Rethinking Exchange Rate Competitiveness
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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 of2.2: 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 the2.2: 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: http://pwt.econ.upenn.edu/
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 market2.2: 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.
November.
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
(CICUP).
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.”
105
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,
2001.
5 Admittedly, running a deficit is not an option when a country is in
default!
6 For a detailed description of the data, see Heston et al, 2002, online at
http://pwt.econ.upenn.edu/
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.
References
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
