Standard economic theory predicts that a devaluation that changes relative prices can raise growth by boosting international competitiveness only in the short term. In Discussion Paper No. 970, Andrea Boltho argues that such a devaluation may nevertheless have sustained effects on non-price competitiveness if foreign competitors are permanently displaced or the additional profits from the devaluation are used to open markets, improve product quality or finance R&D spending. Since investment responses of this type are more likely to arise under fixed rates than a float, when real exchange rate depreciations may be viewed as temporary, Boltho focuses on four West European countries in the Bretton Woods era. Germany and Italy's initial choices of parities in 1948-9 allowed them to enjoy low exchange rates in the 1950s, and devaluations by France and Spain in the late 1950s enabled them to maintain a competitive price advantage for much of the 1960s.

Measures of output growth, investment ratios and export market shares suggest that Germany and Italy benefited from `export-led' growth in the 1950s and that all four countries underwent structural transformations in the composition of their exports and strengthened their presence in markets for goods whose shares of world trade were increasing (especially machinery). This provides some support for the view that low exchange rates improved non-price competitiveness, but the four economies' rapid opening to foreign competition during this period may also have played a role in enhancing their competitiveness. Boltho maintains that both effects were probably at work and that this combination of liberalization with a low exchange rate was optimal. This devaluation may have overcome political opposition to trade liberalization and this package also enhanced competition, profits and investment !] opportunities both at home and abroad. Boltho cautions, however, that this strategy of export-led growth via devaluation, which was viable when accompanied by liberalizing measures under quasi-fixed exchange rates in the Bretton Woods era, would be unlikely to work in Europe today. Most trade barriers (outside agriculture) are very low already and greater currency flexibility has reduced the responsiveness of investment to changes in real exchange rates that are often viewed as merely transitory.

Convergence, Competitiveness and the Exchange Rate
Andrea Boltho

Discussion Paper No. 970, June 1994 (HR)