Exchange Rate,Capital Control, and Industrial Policy

1
Exchange Rate,Capital Control, and Industrial
Policy

• Filomeno S. Sta. Ana III
• Action for Economic Reforms

2
Outline

• Exchange rate, institutions, and long-term growth
• Basic concepts
• Problems with currency overvaluation
• Policy preference for undervaluation
• The relevance of capital control
• Challenges

3
Exchange Rate and Institutions

• Quality of institutions is a determinant of
  long-term economic growth (see Dixits survey of
  literature, 2005).
• Skepticism on policy being a predictor of growth
  (e.g., Easterly, Rodrik)
• But policy can help shape or change institutions
• For example, good tax policy and administration
  can change behavior of taxpayers, making them
  comply to rules.
• So is the case of exchange-rate policy
  Incentives arising from competitive or
  undervalued currency unleash entrepreneurship,
  productivity, innovation, and social cohesion.

4
Behavior of the exchange rate

• The difference between the rate of return on
  domestic assets (r) and the rate of return on
  foreign assets (R) is equal to the sum of the
  risk premium (z) and the expected rate of
  depreciation.
• Thus, we have this equation r-R z (E-E)/E.
• Or EE/(r-R-z 1)
• when E goes up, so does E (depreciation) when r
  gt R increases, E decreases (appreciation). When
  z increases (note the minus sign before z), E
  likewise increases (depreciation).

5
Behavior of the exchange rate

• A bullish stock market or a boom in real property
  (an increase in r -R) attracts foreign currency
  inflow, thus contributing to currency
  appreciation.
• Political disturbances and uncertainty (an
  increase in z) discourage inflow and abet
  outflow, thus resulting in depreciation.
• Economic shocks or crises trigger massive capital
  flight, causing the currency to take a sharp
  plunge.

6
Is there a market-determined exchange rate?

• Policies have an impact on exchange
  rate--interest rate, taxation, public spending,
  labor policy, inflation targeting, signaling
  etc.--which influence market behavior on exchange
  rate.

7
Nominal rate vs. real exchange rate

• What matters is the real exchange
  rate--purchasing power parity (PPP)
• This is expressed as P V x P Where P is the
  price of domestic goods, P is the price of
  foreign goods, and V is the real exchange rate.
• The real exchange rate V is the ratio of P/P. An
  increase in the price of domestic goods relative
  to foreign goods increases (depreciates) the real
  exchange rate.

8
Costs of overvaluation benefits of
undervaluation

• An overvalued currency is bad for growth but more
  to the point, an undervalued currency translates
  into higher long-term growth.
• Overvaluation shifts incentives away from
  investments in exports, domestic industries, and
  non-traditional agriculture, thus likewise
  adversely affecting job creation.
• Undervaluation enhances relative profitability
  of tradable goods.
• For developing countries, undervaluation
  compensates for prevalence of institutional and
  market failures. Competitive price makes up for
  these failures.

9
Undervaluation as Growth Booster

• Rodrik High undervaluation enhances growth a 10
  percent undervaluation translates into an
  increase in growth .026 percentage points. In
  China, a 10 percent undervaluation boosts growth
  by .086 percentage points!
• Undervaluation has a causal impact on growth.
  (Reverse does not apply.)

10
Necessity of Undervaluation

• Growth of tradables of developing countries is
  constrained by a) institutional or government
  failures and b) market/ coordination failures.
• Undervaluation compensates for these failures
  e.g., tradables, more than non-tradables, suffer
  from market imperfections

11
Strategy of Undervaluation

• To reiterate, overvaluation is bad a nominal
  exchange rate aligned to real exchange rate is
  insufficient and undervaluation boosts growth.
• But a strategy of undervaluation is not easy to
  do.
• Sterilizing inflows is costly high opportunity
  costs.
• Taming of inflation that is, depreciation rate gt
  inflation rate

12
Hence, the importance of Capital/Financial Control

• Sends the signal about the desired future
  exchange rate (increase E).
• Or decrease r (rate of return on domestic assets)
• Thus driving up E (exchange rate).
• Nudge or redirect capital towards the real sector.

13
Challenges

• End of the period of export orientation, in light
  of the 2008-09 global economic shock.
• But undervaluation is not just about exports.
• What matters is not export output but output of
  tradables.
• Import substitutes also benefit from
  undervaluation.
• Undervaluation serves the whole real sector.

14
Challenges

• Global imbalances contributing to global
  recession (thought not a principal factor) will
  make undervaluation undesirable from the
  perspective of macroeconomic stability.
• But what options are available to developing
  countries, if the tool of undervaluation is taken
  away from them?

15
Undervaluation is a form of industrial policy

• Price competitiveness substitute for tariff.
• Undervaluation strategy became the first option
  because of the constriction of space for a wide
  range of industrial policy tools.
• To address the tension between global macro
  objectives and developing countries growth and
  development objectives, it will be necessary to
  relax the global rules (e.g., WTO rules) that
  discourage the use of industrial policy.

16
State capacity

• Neoliberals frown upon managing exchange rate and
  having industrial policy for developing
  countries, arguing that the costs are too high.
• Their argument Regulatory capture by vested
  interests especially when the state is soft or
  weak.

17
Market failure versus state failure (The Fabella
line)

• How to maximize public welfare, when market
  failure is prevalent (e.g. financial markets)?
• Market failure occurs when un-intervened social
  outcome W is inferior to a feasible desired
  social outcome W (W gt W).
• Realizing W requires state or institutional
  intervention, but such intervention will entail
  some kind of transactions cost or C(m).

18
Market failure versus state failure

• If the transaction costs are too high, to the
  point of negating W, (in other words, state
  failure), it does not make sense to have
  intervention (rein back the state).
• To quote Fabella A market that the relevant
  state cannot improve upon is not a market
  failure.

19
Response to the Fabella line

• As applied to capital/financial markets, W gt
  C(m) W. In other words, the gains from
  output, incomes and employment arising from
  capital/financial regulation far outweigh the
  costs of corruption and rent seeking and the
  inferior gains from the status quo.
• In other words, a level of predictable corruption
  and rent-seeking can be tolerated.
• But at the same time, we need to strategically
  address the C(m) or strengthening states
  capacity as enabler and regulator. This is in the
  main a political, institutional agenda,
  preferably done by winning political power.