Real Exchange Rates, Financial Repression and Political Regime Type - A Political Economy Analysis of Sustained Real Exchange Rate Undervaluation

Abstract

For a number of reasons, including enhanced economic growth, greater competitiveness for the export sector, and increased capital formation, governments might wish to undervalue their country's real exchange rate. However, pushing a key price of the global market like the real exchange rate out of equilibrium should, in theory, be unsustainable due to automatic adjustments in either the price level or the nominal exchange rate unless frictions are introduced into either of these two adjustment channels. I argue here that financial repression is a policy option that governments can pursue in order to introduce a substantial friction into the nominal exchange rate adjustment channel. Furthermore, I argue that due to the political costs associated with a sustained undervalued real exchange rate, such as repressed consumption and reduced purchasing power for the populace, autocracies are more likely to pursue these policies in order to achieve a sustained undervaluation. In order to test these hypothesized relationships, I use two random-effects logistic models to examine sustained periods of real exchange rate undervaluation lasting at least 3 and 4 years, respectively, and an ordinary least squares regression for a 5-year averaged dataset. I construct a main dataset consisting of 2591 country-year data points covering the time period of 1973-2005, and a 5-year averaged dataset consisting of 554 country-time-period data points covering 6 time periods. I draw on the work of Rodrik (2008) for my measure of real exchange rate undervaluation; Abiad, Detragiache, and Tressel (2010) and Ito and Chinn (2006) for my measures of financial repression; and Marshall and Jaggers (2002) for my measure of political system. Taken together, the results of these models provide support for the hypothesized relationship between autocracies and financial repression on the one hand, and a sustained undervaluation of the real exchange rate on the other hand.