<mark>markets. A case in point is the recent local coffee price hike in Ethiopia, which exceeded foreign prices and resulted in partial reorientation of coffee sales from export markets to local ones.</mark>

# **<mark>4.4     East Asian economies pursued undervaluation in their heyday</mark>**

Historically, the fastest-growing Asian economies followed the well-trodden path of systematic currency undervaluation, with significant positive effects on growth and exports. The RER played an important role in promoting tradable industries and unleashing structural transformation <mark>during the heyday of East Asian countries</mark> (Dollar, 1992; Rodrik, 2008a; Bhalla, 2008a,b). Figure 13 (in Annex I) plots Nguyen’s (2014) real undervaluation index against the GDP per capita growth rate for four Asian (China, India, the Republic of Korea, Thailand) and two African (Uganda and Tanzania) countries for the period 1950-2011. The Asian countries have experienced a very strong comovement between growth and undervaluation.

Growth in China has been rapidly increasing in tandem with the increase in undervaluation (from an overvaluation of around 60 percent to an undervaluation of close to 50 percent) since the early 1970s, and both slowed down in the late 1990s. China’s spectacular growth is partly due to a deliberate policy of systematic undervaluation of the real exchange rate (Bhalla, 2008a). For India, the comovement between growth and undervaluation appears less pronounced; however, the story is by and large the same as that for China. For Korea and Taiwan, China, both growth and undervaluation have followed by and large a similar pattern, with growth tending to increase when undervaluation increases and vice versa. In general, East Asian countries have accomplished rapid growth on the back of unorthodox strategies including, but not limited to, intentional currency undervaluation.

The empirical regularities in the link between undervaluation and growth are not unique to Asian countries and are also observed in African economies. In line with the Asian experience, Uganda and Tanzania saw a reasonably strong comovement between undervaluation and growth. Uganda kept a somewhat undervalued currency since the late 1980s. Similarly, Tanzania’s real exchange rate was largely overvalued until the mid-1980s, after which undervaluation increased sharply. It is particularly notable that economic growth in both countries closely tracks the movements in the undervaluation index. Periods of growth slowdown were characterized by increasing overvaluation, and pickups in growth coincided with a rise in undervaluation. The IMF’s Article IV estimates for selected regional comparator countries (Uganda, Tanzania, Rwanda, and Kenya) indicate that, unlike Ethiopia’s increasingly overvalued currency, the REER of these countries were in (or close to) their respective equilibrium levels in recent years. Uganda’s effective exchange rate was only slightly overvalued in the year 2015 (by about 1.1 percent) and the estimated overvaluation for the period 2012-15 falls in the range 1-3.5 percent. Similarly, Tanzania’s currency was close to equilibrium in 2015 and there is no significant evidence of currency misalignment in the past few years. For Rwanda, the latest available estimate for 2014 points to an overvaluation of about 3 percent and the REER was broadly in line with fundamentals since 2009. Estimates for Kenya tell a similar story: the currency was about 10 percent overvalued in 2014 whereas there was no significant misalignment in the early 2010s.

<mark>Regression analyses in Rodrik (2008a) and Nguyen (2014) corroborate the graphical observations. Empirical analysis in Rodrik (2008a) suggests that a 10 percent real undervaluation is associated with an increase in GDP per capita growth of about 0.17 percentage points a year. The estimates imply that the growth impact of a similar undervaluation for Brazil, China, India, and Ethiopia at their current levels of income are 0.09, 0.12, 0.16, and 0.29 percentage points, respectively.</mark> Nguyen (2014) provides empirical evidence generally confirming the above-discussed findings. The results indicate that if a country keeps its RER undervalued by 10 percent, its real output growth becomes 0.88 percentage points higher.

<mark>For the Asian countries, perio</mark> ds of rapid export growth were also associated with large currency undervaluation (Nguyen, 2014) <mark>. Figure 12 (in Annex I) shows the graphs of export growth and Nguyen’s (2014) real undervaluation index for four Asian (China, India, Korea, and Thailand), four Latin American</mark> 12