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336
Cato Journal
PWT 6.2 data.
17
Table 6 introduces the effect of currency misalign-
ment in the conventional fashion as the average value for the
19702004 period. The Easterly UV variable is not significant, in line
with results obtained by several reports using this variable. All the
other three average UV variables (JOS, SAE, and Razin-Collins) are
statistically significant and with similar magnitudes, around 0.014.
The three have been estimated by very different methods, and the
result that they are all significant and of a similar magnitude can be
interpreted to mean that currency undervaluation is a significant
determinant of economic growth. Also, the fact that the Dollar-
Easterly undervaluation variable is not significant may have more to
do with the method of construction (whose large measurement error
has been noted earlier) than with the relevance of currency under-
valuation as a growth determinant. Nevertheless, the low magnitude
of the coefficient, an extra 10 percent real devaluation leads to only
a 0.14 percent extra growth,
18
is not indicative of currency policy
being of major importance.
Table 6 also reports the results for the effect of undervaluation on
growth when both the initial 1970 level and the average change in
undervaluation are introduced into the regressions. This makes no
difference to the results for the Dollar-Easterly data as both under-
valuation terms are insignificant; for the Razin-Collins variable, only
the initial UV variable is significant; and for the JOS and SAE meas-
ures, both undervaluation variables are significant and with the
expected negative sign. The coefficient of the dUV term is large, very
significant, and for the SAE model, yields a value of 0.43; thus each
sustained 1 percent annual decrease in the real exchange rate yields
an extra 0.43 points of per capita GDP growth per year. For China,
the average value of dUV for the 19702004 period was 6.7 percent
per annum yielding (6.7 x 0.43) 2.9 percent extra growth. Average
per capita growth in China during this period was 5.7 percent per
annum so approximately half of this miracle growth was attributa-
ble to Chinas aggressive policy of exchange rate devaluation.
17
I would like to thank Arvind Subramaniam for kindly making the PRS data avail-
able and allowing for replication of their specifications and results.
18
PRS (2007: 199) erroneously report that the impact of UV is much larger at 0.4 for
each 1 percentage point change. Their coefficients for different models range from
0.006 to 0.039; the maximum effect they find is 0.04 for each 1 percentage point
change (p. 200).
337
Currency Undervaluation
There are several other results that emerge from estimating the
PRS model with measures of currency misalignment. In their base
model, PRS find that the current account surplus variable is positive
and statistically significant. The authors interpret this finding as evi-
dence that (paradoxically) access to foreign capital may not have
played a productive growth role in developing countries. Upon intro-
duction of the exchange rate undervaluation variables (both as aver-
age and as initial level and change), the coefficient of the current
account balance variable is rendered insignificant. This suggests that
the PRS assertion that high economic growth is associated with cur-
rent account surpluses is incorrect; a cheaper exchange rate can lead
to an excess in the current account.
Foreign capital is most likely attracted to countries with a cheap
exchange rate. This leads to higher growth, and the desire to perpet-
uate the virtuous cycle. More undervaluation, more foreign invest-
ment, higher growth, and intervention to keep the real exchange rate
cheap. Some countries accumulate reserves, and have a high growth
rate; others import more than they can export, and have current
account deficits. Current account surplus or deficits are just not
related only to differences in growth rates. This result is also obtained
with PRSs own variable of currency undervaluation.
The other prominent side result of this exercise is the reduced size
of the Africa dummy once currency misalignments are accounted for.
Depending on the measure used, the coefficient drops from a high
1.7 (Easterly) to 1.05 (SAE). This suggests that part of the impor-
tance of the subSaharan Africa dummy found by various authors is
due to the misspecification of the currency undervaluation variables.
Stated differently, it is likely that African countries grew at lower
rates than expected (not unlike Latin America) because their
exchange rates were overvalued. This is the flip side of the miracle
growth explained by currency undervaluation for several countries,
like China. Low growth, just like high growth, is in large part a func-
tion of currency overvaluation or movements toward overvaluation.
Conclusion
Considerable research exists on the question of the determinants
of economic growth. This article offers a new perspective: The pat-
tern of investments and economic growth can in large part be
explained by the level, and change, of currency undervaluation.
338
Cato Journal
Generally, each 1 percent per annum sustained increase in underval-
uation leads to an extra 0.3 to 0.4 percent of GDP growth. Each 1
percent of initial undervaluation leads to only a 0.01 percent increase
in growth. The change in the undervaluation effect (not emphasized
in the literature) is considerably stronger than the level effect. The
results are especially strong for a new measure of currency underval-
uation offered here and in Bhalla (2008b)this measure is based on
an expected S-shaped pattern of income growth and real exchange
rate appreciation.
The opposite side of the argumentthat real exchange rates are
endogenously determined and therefore cannot be a policy choice
variableis also examined. Country and regional experiences are
evaluated to document the veracity of the exchange rate is endoge-
nous hypothesis. Several definitions, and measurement, of the real
exchange rate are explored. Across a variety of definitions, the robust
result still obtains: the real exchange rate is policy determined, with
undervaluation promoting growth and overvaluation harming
growth. The literature has mostly emphasized the latter.
Confirmation of the former effect has not generally been obtained,
most likely because of mismeasurement of the variable representing
currency overvaluation.
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