Does real exchange rate undervaluation really promote economic growth?

Abstract

This article seeks to reassess the empirical literature on real exchange rate misalignment and growth in light of the extensive discussion about the relationship between income distribution and growth in developing economies. We state that the dynamic relationship between changes in the real exchange rate and output growth can be characterized by two conflicting partial effects, as follows: i) undervaluation promotes growth-enhancing changes in the productive structure of the economy by stimulating technological progress and knowledge spillovers, thus affecting positively output growth; ii) undervaluation raises income inequality and hence harms output growth. Though there are a vast number of empirical studies presenting robust evidence of a positive relationship between currency undervaluation and growth for developing economies, none has yet explicitly considered the potentially negative distributional effects of undervaluation on growth. Our empirical model adds to this literature by suggesting that, once both functional income distribution and the level of technological capabilities as relevant features of the structure of the economy are explicitly taken into account, the direct impact of real exchange rate misalignment on growth becomes statistically non-significant for a representative sample of developing countries. Further, based on our results, we state that the real exchange rate only affects growth indirectly through its impacts on functional income distribution and technological innovation. Our estimates have shown that the indirect impact of undervaluation on growth in developing countries is negatively signed. The results are robust to accounting for reverse causality through GMM-system analysis, using lagged observations in difference and level of endogenous variables as instruments.