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Exchange Rates, Foreign Capital, and Development Arvind Subramanian Peterson 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 “valueadded”) 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) .05 .1 .15 .2 Development is about diversification 1970 1980 1990 2000 Year Asia India Latin America China • Subramanian, 2007 based on Imbs and Wacziarg, 2003 And diversification can help growth .4 Diversification Index .3 AS .2 BH MP OR .1 JK GJ UP PJRJ KL WB DLMHAP TN KK 0 HY 1 2 3 4 Average annual growth rate of NSDP per capita 1980-2000(%) • Kochhar et. al., 2006 5 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) 40 30 Manufacturing Exports to GDP Asia 20 China 10 Latin America Sub-Saharan Africa India 0 1960 1965 1970 1975 1980 1985 Year 1990 1995 2000 2005 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 Sub-Saharan Africa Overvaluation 20 Latin America 0 -20 Asia -40 -60 1960 1965 1970 1975 1980 Year • Johnson, Ostry, and Subramanian, 2007 1985 1990 1995 2000 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) -20 -30 -2 -40 0 2 4 Overvaluation (percent) 6 8 -10 Overvaluation and growth—contd. -10 -5 0 5 10 T Real per capita GDP growth • Prasad, Rajan and Subramanian, 2007 Overvaluation 15 -1 .04 0 .02 -.5 growth .06 0 .08 .1 .5 Some country examples: China 50 60 70 80 period_code... log undervaluation • Rodrik, 2007 90 growth 100 .01 -.2 0 .02 .2 growth .03 .4 .6 .04 Some country examples: India 50 60 70 80 period_code... log undervaluation 90 growth 100 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 Figure 6. Current Accounts, Investment and Growth in Developing Countries Average Per Capita GDP Growth 3.00 2.00 1.00 Above Median 0.00 Below Median Above Median Below Median Investment/GDP Current Account/GDP -6 -4 -2 0 2 4 Growth and the Current Account Balance over Time: Non-parametric Relationship -5 0 5 10 Average current account balance to GDP 1970-79 1990-97 1985-97 1999-04 15 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 100 Foreign capital and Overvaluation, 1970-2004 50 NGA TZA ISR TUR KOR IRN GHA UGA VEN ARG BRA CYP 0 PAN JAM CHN MEX CMR MDG SEN CIV CHL HND URY CRI ETH JOR DOM MWI KEN ZAF MLI DZA COL THAPER EGY MAR GTM RWA GUY ECU TUN IND IDN SLV PAKPRY LKA BGD ZWE PHL -50 ZMB SLE TTO MYS BOL MUS HTI -.02 -.01 0 .01 .02 Residuals of average net fdi flows to GDP coef = 837.49992, (robust) se = 363.32526, t = 2.31 .03 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