Exchange rate misalignments and the external balance under a pegged currency system

• DOI: http://doi.org/10.1111/roie.12290
• Author: Blaise Gnimassoun
• Date: 01 November 2017
• Published date: 01 November 2017

ORIGINAL ARTICLE

Exchange rate misalignments and the external

balance under a pegged currency system

Blaise Gnimassoun

Bureau d’Economie Th

eorique et

Appliqu

ee (BETA)–Centre National de la

Recherche Scientifique (CNRS),

EconomiX–CNRS, Universityof Loraine,

Nancy, France

Correspondence

Blaise Gnimassoun, Bureau d’Economie

Theorique et Appliquee (BETA)–Centre

National de la Recherche Scientifique

(CNRS), EconomiX–CNRS, University

of Loraine, Nancy, France.

Email: blaise.gnimassoun@univ-lorraine.fr

JEL Classification: F31, F32, C11

Abstract

This paper analyzes the link between the exchange rate mis-

alignments and the external balance under a pegged

currency system focusing on the former French colonies of

Africa (the CFA zone). Having discussed and chosen an

appropriate analytical framework, it addresses the issue of

model uncertainty regarding the equilibrium exchange rate

model before estimating currency misalignments. The results

show that misalignments have a negative and asymmetric

impact on the current account. While overvaluation of the

CFA franc deteriorates the current account, undervaluation

does not improve it. Finally, our results highlight that the

export concentration tends to exacerbate the overall negative

impact of currency misalignments.

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INTRODUCTION

It is a well-established fact that the real effective exchange rate (REER) is an important macroeconomic

variable for economic policy at both the national and the international level. If it can be used as an

instrument of competitiveness for stimulating growth of nontraditional exports (noncommodity

exports) at the national level, particularly in developing countries, at the international level, it is the

focus of discussions on the stability of the global economy, as we have seen in the worrying develop-

ment of external imbalances since the early 2000s (see Obstfeld and Rogoff, 2005; Bergsten, 2010;

Goldstein, 2010). The line followed by the Washington Consensus is that the exchange rate indevelop-

ing countries should remain sufficiently competitive to enable them to increase their exports and conse-

quently strengthen their economies while ensuring that it is consistent with the potential production

and sustainability of the external balance in those countries (Williamson, 1990). Thus, if undervalua-

tion seems beneficial for exports and growth, it should remain at a reasonable level so as not to shake

the confidence of private investors owing to inflationary pressures, which could hurt exports and

growth. In other words, the Washington Consensus believes that the real exchange rate should remain

Rev Int Econ. 2017;25:949–974. wileyonlinelibrary.com/journal/roie V

C2017 JohnWiley & Sons Ltd

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949

Received: 22 October 2015

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Revised: 20 January 2017

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Accepted: 2 February 2017

DOI: 10.1111/roie.12290

at a level compatible with both the internal balance and the external one, known as the equilibrium

exchange rate (Berg & Miao, 2010). Consequently, any distortion of exchange rates (or misalign-

ments)—real overvaluation and real undervaluation—is harmful to the internal balance (economic

growth) and the external balance (current account).

Researchers have frequently studied the consequences of misalignments for growth, paying

little attention to their impact on the current account (Ghura & Grennes, 1993; Razin & Col-

lins, 1997; Bleaney & Greenaway, 2001; Aguirre & Calder

on, 2005; Rodrik, 2008; Berg &

Miao, 2010; Gala, 2008; B

ereau, Villavicencio, & Mignon, 2012; Schr€

oder, 2013, among

others). The increase in external imbalances in developed countries, in particular in the euro

area, made this question more attractive (Obstfeld & Rogoff, 2005; Belke & Dreger, 2013;

Gnimassoun & Mignon, 2014). However, based on the definition of the equilibrium exchange

rate, one can clearly deduce that exchange rate misalignments could be detrimental to the cur-

rent account. Moreover, considering the logic of competitiveness, the current account is more

directly exposed to currency misalignments and is the main channel through which they affect

growth. On this basis, the study of the relationship between exchange misalignments and cur-

rent account usefully complements those regarding the link between growth and misalignments

that are far from unanimous. Indeed, while Schr€

oder (2013) finds evidence supporting the view

that the economic policies suggested by the Washington Consensus work by showing that

undervaluation, like overvaluation, negatively affects economic growth for developing coun-

tries, Rodrick (2008) provides theoretical and empirical arguments showing that undervaluation

is beneficial for developing countries. Berg and Miao (2010) lean towards Rodrick (2008) by

showing that only overvaluation has negative consequences for growth and that undervaluation

is beneficial. Supporting the thesis of Rodrick (2008), Nouira, Plane, and Sekkat (2011) find

that some developing countries have used a deliberate policy of undervaluation to strengthen

the price competitiveness in their manufacturing sector. Other authors also emphasize a thresh-

old effect in the relationship between exchange misalignments and growth suggesting therefore

that the latter is nonlinear (Razin & Collins, 1997; Aguirre & Calder

on, 2005; B

ereau et al.,

2012).

This paper is part of the literature on the relationship between exchange rate misalignments

and macroeconomic imbalances and focuses on the part of the story that has been little

explored, namely the link between the exchange rate misalignments and the current account. It

also focuses on the particular case of countries under a monetary union with an external nomi-

nal anchor—the former French colonies of Africa (the CFA zone)—for which a proactive pol-

icy of undervaluation is unlikely. Roughly speaking, the CFA zone is a monetary, economic

and cultural space stemming from the colonization by France of some countries in West Africa

and Central Africa. It consists of two separate blocks: the West African Economic and Mone-

tary Union (WAEMU) and the Central African Economic and Monetary Community

(CAEMC). The WAEMU, the monetary policy of which is conducted by the BCEAO (Banque

Centrale des Etats de l’Afrique de l’Ouest), consists in 2017 of eight countries, namely Benin,

Burkina Faso, C^

ote d’Ivoire, Guin

ee-Bissau, Mali, Niger, Senegal, and Togo. As for the

CAEMC, it consists of six countries, namely Cameroon, Congo, Equatorial Guinea, Gabon,

Central African Republic, and Chad, and its monetary policy is conducted by the BEAC (Ban-

que des Etats de l’Afrique Central). Each of the two central banks manages the issuance of its

own CFA franc (the franc of the “Communaut

e Financière d’Afrique”for the BCEAO and the

franc of the “Coop

eration Financière d’Afrique centrale”for the BEAC), which has had fixed

parity with the French franc and then the euro since January 1, 1999. Although the two CFA

francs have the same parity with the euro, they are neither interchangeable nor convertible into

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GNIMASSOUN