How exchange rate policy reshapes global supply chains and productivity growth

Global current account imbalances are widening again. This column argues that currency undervaluation, supported by reserve accumulation under capital controls, can permanently reshape industrial structure and raise manufacturing productivity. Panel evidence from 45 countries shows that this policy mix expands manufacturing employment, firm entry, and domestic sourcing of intermediate inputs. A model with firm dynamics and trade hysteresis explains why: sustained exchange rate policy can induce firm entry and exit, reallocating firms across countries and expanding the domestic capture of supply chains. The effect of the policy on the trading partner hinges on whether foreign firms are pushed to exit.

Global current account imbalances are widening again. China’s surpluses have prompted warnings of a second ‘China shock’, and research on exchange rates and industrial policies is proliferating in response. Gourinchas et al. (2026) recap the prevailing prior on the instruments involved: tariffs barely move external balances, and successful sector-specific industrial policies should, if anything, shrink surpluses. The macro policies that do reliably generate surpluses ― among them reserve accumulation with capital controls, which is the capital account policy we study ― do so by suppressing domestic consumption. Yet recent work leaves doors open on every side. Ottonello et al. (2025) show that currency undervaluation can raise welfare ― an ‘exchange rate industrial policy’ ― but only in an economy converging to the frontier, and in a small-open-economy setting silent on trading partners. On the receiving side, Benigno et al. (2025) show that persistent capital inflows from high-saving countries shrink the US tradable sector and depress innovation ― a ‘global financial resource curse’ ― though those flows stem from saving propensities rather than explicit policy. And Rodrik (2016) and Sposi et al. (2026) document that industrialisation has polarised across countries ― the cross-country variance of log manufacturing shares more than doubled between 1990 and 2011 ― driven in their model by trade specialisation, with trade imbalances left exogenous. Missing from the middle of this picture are the policy that generates the imbalances, and the margin through which it durably moves productivity.

In recent research (Bergin et al. 2026), we supply both. We propose a mechanism linking exchange rate policy to structural change and productivity growth through a ‘production relocation’ externality familiar from trade theory (Ossa 2011): sustained undervaluation promotes entry of manufacturing firms and redirects supply chains towards domestic suppliers. Our mechanism reflects a long-standing understanding in the development literature that a greater variety of specialised inputs is integral to structural change (Matsuyama 2008, Rodrik 2008). Because our framework has two countries, it speaks to both sides of the China shock debate.

Capital account policy and firm dynamics: Evidence from 45 countries

Essential to our empirical work is a two-part measure of capital account policy: capital controls combined with reserve accumulation. Compared to undervaluation measures used in the literature, this indicator is more plausibly exogenous and certainly easier to measure. The balance of payments identity makes the logic transparent: reserve accumulation under full capital controls directly implies an equivalent trade surplus, which is the trigger of our growth mechanism. This sidesteps contentious debates over the equilibrium benchmark for undervaluation and the relevant trade elasticity.

That this policy mix moves the current account is not in dispute (Choi and Taylor 2022), and our earlier work showed that it is associated with faster economic growth (Bergin et al. 2023). The question here is what happens on the supply side while the surplus lasts, and which firm-level adjustments account for the productivity gains. Using panel data for 45 countries ― 22 emerging markets and 23 advanced economies ― over 1985–2007, we document that capital account policy raises labour productivity growth in manufacturing but not in non-tradables. The effect is large: an economy that fully restricts its capital account and raises reserves by one percentage point of GDP per year enjoys manufacturing labour productivity growth higher by roughly 1.3 percentage points over five years. We ask through which channels this operates.

First, capital account policy expands the manufacturing sector: the interaction of capital controls with reserve accumulation significantly raises the manufacturing share of employment. This resonates with Rodrik’s (2016) observation that Asian economies ― in our sample, those with high reserves and relatively closed capital accounts ― have resisted the premature deindustrialisation seen elsewhere.

Second, the evidence points to greater firm entry, measured either as the extensive margin of exports or the number of firms listed on domestic exchanges. The policy thus expands the set of exporting activities rather than raising sales by existing exporters.

Third, capital account policy raises the share of intermediate inputs sourced domestically. This is a distinctive prediction of our supply chain mechanism, and motivates the theory that follows.

From trade surplus to productivity: A model of supply chain capture

To interpret this evidence, we build and simulate a dynamic two-country general equilibrium model. In a highly simplified policy environment, one country prohibits private international capital flows, and its government accumulates reserves sufficient to engineer an undervaluation that generates a target trade surplus. Standard solvency and intertemporal constraints imply a reversal after the policy ends, with eventual appreciation and a trade deficit, yet the effects on industrial structure endure. The traded (manufacturing) sector features firm entry subject to a one-time sunk cost and a fixed continuation cost ― the configuration that generates trade hysteresis in the sense of Baldwin (1988) ― roundabout production, in which firms use domestic and imported manufactured goods as intermediate inputs, and firms with a finite planning horizon. 

The experiment is calibrated roughly to the Chinese experience: the home government purchases reserves at 5% of GDP annually for ten years and then holds the stock constant, implying a peak close to 50% of GDP ― approximately China’s holdings in 2014. 

The transition exhibits the cost the sceptical view emphasises: home consumption falls and labour supply rises while reserves accumulate, temporarily lowering home utility. But something else happens at the same time ― the number of home manufacturing firms rises by 7.5% after five years (Figure 1). The firm value panel shows why the expansion is permanent: the surge in export profits pushes firm value to the entry threshold, drawing in new firms. Even after the policy ends and export profits fall, firm value declines but remains above the exit threshold. No firm exits, and the policy leaves a permanently larger number of firms.

Figure 1 Simulation of benchmark model

Notes: Impulse responses to a home reserves policy of purchasing reserves worth 5% of GDP annually for ten years. Vertical axes show percent change from the value prior to the change in reserves policy; horizontal axes show years.

As new home firms enter, the share of domestic varieties in the intermediates bundle rises and the price index of manufactured inputs falls. This is the heart of the mechanism, which we call domestic capture of the global supply chain: as firms source more specialised inputs from nearby suppliers, the domestic manufacturing sector grows more complex and measured labour productivity rises. The externality is analogous to that of Ossa (2011), but where Ossa studied consumer gains from saving on trade costs, here the cost saving accrues to firms through cheaper intermediates, amplified by roundabout production.

After a brief dip on impact, home manufacturing labour productivity rises ― tracing the path of firm entry ― and remains permanently about 3% above its initial level. The benchmark model accounts for 45–54% of the productivity effect estimated in our regressions; with a higher but still defensible intermediate input share, it accounts for all of it. 

Once we account for the long-run productivity gains, the conventional welfare critique is overturned. During the policy, home households pay the real cost it emphasises: financing reserve purchases forces higher saving, lower consumption, and more work. Where saving and investment are the whole story, that suppressed consumption is a deadweight sacrifice. In our framework, it finances something durable: a permanently larger variety base and cheaper domestic intermediates ― an external benefit that individual firms would not take into account. Once the policy ends, consumption and leisure rise on the back of permanently higher productivity, and the reserves policy raises home welfare by 1.55% in consumption-equivalent terms.

Strikingly, in this benchmark case, foreign welfare also rises, by 0.72%: the policy is not even beggar-thy-neighbour, as the foreign country benefits from cheaper imported varieties and from its own firm entry once the trade balance reverses.

When the policy is beggar-thy-neighbour: Foreign firm exit

Figure 2 shows the same experiment under an alternative initial condition, in which foreign firms begin at the exit threshold rather than the entry threshold, making them vulnerable to even a modest fall in profits.

Figure 2 Simulation of model with foreign firm exit

Notes: Impulse responses to the same reserves policy as in Figure 1, under the alternative initial condition that foreign firm value starts at the exit margin. Vertical axes show percent change from the value prior to the change in reserves policy; horizontal axes show years.

Home outcomes are nearly identical to the benchmark. However, the fall in profits now triggers substantial exit: the number of foreign firms falls by 6.9% by year five ― comparable in size to home entry ― and the loss is permanent. Foreign welfare falls by 1.57% in consumption units. 

The lesson is sharp: whether a reserves policy helps or hurts a trading partner hinges on whether it induces foreign firm exit. For countries on the receiving end, the intertemporal budget constraint offers some hope ― the imbalance must eventually flip, and when it does, it can spark a recovery in firm entry. But if the initial contraction destroys firms, the deindustrialisation is permanent, and no reversal of trade flows undoes it. Our mechanism thus adds a policy-based driver to accounts of industry polarisation built on technology and trade costs: the trade imbalances that Sposi et al. (2026) treat as exogenous are, in our framework, the product of policy ― and one country’s industrialisation by exchange rate policy can be another’s premature deindustrialisation.

Conclusions

The growth success of China and other Asian economies has spurred enduring interest in reserve accumulation and undervaluation as instruments of export-led growth. While reserve accumulation under capital controls suppresses consumption during the transition, sunk entry costs generate hysteresis and roundabout production transmits variety gains to productivity. 

Two implications follow. First, differences in capital account and exchange rate policies may help explain the growing polarisation of industrialisation: undervaluation that promotes manufacturing in some countries implies premature deindustrialisation in others. Second, for the long-run relationship between China and the US, our analysis identifies conditions that determine whether US deindustrialisation is reversible ― the configuration of fixed and sunk costs governing firm dynamics determines whether manufacturing dynamism revives once the long-run equilibrium emerges. 

Source : VOXeu