My blogs and edited opinions

The Folly of “Competitive Devaluation”

By Xuehui Han

September 9, 2016

MANILA – Can a country seeking to increase its exports boost its competitiveness by devaluing its currency? The conventional wisdom is that, ceteris paribus (that is, no retaliation by trading partners), a weaker currency makes a country’s goods more attractive to foreigners. In fact, the impact of currency depreciation on exports depends on which currency is on the other side of the exchange rate.

Export-oriented economies naturally depend on a healthy tradable sector for steady growth. In Asia, export-oriented economies include Taiwan* – where exports account for about 65% of GDP – as well as Singapore, the Maldives, Vietnam, Malaysia, Thailand, and Cambodia, where exports account for at least 60% of GDP. All of these countries have placed consistent, healthy export growth at the center of their economic policies.

Export-oriented economies’ growth strategies must also take account of trade partners’ policies. In the case of Taiwan, its relationship with major trade partners has evolved over time. After the People’s Republic of China joined the World Trade Organization in 2001, the share of Taiwan’s exports to the PRC grew dramatically, from around 3% in 2000 to 15% in 2003, and has remained above 25% since 2007. Although exports to the United States dropped from 23% in 2000 to 12% in 2015, the US remains an important trading partner for Taiwan.

Economic growth in both the PRC and the US affects Taiwan’s export performance, which relies on external demand. Using a regression analysis, we find that a 1% increase in GDP growth in China brings about a 2% increase in exports in Taiwan, while a 1% increase in GDP growth in the US results in a 4.5% increase in Taiwan’s exports.

These findings seem to suggest that a competitive devaluation of the Taiwanese dollar against the Chinese renminbi and the US dollar would boost Taiwan’s exports, at least in the short term. But our research results do not support this hypothesis. Instead, correlation analysis indicates that a depreciation of the Taiwanese dollar against the renminbi or the US dollar would not increase demand for Taiwan’s exports. On the contrary, as the graph shows, exchange-rate depreciation would reduce the volume of export orders from China, as well as of export orders overall.

To understand why, we introduced South Korea, Taiwan’s main export competitor, into the picture. Exports of electrical machinery to China alone account for 10% of Taiwan’s total exports and 7% of South Korea’s total exports. The correlation results show that depreciation of the Taiwanese dollar against the Korean won increases overall export orders, as well as export orders from China and the US. This result (shown below) implies that competitive devaluation by competing exporters, especially South Korea, would nullify a depreciated Taiwanese dollar’s effect.

Indeed, monthly exchange-rate data from January 2001 to December 2015 point to the futility of such a policy. While the Taiwanese dollar depreciated against the renminbi, it appreciated against the won half the time. This indicates that any depreciation of the Taiwanese dollar against the renminbi or the US dollar is likely to be followed by a larger depreciation of the won against the same currencies, rendering ineffective any policy aimed at promoting exports through currency depreciation.

These findings cast doubt on the old export-promotion strategy of using competitive devaluation to gain an advantage. Given today’s complex dynamics among export partners and competitors, economic policy should focus on encouraging innovation and promoting productivity growth. Relying on the exchange rate to boost exports would yield only disappointing results – and could backfire – while distracting attention from the fundamental reforms needed to boost long-term competitiveness.