Exchange Rates, Foreign Capital, and Development

Arvind SubramanianPeterson Institute for International Economics, Center for Global Development, and Johns Hopkins University

XXV Meeting of Latin American Network of Central Banks and Finance Ministries

May 17, 2007

Outline• What is development about?

• Modes of escape from under-development

• Exchange rate, especially avoiding overvaluation, can play a very useful role

• Foreign capital limits the ability to influence real exchange rate

• Other policies for boosting domestic savings?

What is Development?

• Development is ultimately about doing different and more sophisticated (high “value-added”) things

• Important stylized fact: Countries first diversify on their way to development and specialize only later, much later (Imbs and Wacziarg, 2003)

• And doing different things can itself boost growth (virtuous circle)

Development is about diversification

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.1.1

5.2

Herf

inda

hl In

dex o

f C

on

cen

tra

tion

1970 1980 1990 2000Year

Asia Latin AmericaIndia China

• Subramanian, 2007 based on Imbs and Wacziarg, 2003

And diversification can help growth

• Kochhar et. al., 2006

AP

AS

BH

DL

GJ

HY

JK

KK

KL

MH

MP

OR

PJRJTN

UPWB

0.1

.2.3

.4

Herf

inda

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198

2

1 2 3 4 5Average annual growth rate of NSDP per capita 1980-2000(%)

Diversification Index

Modes of Escape• Three or four different patterns of escape from

underdevelopment

• Manufacturing– China, East Asia, Mauritius, Tunisia, Chile?

• Services – India

• Commodities (escaping the natural resource curse)– High endowment per capita (Dubai, Saudi Arabia, Brunei,

Kuwait)– Not very high endowment per capita but reasonable initial

institutions (Botswana, Chile?, Indonesia??)

Escape through manufacturing

Chart 1. Manufacturing Exports to GDP (1960-2005)(in percent)

0

10

20

30

40

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Year

Man

ufac

turi

ng E

xpor

ts to

GD

P

Asia

Latin America

China

Sub-Saharan AfricaIndia

Tradables and exchange rates• Combine diversification and modes of escape: Empirically, new and

different things are largely tradables, typically manufacturing but also agricultural (Chile) and services (India)

• Important distinction not necessarily manufacturing versus services but non-commodity tradables versus others

• Many reasons for why tradables might be important and why they are prone to being under-produced– Tradables are institutions-intensive

• What are the mechanisms for and determinants of doing new and different things, i.e. for tradable manufacturing and services?

• Many determinants: human capital; institutions etc. but exchange rate an important one

Alternative Instruments• Compare three policy instruments: industrial policy/protection; trade

preferences and exchange rates

• Conventional industrial policy: picking winners; rent-seeking and administrative costs; credible withdrawal; market test

• Trade preferences: minimizes rent-seeking and administrative; but uncertain value subject to depreciation based on external factors (Mauritius, Mexico)

• Exchange rate has the following virtues:– Helps all tradables not just import-competing of exports– Avoids costs (rent-seeking, corruption, picking winners and

losers) of industrial policies– Is self-targeting and rewards efficient performance– Is self-eliminating (trend appreciation)?

Exchange Rates (overvaluation) and Growth

Chart 3. Exchange Rates: Exchange Rates: Deviation from Long-Run Equilibrium (1960-2000)(+ deviation signifies overvaluation)

-60

-40

-20

0

20

40

60

1960 1965 1970 1975 1980 1985 1990 1995 2000

Year

Ove

rval

uati

on

Asia

Latin America

Sub-Saharan Africa

• Johnson, Ostry, and Subramanian, 2007

Overvaluation and growth—contd.• Defining overvaluation (Johnson, Ostry and

Subramanian, 2007)—departure of country’s exchange rate from very long run PPP rate

• Africa: Average overvaluation=18 percent compared with -17 percent for Sustained Growth countries

• Econometric evidence: – A 1 percentage point overvaluation reduces long run

growth by about 0.1 percent (Prasad, Rajan and Subramanian, 2007, and Rodrik, 2007). Symmetric?

– Overvaluation reduces the growth of manufacturing exports (Rajan and Subramanian, 2005 and Prasad, Rajan and Subramanian, 2007)

Overvaluation and growth—contd.

-40

-30

-20

-10

Overv

alu

atio

n (

pe

rcen

t)

-20

24

68

Rea

l pe

r ca

pita

GD

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row

th

-10 -5 0 5 10 15T

Real per capita GDP growth Overvaluation

• Prasad, Rajan and Subramanian, 2007

Some country examples: China

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8.1

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-1-.

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50 60 70 80 90 100period_code...

log undervaluation growth

• Rodrik, 2007

Some country examples: India

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-.2

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log

und

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50 60 70 80 90 100period_code...

log undervaluation growth

Is the real exchange rate susceptible to policy?

• The RER is an endogenous variable: determined in equilibrium by the balance between saving and investment

• Less foreign savings and more domestic savings, the less overvalued the exchange rate and hence greater growth

Above Median

Below Median

Below Median

Above Median

0.00

1.00

2.00

3.00

Ave

rage

Per

Cap

ita

GD

P G

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Investment/GDP

Current Account/GDP

Figure 6. Current Accounts, Investment and Growth in Developing Countries

Growth and the Current Account Balance over

Time: Non-parametric Relationship

-6-4

-20

24

Pe

r ca

pita

GD

P g

row

th

-5 0 5 10 15Average current account balance to GDP

1970-79 1985-971990-97 1999-04

Foreign Savings and Growth

• Foreign capital makes real exchange rate management difficult (level not volatility). Leads to appreciation and lower growth– Impact of foreign aid on exchange rates and exports

(Rajan and Subramanian, 2005)– Impact of private capital on exchange rates and

exports (Prasad, Rajan and Subramanian, 2007)

• Sterilized intervention– Recent experiences of China and India

Foreign capital and Overvaluation, 1970-2004

KOR

IRN

BGD

IND

ETH

DZAZAF

MUS

GUY

TUR

URY

LKAZWE

ISR

MDG

HTI

MWIKEN

PAKIDN

CMR

SLV

RWA

PRY

COL

VEN

SEN

ARG

MAR

BRA

JOR

GHA

PHL

CIV

MLI

GTMECU

UGA

THA

CHLHND

DOMPEREGY

CHN

TZA

JAM

TUN

CRI

MEX

CYP

NGA

SLE

ZMB

TTO

BOLMYS

PAN

-50

05

01

00

Resid

uals

of ave

rag

e o

ve

rvalu

ation

-.02 -.01 0 .01 .02 .03Residuals of average net fdi flows to GDP

coef = 837.49992, (robust) se = 363.32526, t = 2.31

Domestic Savings

• For Latin America, genie is out of the bottle, so need to focus on domestic savings

• Government savings: Fiscal policies may need to be even stronger than suggested by normal macroeconomic/fiscal criteria

• Private savings

Conclusions

• Development—doing different things and fostering tradables--requires keeping an eye on the real exchange rate.

• Challenge is how? Probably a variety of things

• Especially challenging for Latin America with open capital accounts