Economic Research Forum (ERF)

Exchange rate undervaluation: the impact on participation in world trade

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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.

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