Economic growth and the role of currency undervaluation

In this paper, we demonstrate that currency undervaluation benefits national economic growth based on cross-national and sectoral evidences. Weak currency effectively stimulates a country’s participation in the international trade market, and facilitates national economic component transformation, both in its value creation process and output allocation phase. We study three manifestations of exchange rate undervaluation as an accelerator to economic development. The currency depreciation effect is both significant and economically sizeable. We first show the positive relationship between the national and sectoral economic growth rates and the extent of real exchange rate undervaluation. This level-based effect implies that a 50 percent undervaluation, approximately a standard deviation of our depreciation measure, is associated with a contemporaneous growth boost ranging from 0.7 percentage points to 7.5 percentage points per annum for various sectors. We then show that exchange rate depreciation stimulates national growth through economic component change: we establish that currency undervaluation tends to facilitate the development of tradable-intensive economic activities at the expense of squeezing some other non-tradable-intensive economic activities and exchange rate depreciation encourages savings, contributing to capital accumulation, which may further counteracts the negative impact of a weak currency on consumption and service sectors through a spillover effect. Finally, we construct a tradability index for 21 out of 23 manufactures. According to this measure, we actually demonstrate that the undervaluation effect is stronger in sub-sectors in which goods are more tradable in the international market. Our results are robust to controlling for a variety of alternative explanations and to instrumenting exchange rate undervaluation to alleviate concerns of reverse causality.