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 “value- added”) 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)

Development is about diversification Subramanian, 2007 based on Imbs and Wacziarg, 2003

And diversification can help growth Kochhar et. al., 2006

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

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 Johnson, Ostry, and Subramanian, 2007

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)

Overvaluation and growth—contd. Prasad, Rajan and Subramanian, 2007

Some country examples: China Rodrik, 2007

Some country examples: India

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 growth

Growth and the Current Account Balance over Time: Non-parametric Relationship

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

Foreign capital and Overvaluation,

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