FRBSF Economic Letter
98-11; April 10, 1998
Long-run Determinants of East Asian Real Exchange Rates
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
Since the summer of 1997, when many East Asian currencies began to fall,
a good deal of attention has been paid to the causes and consequences
of exchange rate movements. This Economic Letter sheds some light
on these issues by summarizing recent research into the long-run determinants
of real exchange rates in East Asia (Chinn 1997).
I begin with a discussion of the theory underlying movements in real
(that is, inflation-adjusted) exchange rates; this theory focuses on differences
in the relative productivity of one country versus another, as well as
on differences in the relative productivity of an individual country's
tradable goods sector versus its nontradable goods sector. I then present
results of empirical tests of the theory, which suggest that, in many
instances in East Asia, enhanced productivity growth in the tradable goods
sector is associated with a long-run strengthening of the real exchange
rate. Finally, turning to the recent currency crisis, I examine whether
these empirical tests could have helped anticipate it.
The determinants of real long-term
exchange rates
The nominal exchange rate is the rate at which the currency of one country
trades against that of another. The level of a country's economic activity,
however, depends more on its real, or "inflation-adjusted,"
exchange rate, that is, the price at which goods and services produced
at home can be exchanged for those produced abroad. It is movements in
this variable we wish to understand.
Unfortunately, exactly what moves the nominal and real exchange rates
day to day, let alone month to month, is difficult to determine. In the
short run, nominal exchange rates depend primarily on financial market
variables and expectations; and, if the prices of goods and services are
slow to change, nominal exchange rate movements will be reflected immediately
in real exchange rate changes. Over the longer horizon, economic theory
suggests real-side variables come more into play in affecting the real
exchange rate. In particular, assuming that financial capital is relatively
free to move internationally, and that trade in goods is relatively unhindered
by tariffs and quotas, a country's real exchange rate is determined by
how efficient labor and capital are in producing tradable goods compared
to producing nontradable goods. We can think of traded goods as "manufactured
goods" and nontraded goods as "services." (This categorization
seems appropriate since most services-such as haircuts-are difficult to
trade.) According to the traditional model, (the "Balassa-Samuelson
model"), if the productivity of a country's workers in producing
manufactured goods relative to their productivity in producing services
grows faster than abroad, then the country's currency will appreciate
in real terms; i.e., the rate of exchange of domestic for foreign goods
rises. Conversely, if the relative productivity growth of manufacturing
goods workers is lower than abroad, the currency depreciates.
The logic of the Balassa-Samuelson model flows from several assumptions.
The first is that domestic workers' wages are equalized by competition
between the tradables and nontradables sectors. This implies that if the
productivity of workers and capital in the sector producing traded goods
grows faster than that of their counterparts in the sector producing nontraded
goods, then the price of nontraded goods relative to traded goods should
rise. Thus the price of haircuts and restaurant meals become more expensive
relative to televisions and cars. The second is that traded goods prices
in different countries are tied together by international arbitrage activities,
so that the price (in a common currency such as the dollar) of a traded
commodity -- say a television -- is the same in Korea or the U.S. (aside
from the effects of tariff barriers and transportation costs which we
are ignoring). Since a country's overall price level consists of the prices
of both traded and nontraded goods and the prices of traded goods are
(more or less) equalized across countries, it follows that the overall
price level will tend to rise faster in countries where nontraded goods
prices are rising faster, i.e., with relatively high productivity growth
in the manufacturing sector (as compared to the service sector). In turn,
this implies that countries with relatively high manufacturing productivity
growth will have growing real purchasing power over foreign goods, and
their currencies will appreciate in real terms.
At first glance, the model's conclusions would appear to suggest that
it is desirable to have relatively low service sector productivity growth
and consequently an appreciating strong currency; but that would represent
an incorrect view, equating an appreciating currency with a higher level
of economic welfare. In general, there is no straightforward link between
how well an economy is doing and the real exchange rate. Consider the
fact that society is usually made better, not worse, off by higher productivity
in services (as well as in manufacturing).
Empirical evidence
What is the empirical evidence regarding a relationship between relative
productivity levels and real exchange rates? In Figure 1, the average annual change
in the real exchange rate is plotted against the average annual change
in relative productivity levels for seven different countries vis-à-vis
the United States, where the exchange rate is defined in terms of how
many real U.S. dollars are needed to obtain a single unit of the local
currency, and productivity growth is defined as productivity in manufacturing
relative to services. The scatter plot indicates that the fewer U.S. dollars
that are needed to buy local currency, that is, the more rapidly the local
currency is appreciating against the dollar, the more rapidly local productivity
(in traded to nontraded production) is gaining on U.S. productivity.
In a recent study (Chinn 1997), I verify that there is time-series evidence
of a similar nature for the Indonesian rupiah, the Korean won, the Malaysian
ringgit, and the Philippine peso. Roughly speaking, a 1% increase in the
level of local productivity in the manufacturing sector causes a ½
% appreciation in the real value of the currency, holding everything else
constant. Hence, it appears that, like the experience of the Japanese
yen, more rapid productivity growth is associated with a more rapid secular
appreciation over long spans of time in Asian countries.
While trends in productivity matter for long-run exchange rates movements,
other factors, such as oil dependency and government spending, also appear
to influence the real exchange rate. For instance, due to the Indonesian
economy's reliance on oil exports, a permanent 1% increase in the real
price of oil induces a permanent appreciation of the rupiah of 0.4%. For
the oil-importing dependent economy of Korea, a growth rate of 1% in the
real price of oil causes a tenth of a percentage point depreciation of
the won, in real terms. In the short run at least, there is also evidence
that higher government spending appreciates a country's currency. For
to the extent that such spending falls on local goods, it creates domestic
price pressure that, in turn, induces a real appreciation of the local
currency to dampen demand. The Malaysian ringgit proves to be the only
exception to this pattern.
Exchange rate overvaluation on the eve of
the fall?
A natural question to pose is whether, using the estimated relation
between the exchange rate and productivity, the East Asian currencies
were overvalued in June 1997; i.e., had they appreciated in value above
the equilibrium level implied by productivity growth trends? Unfortunately,
the sectoral productivity and price deflator data necessary for calculating
equilibrium exchange rates extend only up to 1991. However, as an approximation,
we can extrapolate from 1977-1991 trend data in relative productivity.
Thus, for example, in Thailand, assuming the exchange rate was at equilibrium
in 1991, I find that the Thai baht was overvalued by approximately 18%
in 1996. If Thai manufacturing productivity growth was less than is assumed
in this scenario, then the actual degree of overvaluation could have been
even more pronounced than implied by my calculations. (It must be noted,
however, that the 95% confidence band on the predicted exchange rate encompasses
the observed rate in 1996, so, statistically speaking, even this seemingly
obvious overvaluation cannot be classified as such with statistical certainty.)
How did this overvaluation occur? The Thai authorities implicitly pegged
the baht to a basket of currencies which placed a heavy weight on the
U.S. dollar. As Thai inflation exceeded U.S. inflation and Thai manufacturing
productivity slowed, the Thai baht became increasingly overvalued relative
to the U.S. dollar. This finding of overvaluation accords with one's intuition
and is consistent with Thailand's trade deficits recorded in recent years
(the cumulative 1990-1996 trade deficits amounted to 36% of 1996 GDP).
Conclusions
There is substantial evidence in favor of the hypothesis that over long
periods of time, relative productivity growth (between sectors and between
countries) determines the strength of a currency's real purchasing power.
In the short run, other variables, such as government spending, oil price
changes, and monetary policy can move the exchange rate from its long-run
path.
Implementing the calculations for policy purposes is complicated by
the fact that the requisite productivity data are not available on a "real-time"
basis. This is not an irrelevant criticism. In the months preceding the
1994 Mexican peso crisis, some observers argued that the peso was not
overvalued given purported (but unmeasured) rapid productivity growth
in the Mexican manufacturing sector. With hindsight, one knows that these
assertions were incorrect. These data difficulties suggest that government
policies that seek to stabilize currencies may prove problematic, if policymakers
should happen to misidentify the equilibrium rate.
Menzie David Chinn
Associate Professor,
U.C. Santa Cruz and Visiting Scholar,
Federal Reserve Bank of San Francisco
References
Chinn, Menzie. 1997. "The Usual Suspects? Productivity and Demand
Shocks and Asia-Pacific
Real Exchange Rates." NBER Working Paper #6108.
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