Currency Undervaluation: The Formula for Growth?

L to R: Surjit Bhalla, author and Chairman of Oxus Research and Investments, and Rajiv Lall, Vice Chairman and Managing Director, Infrastructure Development Finance Company (IDFC) in Mumbai on Dec. 19, 2012. (Asia Society India Centre)

MUMBAI, December 19, 2012 — Currency undervaluation can occur if wages are lower than productivity, and this can have a large impact on economic growth because of the resulting extra profits, which can lead to further investments and higher growth. To explore this topic, Asia Society India Centre hosted a discussion on Devaluing to Prosperity with Surjit Bhalla, author and Chairman of Oxus Research and Investments, and Rajiv Lall, Vice Chairman and Managing Director, Infrastructure Development Finance Company (IDFC), including remarks by Uday Kotak, Executive Vice Chairman and Managing Director, Kotak-Mahindra Bank.

Bhalla said that finding the determinants of growth is like searching for the Holy Grail and argued that the major finding to date is "convergence," emphasizing that poorer countries have a tendency to grow at a faster rate than richer ones. On currency devaluation, Bhalla explained that if wages are lower than productivity, currency is undervalued, and if wages are higher than productivity, currency is overvalued.

As an explanation for growth, Bhalla argued that currency undervaluation “turns out way ahead of institutions." Lall added that "institutions do not lead to better growth but develop as growth accelerates."

Bhalla argued that "broadly there are two institutions — economic freedom and political freedom. So, the more political freedom you have — all other things being equal — the higher you'll grow; and the more economic freedom you have, the higher you'll grow." Bhalla also noted that countries that grew well had more economic freedom partly due to the undervaluation of the exchange rate.

Bhalla argued that there is no evidence to support the middle income trap as it does not take into consideration the idea of convergence. He further added that, "it becomes difficult to undervalue your currency, because what happens when you're growing fast, foreign capital comes in and that has a tendency to push up the exchange rate, appreciate the exchange rate, and if you are not China, it becomes very difficult to do that." He proceeded to say that "the appreciation of the exchange rate helps workers, helps wages, increases your standard of living and it keeps a balance between workers and capital, in a capitalistic balance; whereas in China we have a neo-Marxist imbalance where the profits are much more favored than wages are, so no other country can do that and that is why the middle income trap is not observed."

Lall highlighted the middle income trap experienced by the Philippines and Bhalla explained that it was an exception as the Philippines was one of the few Asian countries that didn't grow while the rest of East Asia was growing in the '80s and the '90s, as it had an overvalued currency; whereas South Korea, Malaysia, Singapore, Hong Kong, Taiwan and Indonesia had an undervalued currency. Lall also noted that the East Asian crisis was started in Thailand as its currency was extremely overvalued.

On the Reserve Bank of India's (RBI) policies, Bhalla added that "neither my research nor my views support what the RBI has done with the rupee for the last three years." He added that "India's depreciation of the currency is devaluation from weakness and does not contribute to growth. What contributes to growth is devaluation from strength."

In response to Lall's question on how currency undervaluation contributed to the global predicament, Bhalla argued that it was "China's policy of undervalued currency that has contributed to the global crisis that we just experienced in 2008 through misaligned currency and their growth consequences." He explained that "misaligned currency has consequences for the whole system, because one country's undervaluation is another country's overvaluation and in this case the other countries are the rest of the world." Bhalla added that currency devaluation has been witnessed in Korea, Singapore and Thailand but what is different about China is its size. Therefore, "when Singapore undervalues, it doesn't affect the system but when China undervalues the currency, it disrupts the entire system."

Bhalla also argued that "when the U.S. dollar is undervalued, it not only helps us grow, it helps other countries' growth and that is a good thing for the world. It means prices are lower. When China's currency is undervalued, it steals from other countries' growth. Other countries have lower growth than they would have with China's undervaluation." Bhalla added that there is no example in history of undervaluation of the extent that China has undervalued.

Concluding the discussion, Bhalla emphasized that the number one objective for India's policy makers should be growth — "If we are able to get growth, the rupee will appreciate because the assets follow growth. Foreign flows coming in will be higher." He added, "I think there is not one example in history of a country whose growth rate has collapsed so fast and so much than India in the last two years." "There should be some questions about it and hopefully there should be some answers."

Video: Highlights from the discussion (9 min., 16 sec.)



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