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Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook Central,
 DEMANDING
DEVALUATION
Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 A volume in the series
Cornell Studies in Money
edited by Eric Helleiner and Jonathan Kirshner

A list of titles in this series is available at www.cornellpress.cornell.edu.

Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 DEMANDING
DEVALUATION
Exchange Rate Politics
in the Developing World

David A. Steinberg
Copyright © 2015. Cornell University Press. All rights reserved.

CORNELL UNIVERSITY PRESS ITHACA AND LONDON

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Cornell University Press gratefully acknowledges support from the College of
Arts and Sciences, the Department of Political Science, and the Oregon Humanities
Center, University of Oregon, which aided in the publication of this book.

Copyright © 2015 by Cornell University

All rights reserved. Except for brief quotations in a review, this book, or parts
thereof, must not be reproduced in any form without permission in writing from
the publisher. For information, address Cornell University Press, Sage House,
512 East State Street, Ithaca, New York 14850.

First published 2015 by Cornell University Press

Printed in the United States of America

Steinberg, David A., 1980– author.

Demanding devaluation : exchange rate politics in the developing world /
David A. Steinberg.
pages cm — (Cornell studies in money)
Includes bibliographical references and index.
ISBN 978-0-8014-5384-7 (cloth : alk. paper)
1. Foreign exchange rates—China—Political aspects. 2. Foreign exchange
rates—Developing countries—Political aspects. I. Title. II. Series: Cornell
studies in money.

HG3978.S74 2015
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Copyright © 2015. Cornell University Press. All rights reserved.

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Cornell University Press strives to use environmentally responsible suppliers

and materials to the fullest extent possible in the publishing of its books. Such
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Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 For Sarah
Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Contents

List of Figures viii

List of Tables ix
Acknowledgments x
List of Abbreviations xii

Introduction 1

1. A Conditional Preference Theory of Undervalued

Exchange Rates 20

2. Cross-Country Patterns in Exchange Rate Policy

and Preferences 55

3. Why China Undervalues Its Exchange Rate:

The Domestic Politics of Currency Manipulation 78

4. The Political Appeal of Overvaluation: Industrial Interests

and the Repeated Overvaluation of the Argentine Peso 118

5. Interests, Institutions, and Exchange Rates in South Korea,

Mexico, and Iran 163

Conclusion 218
Copyright © 2015. Cornell University Press. All rights reserved.

Appendix: Author Interviews 235

References 239
Index 265

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Figures

0.1. Economic performance in China and Argentina, 1990–2006 2

0.2. Causal model 10
2.1. State-owned banks and undervalued exchange rates 62
2.2. Labor restrictions and undervalued exchange rates 65
2.3. State-owned banks and exchange rate preferences 69
2.4. Labor restrictions and exchange rate preferences 71
3.1. Exchange rate undervaluation in China, 1993–2007 90
3.2. Renminbi-dollar exchange rate, 1994–1996 98
3.3. Renminbi-dollar exchange rate, 2005–2009 106
4.1. Exchange rate overvaluation in Argentina, 1966–2012 129
5.1. Exchange rate undervaluation in South Korea, 1960–1979 168
5.2. Exchange rate overvaluation in Mexico, 1970–1995 183
5.3. Exchange rate overvaluation in Iran, 1955–1997 203
C.1. Trade and exchange rate protectionism in 2006 227
Copyright © 2015. Cornell University Press. All rights reserved.

viii

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Tables

0.1. Exchange rate overvaluation in five developing regions 5

0.2. Summary statistics of the five cases 14
0.3. Case selection 15
1.1. Exchange rate preferences 36
1.2. Summary of interest group preferences 36
1.3. Characteristics of service and manufacturing firms 39
1.4. Summary of the argument 52
2.1. Summary statistics (time-series cross-sectional dataset) 57
2.2. Association between state-owned banks and undervalued
exchange rates 61
2.3. Association between labor restrictions and undervalued
exchange rates 64
2.4. Summary statistics (survey data) 67
2.5. Association between state-owned banks and exchange
rate preferences 68
2.6. Association between labor restrictions and exchange
rate preferences 71
Copyright © 2015. Cornell University Press. All rights reserved.

2.7. Description of control variables 75

2.8. Regression results (time-series cross-sectional data) 76
2.9. Regression results (survey data) 77
3.1. Exchange rate politics in China, 1993–2009 92
4.1. Exchange rate politics in Argentina, 1966–2012 132
4.2. Obstacles to business in Argentina 157

ix

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Ac know ledg ments

This book could not have been written without the support of many friends,
family members, and colleagues. I began working on this project at Northwest-
ern University. During and since my time at Northwestern, Hendrik Spruyt has
provided inspiration, encouragement, and exceptional advice on this project.
Ben Schneider has been very generous with his time and energy, and his many
challenging questions helped me refine and improve this work considerably.
I am deeply indebted to Victor Shih for his camaraderie and for going way be-
yond the call of duty in order to help me develop a better understanding of Chi-
nese politics. Anne Sartori provided many excellent suggestions on the project,
especially regarding its methodology. I also received helpful comments from
Sean Gailmard, Jim Mahoney, and Kathleen Thelen. My colleagues Toby Bolsen,
Diego Finchelstein, Rick Hay, Olivier Henripin, Patrick Johnston, and Sebastian
Karcher helped me formulate many of the preliminary ideas in this book and
provided useful distractions from work.
The University of Pennsylvania’s Christopher H. Browne Center for Interna-
tional Politics provided a fun and intellectually stimulating environment to
work on this book. There, I benefited from conversations over lunch and happy
hour with many individuals and owe special thanks to Avery Goldstein and Ed
Mansfield for their support and mentorship. The Browne Center also funded a
book workshop where I received outstanding comments from Jeff Frieden, Steph
Copyright © 2015. Cornell University Press. All rights reserved.

Haggard, Ed Mansfield, and other attendees; their input made the book much
stronger. I thank the Browne Center for financial support and participants in the
workshop for their guidance.
At the University of Oregon, I received helpful comments on this work from
Gerry Berk, Alison Gash, Ron Mitchell, Nick Thompson, and participants in the
“Junior League” workshop. Special thanks are due to Karrie Koesel and Lars
Skalnes, who read multiple chapters and provided tons of great advice. I also
benefited from the stellar research assistance of several Oregon graduate stu-
dents: Thibaud Henin, Yongwoo Jeung, Zhuo Li, Kevin O’Hare, Gulce Tarhan,
and Patrick Van Orden.
This research also benefited from comments from many other colleagues, in-
cluding David Bearce, Bill Bernhard, Jeff Colgan, Randy Henning, Ashley Jester,
Andrew Kerner, Patrick Leblond, James Morrison, Angela O’Mahony, Tom Pe-
pinsky, Maggie Peters, Molly Roberts, David Singer, Felicity Vabulas, and Ste-

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 ACKNOW LEDG MENTS xi

fanie Walter. I thank the editors at Cornell University Press—Roger Haydon,

Eric Helleiner, and Jonathan Kirshner—for their guidance, as well as two anony-
mous reviewers for their extraordinarily detailed, constructive comments that
greatly improved the manuscript.
This book would not have been possible without the generous help of many
people in Argentina and China who took the time to answer my questions. Vic-
tor Shih provided extensive support, without which field research in China
would have been impossible. Simon Rabinovitch also gave excellent guidance
on my research in China, and Haiyan Duan and Kai Kang were helpful research
assistants. My research in Argentina owes much to the help of Sebastián
Etchemendy, Jesús Monzón, and especially to Diego Finchelstein and his family.
I thank the following institutions for their financial assistance: the Social Sci-
ences and Humanities Research Council of Canada; the Graduate School and the
Buffett Center for International and Comparative Studies at Northwestern Uni-
versity; the Christopher H. Browne Center for International Politics at the Uni-
versity of Pennsylvania; and the College of Arts and Sciences at the University of
Oregon.
Portions of chapter 4 originally appeared in David A. Steinberg and Victor C.
Shih, “Interest Group Influence in Authoritarian States: The Political Determi-
nants of Chinese Exchange Rate Policy,” Comparative Political Studies 45, no. 11
(2012): 1405–1435. I thank Sage Publications and Victor Shih for granting me
permission to reuse this material.
My biggest debt of gratitude is to my family for their enduring support. I
greatly appreciate the support of my in-laws, Rhonda and Larry, and wish that
Larry had a chance to read this book. I have no doubt that he would have found
much to object to. My sister, Jessica, is a close friend who has been there for me
Copyright © 2015. Cornell University Press. All rights reserved.

as long as I can remember. This book could not have been completed without
the exceptional generosity and loving support of my parents, Buddy and Gra-
ciela. Finally, I will never be able to adequately repay my wife Sarah for every-
thing she does for me. The last few years that I spent working on this book would
have been far less enjoyable were it not for Sarah. For that, I dedicate this book
to her.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Abbreviations

ABM: Asociación de Bancos de México (Association of Mexican Banks)

ACFTU: All China Federation of Trade Unions
ADEFA: Asociación de Fábricas de Automotores (Association of Automotive
Makers [Argentina])
ADIMRA: Asociación de Industriales Metalúrgicos de la República Argentina
(Association of Metallurgical Industries of Argentina)
BCRA: Banco Central de la República Argentina (Central Bank of the Argentine
Republic)
CANACINTRA: Cámara Nacional de la Industria de Transformación (National
Chamber of Industrial Transformation [Mexico])
CASS: Chinese Academy of Social Sciences
CCE: Consejo Coordinador Empresarial (Business Coordinating Council
[Mexico])
CCP: Chinese Communist Party
CGE: Confederación General Económica (General Economic Confederation
[Argentina])
CGT: Confederación General del Trabajo (General Confederation of Labor
[Argentina])
Copyright © 2015. Cornell University Press. All rights reserved.

CMHN: Consejo Mexicano de Hombres de Negocios (Mexican Council of

Businessmen)
CONCAMIN: Confederación de Cámaras Industriales (Confederation of
Industrial Chambers [Mexico])
CONCANACO: Confederación de Cámaras Nacionales de Comercio, Servicios y
Turismo (Confederation of National Chambers of Commerce, Services, and
Tourism [Mexico])
CTM: Confederación de Trabajadores de México (Confederation of Mexican
Workers)
FKTU: Federation of Korean Trade Unions
GDP: gross domestic product
ILO: International Labour Organization

xii

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 ABBREVIATIONS xiii

IMF: International Monetary Fund

INDEC: Instituto Nacional de Estadística y Censos (National Institute of
Statistics and Censuses [Argentina])
ISI: import substitution industrialization
MOC: Ministry of Commerce (China)
NDRC: National Development and Reform Commission (China)
OECD: Organization for Economic Co-operation and Development
OEP: open-economy politics
PBC: People’s Bank of China
PBSC: Politburo Standing Committee (China)
PPP: purchasing power parity
PRI: Partido Revolucionario Institucional (Institutional Revolutionary Party
[Mexico])
SDPC: State Development and Planning Commission (China)
SDR: special drawing rights
UIA: Unión Industrial Argentina (Argentine Industrial Union)
Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
Copyright © 2015. Cornell University Press. All rights reserved.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 Introduction

During most of the last twenty years, China’s government has intervened in the
foreign exchange market to suppress the value of China’s currency, the renminbi.
This policy of undervaluing the renminbi gives Chinese firms a competitive ad-
vantage over their foreign rivals. As a result of China’s interventions in the for-
eign currency market, it takes more renminbi to buy each dollar, and Chinese
citizens find it expensive to import goods from abroad. China’s “undervalued”
exchange rate therefore has similar effects to more traditional protectionist in-
struments, such as tariffs. Some believe that China’s currency manipulation is “the
largest protectionist measure maintained by any major economy since the Sec-
Copyright © 2015. Cornell University Press. All rights reserved.

ond World War” (Bergsten 2010). China’s undervalued exchange rate also makes
Chinese goods cheaper for consumers in the United States and elsewhere, and has
been a major driving force behind the astonishing growth of China’s exports, which
increased over 1400% between 1990 and 2006 (see figure 0.1). This has been a
colossal boon to Chinese businesses, but it has been an equally large burden for
China’s foreign competitors, such as the United States. China’s undervalued ex-
change rate is also highly problematic for some groups within China, such as con-
sumers who cannot afford imports. But it is undeniable that China’s underval-
ued exchange rate has contributed to China’s miraculous development and helped
bring millions out of poverty.1 Aided by rapid export growth, the income of the
average Chinese citizen was more than four times higher in 2006 than in 1990.

1. Rodrik (2010) and Herrerias and Orts (2011) discuss the important effects of undervaluation
on Chinese economic growth.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 2 INTRODUCTION

1,500
Exports (1990=100)

1,000

500

0
1990 1994 1998 2002 2006
GDP per capita (1990=100)

400

300

200

100
1990 1994 1998 2002 2006
China Argentina

Figure 0.1. Economic performance in China and Argentina, 1990–2006. Data

are from World Bank (2010).

China was not the first developing country to reap the rewards of an under-
valued exchange rate. South Korea followed a similar exchange rate policy in
the 1960s and 70s, and achieved equally remarkable results. Despite the posi-
tive examples set by China, Korea, and others, few countries in the developing
world have followed this path. In fact, many governments in the developing
world do the exact opposite: intervene in the foreign exchange market to keep
Copyright © 2015. Cornell University Press. All rights reserved.

their exchange rates strong and “overvalued.” This occurs in spite of the fact
that keeping the exchange rate overvalued usually inflicts serious damage on
national economies.
Argentina provides a clear example of a country that has repeatedly overval-
ued its exchange rate and suffered as a result. During the 1990s, Argentina’s
overvalued exchange rate made it affordable for middle-class consumers to
import Gucci handbags and go on vacation in Miami, and helped businesses pay
off their foreign debts with ease. Unfortunately, Argentina’s overvalued ex-
change rate also made the country’s goods prohibitively expensive, and its
export growth was relatively slow as a result. Due in part to a lack of external
competitiveness, economic growth in Argentina was mediocre throughout the
1990s. Even worse, overvaluation in the 1990s contributed to a massive eco-
nomic crisis that led to a 22% fall in average incomes between 1998 and 2002.
Argentine officials attempted to keep the exchange rate undervalued in the after-

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 3

math of the 2002 crisis, but the peso did not remain undervalued for long. Over-
valuation in Argentina has created serious economic problems once again, and
ultimately contributed to another financial crisis in January 2014. Argentina’s
poor performance and China’s stellar success obviously result from a multitude
of factors. There is little doubt, though, that exchange rate policy has contributed
to these outcomes.
Whereas the economic effects of undervalued exchange rates are well under-
stood, the political sources of undervalued exchange rates remain elusive. It is far
from obvious why some policymakers undervalue their country’s exchange rates
while others choose to overvalue despite the widely recognized problems that over-
valuation brings. The purpose of this book is to explain why a relatively small num-
ber of developing countries keep their exchange rates undervalued while many
more overvalue their exchange rates.
The origins of exchange rate policy lie at least in part in a country’s domestic
political arrangements. Two characteristics of domestic political systems influ-
ence the exchange rate level: (1) the power of the manufacturing sector and (2)
the design of national labor and financial market institutions. Exchange rates
tend to be most undervalued in countries with powerful manufacturing sectors
and state-controlled labor and financial systems. Manufacturing sectors that have
many power resources tend to have substantial influence over exchange rate
policy decisions. State control of labor and finance enables state leaders to push
most of the costs of an undervalued exchange rate onto workers and banks.
When both factors are present, as they are in China, the manufacturing sector is
likely to prefer an undervalued exchange rate and often has the ability to con-
vince policymakers to adopt this policy. By contrast, in countries like Argen-
tina, where the state cannot control labor and finance, undervalued exchange
Copyright © 2015. Cornell University Press. All rights reserved.

rates can be costly for manufacturing firms, and manufacturers’ opposition

to undervaluation often discourages politicians from adopting this policy. Fi-
nally, when the manufacturing sector controls few power resources, as in
countries such as Iran, low levels of societal support for undervaluation discour-
age policymakers from sustaining an undervalued exchange rate. Understanding
why countries undervalue their exchange rates requires close attention to do-
mestic political processes, especially the preferences and political influence of
the industrial sector. Using both quantitative data on over one hundred coun-
tries and detailed case studies of five developing countries, this book provides
strong evidence in support of this domestic political explanation of underval-
ued exchange rates.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 4 INTRODUCTION

Why Don’t We See More Undervalued

Exchange Rates?
Developing countries, as a group, have favored overvalued exchange rates to un-
dervalued ones since at least the 1960s. Economists have frequently observed this
tendency. To take just one example, an article by economists Pick and Vollrath
(1994, 556) observes that “in developing countries, exchange rates are usually
overvalued.”2 International financial institutions also judge overvaluation to be
much more common than undervaluation: “only twice has the IMF [International
Monetary Fund] found that a country has deliberately undervalued its currency,
while it has found hundreds of cases of countries overvaluing their currencies”
(Frankel and Wei 2007, 586).
More systematic data buttress these observations. Table 0.1 displays data on one
widely used measure of exchange rate over/undervaluation. Positive (negative)
values on this measure indicate that the exchange rate is more appreciated (depre-
ciated) than one would expect based on a country’s economic fundamentals. The
data indicate that the typical country in Asia had an undervalued exchange rate in
2007, the most recent year for which data are available for a large sample of coun-
tries. However, exchange rates tended toward overvaluation in all four other devel-
oping regions: Africa, Eastern Europe, Latin America, and the Middle East.
It should be noted at the outset that measuring exchange rate undervaluation
is hardly straightforward. No measure is perfect, and the one used in table 0.1 is
no exception. In fact, the data in the table probably underestimate the true ten-
dency toward overvaluation of exchange rates. As chapter 2 discusses in greater
detail, this measure is constructed such that the mean level of over/undervalua-
tion equals zero in each year. If the majority of developing countries adopt poli-
Copyright © 2015. Cornell University Press. All rights reserved.

cies that keep their exchange rates overvalued, as many observers believe, then
this measure understates the true degree of overvaluation for each country.3
Why have countries as diverse as Latvia, Turkey, Venezuela, and Zambia all
converged on overvalued exchange rates? The popularity of overvaluation across
these disparate countries and regions stands at odds with many leading theories
of international relations and political economy. One major ambition of this book
is to understand why overvalued exchange rates are more prevalent than under-
valued exchange rates in the developing world.
The popularity of overvalued exchange rates is of more than purely intellectual
interest. It is also a major driver of poverty and underdevelopment. Economists

2. Frenkel and Taylor (2007, 279), Edwards (1989, 78), Huizinga (1997, 273), and Todaro and
Smith (2003, 571) provide similar descriptions.
3. Despite this limitation, this measure is very useful for comparing levels of over/undervalua-
tion across countries and over time, which is the main way that this book utilizes this data.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 5

TABLE 0.1. Exchange rate overvaluation in five developing regions (%)

REAL EXCHANGE RATE OVERVALUATION

All developing countries 7.7

Asia −14.7
Eastern Europe 24.4
Latin America 7.6
Middle East and North Africa 18.1
Sub-Saharan Africa 10.6

Note: Overvaluation was constructed by the author using data from Heston et al. (2009) and following the
methodology of Rodrik (2008). Positive (negative) values on this variable indicate that the exchange rate is
overvalued (undervalued). Cell entries are the median value for each group. A more detailed description of this
variable is provided in chapter 2.

have long recognized the harmful effects of overvalued exchange rates. The IMF
has actively encouraged developing countries to depreciate their exchange rates
since the 1970s (Polak 1991).4 In the 1990s, the maintenance of a “competitive”
(i.e., non-overvalued) exchange rate was codified as one of the ten elements of
the “Washington Consensus” (Williamson 1990).
Some recent economic theories go further and argue not only that overvalu-
ation harms growth but also that undervaluing the exchange rate actually increases
economic growth. A large number of statistical studies confirm that countries with
undervalued exchange rates tend to grow more rapidly than those with market-
valued or overvalued exchange rates.5 Three plausible explanations have been of-
fered for this finding. First, undervaluation leads to “export surges” (Freund and
Pierola 2012). Since exports are a component of gross domestic product, more
exports mean higher economic growth if all else is equal. Second, undervalua-
Copyright © 2015. Cornell University Press. All rights reserved.

tion encourages firms to invest in complex, technologically advanced industries,

which increases productivity and ultimately growth (Rodrik 2008). A third the-
ory posits that undervaluation promotes growth because it reduces real wages and
thereby increases aggregate investment rates (Levy-Yeyati, Sturzenegger, and Gluz-
mann 2013). Regardless of the mechanism, an abundance of evidence indicates

4. The IMF’s intermittent effort to encourage China to appreciate its exchange rate since 2003 is,
therefore, unusual.
5. See, for example, Béreau, Villavicencio, and Mignon (2012), Berg and Miao (2010), Cottani,
Cavallo, and Khan (1990), Dollar (1992), Easterly (2001), Levy-Yeyati, Sturzenegger, and Gluz-
mann (2013), Gluzmann, Levy-Yeyati, and Sturzenegger (2012), Mbaye (2013), Razin and Collins
(1999), and Rodrik (2008). Although these studies typically use a continuous measure of over/under-
valuation, the Béreau et al., Berg and Miao, Mbaye, Razin and Collins, and Rodrik studies investigate
potential nonlinearities and find that, relative to market-valued exchange rates, overvaluation reduces
growth while undervaluation increases growth.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 6 INTRODUCTION

that countries with undervalued exchange rates grow faster than those with over-
valued exchange rates.
High average rates of growth are not the only benefit of undervaluation. Un-
dervalued exchange rates also help countries sustain high growth rates for longer
periods of time (Berg, Ostry, and Zettelmeyer 2012; Johnson, Ostry, and Subra-
manian 2006) and make growth rates less volatile (Acemoglu et al. 2003). Lower
rates of unemployment are another benefit of undervalued exchange rates. Em-
ployment rises because undervaluation makes it cheaper to hire workers compared
to using alternative inputs, such as imported capital goods (Frenkel and Ros 2006;
Gluzmann, Levy-Yeyati, and Sturzenegger 2012; Levy-Yeyati, Sturzenegger, and
Gluzmann 2013). Finally, undervalued exchange rates are among the most effec-
tive policies available for preventing national financial crises (Reinhart and Rog-
off 2009; Frankel and Saravelos 2012). Although not sufficient for successful de-
velopment, the avoidance of overvalued exchange rates is probably a necessary
condition for sustained economic growth (Bresser-Pereira 2008; Eichengreen 2007;
Frenkel and Taylor 2007).
It is perplexing that large numbers of developing countries adopt exchange
rate policies that impede their long-run development. A growing literature pos-
its that policymakers’ ideas and understandings about the economy determine
their decisions about economic policy. In this view, political decision makers adopt
whichever exchange rate policies they believe are best for the national economy.6
The fact that developing countries “frequently suffer from recurring episodes of
real exchange rate overvaluation . . . [is] puzzling, because it can hardly be the
case that developing country policy makers do not know how to reverse over-
valuations, or that they believe that real exchange rate overvaluation generally
improves economic efficiency and welfare” (Huizinga 1997, 273). Since most ex-
Copyright © 2015. Cornell University Press. All rights reserved.

change rate policymakers realize that undervalued exchange rates are superior to
overvalued ones, policymakers’ ideas about exchange rate policy cannot explain
why so many of them overvalue their exchange rates.
The rarity of undervalued exchange rates also stands at odds with standard
interest-based theories of political economy, often referred to as the “open-
economy politics” approach (Lake 2009). An undervalued exchange rate is a form
of protectionism that, like a tariff or subsidy, provides local producers with a com-

6. Helleiner (2005), McNamara (1998), Morrison (2015), Moschella (2015) and Odell (1982) pres-
ent theories along these lines to explain exchange rate policy. This type of argument has also been
applied to other issue-areas, such as welfare states (Blyth 2002), capital controls (Chwieroth 2007),
and trade policy (Morrison 2012). Related research on financial policy focuses on other ideational
factors, such as social conventions (Nelson and Katzenstein 2014), national identity (Helleiner 2003),
and perceptions of legitimacy (Kirshner 2003). However, these latter variables have received less schol-
arly attention. I focus on the most common version of this approach but accept the possibility that
these other ideational factors might influence exchange rate policy.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 7

petitive edge over their foreign rivals. Interest group theories widely assume that
politicians find protectionist policies virtually irresistible because protectionism
benefits concentrated and well-organized interest groups.7 Along these lines, many
scholars assert that the beneficiaries of an undervalued exchange rate—exporters
and import-competing firms—are more powerful than the opponents (Broz and
Frieden 2001, 333; Eichengreen 1996, 152; Frieden 1997, 85; Henning 2006, 123).
According to conventional wisdom, the benefits of an overvalued exchange rate are
“spread out broadly among the population. These benefits often don’t seem large
enough to create a viable constituency . . . In contrast, exporters are a powerful
political block, and the costs of currency appreciation hit them directly in the gut.
Their complaints tend to resonate much more with politicians” (Prasad 2014, 16).
By overvaluing their exchange rates, the majority of developing countries are going
against the interests of what many political economists believe are the most power-
ful interest groups within these countries. Traditional interest-based theories have
difficulty explaining why undervalued exchange rates are not very common.
Realist and mercantilist theories of international politics also have difficulty
making sense of the why overvalued exchange rates are so popular. Many observ-
ers assume that “improvement[s] in competitiveness resulting from devalua-
tion . . . are likely to be welcomed in our still mercantilist world” (Cooper 1975,
72). Realists and mercantilists believe that policymakers favor undervalued ex-
change rates and other protectionist policies because this increases a state’s wealth
and power at the expense of its trading partners (Gilpin 2001, 90). From this per-
spective, overvaluing the exchange rate is completely perverse. Overvaluation is
equivalent to subsidy on imports and a tax on exports (Broz and Frieden 2001).
When a government chooses to overvalue its exchange rate it is choosing to provide
favorable treatment to foreign industries over domestic ones. Overvaluation does
Copyright © 2015. Cornell University Press. All rights reserved.

not just thwart the national interest; it also furthers other nations’ interests. The
frequent adoption of “anti-protectionist” exchange rate policies, which impose
both absolute and relative losses on national economies, begs for an explanation.

The Argument in Brief

My political explanation of undervalued exchange rates, which is fleshed out in
greater detail in chapter 1, has two main aims: (1) to explain the general tendency
toward overvalued exchange rates in the developing world and (2) to explain
why certain developing countries buck this trend and keep their exchange rates

7. The political advantage of protectionist interest groups is a common explanation for the ubiq-
uity of protectionist trade policies (e.g., Schattschneider 1935; Ehrlich 2007).

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 8 INTRODUCTION

undervalued. To answer these questions, I developed what I refer to as a “condi-

tional preference theory.” The label for this theory highlights two of its main
contributions. The first is an assertion that the preferences of powerful interest
groups are a major driving force behind exchange rate policy. The second contri-
bution is to show that those preferences are context-dependent, meaning that an
interest group favors different types of exchange rate policies across different po-
litical, economic, and institutional contexts. I argue that politicians rarely under-
value their currencies because most interest groups dislike undervaluation most
of the time, and that undervaluation is most likely in countries where powerful
interest groups do prefer this policy.
Exchange rates are inescapably political because it is government officials who
are primarily responsible for the valuation of exchange rates. Government offi-
cials have numerous instruments that they can—and indeed do—use to control
the value of their exchange rate. These instruments include intervening in for-
eign exchange markets, altering interest rates, changing tax rates and government
spending levels, and regulating international capital flows. Should they choose to
do so, governments are capable of keeping their exchange rates “undervalued,”
meaning that the currency is below its market value and domestic goods are cheaper
than foreign goods. Governments are also capable of keeping their exchange rate
“overvalued,” which refers to a situation in which domestic goods are more ex-
pensive than foreign goods.
Why do more policymakers choose to use these policy instruments to main-
tain an overvalued exchange rate instead of an undervalue one? When politicians
choose whether or not to undervalue their exchange rate, one consideration stands
above the rest: the need for domestic political support. This imperative arises be-
cause national leaders that lack support from powerful interest groups do not re-
Copyright © 2015. Cornell University Press. All rights reserved.

main national leaders for long. Politicians, therefore, choose exchange rate poli-
cies favored by the most powerful interest groups—groups with the most economic
resources, strongest organizations, and highest levels of prestige.
Politicians frequently forego undervaluation because, even though underval-
ued exchange rates contribute to the long-run development of an economy, they
often have some harmful effects on powerful interest groups over the short run.
Many interest groups, from labor unions to banks and construction companies,
oppose undervalued exchange rates because undervaluation makes it more ex-
pensive for these groups to purchase foreign imports or to pay off their foreign
debts.8 Of course, some groups do benefit from an undervalued exchange rate.

8. Frieden’s (1991a) seminal theory convincingly argues that nontradable industries, such as ser-
vices and banking, oppose undervaluation. Others argue that labor opposes an undervalued exchange
rate because it reduces their real wages (Cooper 1971; Dornbusch and Edwards 1991).

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 9

Manufacturing firms and others that produce internationally tradable goods ben-
efit from an undervalued exchange rate because it gives them a competitive edge
over their foreign rivals (Frieden 1991a).
However, even though an undervalued exchange rate benefits the manufac-
turing sector in some ways, undervaluation does not necessarily increase manu-
facturing firms’ profits. Undervaluation also harms manufacturing firms in vari-
ous ways. An undervalued exchange rate increases the costs of manufacturers’
imported inputs. Undervaluation also increases the debt burdens of manufactur-
ing firms that borrow in dollars or another foreign currency. The process of main-
taining an undervalued exchange rate often requires central banks to purchase
foreign currency and sell domestic bonds, which pushes up domestic interest rates
and makes it more expensive for manufacturing firms to borrow money from
local banks. Increased labor costs are another common consequence of an un-
dervalued exchange rate: when faced with an undervalued currency, workers
naturally demand higher wages to help them increase their purchasing power; if a
firm must raise its employees’ wages, these added costs may outweigh any benefits
from undervaluation. Therefore, industrialists are hardly stalwart proponents of
undervalued exchange rates. They are likely to favor an undervalued exchange
rate in some circumstances, but not in others. One major reason why so few
policymakers undervalue their exchange rates is that their constituents typically
dislike this policy.
Although interest-based theories of international political economy typically
assume that actors’ policy preferences are fixed and immutable, some scholars,
such as McNamara (1998) and Helleiner (2005), have recognized that the manu-
facturing sector’s exchange rate preferences are context dependent. I advance this
important insight in a new direction. Whereas McNamara and Helleiner suggest
Copyright © 2015. Cornell University Press. All rights reserved.

that the contextual nature of preferences renders interest-based approaches of

little help in explaining exchange rate policymaking, I show that a (slightly) more
complex interest group theory is very useful for analyzing exchange rate politics.9
To do so, this book explores how certain contextual factors help determine whether
the manufacturing sector supports or opposes an undervalued exchange rate. The
approach followed here is broadly similar to that of Henning (1994), which shows
that one contextual factor—the structure of financial markets—can transform
the exchange rate preferences of banks. Although Henning’s study focuses on a

9. Helleiner (2005, 41) argues that “private sector preferences vis-à-vis exchange rate regimes are
highly context-specific, and thus not easily modeled on the kinds of ‘rationalist’ deductive models”
that are often employed. Similarly, McNamara (1998, 7) suggests that her findings “cast doubt” on the
usefulness of interest-based approaches because these theories “fail to address the high degree of
uncertainty about the microeconomic costs of different monetary regimes and the contextual nature
of actor’s preferences.”

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 10 INTRODUCTION

State-controlled Manufacturing
labor & sector prefers
financial undervalued
systems exchange rate

Undervalued
exchange rate

Manufacturing
Powerful
sector influences
manufacturing
exchange rate
sector
policy

Figure 0.2. Causal model.

different interest group (the financial sector) and a different set of countries (ad-
vanced industrialized nations), it provides compelling evidence that contextual
variables can influence preferences in a systematic fashion. Along these lines, my
conditional preference theory aims to demonstrate that exchange rate preferences
are not constant, but they are coherent.
This book brings attention to the important ways that institutions influence
preferences. A variety of different institutional arrangements are likely to deter-
mine whether the manufacturing sector prefers an undervalued exchange rate.
In this book, I focus special attention on labor and financial market institutions.
Their importance stems from the fact that undervalued exchange rates often in-
crease firms’ labor and financing costs, and these two factors comprise a large share
of the total costs of many manufacturing firms.
Copyright © 2015. Cornell University Press. All rights reserved.

I argue that institutional structures that expand state policymakers’ control over
labor and financial markets increase support for undervaluation. When the state
controls the financial system, policymakers can channel cheap credit to indus-
trial firms. Thus, an undervalued exchange rate is less likely to push up industri-
alists’ borrowing costs in state-controlled financial systems than in private finan-
cial systems. Institutions that enhance state control over labor markets, such as
legal restrictions on organized labor, suppress wage costs for industrial firms. Un-
dervalued exchange rates are likely to be profitable for manufacturing firms in
countries with state-controlled labor institutions because wage rates are unlikely
to rise following an exchange rate devaluation. By contrast, when policymakers
are unable to control and repress workers, undervalued exchange rates are likely
to push up wage rates and manufacturers’ costs. Other things being equal, increased
state control over labor and financial markets strengthens the manufacturing sec-
tor’s support for undervaluation.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 11

By bolstering the demand for undervalued exchange rates, state-controlled la-

bor and financial-market systems can encourage policymakers to undervalue their
exchange rates. Although preferences are hugely important, they do not deter-
mine exchange rate policy on their own. Power also matters.
This book pays particular attention to the preferences and power of the man-
ufacturing sector because this sector plays a unique role in developing countries.
Manufacturing is the archetypal tradable industry, and therefore one of the stron-
gest potential beneficiaries of an undervalued exchange rate.10 Additionally, the
manufacturing sector often has exceptional political clout. There are two main
reasons for this. First, most policymakers in developing countries covet indus-
trial development, a good that only manufacturing firms can deliver. Second, man-
ufacturing firms’ large size and geographic proximity to one another provides them
with organizational advantages over other sectors (Bates 1981; Bellin 2002). There
are also more pragmatic reasons to focus on this one interest group. While there
is strong agreement that the manufacturing sector plays an important role in ex-
change rate politics, the nature of that role is poorly understood. My manufacturing-
centered theory does not provide a complete explanation of exchange rate politics,
but an in-depth analysis of the manufacturing sector delivers large analytical
payoffs because it greatly improves our understanding of this key player.
Policymakers have strong incentives to undervalue the exchange rate when the
manufacturing sector supports this policy and this sector is politically influen-
tial. The political influence of the manufacturing sector depends upon this sec-
tor’s “power resources” (Korpi 1985).11 When the manufacturing sector controls
a large amount of economic, organizational, and normative resources, policymak-
ers have strong incentives to keep the exchange rate at whichever level industrial-
ists prefer. The manufacturing sector is likely to have limited influence on exchange
Copyright © 2015. Cornell University Press. All rights reserved.

rate policy when other interest groups have more power resources. In this latter
case, policymakers are likely to overvalue the exchange rate in adherence to the
demands of other, more powerful, interest groups. Since the manufacturing sec-
tor is more likely to support undervalued exchange rates when labor and finan-
cial markets are state controlled, my conditional preference theory predicts a ten-
dency for exchange rates to be most undervalued in countries that combine a
powerful manufacturing sector with state-controlled labor and financial institu-
tions. Figure 0.2 summarizes the argument graphically.

10. Chapter 1 explains why agriculture, though also a tradable sector in principle, is not always
tradable in practice.
11. Following Cox and Jacobson (1973), this book maintains a sharp distinction between
“power,” which refers to an actor’s internal attributes, and its “influence,” defined as an interest group’s
control over policy outcomes.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 12 INTRODUCTION

Implications and Scope of the Argument

The conditional preference theory has three important implications for our un-
derstanding of the global political economy. First, it forces us to take politics se-
riously. The theory suggests that an adequate understanding of global economic
trends requires us to look beyond economics and to pay close attention to poli-
tics and political incentives.
Second, the theory points to some important limitations of prevailing theo-
ries of interest group preferences, which assume that “interests are determined
largely by a unit’s production profile or position in the international division of
labor” (Lake 2009, 231). The conditional preference theory suggests that an in-
terest group’s production profile cannot fully explain its preferences. This book
shows that largely identical groups prefer different exchange rate policies in dif-
ferent situations. Scholars need to be more sensitive to the ways in which contex-
tual factors influence preferences.
Finally, my theory suggests that institutions may be even more important than
is often appreciated. The consensus among scholars of international political econ-
omy is that institutions matter because they “aggregate preferences”—they de-
termine which interest groups influence policy (Moravcsik 1997; Milner 1998; Lake
2009; Rogowski 1999). By contrast, my theory suggests that institutional struc-
tures do not merely determine how preferences get aggregated. Institutions also
play a more profound role: they influence what interest groups want. Historical
institutionalists have previously recognized that institutions can shape preferences,
but the field of international political economy has largely ignored this impor-
tant insight.12
Before proceeding, it is important to clarify that my theory applies only to de-
Copyright © 2015. Cornell University Press. All rights reserved.

veloping countries (i.e., low- and middle-income countries), and is not intended
to apply to the advanced industrialized economies.13 The exchange rate level has
different—and generally more important—effects on developing countries. Un-
dervalued exchange rates are more beneficial, in terms of economic growth, in
developing countries than in countries that are already highly developed (Mbaye
2013; Rodrik 2008). At the same time, undervalued exchange rates also impose
larger costs on developing countries. For example, developing countries are more
heavily reliant on foreign-currency debt (Eichengreen, Hausmann, and Panizza
2005), and undervaluation makes it harder to repay these debts. Developed and

12. Henning (1994) and Farrell and Newman (2010) are rare examples of IPE scholarship that
recognize this important point. For further discussion of historical institutionalist theories of prefer-
ences, see Fioretos (2011), Steinmo (1989), Thelen (1999), and Thelen and Steinmo (1992).
13. The advanced industrial countries consist of the Australia, Canada, Japan, New Zealand, the
United States, and the eighteen countries that make up Western Europe.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 13

developing countries also have very different political structures, and the specific
institutional variables highlighted by my theory are much rarer in the developed
world.14 While my general arguments about the importance of interests and in-
stitutions should also apply to the industrialized world, the specifics are likely to
be quite different in developed countries. Excluding the developed countries helps
me provide a more detailed understanding of the politics of undervalued exchange
rates in the developing world, where the stakes of this policy are highest.

Evaluating the Argument

In order to corroborate my theory it is necessary to demonstrate that it provides
an accurate explanation of both when and how undervalued exchange rates emerge.
The conditional preference theory argues that undervalued exchange rates are most
likely when the manufacturing sector is powerful and the state controls labor and
financial markets. I argue that governments undervalue in these conditions as a
result of two distinct causal processes: (1) powerful manufacturing sectors have
high degrees of political influence over exchange rate policy; and (2) the manu-
facturing sector has a preference for undervalued exchange rates in countries with
state-controlled labor and financial systems. Since no single method is sufficient
for evaluating every aspect of the conditional preference theory, this book exam-
ines different types of data to assess various aspects of the theory. This book com-
bines national-level quantitative data, firm-level survey data, and qualitative case
studies of five different countries to provide a comprehensive evaluation of my
conditional preference theory.
As a first cut, it is necessary to examine general patterns in exchange rate val-
Copyright © 2015. Cornell University Press. All rights reserved.

uation across countries and over time. To this end, I gathered data on the exchange
rate level, the power of the manufacturing sector, and state control of labor and
financial systems for a large sample of developing countries between 1975 and 2006.
This quantitative dataset is crucial for assessing whether my theory accurately ex-
plains variation in the degree of exchange rate undervaluation across countries.
Quantitative data is also useful for assessing whether the preferences of the man-
ufacturing sector are context dependent. To help answer this question, I utilize a
survey of more than two thousand manufacturing firms from over fifty countries
fielded by the World Bank in 1999. This survey, which asked firms their opin-
ions about exchange rates, provides a unique opportunity to investigate whether

14. According to Cingranelli and Richards’s (2010) data, no developed state severely restricted
labor rights in 2006. In Micco, Panizza, and Yañez’s (2007) dataset, no developed state owned more
than 26% of its country’s bank assets in 2002, the most recent year with wide data coverage.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 14 INTRODUCTION

TABLE 0.2. Summary statistics of the five cases (%)

MANUFACTURING/ STATE-OWNED LABOR
COUNTRY GDP BANKS RESTRICTIONS OVERVALUATION

China (1993–2009) 33 100 100 −38

South Korea (1961–1979) 20 57 100 −21
Argentina (1966–2012) 27 35 0 14
Mexico (1970–1994) 22 24 0 −3
Iran (1953–1997) 9 43 100 25

Note: Overvaluation was constructed by the author using data from Heston et al. (2009), following the
methodology of Rodrik (2008). Positive (negative) values indicate that the exchange rate is overvalued
(undervalued). Manufacturing/GDP is manufacturing production as a percentage of gross domestic product,
using data from World Bank (2010). State-owned banks indicates the percentage of bank assets held by
state-owned banks; data are from Micco et al. (2007) for all countries except South Korea, whose data are
obtained from La Porta et al. (2002). Labor restrictions indicates the percentage of years in which governments
prohibited strikes or unionization and is coded based on Cingranelli and Richards (2010). Cingranelli and
Richards’s data starts in 1981 and therefore there is no data for Korea during the period of interest; since
Korea is coded as being labor restrictive for every year from 1981 to 1985, and labor restrictions were similar,
if not stricter, in the previous period, I imputed the values accordingly. Cell entries are the mean value for each
group, except for labor restrictions, which indicates the percentage of observations for that country coded as
restrictive. Chapter 2 provides more details for each variable.

manufacturing firms favor undervaluation and if labor and financial market in-
stitutions influence this preference.
These two sets of statistical analyses are extremely valuable for detecting when
countries undervalue the exchange rate and when firms support such policies.
However, quantitative analyses are less helpful at identifying the causal mecha-
nisms that influence exchange rate policy and produce the correlations observed
in the quantitative datasets. Qualitative case studies are better suited to this end.
The case studies in this book illuminate why and how state-controlled labor and
Copyright © 2015. Cornell University Press. All rights reserved.

financial institutions influence interest group preferences, and whether interest

groups truly impact government decisions about exchange rates. This book ex-
amines the politics of undervalued exchange rates in five countries: China, Ar-
gentina, South Korea, Mexico, and Iran. The analyses of China and Argentina are
based upon field research in these countries.15 The case studies of Korea, Mexico,
and Iran rely primarily upon the large secondary literatures on these countries.
Table 0.2 provides summary statistics for the main variables of interest in each
of the five countries. Although the case studies use much richer information to
code these cases, these quantitative indicators are useful for initial comparison.
Table 0.3 classifies the five cases according to whether they have weak or powerful

15. I gathered data in Argentina in August 2007 and September–November 2008, and in China
during July–August 2008 and March–April 2009. During that time, I conducted elite interviews and
collected primary documents.

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
 INTRODUCTION 15

TABLE 0.3. Case selection

LABOR AND MANUFACTURING SECTOR
FINANCIAL MARKET
INSTITUTIONS WEAK POWERFUL

PRIVATELY- Argentina (1966–2012)

CONTROLLED Mexico (1970–1994)

Iran (1953–1997) China (1993–2009)

STATE-CONTROLLED
Korea (1961–1979)

manufacturing sectors and whether the state controls labor and financial markets.
In two of the cases, China and South Korea, a powerful manufacturing sector
coexists with state control over the financial and labor system. Two other cases,
Argentina and Mexico, mix powerful manufacturing sectors with privately con-
trolled labor and financial systems. Finally, Iran has a weak manufacturing sector
and state-controlled labor and financial markets.16 Countries with weak manufac-
turing sectors and states that lack control over their labor and financial systems
would provide little analytical leverage because exchange rate policy is “over-
determined” in such cases.17 For this reason, this book does not include case stud-
ies of the latter type of country. I also do not include cases where the state controls
one type of market but not the other; my theoretical expectations are more am-
biguous in such cases.
I chose dates for the case studies based upon major political and economic turn-
ing points within each country. Since these countries underwent “critical junc-
tures” at different times, each case study covers a different period of time.18 The
studies of Argentina, Korea, and Iran begin with radical changes in each coun-
try’s political regime. The Chinese and Mexican case studies start with the inau-
Copyright © 2015. Cornell University Press. All rights reserved.

guration of a new President that initiates a major change to their country’s eco-
nomic model. The case studies of Argentina and China are brought as far forward
in time as was feasible. The other three cases end with important changes in gov-
ernment. For each country, I divide the analysis into several different sub-periods,
which means that there are multiple “cases” per country.

16. I focus on two cases of a powerful manufacturing sector with private controlled institutions
and one case with the opposite combination because the former type is more important theoretically.
Most theories expect industrialists to support undervaluation under these conditions. My condi-
tional preference theory expects this type of country to overvalue its exchange rate because industri-
alists are likely to oppose undervaluation in this context. As my theory makes fewer unique predictions
in the combination epitomized by Iran, it is less essential to study multiple such cases.
17. Hence, Mahoney, and Goertz (2004) call these “irrelevant cases.”
18. The decision to start and end each case study according to when each country experiences a
critical juncture follows the classic comparative historical approach of Collier and Collier (1991).

Demanding Devaluation : Exchange Rate Politics in the Developing World, Cornell University Press, 2015. ProQuest Ebook
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