Currency Policy

in Developing Nations
Q: Many developing countries maintain overvalued currencies.
When is a currency overvalued?
A: In order to buy goods and services from other countries, businesses
and consumers must pay for those items in the seller country’s
currency. Thus if I wanted to buy wheat in Argentina, I would have to
sell U.S. dollars to obtain Argentine pesos. A country’s currency is overvalued when it has
“unusually high” purchasing power on the world market. This typically occurs when a
country’s currency is pegged to another currency. For example, the Argentine peso is
pegged to the US dollar at a ratio one-to-one (1 peso = 1 dollar). In the year that the peg
was created, an Argentine could buy $10,000 worth of goods for 10,000 pesos. Over time,
the price of currency may shift (see below) and in 1995 that same Argentine could now buy
$10,000 worth of goods for only 5,000 pesos. An Argentine peso buys more in 1995 than
in 1990 based upon the overvaluation of Argentina’s currency (holding domestic
productivity gains constant).

Q: Why do currencies become overvalued?

A: There are many reasons why a currency increases in value, including trade surpluses, high
interests rates, and foreign investment. All of these things create a demand for a home
currency and push its value up (via simple supply and demand). However, the most
common reason in developing countries for an overvalued currency is inflation. As
governments try to industrialize rapidly, the often end up “printing money” to encourage
capital investment and consumer spending. If inflation in one country outpaces another
country, the currency of the high-inflationary economy appreciates. The effects are most
pronounced when the two countries have a “pegged” exchange rate – i.e., the rate at which
one buys and sells currency is fixed at a set amount.

Imagine the following scenario. Argentina pegs its currency to the US dollar at a one-to-
one ratio in 1992. You go down to Buenos Aires to buy a pastry that costs 1 peso, thus you
are essentially spending $1. Let’s say that no inflation occurs in the U.S. over the next 5
years, but prices in Argentina double (i.e., 100% inflation) over the same time period. A
pastry now costs 2 pesos in Buenos Aires. In line with the inflation rate, most Argentines
will see a similar doubling of their income, thus while a pastry is nominally twice as
expensive, the real price of that pastry for Argentine citizens has not changed. However,
since your wages did not increase in the US (because of 0% inflation), you
must cough up $2 for the exact same bakery item. You end up
paying twice as much in real terms for that delicious donut.
Just imagine now if you were buying 30 metric tons of
Argentine wheat to make pastries back in the US; your
input prices would double in real terms. Reverse this
scenario. Say an Argentine gaucho wants to buy a
$10,000 John Deere tractor for his ranch. In 1990, this
would have cost him 10,000 pesos in real terms. But by
1995, his annual income has doubled though the nominal price
of the tractor has not, thus in real terms the tractor would cost half as much. A good deal!
Not surprisingly, Argentine gauchos would also enjoy cheap vacations to Disneyland.
 Q: What are the effects of an overvalued currency?
A: As can be seen from the scenarios above, a country with an
overvalued exchange rate finds that imports (e.g., tractors) are cheaper
while their exports (e.g., wheat) are more expensive. Not surprisingly,
Argentines will want to import more goods from abroad, while non-
Argentines will be more reluctant to buy Argentine goods. Thus, an
overvalued exchange rate helps consumers and industries that rely on
imports, but hurts the export sector. (In developing countries, the
export sector is usually agriculture and/or mineral extraction.) Over
time, imports will exceed exports and drain the amount of foreign
exchange a country holds (creating a foreign exchange crisis). This makes
it more difficult to buy goods from abroad. Or, if a country is servicing a debt to
another country, it makes it difficult to pay off that loan. This is what happened in Mexico
in 1994.

Q: Why do countries maintain an overvalued exchange rate?

A: Simple “interest group” logic dictates that industries reliant on imported inputs will lobby
extensively to preserve an overvalued exchange rate, while exporters will want a
devaluation. In countries trying to industrialize, capital-importing industries tend to be
favored over the more traditional agricultural import sector, thus they win the policy
debates and the currency remains overvalued. This policy cannot be pursued in the long
term, however, since eventually the country will run out of foreign currency reserves and
be unable to buy anything abroad (or pay off any foreign debts).

Q: Why do countries devalue their currency?

A: When foreign currency reserves run low and/or the export sector can no longer sell its
goods abroad, the government becomes hard pressed to devalue its currency. With an
overvalued peso, Argentines find it hard to sell their wheat and beef to the U.S., thus they
cannot earn dollars with which to buy John Deere tractors. The country devalues either by
setting a new fixed exchange rate that is in line with real purchasing power (e.g., 2 pesos =
1 dollar), or allowing it to “float” and find its international market value.

Q: What are the effects of a devaluation?

A: Typically, devaluations make a country’s exports less expensive while making imports
more expensive. This helps to reverse a country’s trade deficit (imports exceeding exports)
and allows them to earn foreign exchange. However, it also has some serious short-term
side effects. To the extent that a country’s relies on imported capital and consumer goods,
inflation will immediately heat up. This is ironic in that the country’s currency originally
became overvalued because of inflation. Inflation tends to dampen both foreign and
domestic investment because future prices (and hence returns on investment) become
unpredictable. Governments often respond by taking measures to prevent inflation from
soaring – e.g., high interest rates, cut government spending, raise taxes. These policies tend
to have a recessionary effect, thus the typical effect of a devaluation is “stagflation” (i.e.,
high inflation combined with a slowdown of economic activity). Lots of
businesses go bankrupt, people lose their jobs and can’t afford the
higher price of goods. The more drastic the
devaluation, the more severe the economic crisis that
follows. Consider Mexico in 1995 and much of
Southeast Asia in 1998.
Q: If overvalued currencies and the “inevitable” resulting devaluation are so harmful to
a country’s economic well being, why not just allow the currency to “free float”?
Why maintain a fixed exchange rate?
A: This is a tough question that gets to the heart of a great debate among economists. While
many economists advocate a “free float” (i.e., letting the international market determine the
value of a country’s currency), such a policy can often lead to rapid and radical fluctuations
in a country’s currency, often on a daily basis. Speculation (making money by betting on
what the currency will be valued at) often increases this volatility. Many business
transactions are negotiated with contracts that require delivery of goods and/or payments
several months down the road. If the value of a currency is unpredictable, businesses are
less likely to invest in, or buy goods from, that country. After all, who wants to invest in a
country when that investment could become worthless overnight?

A fixed exchange rate, on the other hand, provides some certainty about future prices and
can encourage investment. It is also a hedge against currency speculation. However, this
can lead to eventual overvaluation and all the problems noted above. Furthermore,
devaluations are often announced without warning. It is risky for a business to invest in a
country with an overvalued exchange rate since the government may announce a
devaluation at any time. Also, speculators often wait in the wings trying to anticipate when
a devaluation will occur thereby putting greater pressure on the overvalued economy’s
foreign reserves (if the Argentine government looks like it will devalue, you want to be
holding dollars, so many foreigners and Argentines start to stockpile dollars). In recent
years, governments have committed themselves to a pegged exchange rate (usually against
a stable currency like the US dollar) and pursued policies that are designed to keep inflation
low. This provides a signal of security to the international market, but may create
recessionary pressure in the home country (especially if there are other inefficiencies in the
rest of the economy – e.g., a rigid labor market or ill-specified property rights).

Some countries (e.g., Chile) have resorted to a “crawling peg” system that allows them to
devalue their currency at a predictable rate and at regular intervals. This prevents
overvaluation while simultaneously providing predictability to investors. Unfortunately,
this often creates a “self-fulfilling prophecy” of anticipated devaluations making it difficult
for a country to stabilize its currency and encouraging
inflationary pressures when none would “naturally” exist.
Furthermore, such a regime is only effective in country’s
that have fairly stable, low inflation economies. In short,
creating an “ideal” foreign exchange policy is very
difficult at best.

Now this isn’t the whole story behind currency policy. Many other things – such as trade,
debt servicing, etc. – can affect the international price of a currency. However, the story
laid out above is pretty typical and is useful to understand when reading Robert Bates’
Markets and States in Tropical Africa.

P.S. I wrote this sheet back in 1998. Argentina was pretty expensive for gringos back then. Since it
devalued its currency, traveling to Argentina (and buying Argentine wine) has become a much better
value – if you don’t mind political instability.