The Conditional Effect of Interest Groups on Undervalued Exchange Rates David Steinberg University of Oregon

The Puzzle Undervalued Exchange Rates are Beneficial – Increases economic growth (Dollar 1991; Rodrik 2008) – Reduces unemployment (Frenkel & Ros 2006) – Prevents financial crises (Reinhart & Rogoff 2009) Exchange Rate Overvaluation (Median 2006) All Developing Countries3.4% Middle East & North Africa18.1% Sub-Saharan Africa7.9% Latin America7.9% Eastern Europe25.9% Asia-22.4% …but Rare

Overview Question: Why do (only) some developing countries maintain “undervalued” exchange rates? – Undervaluation defined: Domestic goods cheap relative to foreign goods Theory: Conditional interest group approach – Manufacturing sector only promotes undervaluation when state controls bank sector Empirics: Two tests – TSCS: Determinants of undervalued exchange rates – Survey: Determinants of exchange rate preferences

Preferences Manufacturing Firms’ Preferences: Ambiguous – Benefit: External competitiveness – Cost:  Cost imported inputs & foreign debt – Cost: Sterilized intervention   interest rates Cost-reducing Compensations: Increase support for undervalued exchange rates – No compensations: Undervaluation increases both revenues & expenses – Compensatory policies: Undervaluation increases revenues; expenses do not increase

State-Owned Banks State-Owned Banks: Reduce business costs – Targeted credit (i.e. “industrial policy”) – Forced placement of sterilization bills Hypothesis 1:  state-owned banks,  industry support undervaluation

Conditional Effect of Interest Groups Hypothesis 2: Undervalued exchange rates are most likely in countries with large manufacturing sectors AND state-controlled financial systems

Analysis I: Determinants of Undervalued Exchange Rates Sample: Developing countries, Dependent Variable: RER Overvaluation (Rodrik) – Overvaluation = RER it - RERPREDICT it Independent Variables – Manufacturing: Manufacturing/GDP (WDI) – State-owned banks: 4-category ordinal var. (Abiad et al) – Interaction Term: Manufacturing  State-Owned Banks Estimation: AR1, PCSE, Fixed Effects

Analysis II: Determinants of Exchange Rate Preferences Sample: Manufacturing firms in developing countries in 1999 (World Business Environment Survey) Dependent Var.: Exchange Rate Problem (Broz et al) Independent Variables – Overvaluation: Same as before (Rodrik) – State-owned banks: Continuous var. (Micco et al) – Interaction Term: Overvaluation  State-Owned Banks Estimation: Ordered Probit, Robust SE

Conclusions Exchange Rate Politics – Interest groups matter…but only under certain conditions – Undervalued exchange rates rare b/c tradable industries do not always support undervaluation Implications for IPE: – Preferences are context-dependent – States (capacity) shapes preferences Implications for Policymakers – Various elements of the Washington Consensus incompatible