Do Real Exchange Rates Follow a Non-Linear Mean Reverting Process in Developing Countries?

In an effort to fight relatively high inflation, many developing countries try to manage their nominal exchange rates through official intervention. In addition, developing countries tend to have high transportation costs, tariffs and non-tariff barriers. These factors are among the sources of generating nonlinearity in real exchange rates and hence some nonlinear adjustment towards purchasing power parity (PPP) in developing countries. In this paper, we employ monthly real effective exchange rate data from 88 developing countries and test the null of nonstationarity versus an alternative of linear stationarity by the means of a conventional unit root test and compare the results to those obtained from a new test in which the null is the same but the alternative hypothesis is non-linear stationarity. The latter test supports the PPP theory in twice as many developing countries as the former test, suggesting that nonlinear adjustment towards PPP in developing countries is an important phenomenon. Reported country characterizes indicate that PPP holds more often for high-inflation countries and for countries with high flexibility in their exchange rates