Devaluation and growth

Print edition : March 22, 2013

Images of 100-dollar and 100-yuan notes. "Being large, having a deeply undervalued currency and having current surpluses are a recipe for individual success and a world disaster," the author reiterates, pointing the needle of suspicion at China. Photo: PETAR KUJUNDZIC/REUTERS

An in-depth examination of the effect of devaluation of currency on exports, trade and economic growth.

THE title of the book under review, Devaluing to Prosperity: Misaligned Currencies & Their Growth Consequences, is a paradox in that in the real world no country has experienced sustainable growth and a prolonged spell of prosperity through devaluation of its currency vis-a-vis its trading partners.

But this paradox gets resolved in the preface by Prof. C. Fred Bergsten, a distinguished economist of the Jimmy Carter era, where he says: “The last three decades have witnessed high economic growth in developing countries, a widening global imbalance and a sharp spurt in reserve accumulation, especially among high-growth Asian economies. The role of the Chinese economy has been linked at least in part to the manner in which it has set the exchange value of its currency.” Hence the “near universal demand for significant revaluation of the Chinese currency in recent years”, he argues, straightaway identifying the Middle Kingdom as the villain of the piece. Bergsten says the nub of the book is that “the real exchange rate can be affected by nominal devaluations. Currency undervaluation does help growth but the global economic system becomes unstable if too many countries, especially large countries, pursue this beggar-thy- neighbour approach.” This is the reigning debate in the currency wars across the advanced nations now.

Making out a case for re-examination of the export-led growth strategy, which is a politically correct version of exchange rate management, Prof. Surjit S. Bhalla, the author of the book, explores the critical role of currency undervaluation in economic growth, for currency undervaluation accounts for the real variable behind policies ostensibly directed at export-led growth. The book examines in depth how this key variable affects exports, trade and economic growth by giving the authorities the ability to improve their economy’s competitiveness by pruning the production costs of their exports and making them cheaper in overseas markets. How does currency undervaluation spawn extra growth? The author answers the question by pointing out that it works through investment, a finding backed by robust empirical data. Devaluation decreases the dollar costs of production and increases profitability, while investors respond by increasing the investment rate, which propels the growth rate, and the virtuous cycle continues.

The author has taken considerable pains to arrive at this paradigm by subjecting the currency undervaluation-growth model to a wide variety of sensitivity and robustness tests across divergent time periods (historical from 1870 to 1938 and contemporary from 1980 to 2011, and for periods in between), and deploying a host of estimation techniques, and through joint testing with a wide range of variables such as health, education, openness, geography, initial conditions and fiscal deficits. The end result remains the same. Currency undervaluation matters for growth, the author remarks, adding that the policy works thus: produce a product cheaply and conquer the world markets. While some deem this trade-oriented use of currency undervaluation to be a pure sign of market economics, others see it, when pushed to its extremes, as synonymous with mercantilism.

According to the author, an index of mercantilism to differentiate between current account surpluses resulting from high savings generated by cultural and historical factors and those flowing more from currency undervaluation shows that if a country scores high on both factors, then it can be deemed mercantilist. This is what made the author to name China, as it perfectly fits the bill. Taking this point farther, he argues that not every country is allowed the luxury of currency undervaluation. There is also evidence that small countries can practise undervaluation for extended periods; that countries are even encouraged to decrease the overvaluation levels of their currencies; that countries can devalue their way to prosperity as long as their current account is in deficit. “But being large, having a deeply undervalued currency and having current surpluses are a recipe for individual success and a world disaster,” the author reiterates, pointing the needle of suspicion at China.

An important stylised fact of development is the Balassa-Samuelson effect (Bela Alexander Balassa and Paul A. Samuelson were two eminent post-War economists), according to which a currency has a tendency to appreciate with fast growth; but in recent years, this effect has been blunted by countries intervening to keep their exchange rates “competitive”. Again, the author approvingly cites China as having taken the lead, with others, particularly Asian countries, having followed suit. Such interventions to keep the currency cheap, in the absence of excess inflation, have led the Asian currencies to become even more undervalued. This “standing still” real depreciation is a large part of the currency story in the wake of the Asian crisis of 1997-98 and one of the important conclusions of this tome.

For all the indictment on misaligned currencies and their growth consequences with the spotlight on China, recent evidence from studies jointly undertaken by the rich countries club, the Organisation for Economic Cooperation and Development (OECD) and the World Trade Organisation (WTO), of which China is also a member, does not bear out this argument. Presumably, this also helps in taking the sting out of the shrill calls in the United States to nail and rail China as a currency manipulator. The first batch from the OECD-WTO database, released by the OECD on January 16, reveals that the much-talked about trade deficit in the world—the U.S. with China—is actually much smaller when one duly factors in the value-addition in Chinese exports that comes from third countries or even the U.S. itself. Giving the case of iPhone, the smartphone designed and marketed by Apple Inc., it said China keeps only a fraction of the cost of the production of iPhone with supply chains. Going by a latest study, China’s bilateral trade surplus with the U.S. shrinks by 25 per cent on a value-added basis, reflecting the high level of foreign-sourced content in Chinese exports.

The iPhones are manufactured by nine businesses based in five countries, including the U.S. All the components are delivered to Foxconn, a China-based Taiwanese firm, which assembles iPhones and transports them to the U.S. In 2009, the bill for the businesses, none of which was based in China, was $172.46 for each phone. The manufacturing cost levied by Foxconn was $6.50. But in the bilateral trade figures this was represented as a $178.96 (for each iPhone) credit to China. Foxconn’s involvement in the production of iPhone showed up as $2 billion credit on China’s balance of trade, although most of this $2 billion was transferred to overseas firms, including in the U.S., where manufacturers received $10.75 for each phone sold for purveying parts for each iPhone. While this evidence nails the lie about currency manipulation behind the bulging U.S. trade deficit, it also highlights the fact that imports that displace a country’s domestic products may simultaneously be the lifeline of its exporting sectors, as has been the case with the U.S. with regard to iPhone.

The book has been published at an inappropriate time when no single factor can be advanced for the hefty trade gap a country is plagued with. This is especially the case when each country is striving to implement policies that help its firms better manage its slot in global value chains by honing its competitiveness in the global market.

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