E xchange Rate Volatility and Productivity Growth: The Role of Financial Development Aghion, Bacchetta, Ranciere, and

1. Exchange Rate Volatility and Productivity Growth: The Role of Financial DevelopmentAghion, Bacchetta, Ranciere, and Rogoff Comments by Valerie Cerra

2. Main point • Real exchange rate volatility, and thus the exchange rate regime affect growth • Impact depends on the country’s level of financial development

3. Related Literature on exchange rate regimes and growth • Ghosh, Gulde & Wolf: hard pegs work best • Sturzenegger & Levy-Yeyati: floats are best • Reinhart-Rogoff: lntermediate flexibility performs best

4. Correlations Among Regime Classification Schemes (Frequency of outright coincidence, in %, given in parentheses) Sample: 47 countries. From Frankel, “Experience of and Lessons from Exchange Rate Regimes in Emerging Economies,” in Monetary and Financial Integration in East Asia, ADB, 2004. Table 3, prepared by Marina Halac & Sergio Schmukler.

5. Empirical finding

6. Empirics: robustness tests • Alternative measures: real ex rt volatility, real ex rt overvaluation, Reinhart Rogoff regimes, Gosh et al regimes, Levy-Yeyati and Sturzenegger • Time windows • Measures of financial development • Crisis dummies • Continents • Nonlinearities

7. Theoretical mechanism • Productivity growth occurs through innovation that requires payment of liquidity cost • If country has low level of financial development, liquidity cost must be paid through operating profits • Nominal wages are sticky one period and Pt = St due to PPP assumption • Operating profits depend on price (thus ex rt) surprises that generate real wage losses

8. Theoretical mechanism • Unexpected nominal appreciation •  lower price level and higher real wage than expected •  High operating profits fund the liquidity cost •  higher productivity growth • Unexpected nominal depreciation • lower productivity growth

9. Theoretical mechanism:Exchange rate volatility and growth • Probability of innovation profits Financial development Concave distribution of liquidity cost shocks Cost of innovation

10. Comments: Empirics • Useful finding that exchange rate regime has macro impact • But is it a story about real exchange rate volatility rather than regime? • Robustness of regime classification: LYS not significant—free fall or dual ex rt?

11. Comments: Empirics • All relevant control variables present? • Savings or investment rates • Political crises and wars • Capital account openness • Govt investment, esp infrastructure • Govt deficits or debt overhang • Proper lags? • Secondary enrollment

12. Measure of financial development • Private credit to GDP – often used to measure financial development for long-term growth • Hardy and Pazarbasioglu (1998) – boom and bust pattern in advance of banking crises. Kaminsky and Reinhart (1996) – growth in domestic credit to GDP accelerates steadily and markedly as the crisis approaches, peaking at the time the crisis erupts. • Sachs, Tornell, and Velasco (1996), Radelet and Sachs (1998) and Corsetti, Pesenti, and Roubini (1998) argue that this measure proxies for financial fragility, as the quality of bank loans is likely to deteriorate significantly when bank lending grows at a rapid pace in a relatively short period of time. • Five year averages and within country estimation – relates to short-term changes, thus possibly financial fragility rather than development

13. Use of 5 year growth averages • To “filter out business cycle fluctuations” • Standard, but only true if there are business cycle fluctuations • Cerra and Saxena, 2005, “Growth Dynamics: The Myth of Economic Recovery” • No “cycles” – Shocks are permanent • Nominal wage rigidity much shorter than 5 years • Model relies on operation profits changing due to business cycle mechanism, so why filter? • Measure of financial development argues for between country regressions

14. Empirics • Verify whether there is a weak instrument problem using lags of variables as instruments in GMM? • Heterogeneity in the estimates? • Try direct measure of corporate profitability or dependence on external finance

15. Theoretical model • Robustness of cost distributions and production technologies? • Prob of innovation may be convex in St • E(r) increasing in volatility Convex if labor share is greater than 1/2 Uniform cost distribution

16. Model’s link to empirics • Model assumes PPP, providing link between ex rt and price surprise, • P = S • but empirics show result depends on changes in real exchange rate • Model requires unexpected price (ex rt) changes: if workers expect deprec or apprec, it would be built into wage contract

17. Model’s link to empirics • Show evidence that nominal exchange rate appreciation leads to significant rise in real labor costs and decline in operating profits, or that appreciation leads to fall in productivity • Maybe other mechanism: fluctuations in operating profits due to pricing to market • Countries far from technological frontier may upgrade by importing, so appreciation may improve liquidity and thus productivity growth • Balance sheet effects of appreciation could relax credit constraints if net wealth is considered as collateral • Private credit to GDP and output per worker are strongly correlated, so are results on financial development proxy for convergence relationship? • Which interaction predominates if both included in regression?

18. Model • Stabilizing role of flexible exchange rates analyzes nominal ex rt and productivity volatility using Taylor rule • Reaction to productivity shock is not clear—how is it assumed to affect the output gap? • One for one passthrough is counter to evidence, especially for developed countries, that the paper find benefit from volatility • Taylor rule may have forward looking component. Prices may be stable despite nominal ex rt changes, especially if noise in risk premium is temporary

19. Empirics (previous version) • Higher levels of regulation have negative impact on growth as exchange rate is more flexible • Less flexible labor market, product markets and entry  fixed • Counters OCA theory – ex rt flexibility substitutes for other types of flexibility in adjusting to real shocks