Since the imposition of a dollar-centric fiat currency global monetary system by President Richard Nixon in 1971 countries have had to carefully manage their foreign accounts or suffer the consequences. Without the discipline imposed by the golden fetters of the Bretton Woods System (1946-1971), countries that run large current account deficit, accumulate foreign debt and welcome “hot money” flows often have been at the mercy of fickle financial markets and an erratic U.S. Federal Reserve concerned only with the effect of its policies on the U.S. economy. These countries generally have had poor growth and volatile economies and have suffered from low investment, deindustrialization and capital flight. On the other hand, countries which have carefully managed foreign accounts, repressed short-term financial flows and “managed ” their currencies have stabler currencies, grow faster, invest more and successfully move up the industrial value chains.
In emerging markets there has been a clear divergence in economic performance between countries with stable and competitive currencies and those with volatile currencies , with a pronounced advantage for the former. We can separate countries into three groups:
Convergers are high growth, industrializing countries which follow mercantilist policies and financial repression (China, Taiwan, South Korea, Poland, Vietnam). These countries have successfully converged with developed countries in terms of GDP per capita. They all carefully manipulate their currencies and support industries to achieve competitiveness for their manufacturing exports. These countries have been the great beneficiaries of the dollar-centric monetary system as they have exploited the U.S. current account deficits inherent to the system to their great advantage.
Erratic Convergers are countries have maintained a commitment to manufacturing exports but without the discipline, governance and quality of execution of the “Convergers”(Malaysia, Thailand, Indonesia, Turkey, Mexico). These countries have erratic growth and moderate convergence at best. Their economies and currencies are too volatile to sustain high export growth and move up value chains, and they are typically “sandwiched” between the highly competitive “convergers” and lower-cost newcomers (e.g. Vietnam, Bangladesh).
Middle-Income Trappers are countries without the institutional governance to manage growth (Brazil, Chile, Argentina). These countries experience low growth, high economic and currency volatility and rapid deindustrialization. They are often commodity rich countries that periodically go through boom-to-bust cycles and bouts of “Dutch Disease” Suffering from similar problems are the “Basket Cases” commodity producers that verge on the border of failed states (South Africa, Nigeria).
Low Income Convergers: Poor countries in a high-growth catch-up phase driven by urbanization and basic manufacturing (India, Philippines, Bangladesh). These countries experience high growth and convergence, and they will eventually hit the middle-income trap unless they can improve institutional governance and develop competitive manufacturing exports and move up value chains.
We can see the disparate circumstance of these groups in the charts below. The first chart shows the 30-year volatility of the Real Effective Exchange Rate (REER) for each country. (The REER measures the value of a currency against the country’s trading partners). The following charts show the 22-year implied valuations relative to the USD for each country organized by the groups define above, using data from the Economist’s Big Mac Index. This index measures the cost of manufacturing a basic commodity product (the Big Mac Sandwich) in a service industry and has proven to be a good measure of a country’s general competitiveness.
Convergers (China, Taiwan, South Korea, Poland, Vietnam). All these countries have low volatility in the REER, meaning they preserve currency stability, a sine qua non to incentivize investment and export growth. (Vietnam’s high level is distorted by early data but its REER has been more stable over the past 20 years as it has embraced the “China Model” and has become a dynamic exporter. The Big Mac Index data below confirms this low volatility and, more importantly, persistently high competitiveness.
Big Mac Implied Valuation relative to the USD
Erratic Convergers (Malaysia, Thailand, Indonesia, Turkey, Mexico). Malaysia, Thailand and Mexico have low REER volatility while Turkey and Indonesia are at relatively high levels. All of these countries have experienced at least one severe economic shock accompanied by maxi-devaluations over this 30-year period. The Big Mac data below confirms that Malaysia, Thailand, Indonesia and Mexico have learned from their past mistakes and have sustained high levels of currency competitiveness in support of manufacturing. Turkey, however, is a different story . Though the lira is currently competitive, it has gone through multiple cycles over the past twenty years, mainly caused by “hot money” flows tied to domestic credit cycles. It is remarkable that Turkish manufacturing has remained as competitive as it has given these difficult circumstances.
Big Mac Implied Valuation relative to the USD
Middle-Income Trappers: (Brazil, Chile, Argentina). Both Argentina and Brazil experience high levels of currency volatility caused by commodity cycles, “hot money” flows and periodic capital flight. Chile was previously considered a “converger” but in recent years has looked more like its neighbors, with institutional instability and severe capital flight. The data from the Big Mac Index highlights the difficult circumstances faced by exporters of manufactured goods in these countries. In addition to high volatility, these currencies are always expensive relative to Asia, Mexico and Turkey. A decade ago, Brazil had the third most expensive Big Mac in the world, and even today it has the most expensive in emerging markets, even though Brazil is the largest exporter of beef in the world.
Low Income Convergers: (India, Philippines) These countries can achieve high growth because they start from a very low level of GDP per capita and can boost productivity easily by adopting technologies and by boosting the productivity of labor by migrating workers from subsistence farms to modern industries in urban settings. Neither country is following the North-Asian model of growth led by exports of manufactured goods, though they have specialized in the export of niche services (I.T. outsourcing for India and call centers for the Philippines). These exports added to remittances from workers abroad are important sources of dollars.
In conclusion, we look at what the REER and Big Mac Index tell us about current currency values.
The first chart shows current currency valuations on a Real Effective Exchange Rate (REER) basis for both major emerging market countries and developed economies, using data for the past 30 years. This measures a country’s currency relative to its trading partners. The main outliers at the current time are Turkey and Argentina on the cheap side and Russia on the expensive side. Also, on the expensive side we find India, Vietnam, Nigeria, the U.S. and the Philippines. With the exception of Vietnam which may be statistically insignificant because of its short history as a trading nation, all the other countries give low importance to their export manufacturing sectors. Not by coincidence, most dedicated manufacturers (Mexico, Malaysia, Europe, South Korea Taiwan, Poland, China and Thailand are towards the middle of the chart.
The currency values derived from the Big Mac Index largely confirm the REER analysis. The dedicated exporters all have cheap currencies. Low-income growers (India, Philippines) are shown to be appreciating in terms of REER but remain structurally cheap in terms of the Big Mac Index. Middle-income trapped countries (Brazil) are depreciating in terms of REER but remain fundamentally uncompetitive in terms of the Big Mac Index
