An Unpleasant Real Exchange Rate Arithmetic

Real exchange rates influence the competitiveness of tradable goods produced in a country, and thus the latter’s external balance. In the short-run, real exchange rates are influenced by real, as well as monetary variables. With a view to maintain their competitiveness in international markets, exporters are expected not to prefer overvalued local currencies. Thus, the conventional wisdom suggests that the interests and lobbying power of exporters may be directed to the policy makers towards a healthier external trade and current account balance. This article studies the effect of import dependence and profitability/branding levels of export firms on their real exchange rate preference. A simple partial analysis model shows that high import dependence may tilt exporters’ preferences towards overvaluation, rather than equilibrium or undervaluation of the real exchange rate. The model also implies that this “unpleasant real exchange rate arithmetic” may trigger a vicious circle involving an increasing preference for overvaluation leading to an even higher import dependence. Intrinsic profitability/brand equity of exporters, may partially reverse this preference for overvaluation; so this anomaly may rather relate to relatively less developed economies.