Trade and Exchange Rate Competition

• In Event: Exchange Rates and Government Credibility Reconsidered

Abstract

The deliberate undervaluation of exchange rates is a policy tool with stark political trade-offs. By subsidizing exports and raising the price of imports, it provides concentrated benefits to some industries, but at considerable cost to citizens and the public purse, making it unpopular among democracies. Most importantly, the strategy creates international tensions, as manufacturing job losses in importing countries give a boost to populist politicians.
As an economic strategy, undervaluation is strikingly concentrated in East Asia, where we find eight of the ten largest foreign reserve holders. While neither China nor Japan have directly targeted their exchange rate in recent years, Taiwan, Thailand and others continue to do so. What explains this policy choice and its regional concentration?
In this paper, I present a model and empirical estimates showing that export similarity and competition in the same markets are the key drivers of currency undervaluation in East Asia. This leads to much more rapid decline of export prices than e.g. in Europe and alters the political calculus for governments in the region to favour undervaluation. Notably, with industrial upgrading, the “leader” country changes over time: Japan used to set the extent of undervaluation for the region but is increasingly supplanted by China. These findings clarify why currency undervaluation is not more widespread and provide modest grounds for optimism, as currency conflict becomes less likely as China refrains from devaluations.

Author

• Mark S. Manger, University of Toronto