Behavioural​ equilibrium real exchange rates and misalignments: Evidence from large emerging markets

In order to contribute to the debate on whether exchange rate under-valuation was a major factor in global trade imbalances that culminated in the 2008 Global Financial Crisis (GFC), we estimate long-run equilibrium real exchange rates (ERER) for a panel of eight large emerging market economies (EMEs) over 1995–2017 based on structural factors. These include EME-AE (advanced economy) differentials in productivity, dependency and financial development, along with factors like trade openness, sectoral relative price and fiscal procyclicality. Amongst the dominant factors, we find that rising relative productivity appreciates ERER, but is offset by an almost equal depreciation from financial development. Estimated misalignments show both EME under- and over-valuation before the GFC, with under-valuation more prominent in Russia and Turkey. China, India, Indonesia and Mexico were experiencing a correction towards equilibrium from over-valued rates a year or two before the GFC. Post-GFC appreciation in EME ERERs compared to pre-GFC years indicates convergence in EME-AE prices, but misalignments were more in the zone of under-valuation during the period. The absence of substantial under-valuation in pre-GFC years indicates that EME RER misalignments were not a major cause of the GFC. Impulse responses show the limited impact of misalignments on current account imbalances, suggesting that the incentive to devalue was low.