The sudden devaluation in the Chinese currency by 3% in August 2015 was widely interpreted as an instance of currency manipulation in response to weakening export figures, aimed at making Chinese exports cheaper relative to foreign competitors. The announcement unsettled world financial markets, as it set off fears of a currency war.
Competitive devaluation is a long-standing idea in international macroeconomic theory, going back at least to the exit of countries from the Gold Standard (see the discussion by Kindelberger 1973, or Eichengreen and Sachs 1985). When a country devalues its currency, it lowers its relative cost of producing over the time span that domestic wages and prices are sticky in local currency.
While the temptation of a competitive devaluation still recurs during times of economic downturn, it tends not to be viewed as a viable policy recommendation in modern monetary theory and central bank practice. First, competitive devaluations invite retaliation and currency wars. As mentioned above, the sudden devaluation in the Chinese currency in August 2015 set off fears of such a currency war. Second, their discretionary use is bound to be systematically anticipated by firms, worsening the short-run trade-offs between inflation and unemployment. Not surprisingly, the policy debate at times becomes quite heated, at both the international and domestic level.
Towards a new perspective
In a recent paper (Bergin and Corsetti 2015), we take a step back from the current debate and propose a different perspective on how monetary and exchange rate policies can contribute to, or hinder, a country’s international competitiveness. Our aim is to shift the focus of the analysis away from the one-time competitive gains (or losses) from currency devaluation, to focus instead on the medium to long-run implications of monetary and exchange rate policy for the comparative advantage determining what types of goods a country exports.
In the academic literature, the mainstream view of monetary and exchange rate policy has long emphasised the benefits of stabilising the economy over cycles of recessions and booms. According to standard models, a central bank should pursue expansionary policies and allow the currency to depreciate if a demand shock produces a recession, and do the converse in a boom. In these models, firms benefit from policies that help moderate any unexpected future demand and cost fluctuations, so to prevent macroeconomic risk from producing inefficient fluctuations in their markups.
The idea we pursue is that efficient stabilisation policy is likely to have heterogeneous effects across sectors of the economy.
- A stable macro environment can be expected to be more beneficial to industries producing differentiated manufacturing products.
The reason is that such firms typically set prices ahead of time or need to make significant up-front investment to enter the market. They are thus more exposed to the uncertainty of unpredictable aggregate cycles. In other words, macroeconomic stabilisation will tend to create favourable conditions for firms’ entry in such industries.
- Nations pursuing effective macroeconomic stabilisation should thus tend to become exporters of these goods.
This is the ‘monetary dimension’ of comparative advantage. Moreover, to the extent that differentiated goods industries confer benefits such as greater value added or lower transportation costs per value, this defines a new channel through which efficient stabilisation policy can contribute to social welfare.
Towards a new generation of policy models
To clarify this new perspective on international competitiveness, in Bergin and Corsetti (2015) we have constructed a model of two open economies with a novel structure, combining trade and macro theory. Each country is incompletely specialised across two sectors, both of which produce tradable goods. In one sector – manufacturing – firms produce an endogenous set of differentiated varieties operating under imperfect competition (hence they have some monopoly power) and price subject to nominal rigidities. They enter the market paying a sunk cost, which makes firm dynamics particularly sensitive to macroeconomic uncertainty affecting revenues, costs and discount rates. The other sector is less sensitive to macroeconomic uncertainty – for simplicity we assume that firms in this sector operate under perfect competition and produce non-differentiated goods.
Underlying our results is a transmission channel at the core of modern monetary literature – in the presence of nominal rigidities, uncertainty induces firms to set optimal prices including the analog of a risk premium, depending on the covariance of their demand and marginal costs (see Obstfeld and Rogoff 2000, Corsetti and Pesenti 2005). Intuitively, a positive covariance means that times of high demand and (given sticky prices) high production coincide with times when production costs happen to be high (and vice-versa).
Optimal stabilisation policy alters the covariance of demand and marginal costs, typically curbing demand when marginal costs are high, and boosting demand when marginal costs are low. To the extent that it is successful in reducing the variability of the ex post markups, optimal monetary policy contributes to the ability of manufacturing firms to set efficiently low, competitive prices on average, and thus acquire a larger share of the global market. As the country’s exports shift from non-differentiated toward differentiated goods, with the opposite effect in the other country, stabilisation policy affects a country’s comparative advantage in international trade.
A key prediction of the model is that the share of a country’s exports in differentiated goods can be expected to fall if a country deviates from efficient stabilisation. This is the case, for instance, for countries that adopt a unilateral peg or a common currency, hence giving up their monetary instrument, without simultaneously boosting their fiscal stabilisation capacity. When we calibrate the model using standard parameters’ values, we find that a fixed exchange rate implying insufficient output gap stabilisation is associated with a substantial contraction in the manufacturing sector of the economy. The size of the contraction is around 1-2% in our baseline, but we also find circumstances when the sector shrinks by a surprisingly large 9%.
Does this new perspective have any support in data?
In our paper, we conduct the following exercise: we calculate the share of differentiated goods in the exports of all countries to the US, over the sample 1972 to 2004 for which data are available. We then carry out panel regressions of this share on the exchange rate regime, controlling for a number of fixed effects, year effects, time trends and relevant macroeconomic and institutional variables. In light of the results of our model, we should find that, other things equal, pegs and fixed exchange rates are associated with a lower share of differentiated goods in total exports.1
The empirical estimation faces many hurdles. Exchange rate regimes are endogenous and may be a poor proxy for limited stabilisation capacity; fixed effects may be an efficient way to control for comparative advantage when their source is time invariant, but not in the presence of structural change; and commodities producers may tend to peg to the dollar. While we adopt solutions for these and other challenges, empirical results need to be interpreted with caution.
That said, the results are striking. Our empirical findings indicate that when a country adopts a peg, the share of its exports in differentiated goods falls by about 6 percentage points. Given that for the typical country differentiated goods account for about half of its exports, the estimated coefficient implies that the export share drops by about 12% of its value. This is a large effect in the context of the usual results found for the long-run effect of macroeconomic policy on aggregate variables like GDP.2
Competitive devaluation: Old and new wisdom
There is also a second, crucial, implication from the model, well in line with the conventional wisdom – strategic behavior is detrimental from a global welfare perspective. Countries may be tempted to go beyond efficient stabilisation, and use their policy instrument strategically to boost competitiveness on top and above their stabilisation need. As such a monetary regime in a country has negative spillovers on the share of manufacturing production in another, this invites retaliation. From our perspective, this results in a contraction of manufacturing at a global level.
Combining these results from our model, the main message from our analysis is straightforward:
- When it comes to fostering comparative advantage in high-value, branded manufacturing goods, monetary policy can provide a non-negligible contribution by pursuing efficient macroeconomic stabilisation.
Good monetary policy has important implications for firms in such a sector, as it reduces macroeconomic uncertainty weighing on their costs and the demand they face. However, because of negative spillovers from strategic behaviour, it is paramount for countries to have viable ways of pursuing cooperative action.
Chinese currency depreciation has been generally interpreted as a one-time competitive devaluation. From the perspective of our model, an efficient stabilisation policy would be more consistent with long-run goals of upgrading the mix of its exports toward higher-value goods –requiring macroeconomic and financial stability, eventually introducing forms of exchange rate flexibility, relaxing capital controls and, above all, adopting efficient rules of monetary stabilisation.
Bergin, P and G Corsetti (2015), “Beyond Competitive Devaluations: The Monetary Dimensions of Comparative Advantage”, University of Cambridge Working Paper.
Corsetti, G, and P Pesenti (2005), “International Dimensions of Optimal Monetary Policy,” Journal of Monetary Economics 52: 281-305.
Eichengreen, B and J Sachs (1986), “Competitive Devaluation and the Great Depression; A Theoretical Reassessment”, Economics Letters 22: 67-71.
Kindleberger, C (1973), The World in Depression, 1929-1939. University of California Press, Berkeley, CA.
Obstfeld, M and K Rogoff (2000), “New Directions for Stochastic Open Economy Models”, Journal of International Economics 50: 117-154.
Obstfeld, M and K Rogoff (2002), “Global Implications of Self-Oriented National Monetary Rules”, The Quarterly Journal of Economics 117: 503-535.
Rauch, J E (1999), “Networks Versus Markets in International Trade”, Journal of International Economics 48: 7–35.
1 Note that our exercise is related to, but distinct from the vast empirical literature on the effects of exchange rate volatility on the volume of exports. Our question is whether exchange rate and monetary regimes have appreciable effects on the composition of exports by types of good.
2 Results are robust to a number of checks, such as oil exports and oil exporting countries, which might be a concern if countries that discover oil in their territory may choose to peg their currencies to the dollar because these commodities are priced in US dollars. Results are also robust to other attempts to control for endogeneity with a common instrument, although the usual limitations apply.