Real exchange rate appreciation after the financial crisis of 2008–2009: Misalignment or fundamental correction?

• DOI: http://doi.org/10.1111/infi.12133
• Published date: 01 December 2018
• Author: Rodrigo Caputo
• Date: 01 December 2018

DOI: 10.1111/infi.12133

ORIGINAL ARTICLE

Real exchange rate appreciation after the financial

crisis of 2008–2009: Misalignment or fundamental

correction?

Rodrigo Caputo

Universidad de Santiago (USACH) and

CESS, Oxford University, UK

Correspondence

Rodrigo Caputo, Universidad de Santiago

(USACH), Santiago, Chile; and CESS,

Oxford University, UK.

Email: rodrigo.caputo@cantab.net

Abstract

In the aftermath of the 2008–2009 financial crisis, several

emerging economies experienced substantial real exchange

rate appreciations. From the point of view of policy makers,

understanding the sources of these appreciations is crucial

for designing efficient policy responses. The objective of

this paper is twofold. First, we determine the extent to which

appreciation episodes were determined by changes in

fundamentals or if they constitute exchange rate misalign-

ments. Second, we assess the impact that non-fundamental

variables have on the real exchange rate dynamics. Based on

a reduced form model, we conclude that appreciation

episodes, in the aftermath of the 2009 financial crisis, can be

explained by two elements: (i) an improvement in

fundamentals and (ii) a correction of past misalignments.

Hence, the real appreciation observed since 2010 was

driven, mostly, by fundamental elements. In terms of policy

implications, our results suggest that appreciations in that

period should have been tolerated by policy makers.

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INTRODUCTION

In the aftermath of the 2008–2009 global financial crisis, several countries experienced substantial real

effective exchange rate (REER) appreciations. In particular, when compared to the 2000–2007

average, in 2010 the REER appreciated by 55% in Brazil and by around 20% in Colombia, Australia,

Indonesia, and Philippines. Other countries, South Africa, New Zealand, and Chile, experienced less

severe real appreciations (Table 1). This process was quite persistent: by 2012, the REER was still

International Finance. 2018;21:253–272. wileyonlinelibrary.com/journal/infi © 2018 John Wiley & Sons Ltd

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appreciated in most emerging countries (Figure 1). At the same time, due to highly expansionary

monetary policies and a negative economic outlook in advanced countries, many emerging countries

adopted measures to contain capital inflows and limit exchange rate volatility.

There are several reasons why an REER appreciation could be important. On the one hand, some

argue that sustained REER overvaluations (i.e. persistent real appreciations that induce a

misalignment) are an early warning indicator of possible currency crashes (Frankel & Rose,1996;

Kaminsky & Reinhart, 1999; Krugman, 1979). Furthermore, there is evidence that large and medium-

sized REER overvaluations end abruptly, with nominal devaluations that lead to a drastic adjustment of

relative prices and to a decline in the aggregate growth rate of the economy (Goldfajn & Valdés, 1999).

On the other hand, Rodrik (2008) argues that in the presence of institutional and market failures,

sustained REER undervaluations increase the relative profitability of investing in tradables and act, in

second-best fashion, to alleviate the economic cost of these distortions. In the same line, Gluzmann,

Levy-Yeyati, and Sturzenegger (2012) find that undervaluations have positive effects on savings and

investment, as well as on employment. In this case, depreciations, which erode real labour income,

represent a transfer from low-income households to high-income households with a greater propensity

to save, enhancing the economy's investment capacity. In this context, and as noted by Rodrik (2008),

avoiding significant overvaluations of the currency is one of the most robust imperatives that can be

gleaned from the diverse experience with economic growth around the world, and one that appears to

be strongly supported by the cross-country evidence.

The negative impact of overvaluations is expected to be larger in developing countries where

market failures are more severe and where income inequality is larger, when compared to developed

countries. In fact, in a recent contribution, Habib, Mileva, and Stracca (2017) identify a strong and

statistically significant negative effect of real appreciation on real per capita growth over 5-year

average periods. The effect is stronger for developing economies and in countries pegging their

currency, while it is not significant in advanced economies and those floating their currency.

Furthermore, Caputo (2015) finds that the speed of the real exchange rate's convergence to its

equilibrium level is slower in developing countries, when compared to developed ones, in the presence

of fixed exchange rate regimes. As a consequence, the distinction between developing and developed

countries is important when assessing the economic consequences of REER misalignments.

TABLE 1 REER appreciation 2010 versus average appreciation 2000–2007

Brazil 55.01%

Colombia 27.41%

Australia 26.17%

Indonesia 23.21%

Philippines 18.53%

South Africa 12.55%

New Zealand 9.70%

Chile 9.55%

Israel 5.17%

Peru 5.01%

Malaysia 3.55%

Source: IMF.

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