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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)
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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) …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, 1975-2006 • Dependent Variable: RER Overvaluation (Rodrik) • Overvaluation = RERit - RERPREDICTit • 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