The Value of Being Undervalued

The importance of a competitive currency for economic growth is undeniable. But the burden of maintaining a favorable exchange rate cannot be borne by central banks alone.

The paramount policy dilemma that emerging markets face nowadays is this: on the one hand, sustained economic growth requires a competitive (read “undervalued”) currency. On the other hand, any good news is immediately followed by currency appreciation, making the task of remaining competitive that much harder.

So, you finally passed that crucial piece of legislation? Your fiscally responsible political party just won the election? Or your commodity exports hit the jackpot? Good for you! But the currency appreciation that follows will likely set off an unsustainable consumption boom, wreak havoc with your export sector, create unemployment, and sap your growth potential. Success brings its reward in the form of immediate punishment!

In response, central banks may intervene in currency markets to prevent appreciation, at the cost of accumulating low-yield foreign reserves and diverting themselves from their primary goal of price stability. This is the strategy followed by countries such as China and Argentina.

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