The Exchange Rate and Endogenous Productivity – Reverse Causality?

The conventional argument on causal linkages between the exchange rate and productivity focuses on the Balassa- Samuelson (B-S) hypothesis (Balassa 1964; Samuelson 1964).

This is based on the traditional open macroeconomic theory that looks upon productivity as exogenous relative to the nominal exchange rate as well as the exchange rate regime. The B-S hypothesis states that the trends in real exchange rates are accruable to differential trends in the relative price of non-traded goods. These differential trends are in turn driven by differences in national productivity growth rates. However, the B-S theory does not offer any explanations as to the sources of productivity growth rates.

In recent years, the reverse causality issue of whether real exchange rate depreciations have negative consequences on productivity flows has been a central debate in Canada. This has been a result of the substantial depreciation of the Canadian dollar observed in the 1990s.

In particular, Harris (2001) has argued that exchange rate depreciations have a negative long run impact on labour productivity. In turn, this may explain the widening Canada – US productivity gap. As such, Harris (2001) also argues that the widening productivity gap between Canada and US can be seen as a more persistent problem for a small, open economy like Canada. Under a floating exchange rate, it is possible for a small open economy to face a structural transition problem when its major trading partner has undergone a major technological transition. This argument seems plausible for both Canada and Australia. The United States has emerged as a ‘new economy’, and hence the term ‘old economy’ has been coined and applied to Australia, Canada as well as countries in Europe.

The reverse causality link which postulates that exchange rate depreciations can negatively influence labour productivity appears to be a concept applicable to Australia given the substantial long-term depreciation of the Australian dollar against most of its trading partner’s currencies, as well as big swings in the Australian dollar relative to trend that have been observed since the float in 1983. Particularly, in the 1990s, the trade weighted Australian dollar (TWI) has depreciated by more than 10 percent on 4 different separate occasions (Macfarlane 2000).

On the other hand, authors such as Macfarlane (2000) argues that beliefs on Australia being the ‘old economy’ are extremely exaggerated and without fundamental economic substance. As such, he believes that these views will fade. In addition, he also argues that in terms of the growth of labour productivity and multi-factor productivity, and the extent of capital deepening, Australia has matched or even exceeded the remarkable US performance. However, while Australia’s productivity growth reached record highs in the 1990s, it does appear that it remains in a catch- up mode from an international perspective.

In fact, while Australia was at 83 percent of the US’s productivity level in 2003 level, this

was only slightly above where the economy was at in the 1950s (Productivity Commission 2003).

In the following sub-sections, explanations as to how exchange rate movements can affect productivity negatively and positively will be elaborated. Figure 3.1 illustrates the three main propositions of a reverse causal relationship (real exchange rate to productivity) as well as their association with standard of living.

Figure 3.1: The Relationship between the Real Exchange Rate, Productivity and Standard of Living

Supplies and employment rates of productive factors (labour, capital)

“Factor-cost” Channel

3.2.1 Relative Factor Cost Hypothesis

This hypothesis postulates that exchange rate movements affect absolute and relative costs of capital, labour and other factors of production. Hence, this alters the accumulation of different forms of capital and relative factor use. In accordance, labour productivity can be affected in two ways. It will not only be affected by the possible impact of the exchange rate on the acquisition and use of new technology, but also by a possible shift in the

“Innovation Gap” Channel

“Sheltering” Channel

“Balassa-Samuelson” Channel Real Exchange Rate

(level) & volatility PRODUCTIVITY STANDARD

OF LIVING

Technological Change

allocation of capital and other factors per worker. Authors such as Lafrance and Schembri (1999) suggest that on the whole, labour productivity is positively related to the ratio of capital (and other factors) per worker.

The relative factor cost hypothesis works by allowing for a higher cost of production to be

here are several instances whereby this channel can affect capital/labour ratios and hence

we also assume that there is unemployed labour then as the cost of capital goods incurred and the substitution of factors of inputs to take place. When the real exchange rate depreciates, the cost of foreign goods, like imported machinery and equipment, rises in real terms relative to labour, plant and other sources of production for a country like Australia.

In such a small open economy, a real exchange rate movement results in a change in the relative price of traded and non-traded goods. This can influence the allocation of factors of production across the two sectors, and hence affect labour productivity.

T

labour productivity. Firstly, assume there are only two factors of production (capital and labour) and there is always full employment of both factors. If the capital/labour ratios in the two sectors are equal and fixed, a real exchange rate movement that results in a reallocation of capital and labour will not affect labour productivity. However, now assume that traded goods are capital intensive as well. Real exchange rate depreciations will cause relative prices to change. As a result, the traded goods sector will expand and the non traded goods sector will contract. The reallocation in resources will cause the capital/labour ratios, labour productivity levels as well as real wages to fall in both sectors.

This accrues to the fact that labour and capital will move from the relatively labour-rich and capital-poor non traded goods sector into the relatively labour-poor and capital rich traded goods sector.

If

increases, there will be a substitution of labour for capital in the production process. In this case, capital/labour ratios and labour productivity will decline in both traded and non traded sectors as unemployed labour becomes employed. Hence, the real exchange rate depreciation reduces the real wage and increases employment in this instance. Therefore,

exchange rate depreciations can affect the absolute and relative costs of capital, labour and other factors of production. In turn, these exchange rate movements are able to influence productivity.

3.2.2 Innovation Gap Hypothesis

is proposed by Harris (2001), it has been argued

oor performances in R&D and innovation are plausible explanations for a lagging

According to the innovation gap hypothes

that nominal exchange rate depreciations increase the relative price of new technology and of technology workers in a country like Australia. The endogenous productivity growth model developed by Saint-Paul (1993) explains this phenomenon succinctly. In this model, firms must substitute between product-enhancing activities such as research and development (R&D) and output expanding activities in the short run. Hence, according to this view, depreciations increase the tendency for Australian firms to shift resources from technology-producing activities to output expansion, slowing down overall productivity growth.

P

productivity growth. It has been argued that the information industries are both key drivers of the global knowledge economy and the central sources of growth for modern economies (Houghton 2001). Moreover, those OECD countries with significant Information and Communications Technology (ICT) ⁷ producing sectors have enjoyed the fastest productivity growth during the 1990s. Dirk and Anita (2005) have also concluded that in countries like Finland, Ireland and Korea, close to 1 per cent of aggregate labour productivity growth over the 1995-2001 period was due to strong productivity performance of the ICT manufacturing sector. Similarly, in Japan, Sweden and the United States, the ICT-producing sectors have also contributed significantly to productivity growth. Hence,

7 The ICT sector is that part of the economy which produces information technology and telecommunications goods and services. The ICT sector in Australia includes telecommunication services, computer services, and selected manufacturing and wholesale trade industries. While some countries also include radio and TV services within the ICT sector, this has not been included in Australia.

productivity in ICT production appears to be a significant driver of overall productivity growth in many developed countries.

As such, the Australia – US productivity gap has been attributed by a number of observers to the existence of an innovation gap between Australia and US:

(i). According to Australian Bureau of Statistics (ABS) figures released each year, business expenditure on research and development (BERD) as a proportion of Australia’s Gross Domestic Product (GDP) had started to fall after a peak of 0.88 per cent in 1995-96. The ABS figures showed that this proportion fell to 0.80 per cent in 1996/97, 0.67 per cent in 1998-99. Over the period 1998-1999, most other Organisation for Economic Co-operation and Development (OECD) countries increased their BERD/GDP ratios. In 1999-2000, the BERD/GDP ratio fell another 3 per cent to $4.05 billion – 15.6 per cent lower than its historic peak in 1995-96 (ABS 2000a). Vermeesch (2001) noted that during that period, taking R&D as a proportion of GDP, only Hungary, Italy, Spain and Poland invested less than Australia.

Although the BERD/GDP ratio increased to 0.72 and 0.78 percent in 2000-01 and 2001-02 respectively, this ratio remains much lower than the peak of 0.88 percent in 1995-96.

Moreover, Charles (2001) also noted that even when the peak was reached in 1995-96, Australia’s BERD/GDP ratio still lagged behind the OECD average of 1.24 per cent. In addition, the R & D intensity of 4.2 percent for the manufacturing industry was about half the intensity OECD countries were achieving.

(ii). ABS figures also pointed out that although business expenditure on R&D grew by 2 per cent⁸ between 2001-02 and 2002-03, the BERD/GDP ratio in current price terms has decreased from 0.81 per cent in 2001-02 to 0.79 per cent in 2002-03. As we can see, the most recent data has shown us that R&D investment as a proportion of GDP has declined

8 This is the figure after the effect of changes in prices, wages and salaries removed (i.e. chain volume measures) have been taken into account.

(ABS 2004). Moreover, Australia has not hit the peak of 0.88 per cent since 1995-96 and does not appear to be close to hitting it in accordance with ABS figures.

(iii) Finally, Considine, Marginson and Sheehan (2001) have shown that while exports of knowledge intensive goods increased faster than imports between the mid 1980s and the mid 1990s, the reverse occurred after 1995-1996. As Australia failed to invest in knowledge and knowledge-based industries earlier on, the nation is currently experiencing a growing trade deficit in knowledge-intensive products such as pharmaceuticals, computing equipment, telecommunications and road vehicles. According to the authors, the deficit in knowledge-intensive products is sufficient to explain Australia’s overall negative trade balance and the dramatic growth of foreign debt. As a result, it has been argued that this deficit in knowledge-intensive products has been significant in shaping international perceptions of Australia as an ‘old economy’. Of which, this have fed into the weakening market position of the Australian dollar.

3.2.3 Exchange Rate Sheltering Hypothesis

The exchange rate sheltering hypothesis is similar to the ‘lazy manufacturers hypothesis’

as coined by MacCallum (1999). This hypothesis proposes that real exchange rate depreciations protect Australian firms from external competitive pressures. It has been argued that exchange rate depreciations provide Australia with a cost advantage and hence increase Australia’s competitiveness against countries like the US.

In fact, the exchange rate sheltering mechanism is not a new idea. Porter (1998) makes the following observation which explains the exchange rate sheltering idea in a quite succinct manner.

“The more serious problem with devaluation, however, is its effect on the process of upgrading in an economy. The expectation of a lower exchange rate leads firms towards a dependency on price competition and towards competing in price-sensitive market

segments and industries. Automation and other forms of innovation that improve productivity slow down, and the shift to higher-order competitive advantages is retarded.

The best case for devaluation (as a means for driving long run growth) is for nations relatively early in the stages of competitive development (factor-driven or investment-driven). Even here, however, an over reliance on policies that artificially hold back currency appreciation will ultimately block advancement” (Porter 1998, p. 642).

Changes in the degree of competitiveness can influence labour productivity through the following channels:

Firstly, limited managerial resources may cause firms to shift investments from productivity-enhancing and upgrading activities to output expansion type of activities. This reduces the reallocation of resources from low growth to high growth sectors. According to Lafrance and Schembri (1999), an inherent assumption underlying this mechanism will be that firms’ managers are ‘satisficing’ to a certain extent and are not profit-maximisers. This allows managers to feel ‘protected from external forces’ due to the cost savings from depreciations. As a result, aggregate productivity growth is slowed down.

Secondly, exchange rate depreciations can affect entry and exit decisions. Due to the cost advantage created by depreciations, firms are not forced to undertake upgrading, productivity-enhancing activities or cut costs. As a result, low productivity firms that would have exited in the absence of depreciations remain in the industry. In turn, these low productivity firms tend to reduce productivity growth.

It has also been noted by Grubel (1999) that upon depreciation, entrants that were previously considered marginal in contestable industries⁹ may now find it profitable to enter. This will result in the productivity growth in the industry being driven down as a whole as the output share of the low productivity group increases. Finally, in the case whereby economies import technology and capital equipment necessary for upgrading,

9 Contestable industries are defined as industries that have low entry costs.

depreciation under the assumption of sticky wages can possibly move from being capital intensive to labour intensive. As a result, productivity is lowered.

While the three channels discussed earlier argue that exchange rate depreciation will lead to a decline in labour productivity in Australia, it should be reiterated that it is possible for the traditional competitiveness approach¹⁰ to be in place in Australia as well. This approach emphasises the positive impact of exchange rate depreciation for growth. In the closed economy business cycle literature, a positive demand shock can increase productivity growth through several factors such as increased factor utilisation, learning-by-doing effects, or increasing returns to scales. More specifically, this idea emphasises that the major sources of productivity are output growth and increases in market shares, which are driven by price competition. Theoretically, this idea proposes that exchange rate depreciations will increase international price competitiveness, thus increasing output growth and hence resulting in improvements in productivity. In addition, the competitiveness approach also argues that persistent exchange rate depreciations could result in sustained cost advantage for the country which the currency has depreciated, leading to improved export performances. In turn, using standard infant-industry arguments, the improved export performances can lead to an increase in productivity.