
                                                 problems. And we shall see that, even if they could be          because it is unimportant, but because there is a deeper
                                                 properly measured, it is very difficult to form appropriate     problem, one that is far more difficult to negotiate: price
                                                 quantitative benchmarks.                                        levels constructed by national statistical authorities are
                                                       International measures of relative costs and prices are   invariably indices rather than levels.What may seem a
                                                 fraught with technical difficulties.2 For one thing, non-       mundane distinction to the uninitiated, is actually quite
                                                 traded goods form such a large part of GNP in so many           significant, since comparisons of real exchange rates across
                                                 countries today—estimated at over 75 percent in OECD            two countries will show changes over time, while standard
                                                 countries (see Obstfeld and Rogoff, 2001)—that price            data make it difficult to say anything about levels. In other
                                                 developments can be very different across countries, with-      words, we may be able to compare two countries’ price
                                                 out necessarily implying any misalignment. Nor are trade        indices and exchange rates, and say that goods have
                                                 balances necessarily a clear marker of misalignment.            become more expensive over time in, let us say, Poland,
                                                 Sustained trade imbalances can arise for many reasons—          relative to Argentina. But national price level data can
100                                              e.g., borrowing to finance new investment—which do not          never tell us whether levels of exchange rate-adjusted
                                                 necessarily imply lack of long-run sustainability.              prices are higher in one versus the other.
                                                       Sustained one-way currency interventions to either              Consider Table 1, which lists average real “effective”
                                                 support or hold down the value of a country’s currency          (trade-weighted) exchange rates for 59 countries over the
                                                 are more meaningful, though they, too, may simply reflect       period 1990 to 2004, and compares these average levels
                                                 asymmetries in a country’s other capital controls. (Such is     with real exchange rates at the start of 2005. (In Table 1,
                                                 the case in contemporary China, where one-way inter-            the base year is 1990, so that 1990 = 100.)
                                                 vention reflects, in part, a policy that is more open to cap-         At the top of the list, with the most competitive
                                                 ital inflows than outflows.)                                    exchange rate by this measure, is Argentina. Relative to its
                                                       In this essay, I will begin by focusing on the issue of   1990–2004 average, Argentina’s real exchange rate is
                                                 measuring a country’s real exchange rate, and then turn to      extraordinarily low, almost 50 percent below average, due,
                                                 some of the conceptual problems presented by other evi-         in part, to lingering effects of the currency’s deep depreci-
                                                 dence.The main conclusion is that exchange misalign-            ation set off by the 2001 year-end default.Taiwan also has
                                                 ment—i.e., having an overly competitive or an uncompet-         a low real exchange rate relative to the longer-term aver-
                                                 itive exchange rate—remains an important practical prob-        age, due partly to several recent years of deflation.3 At the
                                                 lem in the global financial system. Because the global          other end of the spectrum, the countries of Eastern
                                                 trend toward more unified exchange rate systems (free           Europe have experienced enormous exchange rate appre-
                                                 convertibility of currency) has eliminated many of the          ciation of 30 percent and more, due, in part, to high pro-
                                                 most obvious cases of misalignment, economists and poli-        ductivity growth, but also because of huge capital inflows,
                                                 cymakers must now think more deeply about the entire            driven by the region’s increasing integration with Western
                                                 concept of exchange rate competitiveness.                       Europe. Interestingly, the real effective exchange rate of
                                                                                                                 the United States dollar, for all its gyrations, was very near
                                                                                                                 its 15-year average at the start of 2005, whereas China’s
                                                 Measurement                                                     effective real exchange rate was only 13.6 percent below
                                                 Measuring the so-called real exchange rate broadly aims at      its average.
                                                 comparing the evolution of purchasing power across cur-
                                                 rencies. In principle, there are many alternative measures
                                                 one could look at to compare costs, including, for example,
2.2: Rethinking Exchange Rate Competitiveness
Table 1: Effective real (CPI) exchange rates:                                    Does this mean that Argentina is the cheapest place in
Current versus 1990–2004 average                                            the world to do business and Eastern Europe the most
                                                                            expensive? Of course not. It only tells us that these
                           1990–2004               Current over- (under-)
                            average      Febuary    valuation relative to   regions have real exchange rates farthest from recent
 Country                   (1990 =100)     2005       15-year average       norms. Nevertheless, we should by no means dismiss the
 Argentina                    147.3        77.2          –47.6%             data in Table 1. Economists generally believe that transito-
 Paraguay                     108.9        77.5          –28.9%
 Egypt                        123.9        92.7          –25.1%             ry factors, such as financial shocks balance out over time,
 Uganda                        78.9        59.2          –25.0%             so long-run averages of any country’s exchange rate are
 Algeria                       62.0        46.8          –24.5%
 Brazil                        76.6        58.4          –23.8%             probably a fair measure of equilibrium, provided the
 Taiwan                        92.0        72.3          –21.4%             country’s current account performance over the extended
 Uruguay                      149.2       120.5          –19.3%
 Saudi Arabia                  96.0        78.3          –18.5%
                                                                            period is reasonably stable. In principle, one can improve
 Malaysia                      95.4        78.5          –17.7%             the measurement of underlying long-run equilibrium
 Bolivia                      102.6        84.8          –17.3%
                                                                            exchange rates by adjusting for factors such as differential
 Philippines                  108.6        90.9          –16.3%
 Israel                       103.8        86.9          –16.3%             growth or wealth effects (see Obstfeld and Rogoff, 1996).
 Pakistan                      91.1        79.0          –13.3%             But even so, examining current deviations from long-term
 Indonesia                     84.8        73.9          –12.9%
 Thailand                      92.7        80.9          –12.7%             averages can be instructive, particularly for outliers.
 Ukraine                      110.4        96.6          –12.5%                  Indeed, a cursory examination of the outliers in Table
 Japan                        118.3       106.9           –9.7%
 Chile                        117.1       108.4           –7.4%             1 confirms that, in the absence of a major productivity
 Singapore                    107.9        99.9           –7.4%             shock—such as a big rise in oil prices for an oil
 Sweden                        88.0        82.2           –6.5%
 Costa Rica                   104.0        97.9           –5.9%
                                                                            exporter—a high real exchange rate is usually a harbinger
 Nigeria                      116.3       109.9           –5.4%             of current account weakness.4 Argentina, with a very low
 Finland                       79.5        76.5           –3.8%
                                                                            exchange rate relative to recent norms, is, indeed, running
 Jordan                       112.4       108.4           –3.5%
 United States                109.0       107.5           –1.4%             a sizable current account surplus.5 So, too, with Brazil,
 Kazakhstan                   105.6       104.1           –1.4%             another country whose real exchange rate is also below
 India                         75.8        75.5           –0.4%
 Venezuela                    156.7       156.2           –0.3%             trend.The countries of Eastern Europe, with sharply
 Morocco                      112.9       112.7           –0.2%             appreciated real exchange rates, are running epic current
 Colombia                     128.0       127.9           –0.1%
 Germany                       94.5        94.7            0.1%             account deficits. For countries in the middle, however, the    101
 Switzerland                  104.4       105.0            0.6%             real exchange rate barometer does not send such a clear
 Norway                        95.9        96.7            0.9%
 France                        98.2        99.2            1.0%
                                                                            signal. For example, the United States today is running
 China                         93.6        94.6            1.1%             record current account deficits at roughly the same real
 Mexico                       118.2       120.4            1.8%
                                                                            exchange rate as it had in 1990, when the country’s cur-
 Sri Lanka                    112.9       117.0            3.7%
 Spain                         90.4        94.2            4.2%             rent account balance was tipping into surplus. (Of course,
 Italy                         88.3        91.9            4.2%             as former French President Charles de Gaulle pointed out,
 Korea                         89.2        93.8            5.2%
 Denmark                      100.4       105.9            5.5%             the United States dollar enjoys the “exorbitant privilege”
 Canada                        84.1        89.0            5.9%             of being the world’s reserve currency and therefore, per-
 Netherlands                  104.3       111.5            6.9%
 Ireland                       94.9       104.1            9.7%             haps, is not representative.) Singapore, with an exchange
 United Kingdom               103.0       115.1           11.8%             rate only slightly more competitive than what it had in
 Australia                     88.7       101.7           14.7%
 Kenya                        117.2       136.2           16.2%
                                                                            1990, ran a current account surplus in excess of 25 per-
 Lithuania                    140.7       163.5           16.3%             cent of GDP in 2004.
 New Zealand                   96.2       113.3           17.8%
                                                                                 But current account positions are only one manifesta-
 Russia                       106.3       126.9           19.3%
 Turkey                       104.2       124.3           19.3%             tion of competitiveness, albeit one that captures a lot of
 Botswana                     105.1       126.2           20.1%             attention. As we shall later discuss in detail, one cannot
 Estonia                      115.1       139.7           21.3%
 Poland                       208.5       272.4           30.6%             simply look at any one variable to determine if an
 Czech Republic               106.9       140.4           31.3%             exchange rate is under- or overvalued. A large current
 Hungary                      138.0       188.0           36.2%
 Bulgaria                     112.8       155.2           37.6%             account deficit is often indicative of problems, but if, for
 Romania                       95.8       134.3           40.2%             example, a country is borrowing to finance productive
Source: International Monetary Fund.                                        investment in the export sector—or in infrastructure to
                                                                            support investment—this is far more likely to be sustain-
                                                                            able that when it is borrowing to finance consumption.

                                                                            Measuring the level of the real exchange rate
                                                                            Another way to compare real exchange rates involves
                                                                            looking outside the data provided by national statistical
                                                                            authorities, and using specialized data sets to measure the
2.2: Rethinking Exchange Rate Competitiveness

                                                 absolute cost of identical baskets of goods in different         Table 2: International comparison of price levels
                                                 countries. (The costs are “absolute” in that they measure
                                                 exchange rate adjustment price levels at a point in time,         Country          Price level (US = 100)    Country          Price level (US = 100)

                                                 rather than price level changes relative to a base year, where    Kyrgyzstan                     8.36        Hungary                       41.78
                                                                                                                   Georgia                       11.28        Poland                        42.25
                                                 the real exchange rate might have been far from equilibri-
                                                                                                                   Ukraine                       12.48        Chile                         44.61
                                                 um.) From a methodological point of view, this approach           Kazakhstan                    14.84        Brazil                        45.13
                                                 is vastly superior to looking at conventional price indices;      India                         17.07        Uruguay                       58.47
                                                 the main problem is that much of the data is constructed          Russia                        17.25        Mexico                        60.79
                                                                                                                   Indonesia                     18.06        Korea, Republic of            64.75
                                                 by small research teams commanding far less funding or            Pakistan                      19.93        Argentina                     65.62
                                                 manpower than a national statistical agency.The most              Zimbabwe                      21.33        New Zealand                   66.25
                                                 important source for international comparisons of prices is       Sri Lanka                     21.94        Venezuela                     69.05
                                                                                                                   China                         23.14        Spain                         73.79
                                                 the Penn World Table (Summers and Heston, 1991), from             Bulgaria                      23.29        Australia                     74.57
                                                 the University of Pennsylvania, and maintained also by the        Philippines                   24.90        Canada                        79.30
                                                 World Bank and the Organisation for Economic Co-                  Uganda                        24.95        Singapore                     80.12
                                                                                                                   Kenya                         26.32        Italy                         81.32
                                                 operation and Development (OECD).These data, which
                                                                                                                   Morocco                       27.09        Netherlands                   90.11
                                                 the World Bank uses to compare incomes across countries,          Algeria                       28.71        France                        90.70
                                                 forms price indices by (essentially) looking at what it costs     Thailand                      29.61        Israel                        92.48
                                                 in each country to buy a specific item or group of items          Estonia                       31.97        Ireland                       92.56
                                                                                                                   Romania                       32.52        Germany                       94.96
                                                 in the United States, known as a consumption basket. While        Colombia                      33.10        Finland                       95.99
                                                 there are many subtleties to such comparisons—it is diffi-        Czech Republic                33.29        United Kingdom                98.50
                                                 cult to ensure that one is measuring goods of similar qual-       Bolivia                       33.93        United States                100.00
                                                                                                                   Egypt                         34.43        Sweden                       104.83
                                                 ity, and the approach does not attach enough importance           Lithuania                     36.47        Denmark                      106.83
                                                 to variety—they at least give us a rough common denom-            South Africa                  36.70        Norway                       112.36
                                                 inator for comparing prices in different countries.               Nigeria                       39.26        Syria                        114.30
                                                                                                                   Jordan                        39.85        Switzerland                  118.14
                                                       In Table 2, we see that by this purchasing power pari-
                                                                                                                   Turkey                        40.34        Japan                        144.83
                                                 ty (PPP) metric, the former CIS countries (including              Malaysia                      40.86
102                                              Georgia, Belarus, and Ukraine) have among the lowest                                             (cont’d.)
                                                 price levels in the world, even lower than those in Africa.      Source: University of Pennsylvania, 2002. Online at:
                                                 But one should not press this nuance too far, since the
                                                 data are relatively poor for these countries.
                                                       Japan and Switzerland are the world’s most expensive
                                                 countries, with Japan being almost 50 percent more               Table 3: The Economist Big Mac Index of exchange rate
                                                 expensive than the United States.The main practical prob-        under- and overvaluation
                                                 lem with PPP data is that their availability tends to be
                                                 very sparse. Comprehensive benchmark studies are avail-           Switzerland                     5.05       Brazil                          2.39
                                                                                                                   Denmark                         4.58       Japan                           2.34
                                                 able only at five-year intervals with the most recent being       Sweden                          4.46       Czech Republic                  2.30
                                                 1996. (Even data for 2001 are not available as of this writ-      Euro area                       3.58       Singapore                       2.17
                                                 ing.) The data in Table 2 for the year 2000 are derived by        Britain                         3.44       South Africa                    2.10
                                                                                                                   New Zealand                     3.17       Poland                          1.96
                                                 using various statistical techniques to extrapolate price
                                                                                                                   United States                   3.06       Argentina                       1.64
                                                 developments from the last benchmark year.6                       Turkey                          2.92       Egypt                           1.55
                                                       One other source of international price-level com-          Peru                            2.76       Hong Kong                       1.54
                                                                                                                   Canada                          2.63       Indonesia                       1.53
                                                 parisons is The Economist magazine’s “Big Mac” index,7
                                                                                                                   Hungary                         2.60       Russia                          1.48
                                                 which gives the cost of a Big Mac hamburger in different          Mexico                          2.58       Thailand                        1.48
                                                 countries, translated into US dollars. Although this index is     Chile                           2.53       Philippines                     1.47
                                                 extremely narrow—perishable burgers are not exactly               Australia                       2.50       Malaysia                        1.38
                                                                                                                   South Korea                     2.49       China                           1.27
                                                 tradable—and there are huge differences in restaurant             Taiwan                          2.41
                                                 ambience across franchises, nonetheless, the index is                                            (cont’d.)
                                                 updated annually, and is surprisingly informative.Table 3
                                                                                                                  Source: The Economist, June 2005
                                                 (based on the most recent survey of June 2005) again
                                                 shows Switzerland at the top with a cost of $5.05, com-
                                                 pared to $3.06 in the United States, with China being the
                                                 lowest-cost country (in the sample) at $1.27. (The table
                                                 does not include all the former Soviet republics, although
                                                 Russia itself is relatively cheap at $1.48.)
2.2: Rethinking Exchange Rate Competitiveness
Conceptual issues in interpreting real exchange rates            make manufactured exports less competitive, it would be
and competitiveness indices                                      wrong to conclude that the commodity-driven apprecia-
Of course, even with the measurement problems discussed          tions are necessarily making the overall economy uncom-
in the previous section, there are still situations where we     petitive since, of course, commodity production constitutes
can speak of compelling evidence that exchange rates are         a major industry also. Instead, the interplay of high com-
overvalued. As mentioned at the outset, the clearest case is     modity prices and real exchange rates should be thought
where a country has currency controls, and where there           of as sending market signals for higher investment in com-
are large observable black market premia. Another is that        modities industries (when prices are up), while the high
of emerging markets, whose real exchange rate is very            real exchange rates depress investment in other industries.
high relative to recent norms, and which are borrowing           In general, as long as the investment decisions are market
heavily to finance mainly consumption rather than pro-           driven, this is perfectly healthy, and should not be con-
ductive investment.These examples are often marked by            fused with a lack of competitiveness.
large capital flows which, if in the form of short-term                The situation is admittedly more problematic in
debt, may be subject not only to a flattening, but to a          countries where commodity production is dominated by
sharp reversal. In these cases, a currency may be overval-       state-run companies, and where investment decisions are
ued, in the sense that its current value is not sustainable      driven as much by politics as by market considerations,
according to any reasonable model. Unfortunately, the            such as Mexico’s Pemex oil company, with its long history
cases where one can make summary judgments are rela-             of problems along these lines. In the extreme, the “curse of
tively rare.                                                     natural resources,” first identified by economic historian
                                                                 David Landau, may actually make a country worse off, by
When does productivity growth justify appreciation of the        its corrupting influence on political management. In gen-
real exchange rate?                                              eral, Dutch disease is far more likely to be a serious distor-
Real exchange rate growth, particularly slow steady real         tion in cases where heavy government intervention in an
exchange rate growth does not always signal overvalua-           economy prevents price mechanisms from generating
tion. Countries experiencing rapid productivity growth           appropriate market responses to commodity price shocks.8
may see rising real exchange rates, but it is generally diffi-
cult to rationalize trend changes of more than a couple of       Problems of real exchange rate appreciation driven by aid        103
percentage points a year this way, mainly because produc-        inflows
tivity growth seldom exceeds world averages by more than         The problem of managing exchange rate appreciations is
a few percent, even in very rapidly growing economies.           not unique to rich countries, but can also affect very poor
For example, many of the countries of Eastern Europe             countries receiving aid flows.The problem could present
have experienced faster productivity growth than their           itself some day in sub-Saharan Africa, particularly if rich
neighbors in Western Europe, but not nearly at the same          countries ever step up to the plate and honor their prom-
pace as their real exchange rates have appreciated. It is        ises to provide much higher levels of aid. If aid ever flows
curious that, since its opening in 1979, China’s real            in earnest, African countries will likely see their currencies
exchange rate has depreciated rather than appreciated in         sharply appreciate as money flows in, bidding up demand
real terms. However, the significance of this is difficult to    for domestic goods, making export industries less compet-
interpret, because producers have been able to draw on a         itive, and increasing the risk of aid dependency.This is not
large and underemployed rural population, thereby                a reason to deny the aid, but it is a more significant com-
restraining price and wage pressures. Of course, this transi-    plication than is the case of commodity exporters. For
tion must ultimately slow at some point, as cities increas-      commodity exporters, high prices mean investment
ingly become congested and polluted.                             opportunities which, if well managed, lead to sustained
                                                                 profits in the commodities sector and overall increases in
Dutch disease                                                    national growth rates even as manufacturing industries
Another important related case to consider is that of oil        suffer and are forced to restructure. For African countries,
exporters and other natural resource-rich countries. It is       the aid will be useful, but there is a risk that the exchange
quite common for resource-rich countries to experience           rate valuation effects may hamper growth.
rapid rises in real exchange rates that hamper competitive-            Once again, it goes without saying that this is not an
ness in other industries, the so-called Dutch disease. For       argument against giving aid, but, rather, is an effective
example, in New Zealand, Canada and Australia, all major         argument for making such aid flows steadier and more
commodity exporters, high commodity prices typically             dependable. It is no favor to a country to give large aid
lead to a higher real exchange rate as wealth effects spill      flows that hurt the competitiveness of its exports, and then
over into domestic demand for these countries’ nontraded         withdraw them after the already poor country’s export
goods (see Chen and Rogoff, 2003). Although such effects         sector has dwindled. Dutch disease constitutes an addi-
2.2: Rethinking Exchange Rate Competitiveness

                                                 tional argument for investing in education and infrastruc-             More fundamentally, export growth is not an end in
                                                 ture, so that exporters’ productivity increases as the real      itself. As was discussed in the introduction, consumers pre-
                                                 exchange rate increases. Naturally, given the high levels of     fer a high real exchange rate that makes imports cheap,
                                                 corruption in many poor countries, donors must beware            not a low real exchange rate that makes them expensive. If
                                                 that their donations do not simply end up in offshore            China’s exchange rate is undervalued, this implies that its
                                                 bank accounts.                                                   consumers are paying more than they would otherwise for
                                                                                                                  imports, leading in turn to lower living standards.The
                                                 Are large trade imbalances prima facie evidence of               notion that undervalued exchange rates are somehow
                                                 misalignment?                                                    more popular, and help maintain social stability must be
                                                 What about trade imbalances? If a country has a large            challenged by the fact that in many democratic countries,
                                                 trade balance surplus or deficit, is that not clear evidence     popular pressure for higher consumption leads to overval-
                                                 that it has an over- or undervalued exchange rate? Many          ued exchange rates, not undervalued ones.
                                                 politicians over the years have reached that conclusion.
                                                 Perhaps they are right, but it is not so simple to prove. In a   Does the United States, the world’s dominant borrower,
                                                 world with increasingly globalized capital markets, coun-        influence misalignment risks?
                                                 tries can run deficits and surpluses for macroeconomic           Last but not least, when one looks at exchange rate com-
                                                 reasons that have little or nothing to do with hypercom-         petitiveness today, there is another overarching issue that
                                                 petitive exchange rates. For example, if a country’s govern-     must be mentioned: in recent years, the United States has
                                                 ment is running a large deficit—let us say, to finance mili-     run increasingly massive current account deficits, Indeed,
                                                 tary expenditures or social welfare payments—it typically        the United States so dominates global borrowing that its
                                                 spills over into a country’s overall current account deficit,    current account deficits accounted for roughly 70 percent
                                                 which, for most countries can simply be thought of as a          of all the current account deficits of all deficit countries in
                                                 generalized version of the trade balance deficit. Indeed, it     the world in 2004! Correcting this phenomenon will
                                                 is a matter of simple accounting, that when the govern-          almost surely bring about an eventual depreciation of the
                                                 ment runs a larger deficit, the country as a whole must          dollar, in real terms, broadly across most of the world, not
                                                 also run a larger deficit—expressed in large part through a      least in emerging markets, which collectively ran a
104                                              trade balance deficit—unless the private sector raises its       US$260 billion current account surplus in 2004.Thus,
                                                 savings rate or lowers its investment rate.The reverse holds     regardless of how they score on today’s competitiveness
                                                 when the government raises its surplus.                          indexes, most countries are likely to see significant further
                                                       Many other macroeconomic factors can have an               appreciation as the US current account and trade deficits
                                                 impact on the trade deficit. If, for example, a country          close up.9 Exchange rate competitiveness is a zero-sum
                                                 scales back on domestic investment, perhaps because it           game, and thanks to the United States, the world is in a
                                                 over-invested in an earlier period, then, unless its savings     bubble, where more countries are going to be looking
                                                 rate is also reduced, it is going to have to run a larger        more undervalued and more competitive than usual.
                                                 trade surplus. In this case, the country’s funds will flow
                                                 abroad to advance investment in more productive regions
                                                 elsewhere in the world. In this case, however, to assume         Conclusions
                                                 that the country’s trade balance surplus results from a          The idea that countries must maintain competitive
                                                 highly competitive exchange rate is to completely misin-         exchange rates is enshrined in the Washington Consensus
                                                 terpret the situation.The trade balance surplus is a sign of     (Williamson, 1989), which firmly warns against grossly
                                                 weakness, rather than strength.                                  overvalued exchange rates. Ask any good international
                                                       This does not mean that countries cannot benefit, in       macroeconomist what key variables they most want to
                                                 certain circumstances, by maintaining a low exchange rate,       know in assessing a country’s overall macroeconomic posi-
                                                 and this policy is viewed by many as the core of the Asian       tion, and the “real” exchange rate—the nominal exchange
                                                 model. Still, it does not follow that a country’s long-term      rate adjusted for price-level differences—will often be
                                                 growth necessarily benefits from having an undervalued           near the top of the list. It makes intuitive sense, even
                                                 exchange rate. For example, there is considerable evidence       though any measure of real exchange rate overvaluation is
                                                 that capital goods imports are important for enhancing           of limited value in isolation from a broader assessment of
                                                 productivity growth (see, for example, the literature fol-       the economy.
                                                 lowing from DeLong and Summers, 1991). But maintain-                  Nevertheless, throughout much of the world, the days
                                                 ing an undervalued real exchange rate makes capital goods        are long gone when one could simply look at black mar-
                                                 imports expensive, affecting not only the traded goods           ket or parallel exchange rates and instantly have a sense of
                                                 sector but also nontraded goods, such as housing.                whether a country’s exchange rate is overvalued.Today,
                                                                                                                  with exchange rates increasingly driven by market
2.2: Rethinking Exchange Rate Competitiveness
forces—even in cases where countries peg, they increas-                           Heston, A., R. Summers, and B. Aten. 2002. Penn World Table, Version
                                                                                       6.1. Philadelphia: Center for International Comparisons at the
ingly use market-based instruments—measuring and                                       University of Pennsylvania (CICUP). October.
assessing exchange rate overvaluation, and, relatedly,
                                                                                  International Monetary Fund. No year. World Economic Outlook Database.
exchange rate competitiveness, has become more subtle.
                                                                                  Kaminsky, G., S. Lizondo, and C. Reinhart. 1998. “Leading Indicators of
The notion that trade balance deficits or surpluses alone                              Currency Crises.” International Monetary Fund Staff Papers. March.
constitute evidence of exchange rate misalignment is                                   1–48.
wrong, simply because trade imbalances often reflect                              Melitz, M. 2003. “The Impact of Trade on Intra-industry Reallocations and
macroeconomic forces rather than trade policy, per se.                                  Aggregate Industry Productivity.” Econometrica 71:1695–1725.
      How, then, should policymakers address exchange rate
                                                                                  Obstfeld, M. and K. Rogoff. 1996. Foundations of International
competitiveness? The short answer is that, for most coun-                              Macroeconomics. Cambridge: MIT Press.
tries, it is not a macroeconomic issue until the exchange
                                                                                  ———. 2001. “The Six Major Puzzles in International Macroeconomics: Is
rate gets conspicuously out of line by historical standards,                         there a Common Cause?” Bernanke B. and K. Rogoff, eds. NBER
especially if this is caused by a dramatic change in mone-                           Macroeconomics Annual 2000. Cambridge: MIT Press. 339–90.

tary or fiscal policy, or in capital inflows. Otherwise, coun-                    ———. 2005. “Global Current Account Imbalances and Exchange Rate
                                                                                     Adjustments.” Forthcoming in Brainard, W. and G. Perry, eds.
tries concerned with maintaining competitive exchange
                                                                                     Brooking Papers on Economic Activity. Washington: Brookings
rates will generally be wise to pursue stable and transpar-                          Institution Press.
ent macroeconomic policies, and to ensure that those                              Reinhart, C. and K. Rogoff. 2004. “The Modern History of Exchange Rate
policies enhance competition and flexibility at the micro-                             Arrangements: a Reinterpretation.” Quarterly Journal of Economics
                                                                                       119(1):1–48. February.
economic level.
                                                                                  Rogoff, K. 1996. “The Purchasing Power Parity Puzzle.” Journal of
                                                                                       Economic Literature 34:647–68. June.

Notes                                                                             Summers, R. and A. Heston. 1991. “The Penn World Table (Mark 5): An
                                                                                      Expanded Set of International Comparisons, 1950–1988.” Quarterly
1 Professor of Economics and Thomas D. Cabot Professor of Public                      Journal of Economics 106:327–68. May.
     Policy, Harvard University. The author is grateful to Gian Maria
     Milesi-Ferretti and Jaewoo Lee for helpful advice, and to Augusto            University of Pennsylvania. 2002. Penn World Table. Philadelphia: Center
     Lopez-Claros and Eyal Dvir for helpful comments on an earlier draft.              for International Comparisons at the University of Pennsylvania
2 Witness how much difficulty Europe has had in aggregating inflation
     rates across its member states to form a euro-area inflation rate.           Williamson, J. 1989. “What Washington Means by Policy Reform.”
                                                                                        Institute for International Economics. Mimeo.
3 With the exchange rate against the dollar relatively stable, and with
     inflation in the United States, deflation in Taiwan means that goods
     are becoming cheaper relative to the United States, i.e., that the
     country’s real exchange rate is declining.

4 Empirical evidence on real exchange rates suggests that they tend to
    be more predictable when deviations from trend are large; reversion
    to mean seems faster for large deviations; see Obstfeld and Rogoff,

5 Admittedly, running a deficit is not an option when a country is in

6 For a detailed description of the data, see Heston et al, 2002, online at

7 The Economist, June 2005.

8 An important issue, which cannot be addressed in such a brief article, is
     how resource rich countries may insulate themselves from commod-
     ity price volatility. In principle, this can be done through world capital
     markets, although in practice, political economic problems may inter-
     fere with optimal reserve management.

9 See Obstfeld and Rogoff, 2005, who estimate that if the US current
    account were to be cut in half from 6 percent to 3 percent of GDP
    over one to two years, the trade-weighted dollar would likely fall by
    roughly 15 percent, with Asian currencies rising by 18 percent and
    non-Asian currencies by 10 percent.

Chen, Y. and K. Rogoff. 2003. “Commodity Currencies.” Journal of
     International Economics 60:133–160. February.

DeLong, B. and L. Summers. 1991. “Equipment Investment and
    Economic Growth.” Quarterly Journal of Economics 106(2):445–502.

The Economist. June 2005.
You can also read
NEXT SLIDES ... Cancel