Developmental states and undervalued exchange rates in the developing world

This paper investigates why some developing countries maintain weak and undervalued exchange rates while others do not. I argue that one key feature of the ‘developmental state’ – namely, state control over the financial system – contributes to an undervalued exchange rate. However, state control of finance promotes undervaluation under a narrower set of conditions than most developmental state theories suggest. State-owned banks increase support for exchange rate undervaluation from certain interest groups. When those interest groups are politically important, state-owned banks encourage policymakers to undervalue their exchange rates. Two sets of empirical analyses support the argument. Using time-series – cross-sectional data, I show that state-owned banks are associated with undervalued exchange rates, but only in developing countries with large manufacturing sectors. Second, analyses of firm-level survey data reveal that state-owned banks increase the manufacturing sector's support for an undervalued exchange rate. These findings suggest that state institutions influence exchange rate policy, though their effects are contingent upon the configuration of interests in society.