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The Conditional Effect of Interest Groups on Undervalued Exchange Rates: An Analysis

This study explores the reasons behind the maintenance of undervalued exchange rates in certain developing countries. Undervaluation is associated with economic growth, reduced unemployment, and prevention of financial crises. Employing a conditional interest group approach, the research finds that manufacturing sectors only support undervaluation when state-controlled banks are involved. Two analyses are performed — determining the factors influencing undervaluation and exploring manufacturing firms' preferences regarding exchange rates. The findings reveal that interest groups significantly impact exchange rate politics under specific conditions.

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The Conditional Effect of Interest Groups on Undervalued Exchange Rates: An Analysis

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

  2. 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

  3. 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

  4. 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

  5. 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

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

  7. 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

  8. 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

  9. 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

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