The paramount policy dilemma that emerging markets face nowadays is this: On the one hand, sustained economic growth requires a competitive (read "undervalued") currency. On the other hand, any good news is immediately followed by currency appreciation, making the task of remaining competitive that much harder.
So, you finally passed that crucial piece of legislation? Your fiscally responsible political party just won the election? Or your commodity exports hit the jackpot? Good for you! But the currency appreciation that follows will likely set off an unsustainable consumption boom, wreak havoc with your export sector, create unemployment, and sap your growth potential. Success brings its reward in the form of immediate punishment!
In response, central banks may intervene in currency markets to prevent appreciation, at the cost of accumulating low-yield foreign reserves and diverting themselves from their primary goal of price stability. This is the strategy followed by countries such as China and Argentina.
Or the central bank lets the markets go where they will, at the cost of drawing the ire of business, labor, the rest of the government, and, in fact, practically everyone except financial types. This is the strategy pursued by countries such as Turkey and South Africa, which have adopted more conventional "inflation targeting" regimes.
The first strategy is problematic because it is unsustainable. The second is undesirable because it buys stability at the cost of growth.
The importance of a competitive currency for economic growth is undeniable. Virtually every instance of sustained high growth has been accompanied by a significantly depreciated real exchange rate. This is as true of South Korea and Taiwan in the 1960s and 1970s, as it is of Argentina today. Chile made its transition to high growth in the 1980s on the back of a large depreciation. Since the 1990s, both China and India have received a huge boost from their undervalued currencies.
These are just some of the better-known examples. Looking at the experience of more than 100 countries, I have found in my research that each 10 percent undervaluation adds 0.3 percentage points to growth.
Currency undervaluation is such a potent instrument for growth for the simple reason that it creates incentives for the economy's growth-promoting sectors. It increases the profitability of manufacturing and non-traditional agricultural sectors, which are the activities with both the highest level of labor productivity and with the most rapid rates of productivity increase.
An undervalued currency enables an economy to integrate into the world economy on the basis of strong export performance. It stimulates production (and hence employment), unlike overvaluation, which stimulates consumption.
So what should policymakers do? First, it is important to realize that a strong and overly volatile currency is not just the central bank's problem to fix. While the central bank bears a good part of the responsibility, it needs support from other parts of the government, most notably from the finance ministry. Maintaining a competitive currency requires a rise in domestic saving relative to investment, or a reduction in national expenditure relative to income. Otherwise, the competitiveness gains would be offset by rising inflation.