Exchange rates send powerful and pervasive signals. Output of a product increases when its price relative to that of other products goes up, and such an increase can be caused by changes in the exchange rate. It has been clearly established in the economic literature that—regardless of their geographic location or level of income—farmers react strongly to price incentives. For instance, this has been confirmed by recent surveys of the poorest farmers of the Andean Altiplano. The exchange rate affects the price of tradable goods (exportables and importables) and is thus of immediate relevance to farmers who will be influenced in deciding what part of their efforts is to be devoted to growing crops and what to other activities and, in the growing of crops, what part will be destined for the market and what is to be retained for their own consumption. The recent World Bank report on Africa (Toward Sustained Development in Sub-Saharan Africa) noted the importance of exchange rates: “…for many commodities Africa’s market share has continued to fall. Realistic exchange rates are critical to reverse this trend.” If price signals have so powerful an effect on the production decisions of farmers in the Altiplano and in Africa, they must, a fortiori, influence decisions by entrepreneurs in the nonagricultural sector of developing economies. The evidence is overwhelming that decisions to produce (what? how much? for which market?) and to consume (domestic products? imports?), as well as decisions to save and invest, are influenced by real exchange rates—that is, nominal exchange rates adjusted for relative rates of inflation. Hence exchange rates play a crucial part in economic growth.
Under current exchange arrangements countries are free to adopt the exchange rate system of their choice, that is, floating, pegging to another currency or to a basket of currencies, and so on. In some countries a flexible exchange rate policy is followed and overvaluation may be easier to avoid. But overvaluation can occur regardless of the exchange rate system in force.
Frequently domestic pressures result in inflation, reflected in wages and prices of domestic goods. Inflation can also be the result of many other causes such as commodity price booms or sudden increases in capital inflows. However, the nominal exchange rate is often not allowed to adjust fully to reflect the increased costs. As a result, the real rate appreciates. Since the new rate no longer is an equilibrium one, imports must be curbed and, to achieve this, the government is faced with a choice between reducing economic activity through restrictive monetary and fiscal policy, or establishing quantitative import controls. The first course, if pursued long enough, is clearly inimical to economic growth, while the second course, involving controls, leads to a misallocation of resources, as well as lower growth. A third option is to increase import duties sharply. This option is not used as frequently as quantitative import controls because the latter have a more predictable effect on the quantity of imports. Governments can, of course, step up borrowing or use reserves to finance the deficit and accommodate the appreciated exchange rate; but this becomes unsustainable after a time.
Overvaluation then, can lead to quantitative restrictions (such as import quotas), which will raise the cost of imports, or, if imports remain liberalized for any length of time, to an unsustainable balance of payments deficit and an eventual real devaluation. In short, quantitative restrictions are the usual way in which overvaluation can be sustained for any length of time. Yet, when countries are able to borrow large amounts abroad, overvaluation can be sustained for months or even years, as was the case in Argentina, Chile, and Uruguay before the 1982 debt crises erupted. Moreover, powerful political pressures often build up in favor of overvaluation because of the benefits that accrue to particular groups (such as importers or consumers of imports). These benefits, as noted above, are temporary, but can last for a considerable period of time.
It is not easy to determine in practice at which point exchange rate appreciation becomes overvaluation. The notion of exchange rate equilibrium is elusive, especially when interest rates may be far from equilibrium. Equilibrium can only be defined in relation to some objective, for example the attainment of a particular growth rate of exports and GDP in the light of likely capital inflows. One practical danger signal is the loss in a country’s share in world exports.
How does an overvalued exchange rate affect economic development? And why are governments often so reluctant to reestablish a realistic exchange rate? The remainder of this article addresses these questions in greater detail. The seven propositions that follow are meant to highlight some of the principal consequences of overvaluation, in particular as they affect development. The propositions are by no means exhaustive, and there is unavoidable overlap between several of them.
Proposition 1: overvalued exchange rates undermine exports. The importance of a dynamic export sector in the course of development is well recognized. To the extent overvaluation undermines export profitability and—in cases where the country affects prices—reduces other countries’ incentive to import from the country with an overvalued rate, it strikes at the very core of the development process. Exports are not only vital where they represent a large share of total production and employment; they are also important because, in most countries, the availability of foreign exchange is one of the main determinants of the overall level of economic activity. Even where exports account for only a small portion of GDP, a shortfall in foreign exchange can slow growth for the entire economy. Indeed, it may be argued that countries that have gone farthest in import substitution, and have reduced the share of trade in GDP to the limit, are most vulnerable to foreign exchange shortages because imports can no longer be compressed in a crisis; all imports have become essential for maintaining output.
An overvalued exchange rate undermines incentives to produce not only exports but also import substitutes. This is because exports lose competitiveness and imports become relatively cheaper as a result of the overvaluation, provided no import restrictions have been imposed. Thus the production of all traded goods is undermined by an overvalued exchange rate.
Where quantitative import restrictions do exist, imports may not become relatively cheaper. In this situation, however, exports are further discriminated against because of the general inefficiencies and high costs associated with the quantitative import restrictions. Attempts to offset the anti-export bias through subsidies may prove unsustainable because they will widen the fiscal deficit.
By undermining export growth and diversification, overvaluation (with or without quantitative import restrictions) powerfully retards economic development.
Proposition 2: overvalued exchange rates harm agriculture. This point, leading on from Proposition 1, has been made often; a recent World Bank study of agricultural pricing policies in Mexico concludes that changes in the real exchange rate have, since 1960, had far more impact on agricultural incentives and output than any of the government’s agricultural pricing policies. This is because the effect of the exchange rate was more pervasive than that of the price support mechanism, resulting in a decline in relative prices.
The effect of overvaluation on agriculture deserves special mention because in the early stages of development agriculture is the key sector and the largest source of employment in most developing countries. While industry often enjoys high protection, agriculture typically receives none (or in many cases even suffers from negative effective protection). Clearly, the implications of discrimination against agriculture are wide ranging.
First, the poorest people live in rural areas dependent on agriculture; therefore, discriminating against agriculture harms the poorest. Realistic exchange rates, on the other hand, are more conducive to rural prosperity and have a positive effect on income distribution as well as growth. Second, where the internal terms of trade are so biased against agriculture, fueling migration to the cities, the need for imported foodstuffs rises, and yet more pressure is put on the balance of payments. Third, inadequate agricultural incentives (relative to those in other activities) can have profoundly negative effects on development; there is a close association between agricultural performance and overall economic development, even in countries where agriculture represents only 5 or 10 percent of GDP. To the extent overvalued exchange rates hurt agriculture, they discourage overall development.
The argument can be extended to other resource-based activities. Overvalued exchange rates undermine incentives in forestry, mining, agro-industries, and basic industries. By making imports relatively cheaper, at least temporarily, overvaluation not only discriminates against the development of appropriate domestic technologies, it also, through cheaper imports of capital goods, encourages relatively capital-intensive methods of production, thus discouraging employment creation. Where governments have protected these sectors from foreign competition, this has led to high-cost (relatively small-scale) operations and, eventually, to a stagnation of output and employment. In both cases overvaluation undermines the potential for development of labor-intensive activities and promotes reliance on imported inputs.
Who benefits? Clearly, the perceived or real benefits accrue to the urban population through cheaper food. This, of course, like most of the other “advantages” of overvaluation, is true only so long as the rate can be maintained without quantitative restrictions.
Proposition 3: overvalued exchange rates stimulate imports. In general, overvaluation stimulates demand for foreign exchange as it is made relatively cheaper. This effect is compounded if the public believes that the government will not be able to maintain the rate for long and people buy more foreign exchange to take advantage of the relatively low price. Imports and tourism expenditures abroad will rise. Additional demand for foreign exchange will put pressure on reserves and increase borrowing requirements. Eventually overvaluation generates pressures for increased import controls and, as discussed below, competition for imports will shift from the economic to the political arena.
Who benefits? Unless importers are able to take advantage of the situation, cheaper imports benefit those who can buy them, reflecting the pattern of income distribution. The constituency favoring cheaper imports is an influential one; it includes the most affluent, and therefore often politically powerful, segment of the population, including those who have protected markets for their goods and want cheap inputs. Against this, there is the generally less influential constituency composed of farmers and exporters in general. One silent, but important, opposing group consists of potential exporters, who, because of overvaluation, are unable to secure export markets. Another silent group is the unemployed, who would stand to gain from policies that accelerate long-term economic growth.
Proposition 4: overvalued exchange rates destabilize the capital account and often precipitate debt crises. Overvaluation (often a result of inconsistent underlying policies) exerts pressures on the current account of the balance of payments. These can be offset temporarily through compensating capital flows. A government may be able to step up borrowing to finance additional consumer goods imports. But in the face of increased borrowing requirements which reflect a steadily widening current account deficit—and, usually, declining domestic savings—the debt-servicing burden will increase, eventually leading to a crisis.
Some countries have tried to avoid this sequence of events by encouraging private capital inflows. This can be done in various ways, notably by creating incentives to borrow abroad where foreigners believe they stand to gain by lending to the country. As domestic prices increase faster than the currency depreciates, overvaluation of the currency increases; in this situation if domestic interest rates are attractive to domestic savers, they will be even more attractive to foreign savers. For example, if expected inflation in a country is 20 percent and domestic savers receive 10 percent real interest on their deposits, a constant nominal exchange rate translates into a 30 percent return to foreign savers who invest in the country for one year. The expectation of predictable future overvalued exchange rates in Chile, Argentina, and Uruguay during the early 1980s helped attract massive private capital inflows during these years.
A problem arises, however, as time elapses. If overvaluation persists and the public becomes increasingly aware that capital inflows are taking place while the trade balance is deteriorating, concerns will arise that the situation may not be sustainable. It is increasingly realized that interest payments are financed out of new external borrowing and, eventually, the public will be sufficiently worried about the future that expectations of a massive devaluation build up and prompt capital flight. The government may then step up its own external borrowing to protect reserves, further raising the debt-servicing burden. Eventually devaluation becomes unavoidable and causes severe problems for those who had incurred debt denominated in foreign currency. Experience has shown that private sector debt problems may persist for many years and that the social cost of dealing with debt crises is very heavy. Finally, once a country has gone through this sequence, expectations of further instability can easily develop and inhibit economic growth because such expectations are inimical to long-term productive investment and efficient resource allocation.
Who benefits? While “the going is good,” overvaluation benefits those who are in a position to borrow cheaply abroad. Once a crisis seems imminent, those who participated in capital flight and invested their savings abroad will benefit.
Proposition 5: overvalued exchange rates breed protection against imports. This is another very obvious negative result of overvalued exchange rates. As noted earlier, overvaluation, by making imports relatively cheaper, generates pressures on the part of threatened (import-competing) industries for increased protection. If governments yield to such pressures, as they frequently do, the new protective structure is likely to be less conducive to efficient resource allocation than the earlier one, and inimical to growth. It may be argued that the inevitable, eventual, devaluation of the currency can be coupled with a reduction in tariffs and other protective measures (this is known as “compensated devaluation”); unfortunately it is often far easier for governments to modify the exchange rate than to change the protective structure, and the latter therefore tends to endure.
The protective structures that have existed in some developing countries for decades, erected partially in response to overvaluation, have in turn fostered chronic overvaluation. This is because, on the one hand, tariffs and quantitative import restrictions dampen demand for foreign exchange by raising the price of foreign goods and services; on the other, rationed access to foreign exchange translates into an exchange rate that is more overvalued than that which would have prevailed if the demand for foreign currency were not curbed by protection. The two are mutually reinforcing: overvaluation generates pressure for protection against imports; protection against imports perpetuates overvaluation.
Proposition 6: overvalued exchange rates do not help curb inflation. This is one of the major lessons of economic management during the last decade or so. Because overvaluation means that imports are relatively cheap, governments have often resorted to exchange rate policy in attempts to contain inflation. There are serious problems with this approach. First, while imports do represent a fair proportion of the cost of living “basket” in most developing countries, in many countries their weight is not large enough to make much of an impact on measured inflation. Second, even if overvalued exchange rates do manage to reduce inflation, the unavoidable ensuing devaluation will cause inflationary pressures that usually more than cancel the “benefits” of overvaluation.
Uruguay’s experience is an interesting illustration of why overvaluation does not curb inflation. Throughout the period 1978-82 domestic inflation substantially exceeded the rate of devaluation adjusted for international inflation as (1) local prices of tradables continued to rise rapidly because the local marketing firms were able to capture the gains from cheaper imports, and because of continuing high protection of local manufacturing; (2) prices of non-tradables rose rapidly, notably because of a speculative construction boom; and (3) interest rate arbitrage led to a large inflow of funds from abroad.
Who benefits? Again, so long as “the going is good,” urban consumers benefit from whatever reduction in inflation may occur (because of adverse terms of trade farmers are not among the “beneficiaries”).
Proposition 7: overvalued exchange rates promote rent-seeking economies. By breeding pressures for increased quantitative protection, overvaluation increases the rents (i.e., income that is generated because of an artificially created scarcity) of those with access to import licenses. The same is true for those who have access to (relatively cheap) foreign credits. Besides being less efficient and less conducive to growth, the rent-seeking economy encourages private gain at the expense of public welfare (under quantitative import restrictions, for example, the implicit tariff accrues to the importer, not the government). Corruption almost unavoidably flourishes in such a climate. More generally, overvaluation encourages the politicization of the economic process: the attainment of political power becomes vitally important from a private economic point of view, and this, in turn, fosters divisiveness between those who have political power and can extract rent, and the rest of the population.