Exchange rate volatility and productivity growth: The role of financial development

GAICIL Insights

A result of no effect on average can hide an effect that matters enormously for some.¹ Exchange rate volatility and productivity growth: The role of financial development, by Philippe Aghion, Philippe Bacchetta, Romain Rancière and Kenneth Rogoff, overturns a long-standing empirical result. The literature has long found that exchange rate volatility has small or insignificant effects on real activity. The authors show that real exchange rate volatility can significantly affect productivity growth, with the effect depending critically on a country's financial development.

Interaction is the key. Looking at exchange rate volatility in isolation misses the point; its interaction with both the level of financial development and the nature of macroeconomic shocks is what matters. In countries with thin capital markets, where financial shocks are the main source of macroeconomic volatility, higher exchange rate volatility can stunt growth. In financially developed countries, the effect is much weaker. The same currency swing is a ripple in one economy and a wave in another.

The results are robust to the time window, alternative measures of financial development and volatility, and outliers. A simple monetary growth model shows real exchange rate uncertainty exacerbating the negative investment effects of domestic credit market constraints. Firms facing credit constraints and exchange rate uncertainty cut growth-enhancing investment, lowering productivity growth.

Standard prescriptions need revising. Classical literature holds that the greater the volatility of real shocks relative to financial shocks, the more exchange rate flexibility a country should allow. This analysis suggests modifying that prescription to account for amplified financial market shocks in developing countries with thin, poorly developed credit markets. More fully articulated structural models are needed to measure the trade-offs. Exchange rate advice written for deep financial markets may mislead shallow ones.

Where does this leave AI? Artificial intelligence investment in an interconnected world faces this exact risk. AI investment in developing and emerging economies depends on access to finance and macroeconomic stability. Exchange rate volatility interacting with weak financial development can depress growth-enhancing investment. Countries seeking to attract and sustain AI investment may benefit from financial development and macroeconomic frameworks limiting volatility's damage. A currency crisis can quietly cancel a national AI strategy.

Financial depth is the shield. Deeper markets let firms hedge risks and maintain investment despite volatility. AI-intensive activities, relying on long-term investment and often on imported technology and services, may need financial depth especially. Developing financial markets reduces vulnerability to exchange rate shocks and supports technology investment. For an economy importing compute priced in foreign currency, hedging is an AI policy.

Shock sources matter. Where financial shocks dominate, exchange rate volatility does more damage. Understanding volatility's sources helps policymakers choose exchange rate regimes and complementary policies.

The paper reconciles conflicting evidence constructively. The apparent irrelevance of exchange rate volatility in aggregate studies may reflect averaging across countries with different financial development. Accounting for heterogeneity reveals significant effects where financial systems are weak. Averages across very different economies can manufacture a false null.

The model explains the mechanism. When firms face credit constraints and real exchange rate uncertainty together, the risk that a project cannot be financed to completion rises, and firms scale back productivity-raising investments.

For international economic policy, financial development and exchange rate policy should be considered together. Developing economies may need to prioritize financial deepening to benefit from flexible exchange rates, or adopt regimes reducing volatility while financial systems develop.

The thread running through it all: volatility's effects depend on institutions. Exchange rate volatility can stunt productivity growth where financial markets are thin and has muted effects where they are deep. As AI investment becomes central to growth globally, financial development and macroeconomic stability will help determine which economies can sustain the long-term investment needed to benefit from the technology.

One question to put to emerging economies chasing AI investment: before the data-center subsidy, deepen the bond market. In thin financial systems, currency volatility may act as a heavy tax on long-term technology investment.