of any of the currencies listed in terms of the number of units of a US dollar that would
be received. For example, the exchange rate on May 14 2007 for 1 Mexican peso was
US$0.09278 (= $1 √· 10.77804 pesos).
Currency appreciation and depreciation
Let‚Ä™s consider what happened to the value of Ghana‚Ä™s cedi between 2002 and 2007. From
Table 15.3, the bilateral exchange rate in 2002 meant that to buy 1 US dollar, 7,797.9 cedis
had to be paid. In 2007, the cost of buying 1 US dollar had risen to 9,594.2 cedis. What had
Table 15.3 Bilateral exchange rates, selected countries
Units of foreign currency Units of foreign currency received
received for US$1, Feb. 4 2002 for US$1, May 14 2007
Argentina (peso) 2.025 3.0844
Bangladesh (taka) 59.478 71.035
Brazil (real) 2.5029 2.0214
Cambodia (riel) 4,026.00 4,142.80
China (renminbi yuan) 8.2866 7.6866
Ethiopia (birr) 8.8109 9.2404
Ghana (cedi) 7,797.90 9,594.20
India (rupee) 48.41 41.29
Kenya (shilling) 79.05 67.4639
Malaysia (ringgit) 3.805 3.54356
Mexico (peso) 9.153 10.77804
Pakistan (rupee) 63.023 60.49
South Korea (won) 1,318.00 964.413
Source: http://www.oanda.com/convert/classic. Local currency names in parentheses.
504 The Process of Economic Development
happened to the value of the cedi? Had it gone up (appreciated) or had it gone down (depre-
ciated) in value?
The correct response is that the cedi had depreciated between 2002 and 2007, as it took
more cedis to buy 1 US dollar. Each cedi had less buying power in exchange for US dollars
in 2007 than it had in 2002. At the same time, the US dollar had appreciated relative to the
Ghanaian cedi, as 1 US dollar was able to purchase a larger quantity of cedis in 2007 than in
2002. each dollar was worth more in terms of its buying power in purchasing cedis.
In Table 15.3, six of the thirteen currencies depreciated in value and seven appreciated
in value relative to the US dollar. You should be able to correctly identify these. We will be
using the idea of appreciation and depreciation of currencies throughout the remainder of
the chapter. And we shall see that currency appreciation and depreciation have very direct
effects on a country‚Ä™s balance of payments and the flows of foreign exchange between
nations. But before we look at these connections, let‚Ä™s consider how exchange rate values
Types of exchange rate regimes
exchange rate values are determined in different ways in different countries. exchange rates
can be regulated solely by the free market and the forces of supply and demand, called a
floating exchange rate, or determined by a government at a set value (or range of values) rela-
tive to other currencies, a fixed exchange rate, or the exchange rate value can be determined
by an intermediate mix of government regulation and the forces of supply and demand in the
market. The way in which exchange rate values are determined for a particular country is
referred to as its exchange rate regime.
Freely floating exchange rates
If a country chooses to operate with a freely floating exchange rate regime, the nominal value
of the exchange rate relative to other currencies will depend solely upon the demand for and
the supply of the domestic currency on the foreign exchange market. This can be illustrated
in Figure 15.1, which shows the market demand curve, D$, and the market supply curve, S$,
for US dollars in Sri Lanka, assuming Sri Lanka has a freely floating exchange rate regime.
The vertical axis tells us the ‚Äúprice‚ÄĚ (the exchange rate) in terms of the number of Sri Lankan
rupees that must be given up to buy 1 US dollar.
Who demands US dollars in this foreign exchange market? In other words, who might
wish to exchange their Sri Lankan rupees so as to be able to buy US dollars? 7
1 Importers of goods into Sri Lanka who need to pay their suppliers in dollars.
2 Sri Lankans or others holding rupees who wish to invest in the US stock or bond markets,
to make deposits in US banks, or to otherwise invest in the US or any location in the
world where US dollars might be accepted.
3 Sri Lankans or others holding rupees travelling abroad who will need US dollars for
4 Anyone currently holding Sri Lankan rupees who wishes, for whatever reason, to hold
dollars rather than rupees, e.g., for speculation reasons.
As for most demand curves, it is reasonable to presume that as the price of dollars decreases
then the quantity demanded of dollars will rise. Why? When it requires fewer rupees to buy
Macroeconomic equilibrium 505
per $ S$
D0 D1 Quantity of dollars
Figure 15.1 Exchange rate determination: floating rates.
each dollar, buying a dollar is easier and cheaper. This means that travel to US for those
holding rupees will then be cheaper, goods imported from the US will cost less in terms of
rupees given up, and so on, and it is reasonable to presume that more dollars will be desired.
Thus the demand curve for dollars, D$, is drawn sloping downward to the right.
What determines the supply of dollars entering the foreign exchange market to buy Sri Lankan
rupees? It is more or less the obverse of the factors influencing the demand for dollars.
1 The desire of importers in, say, the United States holding dollars who need rupees to pay
for goods bought from Sri Lankan producers.
2 US citizens (or anyone with US dollars) wishing to travel in Sri Lanka who need to
exchange dollars for rupees for spending while in the country.
3 Investors in the United States, or anyone holding dollars, wishing to make a deposit in
a Sri Lankan bank or to otherwise invest in the economy who needs rupees to do so and
who thus supply their dollars to the foreign exchange market in exchange for rupees.
As for other normally shaped supply curves, it seems reasonable to presume that as the
number of rupees that can be obtained for each dollar given up increases, the quantity supplied
of dollars will be larger. Thus the supply curve for exchanging rupees for US dollars, S$, is
drawn with an upward slope.
Equilibrium with a freely floating exchange rate
The equilibrium exchange rate between the United States dollar and the rupee when there
is a freely floating, or independently floating, rate is determined by the intersection of the
demand and supply curves, D$ and S$. To buy (‚Äúdemand‚ÄĚ) one dollar the price paid at equilib-
rium is 93.665 rupees. Alternatively, selling (‚Äúsupplying‚ÄĚ) one dollar resulted in the receipt
of 93.665 rupees in exchange.8
506 The Process of Economic Development
This is the equilibrium exchange rate toward which the foreign exchange market will tend
if there are no barriers to such adjustments given the demand curve, D$, and the supply curve,
S$. The equilibrium price of 93.665 Sri Lankan rupees for one US dollar will prevail as long
as the demand and supply curves remain constant. What happens, however, if one or the
other, or both, of the curves change?
An increase in the supply of dollars, shown by S$1, results when those holding dollars wish
to trade more of them for rupees at all possible exchange rates. This might happen because
those living in the US wish to purchase more Sri Lankan goods as their incomes rise or
because investment opportunities have improved in Sri Lanka. Or a tourism push by the Sri
Lankan government could make the country seem trendy and attract more visitors from the
US who wish to exchange additional dollars for rupees to pay for their hotels, meals, and
other expenditures. Whatever the reason, the shift to the right of the supply curve of dollars
means that there are more dollars entering the Sri Lankan foreign exchange market in search
of rupees than before at all possible exchange rates.
The shift in the supply of dollars will, with freely floating exchange rates, result in a
new equilibrium value of the exchange rate at the intersection of the demand curve, D$,
and the new supply curve, S$1. With the increased supply of dollars and the demand for
dollars unchanged, the exchange rate value of the dollar will depreciate as the number of
rupees that can be obtained in exchange for US$1 declines from 93.665 to 91.4 rupees. Thus,
someone trading 100 dollars after the increase in the supply would receive only 9,140 rupees
compared to 9,366.5 before the shift in supply. The same quantity of US dollars, 100, is
worth less than previously in terms of the number of rupees that can be bought. In this case,
the value of the dollar has fallen or depreciated, because the supply of dollars increased given
a constant demand.
At the same time that the US dollar‚Ä™s value depreciated, the value of the Sri Lankan rupee
of course must have appreciated. each rupee now is worth more than before the shift in the
supply of dollars. This is because it now takes fewer rupees to purchase one US dollar: 91.4
versus 93.665 before the increase in the supply of dollars. With a higher-valued rupee, the
rupee cost of purchasing anything priced in dollars will now be less in terms of the number of
rupees that must be given up, even when the dollar price of what might be purchased remains
unchanged. Each rupee is worth more than before in terms of its US dollar buying power.
For example, a T-shirt from the US costing US$5 or a music download from the internet
costing US$5 will require the sacrifice of only 457 rupees after the increase in supply of US
dollars compared to 468.325 rupees at the original equilibrium exchange rate, a decrease in
the rupee price of 2.4 percent.
Thus, when the rupee appreciates in value relative to the dollar, it encourages Sri Lankans
to import more US goods and services, to travel more to the US, and to increase their invest-
ments in the United States, because the price of those things, valued in rupees, will be lower.
A higher valued rupee encourages an outflow of foreign exchange from Sri Lanka. This
means that the items in Tables 15.1 and 15.2 that register an outflow of foreign exchange in
the current account and in the capital and financial account will tend to increase in Sri Lanka
as the value of the rupee rises relative to the US dollar, while those that register an inflow
will tend to be reduced.
Herein lies an important connection between the balance of payments and a country‚Ä™s
exchange rate. When the value of the bilateral exchange rate changes, it has an impact on
inflows and outflows of foreign exchange as spending decisions are affected in the current
account and in the capital and financial account.
Let‚Ä™s return to our original equilibrium of D$ and S$ where the exchange rate was 93.665
Macroeconomic equilibrium 507
rupees for one US dollar and consider a different scenario. Now let the demand for dollars in
the Sri Lankan foreign exchange market rise (what factors might cause such an increase in
demand?) from D$ to D$1 with S$ now remaining the same. The dollar would now appreciate
in value from 93.665 rupees per dollar to 96.8 rupees per dollar, as more rupees could be
obtained in exchange for each dollar in the foreign exchange market. Of course, the other
side of this appreciation in the value of the dollar is the depreciation in the value of the Sri
Lankan rupee, as it now takes more rupees to buy each dollar at the new higher equilibrium
This depreciation in the value of the rupee will have the effect of:
a discouraging imports from the United States to Sri Lanka, or any import priced in US
dollars, since these will now require more rupees in exchange for any given dollar
b encouraging the purchase of Sri Lankan exports by those who pay in US dollars since it
now is easier to obtain rupees than before;
c decreasing travel from Sri Lanka to the United States and encouraging travel in the
reverse direction; and
d discouraging Sri Lankans from converting rupees to dollars for investments outside the
country, while encouraging those with dollar holdings to bring dollars to Sri Lanka
where more rupees can be obtained in exchange for any desired investment purpose.
In other words, depreciation in the value of the rupee will tend to encourage an inflow of
foreign exchange from the rest of the world into the Sri Lankan economy and discourage
foreign exchange expenditures from Sri Lanka flowing to the ROW. On both the current
account and the capital and financial account of the balance of payments, the depreciation of
the rupee will tend to increase the values of the positive entries and decrease the values of
the negative entries so that, overall, there is a net effect of encouraging the inflow of foreign
Fully floating exchange rates are strictly market-determined rates. For an economy with
this type of foreign exchange regime, the movements of supply and demand for that country‚Ä™s
currency relative to other currencies determine the ‚Äúvalue‚ÄĚ of the bilateral exchange rate.
A floating exchange rate is one extreme on the exchange rate regime continuum. It represents
a policy of complete laissez-faire with respect to the exchange rate value.
Fixed exchange rates
At the other end of the spectrum from a fully floating exchange rate regime is a fixed or
pegged exchange rate regime. Until the early 1970s, most countries operated with fixed
exchange rates set in cooperation with the International Monetary Fund (IMF) as part of the
Bretton Woods institutional arrangements for international trade and finances established at
the end of the Second World War (see Chapter 17 for a fuller discussion of these matters).
Following a series of crises, first in the United States and then with the oil price hikes of
1973, many countries elected to adopt floating or some intermediate exchange rate regime,
leaving the fixed exchange rate era behind.
Many less-developed nations continue, however, to operate with fixed, or quasi-fixed,
exchange rate systems, so they are not fully a remnant of the past. Typically, the exchange rate
is fixed relative to the currency of the largest trade partner(s), often a former colonial power,
so as to facilitate trade flows. How do fixed exchange rates work, and what is their impact?
508 The Process of Economic Development
When exchange rates are fixed, the adjustment to a new equilibrium exchange rate value
shown in Figure 15.1 cannot take place, since the exchange rate value is locked in at some
pre-determined level. Let us assume that the exchange rate of the Sri Lankan rupee is set by
the government at 93.665 rupees per dollar, as shown in Figure 15.2, a value which coincides
with the current equilibrium at the intersection of the demand and supply curves.
What happens when the demand or supply (or both) of dollars changes, or if the current
nominal exchange rate does not, by chance, correspond with the intersection of the supply
and demand curves?
For example, if the demand for dollars increases to D$1 and the supply curve of dollars
remains unchanged at S$, there will be an unmet demand for dollars in the Sri Lankan foreign
exchange market. This is because the quantity of dollars brought to market at the fixed price
of 93.665 rupees by those wishing to trade dollars for rupees, QS, is less than the quantity of
dollars demanded, QD, by those who wish to exchange their rupees for dollars at the prevailing
fixed exchange rate. As a result, dollars are ‚Äúcheaper‚ÄĚ to buy than they should be, and rupees
are more ‚Äúexpensive‚ÄĚ than they should be compared to what the market equilibrium value
would be at the intersection of the two curves. As a result, not enough dollars are being made
available by those exchanging dollars to meet the demand for dollars of those wishing to sell
rupees in the Sri Lankan foreign currency market. A shortage of dollars equal to QS ‚ą’ QD and
a simultaneous surplus of rupees at the current fixed exchange rate is the result.
What happens to the excess supply of rupees? Where does it go? Alternatively, how is the
problem of the shortage of dollars handled?
The shortage of dollars can be fully met and the surplus of rupees absorbed only if the
Sri Lankan government sells some of its US dollar official foreign exchange reserves equal
to the QD ‚ą’ QS gap. Those foreign exchange reserves, accumulated in the past by exporting
more than importing or as a result of other net dollar flows into Sri Lanka, are a part of the
Sri Lankan government‚Ä™s official foreign exchange reserve savings. When, as in Figure 15.2,
QS QD Quantity of dollars
Figure 15.2 Exchange rate determination: fixed rates.
Macroeconomic equilibrium 509
the quantity demanded of dollars exceeds the quantity supplied at the fixed exchange rate, the
Sri Lankan government must, if the exchange rate is to remain fixed, buy the excess supply
of rupees, and it can do so only by selling off some of its official foreign exchange reserves
of US dollars.
If insufficient dollars are held as official foreign exchange reserves by the Sri Lankan
government to trade for the excess supply of rupees that Sri Lankans wish to exchange for
dollars, or if the Sri Lankan government refuses to supply the quantity needed to cover the
shortage for whatever reason, dollars somehow will have to be rationed to those wishing to
exchange rupees for the limited supply, QS, of dollars being made available on the market at
the fixed price.
For example, requiring import licenses as a prerequisite for obtaining dollars is one way
to allocate the limited supply of dollars relative to the larger quantity demanded at the fixed
exchange rate value. Limits on the quantity of rupees that can be exchanged per transaction
is another way to restrict the quantity demanded so that it is closer to the quantity supplied
on the market. These are all examples of administrative means devised to ration a limited
quantity of dollars among those demanding them.
Other administrative mechanisms for allocating the limited supply of dollars in the foreign
exchange market might include giving precedence in exchanging rupees for dollars to those
importing essential goods from the United States, followed by: importers of non-essential
goods getting secondary priority for buying foreign exchange; Sri Lankans travelling on
business to the United States; and then regular tourists to the United States. Speculators
interested in transferring some of their financial assets to the United States might be last in
the queue for exchanging rupees for dollars. The government could utilize such a priority
ranking to determine how to allocate the dollars traded on the Sri Lankan foreign exchange
market and thus avoid having to dip so deeply into its official US dollar reserve holdings.
There is a risk in using such administrative means to control the exchange of currencies.
Some who hold Sri Lankan rupees and wish to exchange them for dollars, but who find
themselves unable to do so under the administrative rules, will look for alternative avenues
to obtain the dollars they want. Likewise, those who have been able to buy dollars may find it
profitable to re-sell them. Illegal and quasi-legal foreign exchange markets, so-called ‚Äúblack
or gray or parallel markets,‚ÄĚ are likely to emerge. The greater the discrepancy between the
fixed exchange rate value and its equilibrium value, the more likely that such markets will
materialize and the greater will be the quantity of transactions taking place in these secondary
markets (see Focus 15.2 on these secondary markets).
If the government does not use administrative means to limit the quantity demanded of
dollars to the limited quantity supplied, the ability of the Sri Lankan government to maintain
the fixed exchange rate of 93.665 rupees per dollar will be determined by the quantity of
total official foreign exchange reserves and the willingness of the government to continue to
support the fixed exchange rate out of these reserves. As foreign exchange reserves approach
or are reduced below some acceptable level, the Sri Lankan government will be forced to
devalue the rupee (i.e. to increase the number of rupees required to buy each dollar) to a
new value closer to the equilibrium value where D$1 intersects with S$, thus eliminating or
reducing the dollar shortage problem.9
For example, if the rupee is devalued to the equilibrium value of 96.8 rupees per dollar
shown in Figure 15.2 at the intersection of the supply and demand curves, then the dollar
shortage disappears as the quantity supplied of dollars (which is also the new quantity
demanded of rupees) exactly matches the quantity of dollars demanded (which is also the
supply of rupees).10
510 The Process of Economic Development
FOCUS 15.2 PARALLEL MARKETS
One way to gauge the misalignment of exchange rates relative to the equilibrium value is
by examining the parallel market exchange rate. The parallel market includes an estimate
of non-sanctioned or ‚Äúblack‚ÄĚ market exchange rate values and exchange rates prevailing
in non-official ‚Äúgray,‚ÄĚ but legal, markets. In the following table, the values shown are the
parallel market exchange rate premium, which is the percentage difference between the
parallel market rate and the official exchange rate.
Gambia 13.8 21.3
Kenya 15.1 7.3
Mozambique 2,110.8 62.6
Nigeria 232.7 25.1
Tanzania 248.8 74.5
Zambia 46.3 149.7
Zimbabwe 81.3 23.5
Argentina 32.8 42.4
Bolivia 136.2 1.5
Indonesia 4.2 2.6
Mexico 13.9 6.8
Philippines 12.3 7.1
Thailand ‚ą’2.2 2.0
Venezuela 110.3 5.2
A positive percentage exchange rate premium indicates by how much the parallel market
rate exceeded the official exchange rate and is an approximate measure of the extent of
overvaluation of the official exchange rate. Over the period 1981‚Ä“6, for example, Nigeria‚Ä™s
official exchange rate was over-valued by more than 200 percent. In general, economies
in Sub-Saharan Africa had somewhat higher levels of exchange rate overvaluation than
countries in other less-developed regions. Note Thailand‚Ä™s under-valued exchange rate in
the first period and the mild overvaluation in the later period.
With the exception of Gambia and Argentina, there was a tendency to reduce the degree
of overvaluation of official exchange rates between the two periods. This has meant depre-
ciations and devaluations of official rates closer to their equilibrium values, with all the effects
on the balance of payments that such changes engender. (What are those effects?)
You will remember that an over-valued exchange rate makes exports of a country more
expensive than they should be and imports less expensive. While maintaining over-valued
exchange rates is not a priori bad policy, as discussed, extreme overvaluation can lead to stag-
nant, over-protected domestic production and a weak export sector that encourages outflows
of foreign exchange and discourages inflows. That is the worst of all possible worlds.
In examining Sub-Saharan Africa, the World Bank found that for those countries that
had depreciations of their real exchange rate of 40 percent or more, growth rates of per
capita income averaged 2.9 percent. For countries with smaller depreciations, per capita
growth rates averaged ‚ą’0.4 percent. And for those countries where real exchange rates
become more over-valued, per capita growth rates averaged ‚ą’2.7 percent.
Large exchange rate overvaluation impacts negatively on the competitiveness of an
economy and can dramatically slow economic growth. Exchange rate overvaluation is not,
however, the only factor which can impede growth and adversely affect competitiveness,
though it is important.
Macroeconomic equilibrium 511
For example, in a detailed study of Mexico, UNCTAD found that from 1990 to 1994, the
real exchange rate became severely over-valued by more than 50 percent. Not surpris-
ingly, Mexico‚Ä™s international competitiveness in manufacturing decreased, with the index
of competitiveness rising from 136.5 in 1990 to 197.4 in 1993. (The index measures the
unit labor cost of production in constant US dollars. An increase in the index indicates
a decrease in competitiveness.) At the same time as the exchange rate was becoming
over-valued, real wage increases outstripped increases in labor productivity by nearly four
times (+70 percent versus +18 percent).
Overvaluation of the exchange rate thus was not the only factor affecting Mexico‚Ä™s
decreased international competitiveness. Internal structures and slow productivity
growth relative to income growth contributed as well. The latter effects may reflect the
inadequacy of Mexico‚Ä™s past human capital accumulation efforts and weak technological
acquisition skills. Further, the failure of Mexico to pursue export substitution policies
until very recently in the climb up the structural transformation ladder, and the premature
initiation of capital-intensive, higher wage difficult import substitution contributed to the
inability of Mexico to sustain economic growth and development, as was discussed in
detail in Chapter 10.
Sources: UNCTAD 1995: 85; World Bank 1994: 228, 242
A managed float exchange rate regime
Somewhere between freely floating exchange rates and fixed exchange rates lies the managed
float. With a managed float exchange rate regime, a government allows changes in the supply
of and demand for its currency to have an effect on the spot market exchange rate value, but it
may intervene to prevent full and complete adjustment of the exchange rate toward its equi-
librium value to prevent abrupt changes in values or to maintain the value of the exchange
rate within a ‚Äúband‚ÄĚ of values.
For example, in Figure 15.2, if Sri Lanka had a managed float exchange rate regime, then
the shift in the demand for dollars to D$1 might result in a change in the exchange rate from
the initial value of 93.665 rupees per dollar to an intermediate value of, say, 94.5 rupees
per dollar between the initial value and that of the full adjustment to the market equilib-
rium value of 96.8 rupees. The rupee will have depreciated in value ‚Ä“ it now takes more
rupees than before to buy one dollar ‚Ä“ but the depreciation is not as large as it would have
been if the full adjustment to the equilibrium had taken place, as it would if exchange rates
were freely floating. This reduces, but does not fully eliminate, the shortage of the quantity
supplied of dollars in the foreign exchange market compared to what would prevail with a
fixed exchange rate. At any exchange rate below 96.8 rupees per dollar, the QD will still be
greater than the QS.
There thus remains a shortage of dollars supplied to the Sri Lankan foreign exchange
market relative to the demand that will need to be filled through the depletion of official US
dollar foreign exchange rate reserves or some queuing system. A managed float can reduce
but does not necessarily eliminate the need for the Sri Lankan government to supply dollars
from its official foreign exchange reserves or to impose rationing measures to sustain the
exchange rate at a value below equilibrium.
With a managed float, a country exercises some degree of control over its exchange rate,
not letting it simply be buffeted about by market forces as happens with a freely floating
exchange rate. This is often done to foster greater stability in the value of the exchange rate
over time so as to permit those involved in international trade and investment to project with
less uncertainty the future value of the currency.
512 The Process of Economic Development
Other exchange rate regime types
Other possible exchange rate regimes are a crawling peg and a band exchange rate. With
a crawling peg, which is a more transparent type of managed float, the government fixes,
or ‚Äúpegs,‚ÄĚ the currency‚Ä™s value vis-√†-vis one or more foreign currencies, typically of the
country‚Ä™s major trading partner(s). The pegged value is announced and is regularly adjusted
toward its equilibrium value, which is the ‚Äúcrawl,‚ÄĚ but the value is fixed for some period of
time. As we shall see in the next section, the crawling peg may help to keep the real value of
a country‚Ä™s currency from becoming too over-valued, if the ‚Äúcrawl‚ÄĚ downward of the pegged
value is of the proper amount and is done in a timely manner.
A ‚Äúband‚ÄĚ exchange system is a kind of modified float/modified peg. The value of the
currency is allowed to fluctuate freely according to market forces of supply and demand,
but only within an agreed upon range of upper and lower values vis-√†-vis another currency
or currencies. The government commits to maintaining the value of the currency within
that band, so there may be times when it will be necessary either to sell off official foreign
exchange reserves or to accumulate such reserves to preserve the currency‚Ä™s value within the
Few governments have perfectly freely floating exchange rates at all times. Most econo-
mies with floating exchange rate regimes are not so committed to that policy as to forgo some
form of a managed float policy depending on the circumstances. In today‚Ä™s electronically
integrated world economy, where twenty-four-hour trading in currencies is not only possible
but a reality, few countries are willing to let possible temporary disturbances in the foreign
exchange markets completely dictate spot exchange rates because of the potentially adverse
affects this can have on trade and financial flows and domestic income and production. Thus
virtually all countries, developed and less-developed alike, are willing to utilize a managed
float system to avoid wide and unproductive swings in the value of their exchange rates when
it is necessary. Of course, the ability of a country to ‚Äúdefend‚ÄĚ its exchange rate depends upon
having sufficient reserves of foreign exchange to do so.
real versus nominal exchange rates
The nominal exchange rate is the current value of a currency as stated on the foreign exchange
market. In other words, it is the exchange rate that a government controls when it has a fixed
or managed exchange rate, or it is the equilibrium value determined by the intersection of the
supply and demand curves when exchange rates are freely floating.
What, then, is the real exchange rate? How and why would the nominal and real
value of an exchange rate differ? You will remember from Chapter 2 when we compared
nominal and real GDP that it was changes in prices that make nominal and real GDP values
differ. The same is true for nominal and real exchange rates, but now it is the difference
in changes in prices between economies that matters, that is difference in inflation rates
What happens to the real exchange rate, as opposed to the nominal exchange rate, for
pesos versus dollars if there is a difference in inflation rates between the United States and
The real exchange rate will be affected unless there is a freely floating exchange rate
regime. For example, suppose that during the course of 2008, prices in Mexico rose by 10
percent while prices in the United States remained constant. If Mexico had a fixed exchange
rate regime so that 10 pesos traded for US$1 throughout the year (this is the nominal rate), at
Macroeconomic equilibrium 513
the end of December 2008 the real exchange rate of the peso would be 9.091 pesos per dollar
[(10 pesos/US$1) √— (100/110)]. In other words, with a constant nominal exchange rate, the
higher rate of inflation in Mexico meant that the real value of the peso appreciated. It was
easier, in real terms, to buy US dollars with pesos at the end of the year than it was at the
beginning of the year because of the inflation differential.
Even though the nominal exchange rate remained constant at 10 pesos for US$1, the
higher rate of inflation in Mexico versus the US meant that the purchasing power of each
peso increased in terms of its buying power of goods from the US. Of course, the apprecia-
tion in the real value of the peso meant that at the same time the real value of the US dollar
fell, as the purchasing power of each US dollar in the Mexican economy fell.
For the exchange rate to have maintained its real value with inflation in Mexico 10 percent
higher than in the United States over the year, the nominal bilateral rate should have risen
by the end of the year to 11 pesos for US$1 (how was this determined? 10 pesos/US$1 = ? √—
(100/110)). The intuition behind this calculation is as follows. Since prices in Mexico rose
by 10 percent while prices in the United States remained unchanged, the nominal exchange
rate value would have to fall by 10 percent to maintain the real rate. If the real exchange rate
value between the dollar and the peso is to be maintained, Mexicans should need to give up
10 percent more pesos to buy one dollar after the inflation as before. What is 10 percent of
10 pesos? It is 1 more peso, or a total of 11 pesos, that should be required to buy each dollar
if the real value of the exchange rate is to be maintained.
Equivalently, holders of dollars should receive 10 percent more pesos per dollar after the
inflation so that the same number of dollars can buy the same quantity of Mexican goods after
the inflationary episode when prices are 10 percent higher. To pay for higher priced Mexican
goods after 10 percent inflation, more pesos per dollar must be received in exchange. Again,
the required nominal bilateral exchange rate needed to maintain a constant real exchange rate
would be 11 pesos for US$1.
Consider the following example that may make this clearer. Assume that a US importer
was buying handkerchiefs from a Mexican company and that the price of each handkerchief
was 10 pesos on 1 January 2008. The US importer would have needed to exchange US$1 for
each handkerchief imported to obtain the 10 pesos needed to pay the Mexican exporter at the
10 pesos for US$1 exchange rate. After the inflationary episode, and assuming that the price
of handkerchiefs increased at the 10 percent rate of inflation, the Mexican exporter‚Ä™s price
per unit would have risen to 11 pesos per handkerchief (10 pesos √— 1.1). To maintain the real
value of the exchange rate, the United States importer would now need to receive 11 pesos
for each dollar exchanged. At this rate, US$1 continues to be able to buy one handkerchief
just as before the inflation.
If the nominal exchange rate had remained at 10 pesos to US$1, each handkerchief would
have required the United States importer to pay $1.10 to obtain the 11 pesos needed to pay
for each handkerchief, an increase in the dollar price even though there had been no infla-
tion episode in the US. The adjustment in the nominal value of the peso versus the dollar
is necessary to maintain the real value of the two currencies in exchange for one another. If
this adjustment does not happen, countries with high inflation rates relative to their trading
partners will find it easier to spend and invest in the rest of the world, leading to an increased
outflow of foreign exchange from those economies. Likewise, the inflow of foreign exchange
to the higher inflation countries will be adversely affected as it will be increasingly more
expensive for the rest of the world to spend and invest in those economies.
Changes in the real exchange rate value can have profound effects on a country‚Ä™s balance
of payments as currencies become over- or under-valued.
514 The Process of Economic Development
Real exchange rates, over- and undervaluation and the balance of payments
If exchange rates are freely floating, the market will tend to automatically adjust to main-
tain the real exchange rate value of currencies so that any inflationary differentials between
countries will be compensated for by movements of the nominal bilateral exchange rate in
the proper direction.11
On the other hand, if a country has a fixed exchange rate and its domestic rate of infla-
tion exceeds that of its trading partners, its real exchange rate relative to those of its trading
partners will tend to appreciate. This means that the currency is becoming over-valued, that
is, it is worth more than it should be at its equilibrium value. Looking back at Figure 15.2,
if it only takes 93.665 rupees to buy one US dollar instead of the equilibrium value of 96.8
rupees, it is easier to buy US dollars than it should be at equilibrium. The rupee is worth more
than it should be; we would say it is over-valued. An over-valued exchange rate tends to
stimulate spending outside the country and encourages the outflow of foreign exchange at the
same time that it deters spending from the rest of the world in the higher inflation economy
and discourages the inflow of foreign exchange.
An over-valued exchange rate means it will be easier for Sri Lankans to import goods
from the US and cheaper for them to travel in the US than it would be at the equilibrium
exchange rate value. What does that mean for the balance of payments? There will be more
spending in the US and a larger outflow of dollars on the current account of the balance of
payments. Investments in the US also will be easier, so that will encourage an outflow of
foreign exchange on the capital and financial account.
At the same time, Sri Lankan exports will be more expensive to buy for those in the US and
travel to Sri Lanka will be more expensive than it ‚Äúshould be.‚ÄĚ This will reduce the inflow of
foreign exchange on the current account of the balance of payments. Foreign investment in
Sri Lanka will be more expensive, too, and that will reduce the inflow of foreign exchange
on the capital and financial account.
The net effect of an over-valued exchange rate, then, is to encourage outflows of foreign
exchange and discourage inflows, thus tending to push the current account and capital and
financial account balances toward deficit or making them more negative if they already were
in deficit. You will remember from our discussion earlier that the only way a current account
deficit can be financed is either by borrowing foreign exchange from the rest of the world
or through the drawing down of the country‚Ä™s own official foreign exchange reserve assets.
When the exchange rate is over-valued, spending is encouraged and borrowing discouraged,
so there is a tendency to increase the outflow of foreign exchange relative to the inflow
overall in the balance of payments accounts. This puts more pressure, then, on the official
foreign exchange reserves to make up any shortfall in foreign exchange.
Contrariwise, if a country has a fixed exchange rate and an inflation rate that is lower than
its trading partners, the real exchange rate will depreciate and the domestic currency will be
under-valued, i.e., it will be worth less than it should be at its equilibrium value. An under-
valued exchange rate discourages the outflow of foreign exchange and encourages the inflow
of foreign exchange. You should be able to think this through and realize that this can be very
good for a country‚Ä™s balance of payments, since the tendency of an under-valued exchange
rate is to promote a positive net inflow of foreign exchange into an economy by artificially
making exports and foreign investment cheaper, while increasing the price of imports and
investments outside the economy.
If a country has a managed float exchange rate regime and an inflation rate that exceeds
that of those countries with which it has financial and trade relations, then it will be necessary
Macroeconomic equilibrium 515
to allow, or force, a depreciation of the nominal value of the exchange rate by the amount of
the inflation differential to prevent an overvaluation of the exchange rate from occurring.
For those countries with lower inflation rates than their trade and financial partners,
however, a decision as to whether to allow their currency to remain under-valued with a
managed float will depend upon the nature of the trade and financial flows with their partners
and, of course, the actions of the bilateral trade and financial partners to their now over-
valued exchange rates.
If a high-inflation country is a major importer of goods from a country with lower inflation,
an under-valued exchange rate in the low-inflation nation will encourage even further the
purchase of its exports. A country with an under-valued exchange rate often has little incentive
to make any adjustments if it is a major exporter (think of China, for example, which is often
accused of maintaining an under-valued exchange rate). However, if the low inflation nation
imports essential goods from a higher-inflation country, maintaining an under-valued exchange
might be counter-productive to economic growth and/or economic welfare by making such
imports artificially expensive relative to the equilibrium value. In such a circumstance, forcing
an appreciation of the exchange rate might very well be the appropriate policy decision. For
managed exchange rate regimes, the nominal value a country decides upon will depend on
the importance of exports and imports to the economic structure of that particular economy
relative to its trade and financial partners.
Countries with fixed exchange rates that have inflation rates that differ substantially from
those of their trade and financial partners will be aware quite quickly that their bilateral
exchange rates are either over- or under-valued. The greater the divergence in inflation
among countries, the larger the likely disequilibrium in the external balance that is likely to
emerge if exchange rates remain fixed (see Focus 15.2 on parallel markets). Countries that
choose to have a fixed exchange rate system will be compelled to keep their own rate of infla-
tion equal to, or even below, that of their most important trade and financial partners. If they
fail to do so, the country can experience a continual drain on its official foreign exchange
reserves as its currency becomes over-valued and there is a net foreign exchange drain on
the balance of payments accounts. Alternatively, frequent devaluations or mini-devaluations
may be required, thus in effect, creating something more like a managed float regime.
Some economists actually support fixed exchange rates for some countries precisely for
the internal fiscal and monetary discipline they engender, specifically the need to restrain
inflationary pressures that otherwise would disrupt the balance of payments and threaten
official foreign exchange reserves. In reality, countries with fixed exchange rates do have
other options besides exhausting their official foreign exchange reserves when inflation
gets out of hand: rationing of foreign exchange; borrowing on the international market; and
periodic devaluations, so the discipline of fixed rates is not absolute. For nations unable or
unwilling to manage their economic affairs properly, there always seem to exist, for a time
anyway, means to avoid the required adjustments that can facilitate growth and development.
However, continued over-valued exchange rate disequilibrium is typically not sustainable.
Exchange rates and the balance of payments
There is a close relation between a nation‚Ä™s exchange rate, its exchange rate regime (fixed,
floating or managed float), and the balance of payments accounts that we already have
considered briefly. After all, the flows of foreign currencies that end up in a country‚Ä™s foreign
exchange markets are transactions that are captured somewhere in a country‚Ä™s balance of
516 The Process of Economic Development
Balance of payments adjustment with floating rates
If a country‚Ä™s exchange rates are fully floating ‚Ä“ that is, if their value is determined by the
market forces of supply and demand ‚Ä“ it is technically impossible to have a balance of
payments problem. Why is this?
Imagine that Pakistan, at the current spot nominal exchange rate, is running a current
account deficit. This may be due to the fact that Pakistanis wish to spend more on imports
than is earned from Pakistani exports (or any reason that results in current expenditures in
the ROW exceeding current income from the ROW). The quantity supplied of rupees to
the foreign exchange market by those wishing to buy imports will then exceed the quantity
demanded of rupees by those as payment for Pakistan‚Ä™s exports at the current exchange rate,
as shown in Figure 15.3.
At the current exchange rate of $0.04 per rupee, there is a surplus of rupees (equal to mn)
on the foreign exchange market as a consequence of the current account deficit. If exchange
rates are freely floating, however, this surplus will be but a very temporary phenomenon. At
the current exchange rate ‚Äútoo many‚ÄĚ rupees are being offered for exchange relative to the
quantity desired. This means that the current nominal exchange rate of rupees is too high.
The result will be a depreciation of the rupee to its equilibrium value of $0.03 to 1 rupee.
This is the typical textbook adjustment to the equilibrium price whenever there is a surplus
of a good in a competitive market.
As the exchange rate of the rupee falls, i.e., depreciates, and the cost of purchasing a unit
of foreign currency rises, two important effects will result.12 The willingness of holders of
rupees to buy imports from the US falls as it is now more difficult to buy dollars than before
since it takes more rupees to buy US$1 at 1 rupee = $0.03 than when the exchange rate was
1 rupee = $0.04. Imports of goods become more expensive in terms of the rupees that must
m n Current exchange
0 Quantity of
Figure 15.3 Floating exchange rates and the balance of payments.
Macroeconomic equilibrium 517
be given up. As a result, the quantity supplied of rupees declines. On the other hand, the
desire of foreigners to buy Pakistani exports increases as their prices in terms of foreign
currency fall, and thus the quantity demanded of rupees rises. The exchange rate value tends
to automatically adjust toward the equilibrium value at the intersection of the demand and
supply curves in Figure 15.3.
Pakistan‚Ä™s exports will increase and its imports will decrease, and this will continue until
the current account is brought into balance with the value of exports equal to the value
of imports, or, more generally, until the outflows of foreign exchange are balanced by an
equivalent inflow of foreign exchange.
Likewise, differences in the inflows and the outflows on the capital and financial accounts
will result in similar equilibrating tendencies, so that the freely floating exchange rate will
tend toward balance in all the parts of the balance of payments accounts. As a consequence of
these exchange rate movements there will be no systematic tendency for a country‚Ä™s official
foreign exchange reserves to either increase or decrease over time. There may, of course, be
temporary changes in these balances, but these will be smoothed over time so that once a
country has reached its desired level of foreign exchange reserves, a floating exchange rate
regime will tend to maintain its foreign exchange reserves relatively intact over time.
Balance of payments adjustment with fixed exchange rates
If Pakistan operates with fixed exchange rates, then the imbalance between the supply of and
demand for rupees in Figure 15.3 created by an exchange rate value which is ‚Äútoo high‚ÄĚ and
is reflected in a current account deficit is more problematic. At the nominal exchange rate
of $0.04 per rupee, the rupee is over-valued relative to its equilibrium value, that is, more
US dollars are received per rupee than should be. If the exchange rate and the supply and
demand curves remain the same, there will be a persistent current account imbalance created
as foreign exchange outflows are encouraged and foreign exchange inflows by foreigners
are discouraged by the over-valued exchange rate. If the current account is now in deficit,
the deficit will be worsened; if the current account is in surplus, the surplus will shrink over
time and may turn into a deficit.
Let‚Ä™s assume that the current account is already in a deficit situation. Maintaining the
exchange rate at the fixed value of Figure 15.3 likely will require a financial account surplus.
Borrowing or inflows of direct foreign investment from the ROW will be required to compen-
sate for the excess spending relative to foreign exchange income on the current account. In
future periods, such borrowing and investment will exacerbate any current account deficit,
as income payments for interest, dividends, and profits (item F in Table 15.1) are required
to service loans. Alternatively, or most likely in conjunction with such financial inflows,
the government will need to use some of its official foreign exchange reserve holdings to
finance the excess supply of rupees, mn, brought to market as a result of the current account
Currency overvaluation and the possible impact on the balance of
From this brief description of the impact of an over-valued fixed exchange rate on the balance
of payments accounts, one can see why policy-makers need to be very vigilant in monitoring
the balance of payments. At least two alternative general scenarios with quite distinct effects
can result from an over-valued exchange rate.
518 The Process of Economic Development
A beneficial current account deficit
A current account deficit caused by currency overvaluation can allow a country to import at
a lower cost than otherwise critical goods and services that may be required for accelerating
economic development. An exchange rate that is worth more than it should be makes it easier
to pay for capital goods, new technologies, foreign technicians who train local experts, the
training abroad of scientists, engineers and health professionals, and so on. An over-valued
exchange rate can help a country purchase vital inputs relatively cheaply, since overvaluation
reduces the price of imports in terms of the home currency.
If such a strategy is to be successful over time and is not to thwart progress, however,
the exchange rate will need to be adjusted downward toward or even below its equilibrium
value at some time in the future. The enhanced ability to produce created during the transi-
tion period of over-valued exchange rates must be translated into a capacity for the economy
to export an expanding array of goods to foreign markets and to produce import substitutes
competitively with foreign imports. In the best of all circumstances, this productive transfor-
mation will push the current account into surplus. At a minimum, a successful transitional
overvaluation strategy will result in a stable or shrinking current account deficit.
In particular, during the stage of easy import substitution industrialization (ISI), overvalu-
ation can be a means to cheapen the costs of production for new firms. It can have the same
effect on costs as a subsidy by reducing direct costs of production by making it cheaper to
purchase imported inputs, materials, and physical capital.13 When accompanied by other
measures discussed in Chapter 9, currency overvaluation can contribute to overcoming some
of those transitional inefficiencies which make infant industry protection necessary during
ISI. By lowering the costs of production and contributing to technology acquisition and
learning, overvaluation can contribute to the desired goal of having new domestic enterprises
reach levels of international competitiveness more quickly.
Policy-makers walk a thin line in following this policy. Timely mini-devaluations, care-
fully managed to guard against speculative attacks on the currency, can help to create the
conditions for this strategy to be successful. Much like the programmed reduction in infant
industry tariffs that we argued are necessary for ISI to contribute to future progress, over-
valuation as an indirect subsidy to industries which buy imported inputs should have a time
table for phase-out as well. Overvaluation cannot be a sustainable policy for very long; the
risks are just too great.
A debilitating current account deficit
A current account deficit resulting from an over-valued exchange rate may result in eventual
crisis rather than setting the stage for future progress. If protected industries do not become
more efficient, the financial account borrowing required by any current account deficit will
have been wasted. When funds borrowed from the ROW are not directed to productive
investments that have the potential to increase exports or to reduce import expenditures, then
such borrowing will, if sufficiently large, eventually lead to crisis. Sooner or later, increased
payments of interest, dividends, and profits to pay for past borrowing will push the current
account deficit to limits that are difficult or perhaps impossible to finance with new loans
When that happens, more and more of the country‚Ä™s official foreign exchange reserves will
need to be injected into the economy in an effort to maintain the over-valued fixed exchange
rate. There is, of course, a limit to any government‚Ä™s official foreign exchange holdings, and
Macroeconomic equilibrium 519
when those are exhausted, or when the government finally appreciates the unsustainability of
the over-valued exchange rate, action will need to be taken to bring the exchange rate and the
balance of payments accounts into equilibrium. Far too many countries seek temporary and
ill-advised means to try to increase foreign exchange inflows, choices that typically do little
to improve the chances of long-term development (see Focus 15.3 on trade in toxic wastes).
When a country is forced to make a rapid and large devaluation of the currency once
overvaluation becomes impossible to maintain, the result is almost always a slow-down and
often a reversal of economic growth. Devaluation is required to stimulate export sales and
encourage foreign exchange inflows and to simultaneously discourage import purchases and
FOCUS 15.3 TRADE IN TOXIC WASTE: ONE WAY TO
ENCOURAGE FOREIGN EXCHANGE INFLOWS
Balance of payments problems have led some less-developed nations to engage in the trade
of hazardous and toxic wastes. Burdened with large and difficult to finance current account
deficits, some countries have begun to ‚Äúexport‚ÄĚ environmental waste disposal services to
the already-developed countries as a means of earning foreign exchange income.
In effect, in return for a foreign exchange inflow, countries agree to accept toxic waste
materials from more developed countries which have encountered difficulties in disposing
of such substances. ‚ÄúHazardous waste is defined as waste which, if deposited in landfills,
air or water in untreated form, will be detrimental to human health or the environment.‚ÄĚ
Where does such hazardous waste end up? Latin American countries, with their large
current account deficits (look back at Focus 15.1), have recently been a key destination.
Many African nations also have accepted substantial inflows of toxic materials.
‚ÄĘ Guinea-Bissau received 15 million tonnes of waste from the UK, Switzerland, and the
US over a period of five years.
‚ÄĘ The Congo received more than 1 million tonnes of solvents and chemical wastes from
the US and Europe in one year alone.
‚ÄĘ Nigeria had nearly 4,000 tonnes of mixed chemicals and other waste from Europe
dumped, illegally, in the country.
‚ÄĘ Equatorial Guinea received 2 million tonnes of chemical wastes from Europe for a land-
fill on Annoban Island.
Less-developed countries typically have fewer restrictions on the dumping of hazardous
materials, at least partly because they have had less experience with them given their
lower levels of development. And, given the foreign exchange that can be earned by coun-
tries finding it difficult to export with their lack of structural transformation and other fail-
ures of internal policy making, the temptation to accept trade in unsafe materials can be
large. For example, Guinea-Bissau was offered by two British companies an amount per
year equal to half of the country‚Ä™s total GNI for burying hazardous chemicals on its soil!
One can see how attractive this might be to cash-strapped economies and, perhaps, to
government officials willing to bend the rules.
The capacity of less-developed countries to monitor and control the effects of such toxic
waste disposal is low, if it exists at all. In recognition of this, the Organization of African
Unity (OAU) called for a ban on hazardous waste imports in 1988, but it has been ignored
by many member states on the continent. Given their need for foreign exchange earnings,
many less-developed nations with current account deficits continue to be tempted to
provide relatively low-cost dump sites for developed world wastes. With better economic
policies in the future, this Faustian choice would cease to be so attractive.
Source: Elliott 1994: 35‚Ä“7
520 The Process of Economic Development
foreign exchange outflows. However, if a country has failed to invest in export industries,
any growth in export income from devaluation will be less than it could have been if future
export capacity had been strengthened. Often, to be able to achieve a current account balance
or even a surplus sufficient to generate the foreign exchange earnings required to service past
borrowing, imports will need to be repressed severely.
Import repression can be achieved via so-called austerity measures designed to provoke a
domestic recession that reduces the propensity to import by reducing total national income.
Besides currency devaluation, which makes imports more expensive and tends of itself to
depress economic activity, other austerity measures that may be introduced, sometimes in
consultation and at the urging of the multinational lending institutions, especially the Inter-
national Monetary Fund (IMF) and the World Bank, are:
1 a reduction in the rate of inflation via greater control over both the fiscal deficit and the
money supply that create and perpetuate inflation (‚Äústabilization policies‚ÄĚ);
2 an increase in domestic interest rates and a reduction in trade barriers with the ROW
3 limits on wage increases to less than the inflation rate;
4 lay-offs of government employees; and
5 privatization of state enterprises, to name a few.
Such ‚Äúbelt-tightening‚ÄĚ or austerity policies are often instituted at the urging of the Inter-
national Monetary Fund (IMF) when a country‚Ä™s balance of payments difficulties become so
severe that outside intervention seems to be the only solution. economic growth is typically
adversely impacted by such measures, and economic development prospects are put on the
back burner while correcting exchange rate misalignment and the replenishment of official
exchange rate reserves take precedence. This adjustment creates severe hardships for the
great bulk of the population, especially the poor. These issues will be touched upon again in
the following two chapters.
‚ÄúGood‚ÄĚ external imbalances
The discussion in the previous section demonstrates something of great importance: at
times, the correct external imbalance can result in substantial positive economic growth
dividends. A ‚Äúgood‚ÄĚ external imbalance from, say, an over-valued exchange rate can
contribute to a nation‚Ä™s progress where it counts, that is, in stimulating and increasing
domestic employment, income and human development. However, some external imbal-
ances can be harmful to the internal balances and may actually lead to a deterioration of
aggregate economic welfare when, for example, over-valued exchange rates are allowed to
persist for too long.
A current account deficit and an over-valued exchange rate (two external imbalances) can
contribute to more rapid economic growth and development (improvement in the internal
balances) if the borrowing from the ROW is used productively. However, this can only be a
transitional strategy. Over time, a fixed or managed float exchange rate value will have to be
adjusted downward toward and perhaps below its equilibrium value. As the net gains from
an over-valued exchange rate strategy reach the point of diminishing returns, devaluation (or
depreciation, in the case of a managed float) becomes necessary to preserve the gains of the
disequilibrium development strategy.
This is an example of what MIT economist Alice Amsden (1989) has called ‚Äúgetting prices
Macroeconomic equilibrium 521
right by getting some prices wrong,‚ÄĚ that is, promoting more rapid growth and development
via selective disequilibria, a strategy that harkens back to Albert Hirschman‚Ä™s ‚Äúunbalancing‚ÄĚ
recommendation for initiating development (Chapter 5). However, the appropriate institu-
tional structure and the other preconditions for successful structural transformation must be
in place for this strategy of a managed external disequilibrium to have a chance to work. It
is necessary to effectively monitor the external disequilibrium and know when the time has
come to alter policies that can shift the external accounts towards a more balanced state,
as the East Asian economies apparently have been successful in doing, even after the 1997
financial crisis (Wade 1990; World Bank 1993). The transition from easy ISI to easy export
substitution followed by Korea and Taiwan and by other East Asian producers, considered
in Chapter 10, was part of this broader strategy to ‚Äúunbalance‚ÄĚ and expand exports so as to
gain the growth advantages of a good external imbalance over time. But as we discussed
in that chapter, a whole range of policies, from human capital accumulation to government
assistance, is necessary.
A second type of ‚Äúgood‚ÄĚ external imbalance often supplants a prior ‚Äúgood‚ÄĚ imbalance.
Policy-makers may opt for an under-valued exchange rate after operating for some time
with an over-valued exchange rate. They are especially likely to do so, or at a minimum to
substantially reduce overvaluation of the exchange rate, when export substitution (remember
back to Chapter 10) becomes an integral part of the overall industrialization strategy. Then
two ‚Äúgood bads‚ÄĚ can result in substantial positive gains.
Consider Figure 15.4. Given the supply, S$, and the demand, D$, for the United States
dollar in the Korean foreign exchange market, the fixed (or managed float) value of 780 won
to the dollar is ‚Äútoo low.‚ÄĚ The won is under-valued relative to the dollar, so that it takes more
won to buy one dollar than it would at equilibrium. Of course the reverse side of this is that
each dollar exchanged results in the receipt of 780 won rather than the 750 that would be
received at equilibrium.
Won per US S
0 k k Quantity of
Figure 15.4 An under-valued exchange rate.
522 The Process of Economic Development
The undervaluation of the won relative to the dollar will encourage, by making them
cheaper, the sale of Korean exports to the United States. At the same time, it will discourage,
by making them relatively more expensive than they should be, imports into Korea from
the United States market. Of course, the stimulation of exports and the discouragement of
imports will tend, all else equal, to increase economic growth and employment in Korea.
For a country wishing to push its new industrial exports into the international market, under-
valuation of the exchange rate lowers prices and makes them more attractive to foreign
consumers and can help to further spur economic growth.14
If undervaluation persists and is the norm with all, or the most important, of Korea‚Ä™s trading
and financial partners, a current account surplus will, sooner or later, likely be the result.
This means that Korea will be earning more from the ROW than Korea spends in the ROW
on goods and services, unilateral transfers and on profits, dividends, and interest. The other
side of the current account surplus would be a capital and financial account deficit, indicating
that Korea would be accumulating net assets vis-√†-vis the ROW through the extension of
loans, through portfolio and foreign direct investment, or through the build-up of its offi-
cial foreign exchange reserves. This accumulation can be seen in Figure 15.4 as the excess
supply of dollars, k1k2, which measures the additional quantity of US dollars supplied (k2)
to purchase Korean exports, for travel, and for investment in Korea relative to the smaller
quantity demanded (k1) of dollars to purchase goods and services and invest in the US.
Interestingly, a good disequilibrium brought on by a conscious undervaluation of a coun-
try‚Ä™s exchange rate does not impose upon policy-makers the same binding economic need to
eventually remove the source of disequilibrium. A current account surplus disequilibrium as
a result of currency overvaluation is economically sustainable through time since the likeli-
hood of external borrowing is reduced, while official foreign exchange reserves will most
There thus is an asymmetry at work in the impact of exchange rate misalignment on the
balance of payments. economies with an over-valued exchange rate, beyond mild overvalu-
ation, will eventually be forced to devalue, since it is impossible for less-developed countries
to sustain a current deficit indefinitely through external borrowing or the running down of
official foreign exchange reserves. An under-valued exchange rate and a current account
surplus, however, may be economically feasible through time, though not politically sustain-
able (see Focus 15.4 on China‚Ä™s experience with undervaluation).
Summary and conclusions: monitoring the external balances
Countries must carefully monitor what is happening to their balance of payments accounts
and to exchange rates. There is no a priori means of determining if a current account deficit
per se is ‚Äúgood‚ÄĚ or ‚Äúbad‚ÄĚ or if exchange rate misalignment is harmful or not. It depends
upon how the excess of spending financed by any capital and financial account surplus
is being used. If international borrowing is dedicated to improving productivity via tech-
nology development, research and development, funding new physical capital purchases for
export producers, financing more human capital training, or other such expenditures, then
a deficit and an over-valued exchange rate can be ‚Äúgood‚ÄĚ in terms of their contribution
to economic growth. A ‚Äúgood‚ÄĚ current account deficit also will not result in the depletion,
or at least will not contribute to any significant deterioration, of the central bank‚Ä™s official
foreign exchange reserves. An early warning sign for any government that it has a balance
of payments problem and severe currency overvaluation is any sustained deterioration in its
official foreign exchange reserves.
Macroeconomic equilibrium 523
FOCUS 15.4 IS CHINA‚Ä™S CURRENCY UNDER-VALUED?
China is often accused of having an under-valued exchange rate. Can you think why some
analysts might think this? Consider the following data (all in millions of US$).
1985 1990 1995 2000 2005
Trade balance of goods ‚ą’13,123 9,165 18,050 34,474 134,189
Current account balance ‚ą’11,417 11,997 1,618 68,659 160,810
Total reserves (minus gold) 12,728 29,586 75,377 168,278 821,514
Since 1985, China‚Ä™s trade balance in merchandise and the current account balance
have gone from a deficit to an increasingly large surplus (except 1995 for the current
account) as more foreign exchange has been ‚Äúearned‚ÄĚ than has been ‚Äúspent.‚ÄĚ From
our discussions above, this is often the result when a currency is under-valued, that is,
when it is easy for foreigners to buy the currency. Official foreign exchange reserves have
grown rapidly too; total reserves in 2005 exceeded total import expenditures for that
year, providing a very comfortable margin of ‚Äúsavings‚ÄĚ for the economy. This supports
the undervaluation argument.
There would seem to be an imbalance, or one would expect the trade balance or the
current account to trend toward a lower surplus or small deficit over time if the exchange
rate were near its equilibrium value. The problem with this way of looking at China‚Ä™s
exchange rate is that the Chinese currency, the renminbi, is not fully convertible. Chinese
citizens cannot freely exchange their own currency for euros, dollars, yen, or other foreign
Some analysts argue that if the renminbi were made fully convertible there would be
a burst of spending by the Chinese on imports and a rush to make investments abroad
that would rapidly undo the trade and current account surplus and put pressure on the
government to inject official foreign exchange reserves into the economy. Either that or
the exchange rate of the renminbi versus other major currencies would experience a rapid
devaluation. What do you think?
Source: World Bank, World Development Indicators Online
Recurring and chronic current account deficits and over-valued exchange rates accompa-
nied by decreasing official foreign exchange reserves most often reflect underlying problems
in a nation‚Ä™s overall development strategy and the failure to promote the needed internal
productive structural transformations we have been discussing since Chapter 1. It is true
that there may be temporary external shocks to an economy that can create a balance of
payments crisis. However, over a longer time frame of two to three years, the causes of the
continuing crises are most likely to be found in internal failures of economic policy, in the
design of such policies and in their implementation, as well as inattention to overvaluation
of the exchange rate.
Countries have the option of following different paths and of making decisions about their
future. The evolution of a country‚Ä™s balance of payments accounts and the exchange rate
over time can be important indicators of whether the range of internal economic decisions,
within the given external environment, are on the correct course or not. Those countries
which successfully climb the structural transformation ladder discussed in Chapters 9‚Ä“13
are more likely to avoid creating unsustainable current account imbalances and having badly
misaligned exchange rates.
524 The Process of Economic Development
Questions and exercises
1 This exercise will give you practice in putting together the pieces of the current account
of the balance of payments. Choose a less-developed country that interests you or which
you have been assigned. Make a table with your country name at the top and include the
numerical values for the requested items for the two years of data which are available.
Refer back to Table 15.1 for help in how the current account is constructed. You can find
the data at http://devdata.worldbank.org/wdi2006/contents/Section4.htm, Table 4.15 (if
the link no longer works, go to http://www.worldbank.org and find World Development
Indicators; the data will be in the Economics section).
a Record total goods and service exports and imports and calculate the balance of
trade for the two years.
b Record your country‚Ä™s net factor payments (‚Äúnet income‚ÄĚ) for those two years.
c Record your country‚Ä™s net transfers (‚Äúnet current transfers‚ÄĚ) for those two years.
Calculate your country‚Ä™s current account balance for the two years from the data
you have collected and compare it to the value shown at the World Bank website.
Are the two values the same? If not, have YOU made an error or is it them?
e Briefly explain what the current account balance value for your country means.
Is your country spending more foreign exchange than it is earning or is it earning
more than it is spending?
f From the current account balance, do you expect your country to be a net borrower
of foreign exchange from the ROW? Explain.
2 Use the following information to determine (a) the current account balance, (b) the
capital and financial account balance, (c) the change in official foreign currency reserves
within the capital and financial account balance, and (d) the net errors and omissions
of the balance of payments. Refer back to Tables 15.2 and 15.3 for details on which
transactions go into the current account and which into the capital and financial account
Service imports, $14.1 billion; foreign investments from the ROW, $9.9 billion;
service exports, $6.6 billion; total official foreign exchange reserves, beginning
of the year, $42.2 billion; merchandise imports, $28.8 billion; net transfers, ‚ą’$7.8
billion; profits, interest and dividend earnings from the ROW, $7.8 billion; foreign
investments in the ROW, $3.2 billion; total official foreign exchange reserves, end
of the year, $38.7 billion; foreign loans extended to ROW, $15.2 billion; foreign
loans received from ROW, $9.4 billion; merchandise exports, $32.6 billion; profits,
interest, and dividends paid to the ROW, $6.7 billion.
3 Carefully explain what it means to say that a country has a balance of payments problem.
What part or parts of a country‚Ä™s balance of payments accounts might provide an ‚Äúalert‚ÄĚ
that there is the potential for crisis? Explain.
4 Mozambique ran a current account balance of ‚ą’$607 million in 2004, i.e., a deficit.
a Explain what could cause such a deficit on the current account.
b Explain what this deficit likely means about Mozambique‚Ä™s capital and financial
c What might be happening to official foreign exchange reserves? Explain.
d Discuss some steps Mozambique might take in the future to reduce the size of the
Macroeconomic equilibrium 525
current account deficit. Be careful to explain how each policy proposal‚Ä™s specific
impact in correcting the current account deficit.
e Does a current account deficit mean Mozambique has a balance of payments
5 Peru‚Ä™s total official foreign exchange reserves on January 1 2008 were equal to US$18.1
billion. From its capital and financial account data for the balance of payments for 2008,
we also know that item N in Table 15.2 was equal to + US$4.7 billion and item O was
equal to ‚ą’US$5.2 billion. What were Peru‚Ä™s total official foreign exchange reserves on
December 31 2008? Show your work and explain.
6 Find the number of months of import coverage of your country‚Ä™s official foreign
exchange reserves at http://devdata.worldbank.org/wdi2006/contents/Section4.htm,
Table 4a (if that link no longer works, go to www.worldbank.org and look for World
Development Indicators, and then go to the Economics section). How does your country
compare to other countries? Is the coverage high or low by comparison? What does your
country‚Ä™s coverage ratio compared to that of others tell you about your country‚Ä™s official
foreign exchange reserves situation? Do you think the data suggests your country has a
balance of payments problem? Explain.
7 Choose a less-developed country that interests you or which you are assigned. Using the
exchange rate data located at http://www.oanda.com/converter/classic:
list the bilateral exchange rate for today for 1 unit of your country‚Ä™s currency with
the euro (write this as: 1 unit of (your country‚Ä™s currency) = x units of euro);
list the bilateral exchange rate for today for 1 unit of your country‚Ä™s currency with
the US dollar;
now calculate the implied bilateral exchange rate between 1 US dollar and the euro
from what you have found from the two bilateral exchange rates for your country
now look up and list the actual bilateral exchange rate of 1 US dollar and the euro
as found at the OANDA website. Is there any potential for ‚Äúarbitrage‚ÄĚ suggested by
differences in the implied bilateral rate and the actual bilateral rate? In other words,
is there enough difference between the implied rate and the actual rate that one could
exchange dollars for euros (or vice versa) and make a known profit? Explain.
8 Looking back at Figure 15.1, what factors ‚Ä“ economic and political ‚Ä“ might cause a
decrease in the demand for dollars and a downward shift of D$, assuming S$ constant?
Assuming freely floating exchange rates, what effect does the decrease in the demand
for dollars have on the exchange rate for rupees? Does it appreciate or depreciate with
the decrease in demand for US dollars? What effects would you expect such a change in
the exchange rate to have on Sri Lanka‚Ä™s exports? Its imports? Its total national output
and total national income?
Now consider what factors ‚Ä“ again economic and political ‚Ä“ might cause the supply
of rupees, S$, to decrease, now assuming D$ remains unchanged? What would happen
to the exchange rate value of the rupee? To Sri Lankan exports? Imports? Travel in Sri
Lanka? Foreign investment in Sri Lanka?
9 Choose a country that interests you or which you have been assigned. We are going
to look at what was happening to that country‚Ä™s official foreign exchange reserves for
the most recent two years available. You can find the data at http://devdata.worldbank.
org/wdi2006/contents/Section4.htm, Tables 4a and 4.15 (the first year‚Ä™s data is in the
526 The Process of Economic Development
first table, the second in the other; if the link no longer works, go to http://www.world-
bank.org and look for World Development Indicators; the data will be in the Economics
section). Did your country‚Ä™s total official exchange rate reserves increase or decrease
between the two years? Does that change tell you anything about whether your coun-
try‚Ä™s currency value is over- or under-valued? Explain. (Hint: think about the effect of
over- or undervaluation on the balance of payments account, especially the effect on the
current account balance.)
10 Choose a less-developed country that interests you or one you are assigned.
Go to http://www.imf.org/external/np/mfd/er/2004/eng/0604.htm and scroll down
to near the bottom of that page. Find your country in the table. Is you country‚Ä™s
exchange rate regime fixed, or floating, or a managed float, or pegged to some other
currency? Try to make sense of what is there by reading what is in the left-hand
column and along the top rows.
b Does the exchange rate system for your country help to explain why your country‚Ä™s
currency might be over- or under-valued or at equilibrium as you described it in the
previous question? Explain.
11 Many less-developed countries suffer at times from ‚Äúcapital flight,‚ÄĚ as individuals
with sufficient income, banks, and large companies convert their domestic assets into
foreign currencies. They typically do this to invest or deposit these foreign currencies
abroad, usually to escape high inflation, devaluations, and unstable domestic economic,
political, and social conditions. What effect does the return of capital flight money to
less-developed countries have on exchange rates? Show using a graph. What economic
incentives might countries provide to encourage the return of flight capital money and
why should they do so?
12 Assume that the current nominal exchange rate between the British pound and Belizean
dollar is ¬£1: $B2, and that this is the ‚Äúcorrect‚ÄĚ real equilibrium value. During the year,
inflation in Britain is 10 percent, while in Belize it is 20 percent. What new nominal
exchange rate will maintain the real exchange rate value of the two currencies constant?
(Hint: What will the new rate of exchange be in terms of the number of Belize dollars
exchanged for ¬£1?)
13 Which term should be used ‚Ä“ depreciation or devaluation ‚Ä“ in referring to a falling exchange
rate value when there are fully floating rates? Which term should be used ‚Ä“ depreciation
or devaluation ‚Ä“ in referring to a falling exchange rate value when a currency‚Ä™s value is
determined by a managed float? Which term should be used ‚Ä“ appreciation or revaluation
‚Ä“ in referring to rising exchange rate value when there is a fixed exchange rate?
14 What situations might cause a currency to depreciate in value? To appreciate in value?
To be devalued? To be revalued?
15 What are the risks to a country‚Ä™s balance of payment from having an over-valued
exchange rate? Are there any situations under which an over-valued exchange rate might
be beneficial to economic growth? Explain.
16 What are the potential benefits to a country‚Ä™s balance of payments from having an under-
valued exchange rate? Are there any situations when having an under-valued exchange
rate might be harmful to economic growth? Explain.
17 Look at Focus 15.4 on China‚Ä™s supposed undervaluation. Is it still true that China has
a large trade and current account surplus? Are official foreign exchange reserves still
rising? If not, what has happened and, more importantly, why?
Macroeconomic equilibrium 527
1 Our explanation and listing of the specific items in the current account and in the capital and
financial account is a summary exposition. There are many more sub-categories and details for
classifying transactions than are shown here. The details can be found in IMF (1993).
2 When a French resident travels to Spain on holiday and stays in hotels and eats in restaurants, this is
the equivalent of Spain ‚Äúexporting‚ÄĚ a service to France, thus creating an inflow of foreign exchange
for Spain on its current account. The French traveler injects foreign exchange into the Spanish
economy for lodging, food, drinks, entertainment, and other expenditures. The same expenditure
creates an outflow of foreign exchange, recorded as an import of tourism and travel, in the French
balance of payments accounts of an exactly equivalent amount.
3 Again, it is important to remember that that we are summing the different items in the current
account, some of which are signed positive (transactions creating inflows of foreign exchange) and
some of which are signed negative (transactions creating outflows of foreign exchange).
4 Countries also can ‚Äúborrow‚ÄĚ from themselves by injecting foreign exchange into the economy from
the government‚Ä™s holdings of official foreign exchange reserves. This will be discussed later in this
section. Here we are simplifying only to make the point about the relation between the current and
the capital and financial accounts.
5 SDRs are ‚Äúspecial drawing rights,‚ÄĚ a kind of international asset created by the International Mone-
tary Fund and used by countries only when they need to borrow from the IMF.
6 We will be concerned here only with the spot exchange rate, that is, with the rate of exchange for
currencies in the market on a daily, or current, basis. There also are future values determined for
many exchange rates, such that one can buy or sell many foreign currencies to be traded at some
fixed time and a fixed value in the future. These exchange rates also are reported in the major finan-
cial papers, such as the Wall Street Journal or the Financial Times, on a daily basis, as well as in
the business sections of all major newspapers. If you have access to the internet, current bilateral
exchange rates can be found at http://www.oanda.com/convert/classic.
7 Sri Lankans and others holding rupees and who exchange them for dollars in the foreign exchange
market are simultaneously supplying rupees and demanding US dollars. We could just have easily
drawn Figure 15.1 showing the supply and demand for rupees rather than for US dollars.
8 We continue to ignore for simplicity the transactions costs involved in making foreign currency
exchanges. As anyone who has travelled abroad knows, the ‚Äúbuy‚ÄĚ and ‚Äúsell‚ÄĚ prices of currencies
are never the same, the difference being a measure of the cost charged to make such exchanges.
9 Fixed exchange rates are thus not necessarily constant at some given value forever. A country that
has fixed exchange rates may find it necessary to change the fixed value of its currency vis-√†-vis
other currencies from time to time when severe imbalances between the quantity supplied and the
quantity demanded of currencies persist. Fixed exchange rates do not, however, respond automati-
cally, as do floating rates, to changes in the supply of, and the demand for, foreign exchange. Fixed
rates are determined by government fiat and can be maintained only by government intervention of
one sort or another.
10 Devaluation is an administrative means to achieve the depreciation of the rupee that a freely floating
exchange rate would more or less automatically attain through the change in the equilibrium value
via the market. The effect of a devaluation of a currency on the balance of payments is exactly the
same as that of depreciation. The term for the administrative increase in the value of a currency is
re-valuation, the effect of which on the balance of payments accounts is identical to appreciation,
the upward adjustment of a currency value with freely floating exchange rates.
11 Why does this adjustment take place automatically with floating exchange rates? Assume that the
nominal exchange rate of the Mexican peso has not yet reached the 11 pesos to US$1 value, but
that there are freely floating exchange rates. Let‚Ä™s suppose that the current market rate is at 10.5
pesos to US$1. This will mean that, given Mexico‚Ä™s inflation of 10 percent, the nominal exchange
is worth more than it ‚Äúshould be‚ÄĚ compared to its equilibrium value. This will make imports from
the United States, travel to the United States, and Mexican investment in the United States cheaper
than they were before the inflation. This will tend to increase the demand for dollars by Mexicans,
and, assuming all else unchanged, this outward shift of the demand curve will continue until the
real rate of 10 pesos to US$1 is restored at the nominal exchange rate of 11 pesos to US$1. In fact,
the supply curve of dollars will also be decreasing at the same time, as holders of dollars are less
willing to trade them for pesos on account of the higher real price of Mexican goods with inflation
528 The Process of Economic Development
(remember, for holders of dollars, until the real value of the exchange rate is restored, the dollar has
depreciated in value), so the adjustment to any inflation differential between the two countries will
be even more rapid.
This adjustment with floating exchange rates to conserve the real value of the exchange rate
works to maintain purchasing power parity, so that the same traded goods in each country in
terms of a common currency would sell at roughly the same price when prices are converted to a
common currency. If the purchasing power parity condition is violated, the price of traded goods
in one country will differ from that in another measured in terms of a common currency. In fact,
when such differences in traded good prices are observed, this may be evidence of the absence of
self-adjusting, fully floating exchange rates.
12 The rupee depreciates as the exchange rate goes from US$0.04 to US$0.03, since fewer units of the
US dollar are being received per rupee. Each rupee has less purchasing power than before.
13 For example, imagine a metric ton of imported hot rolled steel for a toy factory costs US$750 on
the world market. At the equilibrium exchange rate of US$0.03 per rupee, the imported cost of the
steel would be 25,000 rupees. At the over-valued exchange rate of US$0.04 per rupee, the imported
cost of the steel to the toy factory drops to 18,750 rupees, a saving of 25 percent. Clearly the cost
savings can help to make such an ISI firm more competitive vis-√†-vis imported toys by reducing
average total costs.
14 By simple national income accounting,
Q = Y = C + I + G + (X ‚ą’ M),
where Q is the value of national output, Y is income, C is total consumption, I is gross investment,
G is government spending, X is export value, and M is import value. Clearly, increasing X and
decreasing M, as an under-valued exchange rate tends to do, will increase Q and Y, all else equal.
Two of the important ‚Äúall else equal‚ÄĚ assumptions are (a) that any imports discouraged are not
essential to the domestic production process (e.g., technology, new capital) or that compensating
policies (e.g., subsidies) neutralize such effects, and (b) that the economy is not at full production,
or else increases in X will simply subtract from domestic C or I.
Amsden, Alice. 1989. Asia‚Ä™s Next Giant: South Korea and Late Industrialization. New York: Oxford
Elliott, Jennifer A. 1994. An Introduction to Sustainable Development. London: Routledge.
IMF (International Monetary Fund). 1993. Balance of Payments Manual. Washington, D.C.: IMF.
‚Ä”‚Ä”. 1994. Annual Report 1994. Washington, D.C.: IMF.
‚Ä”‚Ä”. 1995. World Economic Outlook (May). Washington, D.C.: IMF.
‚Ä”‚Ä”. 2002. World Economic Outlook (April). Washington, D.C.: IMF.
‚Ä”‚Ä”. 2005. World Economic Outlook (April). Washington, D.C.: IMF.
UNCTAD (United Nations Conference on Trade and Development). 1995. Trade and Development
Report, 1995. Geneva: UNCTAD.
Wade, Robert. 1990. Governing the Market: Economic Theory and the Role of Government in East
Asian Industrialization. Princeton: Princeton University Press.
World Bank. 1993. The East Asian Miracle. Oxford: Oxford University Press.
‚Ä”‚Ä”. 1994. Adjustment in Africa. Oxford: Oxford University Press.
16 The debt problem and development
after reading and studying this chapter, you should better understand:
‚ÄĘ what external debt is and how it differs from internal debt;
‚ÄĘ the origins of the external debt crisis;
‚ÄĘ petrodollar recycling and OPEC‚Ä™s absorption problem;
‚ÄĘ when it is prudent for a country to accumulate external debt either to finance a
current account deficit or an investment project;
‚ÄĘ how to measure the burden of the external debt and external debt-servicing costs;
‚ÄĘ the impact of ‚Äúdebt overhang‚ÄĚ on current and future growth possibilities;
‚ÄĘ some possible solutions to the external debt problem.
Throughout this book, we have examined fundamental action areas for countries wishing to
accelerate economic growth and human development. We have considered the critical need
for greater attention to education and human capital accumulation. Universal primary educa-
tion and progress toward universal secondary education are important benchmarks for future
advances in growth and development. Tertiary education must be geared to turning out a
larger number of research scientists and technicians so that the needed focus on technology
The creation of an efficient and honest civil service is another goal of education and
training policies. These efforts require that the central government take an active role in
setting priorities, in mapping future projects carefully, in monitoring results, and in devoting
sufficient public resources to all levels of education and professional training so that the
goals which have been set have a reasonable chance of being achieved.
The importance of maintaining moderate or low rates of inflation, of carefully limiting
central government budget deficits within sustainable boundaries, of avoiding severely
over-valued exchange rates, of not running persistently large current account deficits in the
balance of payments, and so on are fundamental policy areas for any economy interested in
improving the pace of economic progress and human development.
Of course, all of these suggestions are premised on the assumption that key decision-
makers truly are interested in achieving a higher level of economic welfare that promotes
greater equity and human progress. It is presumed that leaders in the central government with
such a vision will create the necessary mechanisms and will find the human talent to carry
530 The Process of Economic Development
out their mission, even against the wishes of elites with a vested interest in maintaining the
status quo. The desire to develop must be firmly a part of the vision of the central government
and other leaders, or there can be little hope for sustained progress.1
However, even visionary leaders committed to setting a new path for the future and who
seemingly follow all the rules and avoid the pitfalls of over-valued exchange rates, budget
deficits, balance of payments problems, and so on, still may encounter an entrenched barrier
that can make progress more difficult: excessive external debt accumulation inherited from
the past.2 This is especially true for newly democratic governments attempting to forge ahead
on both the political and economic front.
This predicament has confronted many Latin American and Sub-Saharan African countries
since the early 1980s, when an international debt crisis erupted (the 1997 Asian financial
crisis was more locally contained and less pervasive). Accumulated external debt is not
subject to the sorts of internal policy modifications that allow countries to correct for the
exchange rate or balance of payments problems, or central government budget deficits, or
even to choose an entirely new development path. Yet a large external debt burden may undo
the best-laid plans of the most visionary country. external debt accumulated during previous,
often non-democratic and military, regimes can thwart the efforts of newly democratic
governments seriously interested in promoting economic growth and equity within their
economies. external debt thus can constitute a serious external barrier to necessary struc-
tural transformation, but is one that is not particularly amenable to domestic manipulation.
We will see that the international community has made efforts to reduce external debt, but
there remains work to do.
Origins of the 1970s‚Ä“1980s external debt dilemma
We know from the previous chapter that countries often borrow foreign exchange to be able to
run a current account deficit when desired spending in the rest of the world exceeds the inflow
of foreign exchange into the economy to pay for imports, payments on past borrowing, and for
unilateral transfers. In the 1970s, many economies forgot, or overlooked, the importance of
carefully managing their borrowing of foreign exchange and their external debt accumulation.
For many oil-importing economies, the decision in October 1973 of the Organisation of
Petroleum Exporting Countries (OPEC) to raise the price charged for a barrel of crude oil
marked the beginning of a prolonged crisis, though the actual crisis period was nearly a
decade away.3 The price per barrel of Saudi Arabian light crude oil, a benchmark for other
prices, rose from $2.59 in January 1973 to $5.18 in November 1973 and then to $11.65 in
January 1974. From 1973 to 1980, oil prices rose by about 500 percent after another spike in
price in 1979‚Ä“80 (Wee 1976: 133; Vernon 1987: 290).
OPEC had been in existence since 1960, but it had been unable to effectively function as
a cartel with the goal of limiting production and setting monopoly prices until 1973. Given
that about two-thirds of the world‚Ä™s known petroleum reserves were located in OPEC nations,
as long as the cartel‚Ä™s restricted supply and higher prices remained in effect, every economy
that required imported oil to generate electricity to run its factories and other industries and as
industrial inputs ‚Ä“ not to mention to fuel its motor cars, trucks, and trains ‚Ä“ found their import
expenditures on the balance of payments to be substantially greater assuming the same quanti-
ties of all imports continued to be purchased after the price hikes as were bought before.
For most less-developed oil-importing nations, the OPEC price hike resulted in a trade
deficit as import expenditures ballooned beyond export revenues. This also typically meant
growing current account deficits in their balance of payments. From the previous chapter,
The debt problem and development 531
you will remember that a current account deficit must be financed by a corresponding surplus
on the capital and financial account (ignoring the statistical discrepancy), including any
decrease in official foreign exchange reserves of the central government. Thus a larger oil
import bill as a result of higher petroleum prices forced oil-importing economies to face, at
least in the short term, the need for increased external borrowing or the running-down of
official foreign exchange reserves to finance their current account imbalance.4
It needs to be said that there did exist another option to running larger trade and current
account deficits and undertaking external borrowing to finance a higher level of foreign
exchange spending. Oil-importing economies could have reduced their oil or other import
expenditures sufficiently to maintain their trade and current account balances at the level
they had been prior to the OPEC price hike.
This decision, however, would have meant slower rates of economic growth as there
would have been fewer imported inputs, and the effect would have been stronger the deeper
the import cut-back required to keep import expenditures constant. Such adjustment policies
were pursued voluntarily by only a very few economies in the 1970s. Perhaps not surpris-
ingly, those economies that best adjusted to the oil crisis were East Asian economies like
Korea and Taiwan that did not encounter a debilitating debt crisis, despite what seemed like
high levels of debt accumulation. But we are getting ahead of our story.
With higher prices, oil-importing nations found themselves facing a difficult decision.
They were forced to choose between reducing the overall volume of imports and thus a
slower economic growth rate, or the reality of further accumulation of external debt to pay
for more expensive oil and other desired imports.
However, given that OPEC was a classic, textbook cartel, economic theory suggested
that it would falter and break down as members ‚Äúcheated‚ÄĚ on one another by producing
more than their ‚Äúquota‚ÄĚ of output set by the cartel. After all, cartels can only raise prices by
restricting total output. If members do not respect the supply restraints asked of them and
‚Äúover‚ÄĚ-produce, the cartel cannot keep the price as high as desired.
economists expect such cheating from cartel members and thus many countries might
reasonably have hypothesized that the price increases from the OPEC could be expected
to be temporary, thus providing a justification for short-term external borrowing to smooth
import consumption. And past experience of cartels, including OPEC, suggested this was a
However, once the price hikes had not only been maintained but increased over six months,
a year, and then six years, the logic of borrowing for the short term could not be sustained
As we will explain more fully below, borrowing simply because imports suddenly cost
more because of a price increase for a key product does not meet the standard for incurring
external debt over the long term. Far too many countries ended up making decisions on their
external debt that had adverse effects on their future development prospects. external debt
accumulation, when not handled correctly, can set off a chain of events that result in adverse
path dependence far into the future, and for many economies that is what happened.
Unfortunately, the OPEC price hikes seemed to offer their own solution for meeting the
increased need for borrowing by petroleum-importing nations. Rapidly rising oil revenues
from higher prices created an absorption problem in the OPEC economies. One of the moti-
vations for raising prices in the first instance was to allow oil-exporting nations to share in
532 The Process of Economic Development
the wealth of their own natural resources ‚Ä“ rather than selling it cheaply to other countries
to spur economic development elsewhere, particularly in the Western developed economies,
as had been done for years ‚Ä“ and to use the increased revenues for improving infrastruc-
ture, education, technology, and in a myriad of other uses. However, the increase in export
revenues flowed in so quickly there simply were not enough projects to absorb the additional
revenues fast enough. The OPEC economies faced a classic ‚Äúabsorption‚ÄĚ problem.
OPEC nations thus deposited their excess export earnings in international banks in New
York, London, Tokyo, and Frankfurt in so-called Euro-dollar or Euro-currency markets
where they could earn interest until appropriate private or public uses for the funds could
be initiated. This helped to solve the OPEC nations‚Ä™ need to make productive and profit-
able use of their large and growing oil export revenues. However, the large inflow of OPEC
deposits represented a challenge to the private international banking system which needed
to find sufficient additional borrowers for this large volume of loanable funds if they were
to be able to pay the interest on these new deposits (see Focus 16.1). Though the increase
in deposits would seem to be good news for the banks that received them, the shift in the
FOCUS 16.1 OPEC‚Ä™S AbSORPTION PRObLEM
The increase in oil prices beginning in 1973 resulted in a huge financial transfer from oil-
importing to oil-exporting economies. One measure of the size of this transfer can be seen
in the evolution of the current account balances of importers and exporters of petroleum
over the critical early years of the crisis shown below (figures are in billions of US dollars).
1973 1974 1975‚Ä“8 1979 1980 1981
Middle East oil exporters 6.5 55.9 33.8 61.9 99.6 56.3
Developing countries ‚ą’9.1 ‚ą’21.0 ‚ą’39.5 ‚ą’51.7 ‚ą’68.0 ‚ą’105.1
For the Middle East oil exporters, current account surpluses grew dramatically following each
oil price increase, first in 1974 and again in 1979‚Ä“80. These current account surpluses occurred
even though the Middle East oil exporters increased their own expenditures on imports from
$3.5 billion in 1972 to more than $52 billion in 1982 and invested billions in infrastructure and
other internal investments. These numbers give some idea of the magnitude of the flows of
foreign exchange from oil importers to oil exporters the price increases set in motion.
The other side of the current account surpluses of the Middle East oil exporters was the
growing financial transfer from the oil-importing developing countries, as measured by
the evolution of their current account deficits shown in the second line above, which grew
from small negative to large negative balances over the period.
The OPEC oil exporters could not absorb in productive uses, including expanded import
expenditures, all the new foreign exchange income being earned. There was a need to look
for alternative investment alternatives. In 1974, 51 percent of the $56.2 billion invested
internationally by OPEC nations found its way to private international banks, particularly
in Europe (other uses of these funds were in direct foreign investments, bonds, real estate
in Europe, and so on). When oil prices were increased again in 1979, international bank
deposits absorbed 65.2 percent of the $62.1 billion invested internationally by the OPEC
economies. In 1980, $100.2 billion was placed internationally, 44.2 percent of which went
to private international banks. The size of these new loanable funds flowing to the inter-
national banks gives some idea of the dilemma the banks faced in finding borrowers for
those funds without interest rates plummeting.
Sources: World Bank 1985: 33, 89; Zanoyan 1995
The debt problem and development 533
supply of funds entering the banking system was so large it threatened to reduce interest
rates and profits as the spread between bank lending and borrowing rates shrank.
What the private banking system did to resolve this potential dilemma was to create a
new class of borrower, the so-called sovereign borrower, which expanded the demand for
loanable funds. This helped to keep interest rates and earnings high (you should be able to
see the dynamics of these changes in a simple supply and demand graph with loanable funds
on the horizontal axis and interest rates on the vertical). These new sovereign borrowers
were none other than many of the petroleum-importing countries themselves who became the
recipients of aggressive efforts to provide them with the needed foreign exchange to finance
their growing current account deficits as the price of oil increased over the 1970s.5 In effect,
a portion of the earnings of the OPEC oil exporters deposited in private international banks
was loaned back ‚Ä“ recycled ‚Ä“ to the petroleum-importing countries from which the increased
bank funds had been derived in the first place!
Petrodollar recycling was the name given to this circulation and recirculation of petroleum
revenues from the oil-importing nations to the OPEC economies to the private international
banks and then back again to the oil-importing nations in the form of loans, only to make
the round again and again (Devlin 1989 is an excellent source for the full story of the private
international banking system‚Ä™s aggressive marketing of loans to sovereign borrowers).
The loans made by the private international banks to petroleum-importing nations permitted
them to continue to purchase oil and other goods and services at roughly the same levels as
prior to the OPEC price increases.
Over the years, additional funds were lent to oil importers not just for import purchases
but also to repay the interest and principal coming due on past debt obligations. New external
debt was added just to be able to make interest and principal obligations on prior external
debt, without having to reduce import expenditures to do so. And so began the cycle of
external debt accumulation.
Dimensions of the debt crisis