The Real Exchange Rate and Economic Growth

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ABSTRACT I show that undervaluation of the currency (a high real exchange rate) stimulates economic growth. This is true particularly for developing countries. This finding is robust to using different measures of the real exchange rate and different estimation techniques. I also provide some evidence that the operative channel is the size of the tradable sector (especially industry). These results suggest that tradables suffer disproportionately from the government or market failures that keep poor countries from converging toward countries with higher incomes. I present two categories of explanations for why this may be so, the first focusing on institutional weaknesses, and the second on product-market failures. A formal model elucidates the linkages between the real exchange rate and the rate of economic growth.


Economists have long known that poorly managed exchange rates can be disastrous for economic growth. Avoiding significant overvaluation of the currency is one of the most robust imperatives that can be gleaned from the diverse experience with economic growth around the world, and one that appears to be strongly supported by cross-country statistical evidence. (1) The results reported in the well-known papers by David Dollar and by Jeffrey Sachs and Andrew Warner on the relationship between outward orientation and economic growth are largely based on indices that capture the degree of overvaluation. (2) Much of the literature that derives policy recommendations from cross-national regressions is now in disrepute, (3) but it is probably fair to say that the admonishment against overvaluation remains as strong as ever. In his pessimistic survey of the cross-national growth literature, (4) William Easterly agrees that large overvaluations have an adverse effect on growth (although he remains skeptical that moderate movements have determinate effects).

Why overvaluation is so consistently associated with slow growth is not always theorized explicitly, but most accounts link it to macroeconomic instability. (5) Overvalued currencies are associated with foreign currency shortages, rent seeking and corruption, unsustainably large current account deficits, balance of payments crises, and stop-and-go macroeconomic cycles, all of which are damaging to growth.

I will argue that this is not the whole story. Just as overvaluation hurts growth, so undervaluation facilitates it. For most countries, periods of rapid growth are associated with undervaluation. In fact, there is little evidence of nonlinearity in the relationship between a country's real exchange rate and its economic growth: an increase in undervaluation boosts economic growth just as powerfully as a decrease in overvaluation. But this relationship holds only for developing countries; it disappears when the sample is restricted to richer countries, and it gets stronger the poorer the country. These findings suggest that more than macroeconomic stability is at stake. The relative price of tradable goods to nontradable goods (that is, the real exchange rate) seems to play a more fundamental role in the convergence of developing country with developed country incomes. (6)

I attempt to make the point as directly as possible in figure 1, which depicts the experience of seven developing countries during 1950-2004: China, India, South Korea, Taiwan, Uganda, Tanzania, and Mexico. In each case I have graphed side by side my measure of real undervaluation (defined in the next section) against the country's economic growth rate in the same period. Each point represents an average for a five-year window.

To begin with the most fascinating (and globally significant) case, the degree to which economic growth in China tracks the movements in my index of undervaluation is uncanny. The rapid increase in annual growth of GDP per capita starting in the second half of the 1970s closely parallels the increase in the undervaluation index (from an overvaluation of close to 100 percent to an undervaluation of around 50 percent (7)), and both undervaluation and the growth rate plateau in the 1990s. …