Nonlinear effects of currency undervaluation on economic growth in Iran: Application of Smooth Transition autoregressive (STAR) models

One of the important issues that has attracted economists’ attention, is the increase of competitive power of export commodities through the currency undervaluation in order to achieve the optimal economic growth. Given that the exchange rate system in Iran is a managed floating exchange rate regime, and despite the market forces effect in determining the national currency value, it is expected that the monetary authorities intervene in the foreign exchange market to adjust the national currency value.
Exchange rate is one of the most volatile economic variables in Iran in the past two decades. In the recent years, Iran has repeatedly experienced the exchange rates increases. According to the Central Bank of Iran, in the last 25 years, Iran’s economy has experienced two exchange rate shocks; the first one from 1993 to 1999 and the second one from 2010 to 2011. From 2014 to the end of 2016, the growth rate of the dollar has declined compared to beginning of the period. But, in the early months of 2017, the economy has again experienced a rise in the exchange rates growth and the depreciation of national currency.
Some economists believe that the currency undervaluation will increase exports and reduce imports, and consequently will boost the economic growth. But, most experts believe that currency undervaluation damages Iran's economy by increasing foreign exchange revenues and consequently an increase in the size of the government and also by reducing the purchasing power of the people and high inflation level. Indeed, the currency undervaluation, on the one hand, impacts the basket of assets by reducing the purchasing power of money, and on the other hand affects the demand for import and export. Therefore, due to “imported” inflation, the economic growth will be reduced. China and other East Asian countries, such as the South Korea and Japan, experiences indicate an increase in economic growth through the currency undervaluation. Indeed, for a decade, some economists have refreshed the idea that an active exchange rate undervaluation strategy can efficiently stimulate growth. The revival of this idea has since triggered an intense debate opposing advocators of this claim. Therefore, it is possible that the relationship between currency undervaluation and the economic growth is nonlinear. More specifically, we provide answer to the following question: is there any nonlinear relationship between undervaluation of the Rial and the economic growth of Iran?
The main objective of the present study is to investigate the impact of the currency undervaluation on economic growth in Iran using annual data during the period from 1968 to 2014 in a nonlinear model framework. We calculated the Index of currency undervaluation using CPI of Iran and the United States, then we have adjusted the index according to Balasa-Samuelson effect. In order to answer the above mentioned question and to investigate the nonlinear impact of currency undervaluation on economic growth, we used a smooth transition autoregressive model which is estimated via Newton-Raphson algorithm and conditional maximum likelihood function. The results show that there is an asymmetric behavior of economic growth around a threshold level and different levels of currency undervaluation. In the linear regime (low level of undervaluation), a positive relationship exists between physical capital, size of government, human capital variables and economic growth. In the nonlinear regime (high levels of undervaluation) the relation between mentioned variables and growth is negative. All of our results are consistent with the economic theories. According to the results and in order to achieve the desired economic growth and to avoid the negative effects of national currency undervaluation, this study suggests that monetary authorities avoid to lower excessively the Rial value against other currencies.