their spending by as much as their revenue fell. As noted below, the CFA franc devaluation of 1994 - external adjustment - was followed by a return of economic growth and increased trade.

The CFA zone experience also casts doubt on the claim that countries should avoid devaluations in order to retain international investors. The zone certainly had stable prices and exchange rates, but its failure to solve the problems brought on by the overvalued real exchange rate decreased its attractiveness to foreign investors substantially. Capital flight increased in anticipation of an eventual devaluation (Clement _et al.)._

**Chile 1999.** Faced with weak demand from Asia and falling prices for its principal commodity export, copper, Chile saw its current account deficit widen and its currency come under attack. At first the central bank raised interest rates, but the high interest rates cut domestic demand on top of the decline in demand for exports, and plunged the country into its worst recession in 16 years and its highest unemployment rate in 10 years. On September 2, the Central Bank allowed the currency to float, suspending its formal commitment to intervene in the foreign exchange markets to keep the peso within a band. The currency immediately fell by a small step, from 519.35 to the dollar to 523.25 to the dollar (Torres, 1999).

# **Real Exchange Rate Overvaluation and Cross-Country Economic Performance**

Cottani, Cavallo, and Khan (1990) investigated the effects of real exchange rate misalignment and variability on the economic performance of 24 developing countries from 1960-1983. They found that exchange rate misalignment was strongly related to low growth of per capita GDP. Furthermore, misalignment was also related to low productivity. Capital did not go to the companies or sectors that could make the best use of it. Finally, misalignment was also related to slow export growth and slow agricultural growth.

A study of growth in 12 countries from 1965-1985 (Edwards, 1988 and 1989), reinforced these findings.'<sup>2</sup> The greater the misalignment, the lower the growth during the period. Furthermore, exchange controls and trade impediments, proxied by the black market exchange rate premium, were negatively related to growth. 13 In a study of economic growth in 18 Latin American countries between 1950 and 1980, Cardoso and Fishlow (1989) showed that growth was very uneven among the

> **12** The 12 are Brazil, Colombia, El Salvador, Greece, India, Israel, Malaysia, Philippines, South Africa, Sri Lanka, Thailand, and Yugoslavia.

> **13** Faini and de Melo (1990) took a somewhat dimmer view of the impact of the real exchange rate on economic performance. They found a positive, but usually not significant, relationship between devaluations and the improvement of the trade balance for 49 developing countries between 1965 and 1985. However, they also found for a smaller sample, different because of data availability, that a depreciated real exchange rate promoted investment. Furthermore, they found that for adjusting countries during the 1980s, the higher prices of imported intermediates brought about by devaluations were not important determinants of depressed investment.

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