The literature on export-led growth is essentially about the advantages of keeping the prices of exportables high enough to make it attractive to shift resources into their production. Historically, this has meant the growth of the production for export of light manufactures. Using the real exchange rate to provide an incentive to shift resources into manufacturing thus offers a one-time boost to national income insofar as other distortions make for higher productivity in manufacturing than in agriculture. This process can continue for a considerable period without encountering diminishing returns like those experienced in agriculture as cultivation is expanded onto the extensive margin and in the production of nontradables insofar as relatively inelastic domestic demand means that boosting production will drive down prices. Globalization means that the external demand for manufactures is in effect perfectly elastic, except perhaps for the largest emerging markets. If higher incomes and faster growth support higher savings, it will become possible to finance higher levels of investment out of domestic resources. If learning-by doing or technology transfer is relatively rapid in sectors producing for export, then there will be additional stimulus to the overall rate of growth. That first Japan, then Hong Kong, Singapore, South Korea and Taiwan, and now China have had success with this model has directed attention to the real exchange rate as a development-relevant policy tool. The so-called Bretton Woods II model of the world economy is essentially a story about the external consequences of the adoption of a competitive real exchange rate as a growth strategy by China and other developing countries. But the controversy surrounding this model suggests that there may costs as well as benefits of keeping the real exchange rate low, especially if the authorities stick with the policy for too long.

Other narratives focus not on the level of the real exchange rate but on its volatility. Here it is argued that exchange rate volatility discourages trade and investment, which are important for growth.

That said, the idea that minimizing exchange rate volatility is an essential part of the growth recipe is disputed. The evidence linking exchange rate volatility to exports and investment is less than definitive. The implications of volatility for financial stability will depend on the presence or absence of the relevant hedging instruments and markets. There is some evidence that these markets develop faster when the currency is allowed to fluctuate and that banks and firms are more likely to take precautions, hedging themselves against volatility, than when the authorities seek to minimize volatility. This is evident for example in the accelerating development of these markets and instruments following the Asian crisis. More generally, there is evidence that countries with more variable exchange rates tend to have more liquid foreign exchange markets, since it is their banks and firms that have an incentive to participate.

A stable and competitive real exchange rate should be thought of as a facilitating condition. Keeping it at appropriate levels and avoiding excessive volatility enable a country to exploit its capacity for growth and development — to capitalize on a disciplined labor force, a high savings rate, or its status as attractions as a destination for foreign investment. Absent these fundamentals, policy toward the real exchange rate will accomplish nothing. In this sense it is not surprising that analyses of the correlation between growth and the level or volatility of the real exchange rate produce a variety of statistical results.

The tendency for the prices of nontraded goods to move more sluggishly than exchange rates, except in high-inflation economies, is familiar. Thus, monetary policy shifts and other disturbances that are felt mainly as shocks to financial markets will add to the volatility of the nominal exchange rate and thereby to the real exchange rate. With time, of course, inflation will react, and the prices of nontraded goods will adjust. The implication is that in the long run monetary policy cannot be used to sustain a particular real exchange rate, other than that dictated by the fundamentals. Of course, policies that affect the real exchange rate even in the intermediate run may be enough to have a significant imprint on growth. And, in any case, repeated unpredictable shifts in the stance of monetary policy may result in instability in the real exchange rate to the detriment of investment, trade and growth.

Fiscal policy is likely to have a more sustained impact. Consider first the case where the exchange rate is pegged (or at least heavily managed). Increased public spending (or increased private spending in the case where the fiscal expansion takes the form of tax cuts) falls partly on traded goods, whose prices are given, and partly on nontraded goods, whose prices consequently tend to rise. The pressure of public spending can therefore cause the real exchange rate to become overvalued. It will shift resources into the production of nontraded goods. Conservative fiscal policy thus tends to be part and parcel with the maintenance of a competitive real exchange rate and encouragement of export-led growth.

How conservative depends on how much pressure is felt by the market for nontraded goods from other forms of spending. If household and corporate savings are high, as in China, then the government can engage in additional spending without placing undue pressure on the prices of nontraded goods. If investment spending is relatively weak, as it has been in East Asia since the crisis in 1997-8, then a given level of public spending will be associated with a more competitive real exchange rate.

… The real exchange rate is a relative price and that, as such, it is not under direct control of the authorities. But it can be influenced by policy. For those who believe that the most effective way of jump-starting growth is by encouraging the growth of light manufacturing, many of whose products must be exported at least initially, it is a useful summary indicator of the growth-friendly or unfriendly stance of economic policy.

An alternative view is that it is not the stability of the real exchange rate per se but its average level that matters importantly for growth. If the exchange rate becomes significantly overvalued, then the right approach to fostering growth and development is to realign it. This can be accomplished by nominal depreciation, ideally in conjunction with policies of wage restraint designed to prevent the real effects from being dissipated by inflation, and appropriate adjustments of monetary and fiscal policies, as described above.

But if a competitive real exchange rate helps to foster growth and development, then why isn’t it automatically delivered by market forces and policy choices? One answer invokes Mancur Olson’s theory of collective decision making: while the benefits of a competitively valued real exchange rate are diffuse, the costs are concentrated; hence the incentive to engage in self-interested lobbying is stronger for those who favor overvaluation; conversely, the incentive to free ride — to leave to someone else the choice of making a costly investing in influencing policy — is stronger for those who benefit from avoiding overvaluation.

The other critical question is: what exactly is the mechanism through which a competitive real exchange rate fosters growth? Avoiding real overvaluation may be necessary simply to encourage the optimally balanced growth of traded and nontradedgoods producing sectors. Alternatively, there may be nonpecunary externalities associated with the production of exportables (learning by doing effects external to the firm) that do not exist to the same degree in other activities — meaning that market forces, left to their own devices, may produce a real exchange rate that is too high.

There is now substantial literature, as noted above, linking the level of the real exchange rate to output and employment growth. But none of it addresses the $64,000 question, namely, the mechanism through which the real exchange rate affects economic growth. This is symptomatic of the state of the literature, which has invested more in documenting the growth-real exchange rate correlation than in identifying channels of influence. Here there are two distinct but compatible interpretations, as I have already noted. First, distortions in the political market that give concentrated interests disproportionate sway may allow them to influence policy in ways that produce a real exchange rate outcome that is detrimental for the nation as a whole. Left to its own devices, the market will presumably produce a real exchange rate that encourages resources to flow into sectors producing traded and nontraded goods just to the point where their marginal returns is equalized, and their contribution to growth is maximized. In contrast, political pressures that result in strong favoritism for one sector (in the canonical case the sector producing nontradables) may cause the real exchange rate to become misaligned (in the canonical case to become overvalued) and the marginal return on capital and the productivity of labor in that sector to diminish sharply and aggregate growth to suffer. This points to pro-growth political reforms, or at least to political obstacles that need to be overcome in order to sustain a real exchange rate conducive to steady growth: land reform that empowers rural and, in many countries, export-oriented — interests, more constraints on the executive, and so forth.

In addition, there may exist positive externalities associated with export-linked activities that are not equally prevalent in other sectors. Learning and demonstration effects external to the firm may be more pronounced in export-oriented sectors. Complementarities between different activities that cannot be encompassed within the same firm (that cannot be internalized, in other words) may be more pronounced in export-oriented sectors. Because these additional positive effects are external to the firm or industry, market forces left to their own devices will not allocate sufficient resources to their pursuit. In addition, it is necessary to have a strong government or a political system that endows exporters with disproportionate influence in order to ensure the maintenance of a real exchange rate that does as much as possible to foster growth.

A number of authors have observed that rapidly growing developing countries tend to have unusually large manufacturing sectors and that growth accelerations are associated with structural shifts in the direction of manufacturing. These findings are cited as evidence of the positive externalities associated with manufacturing exports. But the nature of the externality remains obscure. Indeed, it may be that all we are seeing is the elimination of other distortions, not the operation of positive externalities.

Similarly, the literature attempting to document the existence of spillovers from exporting is less than conclusive. While a number of studies report that proximity to other exporting firms increases the likelihood that a subject firm will itself export — and that its profits and productivity will develop favorably — other studies fail to find similar evidence. A charitable interpretation is that the existence of spillovers is contingent on facilitating conditions which may or may not be present. The potential beneficiaries must be close to a port or land border. Or they must possess the organizational flexibility needed to assimilate new technology and adjust their labor force appropriately.

A less charitable interpretation is that the thought experiment is poorly designed and empirical results are contaminated by omitted variables bias. If firms from a given neighborhood have a disproportionate tendency to export, this may simply reflect the operation of an unobservable determinant of behavior that is common to the firms in question, say that they all have links to the same overseas immigrant network. If one firm starts exporting this year and others follow next year, this may simply reflect that they make contact with members of that overseas network at different times, rather than any tendency for the latecomers to learn from the pioneers.

When asked to ponder the fundamental determinants of growth, economists tend to focus on, inter alia, education and training, savings and investment, and the institutional capacity to assimilate and generate organizational and technological knowledge. The real exchange rate is best thought of as a facilitating condition: keeping it at competitive levels and avoiding excessive volatility facilitate efforts to capitalize on these fundamentals.

Even a facilitating condition can be important. Development experience — first and foremost that of the high-growth economies of East Asia but development experience more generally — shows that keeping the real exchange rate at competitive levels can be critical for jump-starting growth.

A real exchange rate that continues to favor export- oriented manufacturing along the coasts stunts the development of the service sector and heightens inequality with other regions. Sooner or later excessive concentration on this sector will translate into declining efficiency of investment. Resisting market pressures for balanced growth means that adjustment will come about through a financially and economically disruptive inflation. Resisting a significant increase in exchange rate variability until hedging markets and instruments develop, where the development of hedging instruments and markets depends in turn on the existence of exchange rate variability, may mean that those markets fail to develop in appropriate time. And of course reluctance to exit from this policy regime contributes to global imbalances, creating financial risks and fanning trade tensions with the United States. Policy makers in China and other developing countries are aware of these issues, but they are uncertain about the appropriate strategy for exiting from the prevailing regime.

Here it may be useful to make two final points. First, the literature on exit strategies points to the advantages of exiting while growth is still rapid rather than waiting until a significant slowdown. Similarly, altering the exchange rate regime — allowing for a significant increase in volatility — will do less to disrupt market confidence when the authorities undertake it voluntarily than when the change is implemented under duress. This literature also points to the existence of status quo bias. As time marches on, interest groups benefiting from prevailing policies come to be in an increasingly strong position to resist change. In addition, the authorities will be understandably reluctant to abandon a tried-and-true strategy for an untested alternative. These arguments suggest that policy makers need to be proactive in the pursuit of adjustment.

Second, how long it pays to stick with a policy mix favoring export-oriented manufacturing depends on the prevalence of nonpecuniary externalities and on whether learning spillovers and other externalities are also present in other sectors. And here, as earlier discussion has emphasized, the evidentiary base is limited. Better documenting the presence or absence of the relevant externalities should be the priority for research. What form do the relevant externalities take - demonstration effects, other learning effects, labor market effects, improvements in the supply of inputs? In what activities specifically are they concentrated? Better answers to these questions are valuable in general, but they also will help to inform decisions regarding the exit problem in particular.