The Wall Street Journal Interactive EditionEditorial Page
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December 20, 1996

The Americas
Mexico's Money Theorists Need
A Tip From Hong Kong


On the second anniversary of its latest devaluation disaster, Mexico remains in the intellectual grip of a notion economists call the "real exchange rate." The argument is that to "stay competitive," a nation has to depreciate its currency to offset internal inflation. That is, if Mexico has 20% inflation and the U.S. has 5% inflation, the peso has to fall so Mexican exports won't be priced out of U.S. markets.

So to avoid another peso disaster later, Mexico ought to devalue now, argues Rudiger Dornbusch, the MIT economist who's something of a cult figure in Mexico. Mexican inflation for the year will come in around 30% against 3% in the U.S., and today the peso trades around 7.8 to the dollar compared to around 7.5 a year ago. So it has become "overvalued," Mr. Dornbusch asserted in a recent Business Week column, and "the trade advantage from the 100% devaluation of the peso in 1994 and 1995 has been dissipating month by month. Mexico's big trade surplus is beginning to shrink fast and will soon disappear."

While Mexican officialdom doesn't buy Mr. Dornbusch's current conclusions, it does accept his intellectual apparatus. The peso "overshot" and was "undervalued" at the beginning of the year, officials believe, so is not "overvalued" just yet. The whole "real exchange rate" argument, indeed, depends on an arbitrary choice of a base year when the solar system was in "equilibrium" and the calculations of relative inflation rates can start. Mexicans may argue about which base to choose, and thus current "overvaluation" or "undervaluation." Mexicans who are willing to challenge the basic argument, though, are very few. (By my count, three.)

An 'Overvalued' Currency

$Hong Kong per $U.S. HK CPI U.S. CPI HK GOP (bn$U.S.) HKExports (bn$U.S.)
1984 7.82 70.6 103.9 33 28.3
1996 7.74 169.9 157.1 159 181.8
Change +0.8% 141% 51% 381% 542%

Mexican Financial History

Pesos/$ (1,000/1-1993) Avg. Yearly Growth (real pesos) 20-YR. Periods ($U.S.)
1955 12.5
1975 12.5 6.7% 13.5%
1995 6,413 2.7% 5.8%

Source: Bear Stearns

So as a test of the supposed doleful effects of an overvalued currency, let us depart a moment from the Americas and ponder the Hong Kong dollar, as recorded in one of the accompanying charts. Since the first full year of Hong Kong's currency board in 1984, its exchange rate has been rock solid, actually appreciating a tad against the U.S. dollar. Over that time, its consumer price index soared 141% against 51% in the U.S. The logic of real exchange rates tells us that the Hong Kong dollar is "overvalued" by about 90%. To create a "trade advantage" and spur growth Hong Kong should devalue forthwith. Yet under its currency board, it's somehow getting rich--its output has more than tripled since 1984, and its exports have soared more than 500%.

To return to the Western hemisphere, consider Mexico's own history. It has suffered four financial crises in less than 20 years, with traumatic devaluations in 1976, 1982, 1987 and 1994. The de facto exchange rate policy has been one devaluation per presidency, though Carlos Salinas held out until turning over the reins. The cumulative effect, correcting for the three zeros dropped in the 1993 currency reform, has been to take the peso from 12.5 to the dollar to 7,800 today.

Despite this record, Mexico was once a stable-currency country. The 12.5 rate held for two decades (until President Luis Echeverría blew Mexican finances by lurching to the left, presumably in compensation for his role as interior minister when troops fired on students in the infamous Tlatelolco massacre). So we have 20 years of exchange-rate stability and 20 years of successive devaluation. With the steady and no doubt "overvalued" peso, Mexico grew more than twice as fast as it did in the period when it repeatedly sought a "competitive" exchange rate.

The "real exchange rate," in short, is utterly detached from reality. What matters to the wealth of Mexico and its citizens is their collective command over world resources, and this needs to be measured by a world currency, in our era dollars. While the Mexican economy is growing this year, it will take many years to restore the dollar-denominated purchasing power wiped out in the 1994 devaluation. The actual effect of repetitive devaluation is to keep down the value of wages earned by ordinary Mexicans, who are paid in pesos, for the benefit of exporting industrialists, who earn dollars.

In this respect, the Hong Kong example is also instructive, in a way that supports another part of Mr. Dornbusch's argument. He argues that developing nations should tolerate inflation rates of up to about 20%. Indeed, Hong Kong's consumer price index has risen rapidly, as much as 11.6% a year, without disturbing either real growth or the exchange rate. Much the same thing seems to be happening under the newer currency board in Estonia.

What this inflation fundamentally represents is Hong Kong citizens getting rich. As Hong Kong wages are arbitraged to world levels, the consumer price index has to rise. In an even more basic sense, the purpose of the price system is to allocate resources where they're most needed and best used. It follows that rapidly developing nations will show higher inflation rates than declining ones. So it might be a mistake for a nation like Mexico to try to drive inflation down to zero, or even U.S. levels.

It is even more clearly a mistake, by the way, to aim for a zero trade balance. This is neither a normal nor necessarily healthy condition. Because the international accounts are an accounting identity, a trade deficit must by definition be offset by investment inflows. Since a developing nation needs investment, a trade surplus is a sign of sickness, not health.

So even if my three Mexican friends could persuade their countrymen that the "real exchange rate" is a snare and a delusion, puzzles remain. If you don't want to ratchet price increases down to U.S. levels, and you don't want to manipulate trade flows, what guideline remains? How do you distinguish between "good" inflation, caused by citizens earning higher world wages, and "bad" inflation, caused by financial excess and wayward monetary policy? What target should guide monetary policy at the Banco de Mexico?

Well, Mexico could always resort to the answer practiced by Hong Kong, and indeed Mexico itself in an earlier era--a simple answer made to order for either a trading island or a nation with a porous 2,000-mile border with the world's biggest and most advanced economy. To wit, the right inflation rate is the one you end up with after you've set monetary policy to stabilize the exchange rate.

Mr. Bartley is editor of the Journal.

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