On the impact of exchange rates misalignments on economic growth using homogenous emerging countries

Abstract

This thesis analyzes the impact of exchange rates misalignment on economic growth and the transmission channels for a sample of homogeneous emerging economies. These countries are called homogeneous as they satisfy criteria set by Standard & Poor for qualifying as an emerging economy. I hypothesize that a weaker exchange rate will spur economic growth through its impact on the tradable sector. Contrary to most literature on the topic, I correct for cross-sectional dependence while computing the exchange rate misalignment index. Moreover, I address the endogeneity issue and test for granger-causality in a non-linear framework. I analyze di erent transmission channels and provide robustness analysis of my ndings. The thesis uses various estimators to address some of the issues found in the literature. In paper 1, chapter 3 of the thesis, I use a parsimonious model and estimate the equilibrium real e ective exchange rate for a set of emerging economies using estimators that are robust to cross-sectional dependence and small sample size bias. Contrary to the Balassa-Samuelson e ect, a rise in relative productivity tends to depreciate the real effective exchange rate. A plausible explanation stems from the fear of appreciation that characterizes most emerging economies. I next compute the exchange rate misalignment as the deviation of the observed real e ective exchange rate from its equilibrium. The results show that the East-Asian economies of China, Indonesia, Pakistan and Thailand have had undervalued currencies since 2008. The results are robust to spatial and temporal changes. In paper 2, chapter 4 of the thesis, I analyze the impact of exchange rates misalignment on economic growth for a larger sample using the panel smooth transition regression model. I use a parsimonious model to estimate the long-run relationship between the real e ective exchange rate and its fundamentals. The results do not support the Balassa-Samuelson e ect as an increase in relative productivity tends to depreciate the exchange rates. I next compute the misalignment index. Using a panel smooth transition regression model, I estimate the impact of misalignment on economic growth. I also note the importance of foreign currency denominated liabilities as an undervaluation strategy will tend to increase the debt burden. Following the estimation results, I nd that small to moderate undervaluation of up to 40% spur growth. Beyond this threshold, there is a reversal. The presence of foreign currency denominated debt poses a threat to growth when currencies are undervalued. Indeed, a rise in foreign liabilities impacts negatively on economic growth. I provide spatial and temporal robustness checks. For the temporal check, the threshold is not very di erent from the previous one. Again, undervaluation spurs growth up to a threshold while foreign currencies denominated liabilities alter it. Although low to moderate undervaluation tends to spur growth, large undervaluation poses a threat. The presence of foreign currency denominated liabilities reduce growth signi cantly. The policy implication is straightforward. Moderate undervaluation will spur growth; however foreign currency liabilities need to be kept in check. Paper 3, chapter 5 of the thesis, looks at the long-run relationship between exchange rates misalignment and economic growth and the issue of causality using a panel smooth transition regression vector error correction model. I use a combination of linear and non-linear unit root and cointegration tests. I nd that the index of misalignment and output are non-linearly cointegrated. Following the rejection of linearity, I estimate a panel smooth transition regression vector error correction model that is robust to crosssectional dependence and endogeneity bias. The results show that exchange rates closer to equilibrium tends to boost growth while larger misalignments hinder it. I next test for granger-causality in a non-linear framework. The results prove that misalignment granger-causes output at any given level of misalignment both in the short and longrun. A weaker granger-causality was found between output and misalignment, raising some important implications. Although emerging economies can use undervaluation as a growth strategy, the bene ts are smaller the larger the undervaluation. There is therefore an incentive to keep exchange rates closer to their equilibrium. Paper 4, chapter 6 of the thesis, investigates the potential transmission mechanisms through which undervaluation impacts economic growth. Rodrik (2008) considers the size of tradables as the operative channel through which undervaluation impacts economic growth. This is due to a poor contracting environment and market failures that are prominent in the tradable sector as bad institutions 'tax' tradables more than non-tradables. I look at this issue and nd that the size of the tradable sector is the operative channel through which undervaluation impacts growth. However, the results rule out that bad institutions 'tax' tradables more than non-tradables. The latter casts doubt on Rodrik (2008) explanation. I nd that a total factor productivity surge induced by an undervaluation increases growth signi cantly. The results highlight the importance of total factor productivity growth induced by an undervaluation in increasing growth. Indeed, an undervaluation strategy coupled with investment in tradables will lead to a rise in total factor productivity and economic growth. In the appendix, I provide an analysis based on the Purchasing Power Parity based index. The results support the absence of the Balassa-Samuelson e ect. Besides, I nd that undervaluation spurs economic growth. There is no signi cant proof that bad institutions 'tax' tradables more than non-tradables. However, a rise in total factor productivity induced by undervaluation tends to increase economic growth.