Economic Research Forum (ERF)

Exchange rate undervaluation: the impact on participation in world trade

350
Can currency undervaluation influence participation in world trade through global value chains (GVC)? This column reports new evidence on the positive impact of an undervalued real exchange rate on the involvement of a country’s firms in GVCs. Undervaluation acts as an economy-wide industrial policy, supporting the competitiveness of national exports in foreign markets vis-à-vis those of other countries.

In a nutshell

A country that has an undervalued currency on global foreign exchange markets is likely to benefit from a positive impact on its firms’ participation in global value chains; this applies to both backward and forward linkages within GVCs.

Exchange rate undervaluation acts as a compensatory factor for countries with weak institutions; the impact of this undervaluation becomes more pronounced as the level of digitisation in the economy increases.

Undervaluation is both feasible and effective as strategy in the short term – perhaps even several years – but it is not a substitute for building robust institutions in the longer run; even in the short term, its effectiveness is contingent on a higher level of digital transformation.

Global value chains (GVC) are increasingly dominating trade relations. Participation in GVCs sustains both high economic growth and the structural transformation of the economy. This is because participating countries can enter niches along the chain without having to produce the whole product through vertical specialisation.

The Middle East and North Africa as a region is still underperforming in GVC participation compared with other emerging and developing regions. Based on our research, we argue that part of the explanation might lie in currency markets since undervaluation of the real exchange rate (RER) is among a set of determinants that matter for GVC participation. This applies to both backward linkages (value added in exports whose outputs are produced by foreign industries) and forward linkages (domestic value added that is embodied in the exports of other countries).

In general, RER undervaluation acts as an economy-wide industrial policy, supporting the competitiveness of a country’s exports vis-à-vis other countries’ exports in foreign markets.

Rodrik (2008) argues that empirical findings on the prominence of RER reflect a deeper causal effect. According to his analysis, to the extent that tradable economic activities are more ‘complex’ and therefore entail more transaction-intensive activities, they tend to be more affected by the cost associated with weak institutions. Hence, the economy-wide subsidy provided by RER undervaluation should at least partially reduce this cost.

Evidence of the robust association between mild undervaluation and fast export-oriented growth could be explained by the fact that, in general, tradables tend to be more dynamic than non-tradables. The equally robust evidence on the negative effect of RER overvaluation could be explained as well. Yet in a world characterised by the increasing role of GVCs since the 1990s and cross-border fragmentation of production, the evidence from previous research may become less intuitive.

Evidence on the role of RER undervaluation typically hinges on the assumption that countries export only final goods that do not require imported intermediate inputs. Such a simplifying assumption does not reflect the complex reality of trade relations, especially GVC trade, where products become multi-country products as intermediate inputs are imported, transformed and then re-exported. Thus, GVC-related trade is expected to respond differently to exchange rate undervaluation compared with traditional trade in single-country goods.

We provide evidence in support of this proposition using a sample of 143 countries over the period 1995-2018 drawn from the UNCTAD-EORA database. Our findings show that undervaluation has a positive impact on forward GVC participation as well as backward GVC participation. While the former finding is intuitive, the latter may initially appear contradictory to prior research. Nonetheless, this result is consistent with the underlying concept that domestic and foreign value-added within GVCs are complementary in the production process. Hence, producing and exporting more domestic value added increases the derived demand for imported foreign value added.

Therefore, in our view, the interplay between domestic and foreign value added would explain the positive impact of undervaluation on backward GVC participation. Moreover, accounting for the quality of institutions and the degree of digitalisation, we demonstrate that undervaluation can serve as a catalyst for GVCs in countries with deficient institutions.

We also find that the positive impact of undervaluation is further magnified for countries with higher levels of digitalisation. Finally, we consistently observe a positive impact of undervaluation, irrespective of a country’s position within the value chain (either upstream or downstream).

Implications for policy

A number of policy recommendations stem from our research. First, undervaluation can act as a second-best solution to mitigate the economic cost of poor institutions and market failures that penalise the tradable sector and value-added exports.

A first-best policy would consist of identifying specific market failures and implementing tailored solutions. But in the presence of a manufacturing sector that has existing or potential capacity to export, undervaluation can be perceived as a short-term stepping-stone before a comprehensive industrial policy can be launched.

Many aspects of an economy, including the level of financial development, the quality of institutions and the degree of digitalisation, matter for the impact of undervaluation on GVC participation. Hence, to maintain the positive effect of RER undervaluation, exchange rate policy should be coupled with other policies.

Nonetheless, while this policy is doable in the short term, it is not sustainable in the long run. Deeper reforms to improve institutions and attain a higher level of digital transformation are needed.

Further reading

Abdou, M, I El Badawi, P Plane and C Zaki (2024) ‘Unravelling the Nexus Between Exchange Rate Undervaluation and Global Value Chains Participation’, ERF Working Paper No. 1709.

Elbadawi, I, and C Zaki (2021) ‘Exchange Rate Undervaluation, Economic Institutions and Exports Performance: Evidence from Firm-level Data’, International Journal of Trade and Global Markets 14(1): 62-93.

Nouira, R, P Plane and K Sekkat (2011) ‘Exchange Rate Undervaluation and Manufactured Exports: A Deliberate Strategy?’, Journal of Comparative Economics 39(4): 584-601.

Rodrik, D (1986) ‘Disequilibrium Exchange Rates as Industrialization Policy’, Journal of Development Economics 23(1): 89-106.

Tan, KG, LN Trieu Duong and HY Chuah (2019) ‘Impact of Exchange Rates on ASEAN’s Trade in the Era of Global Value Chains: An Empirical Assessment’, Journal of International Trade and Economic Development 28(7): 873-901.

Most read

Economic roots of early marriage in Iran

Despite the documented harms of being married off before the age of 18, particularly for girls, early marriage remains common in parts of Iran. This column summarises research that sheds light on the economic factors that drive this practice, using unique provincial data to show that poverty, inflation and income inequality are key determinants –while religiosity is not. The findings suggest that economic policies can play a crucial role in reducing the prevalence of child marriage.

Natural disaster literacy in Iran: survey evidence from Tehran

The frequent floods, earthquakes, and heat waves in the Middle East and North Africa underscore the urgent need to assess the region's preparedness for natural disasters. This column summarizes the state of 'natural disaster literacy' in various parts of Tehran, the capital of Iran and one of the most populous metropolitan areas in MENA. Data from a survey conducted in the winter of 2020/21 enabled the development of a disaster literacy index, which helps to identify the city's most vulnerable districts.

Should Arab countries join the WTO’s agreement on government procurement?

Not all members of the World Trade Organization are signatories of the institution’s Agreement on Government Procurement – the GPA. Indeed, although many developing economies are now joining the agreement or at least acquiring observer status, it has long been thought that the costs outweigh the benefits. This column re-evaluates the pros and cons of GPA accession for Arab countries.

Financial development, corruption and informality in MENA

Reducing the extent of informality in the Middle East and North Africa would help to promote economic growth. This column reports evidence on how corruption and financial development influence the size of the informal economy in countries across the region. The efficiency of the financial sector in MENA economies reduces the corruption incentive for firms to seek to join and stay in the formal sector.

EU climate policy: potential effects on the exports of Arab countries

The carbon border adjustment mechanism aims to ensure that Europe’s green objectives are not undermined by the relocation of production to parts of the world with less ambitious climate policies – but it could impose substantial costs on developing countries that export to the European Union. This column examines the potential impact on exporters in the Arab world – and outlines possible policy responses that could mitigate the economic damage.

Climate change threats and how the Arab countries should respond

The Arab region is highly vulnerable to extreme events caused by climate change. This column outlines the threats and explores what can be done to ward off disaster, not least moving away from the extraction of fossil fuels and taking advantage of the opportunities in renewable energy generation. This would both mitigate the potential for further environmental damage and act as a catalyst for more and better jobs, higher incomes and improved social outcomes.

Exchange rate undervaluation: the impact on participation in world trade

Can currency undervaluation influence participation in world trade through global value chains (GVC)? This column reports new evidence on the positive impact of an undervalued real exchange rate on the involvement of a country’s firms in GVCs. Undervaluation acts as an economy-wide industrial policy, supporting the competitiveness of national exports in foreign markets vis-à-vis those of other countries.

Child stunting in Tunisia: an alarming rise

Child stunting in Tunisia seemed to have fallen significantly over the past two decades. But as this column reports, new analysis indicates that the positive trend has now gone dramatically into reverse. Indeed, the evidence is unequivocal: the nutritional health of the country’s youngest citizens is rapidly deteriorating and requires immediate and decisive action.

Green hydrogen production and exports: could MENA countries lead the way?

The Arab region stands at the threshold of a transformative opportunity to become a global leader in green hydrogen production and exports. But as this column explains, achieving this potential will require substantial investments, robust policy frameworks and a commitment to technological innovation.

Freedom: the missing piece in analysis of multidimensional wellbeing

Political philosophy has long emphasised the importance of freedom in shaping a meaningful life, yet it is consistently overlooked in assessments of human wellbeing across multiple dimensions. This column focuses on the freedom to express opinions, noting that it is shaped by both formal laws and informal social dynamics, fluctuating with the changing cultural context, particularly in the age of social media. Data on public opinion in Arab countries over the past decade are revealing about how this key freedom is perceived.




LinkedIn