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The virtues of undervaluation

Economist Surjit Bhalla argues that countries can boost growth if they keep their currencies undervalued

Laveesh Bhandari 

The question is quite interesting, unlike what textbook economics will tell you: can playing around with the exchange rate in the right manner encourage growth? Is it possible that a simple trick can lead to far higher growth than making a massive effort at reforming and investing? What would new developments in economic theory say and what do data indicate?

ventures where many drawing room discussions have gone, at least among the economist fraternity. But he brings to the discussion his own unique style: massive amounts of data analysis done in many different ways, all to support every single piece of argument. Data are spliced and diced, massaged and mined, and looked at in many different ways. For those who don't mind data analyses like this reviewer, it is a highly enjoyable piece of work. You may or may not agree with the central theme, you may or may not agree with the arguments, but it is a highly educative and fun-to-read volume.

Mr Bhalla does a good job of writing an economics book that is loyal to the established norms of giving credit where due, explaining the arguments and counter-arguments, and at the same time making it interesting. A crisp mention of the long-running arguments in the economics profession runs throughout the volume; there is generous referencing; and there is the author's view that is cleanly differentiated from what others have said. In other words, for students, practitioners, and policy makers there is a lot of masala on the topic at hand.

But - there is always a but - Mr Bhalla appears to be more partial than he actually is. Having a cheaper currency helps growth, and his strong conviction shows through a bit too much in the writing - so much so that you start to wonder whether he is being completely honest. Could it be so obvious? Are the policy makers blind to not to have seen something so obvious? Are there some data that he is hiding? Or is he not referring to some literature to convince the uninformed? And if his data work is so faultless, why did he not publish it in a refereed journal?

No one can very well answer such questions. And, admittedly, some of these may be quite unfair. But Mr Bhalla's results are quite believable. A half-a-per cent boost in growth is possible if decent levels of undervaluation are undertaken. Another way to read this is, you have to do other things right in order to get high growth, and undervaluation gives you a little bit of a cherry on top. In yet other words, Indian growth cannot achieve the same levels as China's even if India resorts to a long-term undervalued exchange rate strategy. For that to happen, it still has to do the other things on governance, infrastructure, labour and so on.

Countries as diverse as those from Latin America, Africa, North America and Europe are examined to show how foreign exchange valuation played a role in accelerating their growth. But other factors are looked at: the relative non-importance of institutions; the large amount of capital or investment that has gone into the economy of these countries; economic orientation and so on. And the author also looks into the inter-relationships between these causal factors as well as forex valuations. The net result is a rewarding experience that provides many glimpses into the complex world of economic inter-relationships. The story he tells is simply this: undervaluation of the currency reduces the costs and, therefore, provides greater returns to investment. This increased investment, in turn, has benefits in terms of both productivity and output growth, which have their own positive outcomes on the economy. A one-time devaluation kick-starts this process and continued undervaluation sustains it.

There are limits to this process, however. If a country is small, it has a minor impact on the rest of the world; however, if a country does this to a large extent and/or is very large, it has a negative impact on the rest of the world. This impact, in turn, feeds into its own growth process. Consequently, countries such as China, which are not only large but have also maintained a high level of undervaluation for a long period of time, will need to revalue their currencies soon if international economic stability is to be maintained.

But what does this imply for India? Will undervaluation help? Yes, the author would argue. But to a limited extent and only when the government is back on the path of economic reforms, this reviewer tends to believe. There are gains from undervaluation that Indian manufacturing could do with. Perhaps it would help ameliorate some of the unnecessary costs they are forced to bear, given the way India and its government work. There are, however, certain inflationary possibilities that are exacerbated in an undervalued forex economy. This can be addressed only if supply hurdles are progressively removed through a renewed reform process.

The reviewer is an economist and heads Indicus

Surjit S Bhalla
Oxford University Press;
263 pages; Rs 850