The Conditional Effect of Interest Groups on Undervalued Exchange Rates

David SteinbergUniversity of Oregon

The Puzzle

Undervalued Exchange Rates are Beneficial

– Increases economic growth (Dollar 1991; Rodrik 2008)

– Reduces unemployment (Frenkel & Ros 2006)

– Prevents financial crises (Reinhart & Rogoff 2009)

 

Exchange Rate Overvaluation (Median 2006)

All Developing Countries 3.4%Middle East & North Africa 18.1%Sub-Saharan Africa 7.9%

Latin America 7.9%Eastern Europe 25.9%

Asia -22.4%

…but Rare

Overview

• Question: Why do (only) some developing countries maintain “undervalued” exchange rates?– Undervaluation defined: Domestic goods cheap relative to

foreign goods

• Theory: Conditional interest group approach– Manufacturing sector only promotes undervaluation when

state controls bank sector

• Empirics: Two tests– TSCS: Determinants of undervalued exchange rates– Survey: Determinants of exchange rate preferences

Preferences

• Manufacturing Firms’ Preferences: Ambiguous– Benefit: External competitiveness – Cost: Cost imported inputs & foreign debt– Cost: Sterilized intervention interest rates

• Cost-reducing Compensations: Increase support for undervalued exchange rates– No compensations: Undervaluation increases both revenues &

expenses– Compensatory policies: Undervaluation increases revenues;

expenses do not increase

State-Owned Banks

• State-Owned Banks: Reduce business costs– Targeted credit (i.e. “industrial policy”)– Forced placement of sterilization bills

• Hypothesis 1: state-owned banks, industry support undervaluation

Conditional Effect of Interest Groups

• Hypothesis 2: Undervalued exchange rates are most likely in countries with large manufacturing sectors AND state-controlled financial systems

Analysis I: Determinants of Undervalued Exchange Rates

• Sample: Developing countries, 1975-2006

• Dependent Variable: RER Overvaluation (Rodrik)– Overvaluation = RERit - RERPREDICTit

• Independent Variables– Manufacturing: Manufacturing/GDP (WDI)– State-owned banks: 4-category ordinal var. (Abiad et al)– Interaction Term: Manufacturing State-Owned Banks

• Estimation: AR1, PCSE, Fixed Effects

Analysis II: Determinants of Exchange Rate Preferences

• Sample: Manufacturing firms in developing countries in 1999 (World Business Environment Survey)

• Dependent Var.: Exchange Rate Problem (Broz et al)

• Independent Variables– Overvaluation: Same as before (Rodrik)– State-owned banks: Continuous var. (Micco et al)– Interaction Term: Overvaluation State-Owned Banks

• Estimation: Ordered Probit, Robust SE

Conclusions• Exchange Rate Politics– Interest groups matter…but only under certain conditions– Undervalued exchange rates rare b/c tradable industries

do not always support undervaluation

• Implications for IPE:– Preferences are context-dependent– States (capacity) shapes preferences

• Implications for Policymakers– Various elements of the Washington Consensus

incompatible