1. Introduction
How do exchange rates affect international trade flows? This has been a recurrent question in the trading community. As the WTO Director General Pascal Lamy recently put it: ‘Exchange rates are, and have always been, a highly sensitive subject in the WTO’ (Lamy, Reference Lamy2012). The sensitivity of this relationship probably has more than one source. First, exchange rates are endogenous variables that result from the complex interaction of macroeconomic, financial, and trade determinants. But from the perspective of individual traders, currency movements are exogenous. The uncertainty and costs associated with exchange rate fluctuations may, therefore, be a reason for the frustration of producers. Second, exchange rate volatility and prolonged deviations of currencies from their equilibrium levels often impose costs on the real economy that are asymmetric between different types of producers and between different economies. These asymmetries may interfere with international competition and distort the efficient allocation of resources between different activities. Third, as highlighted by Irwin (Reference Irwin2011), international trade and monetary relations have certainly undergone more than one period of tension in the course of history, a reflection of their intertwined nature. After the recent financial crisis, as in previous periods of distress for the world economy, exchange rates are perceived to be a transmission belt of financial shocks to the real economy and a vector of ‘monetary dumping’.
Revisiting the question of the trade impact of exchange rates is, therefore, a useful exercise to help policy-makers distinguish perceptions or prejudices from more systematic effects embedded in the theory and the empirical evidence: to separate the ‘is’ from the ‘ought’, as David Hume would have said. This is particularly important to avoid ill-designed policy responses by frustrated governments – such as trade protectionism – based on (more or less justified) accusations of beggar-thy-neighbour behaviour of trading partners.
In recent decades, the economic literature on the relationship between exchange rates and trade has followed the evolution of the policy debate. From the perspective of the trade policy community, two key issues stand out: exchange rate volatility and currency misalignments (i.e. an exchange rate that is above or below the equilibrium exchange rate). A first batch of literature emerged after the end of the gold exchange standard, during the 1970s through the 1990s, focusing on the impact of exchange rate volatility on the incentives to trade – a logical outcome of the increased levels of currency volatility caused by the end of the fixed (but adjustable) system of exchange rates. The effects of currency misalignments gained more prominence after 2000, when sustained deviations of exchange rates were suspected, rightly or wrongly, to be at the origin of global current account imbalances. Still, during this period, the discussion on volatility continued and somewhat expanded, in parallel.
In reviewing the literature, we focus first on the trade impact of exchange rate volatility and then turn to currency misalignments (Sections 2 and 3, respectively). In each section, we begin with a discussion of the theoretical arguments that underpin the relationship between exchange rates and trade, before turning to the review of the empirical evidence. Section 2 emphasizes the cost of uncertainty to traders generated by high volatility, while Section 3 mostly focuses on the potential of misalignments to create short-run and lasting effects on resource allocation and export growth. In both sections, we depart from the basic ‘theory/evidence’ structure to provide an in-depth discussion of certain specific areas of on-going research (e.g. currency unions, the impact of exchange rates on heterogeneous firms, global value chains, and trade policy). While inevitably subjective and non-encompassing, these discussions provide insights from the academic literature on issues that are at the forefront of policy concerns.
A word on what is not included in this survey: the issue of rebalancing the global economy. This has been one of the key policy objectives of the international community in recent years. Adjustment of real exchange rates is unquestionably a component of global rebalancing (as the theory predicts, real exchange rates will adjust, whether through nominal rates or prices). But this debate is clearly much broader than the effect of exchange rates on trade: the distortions that are at the origin of global imbalances are primarily macroeconomic and structural. A narrow trade view would therefore be inappropriate given the complexity of the underlying factors (Blanchard and Milesi-Ferretti, Reference Blanchard and Milesi-Ferretti2009). For this reason, we abstract from the broader debate on the impact of exchange rates adjustment and the reduction of global current account imbalances.
The paper is organized as follows. Section 2 focuses on the effect of exchange rate volatility on trade flows. Section 3 studies the impact of currency misalignments on trade. Concluding remarks that summarize the main messages follow.
2. Exchange rate volatility and trade
After a period of 30 years of relatively stable nominal and real exchange rates under the Bretton-Woods system, increased volatility of exchange rates from the early 1970s triggered a rich and lively debate on the channels through which such increased volatility could affect the real economy. The concerns of the trading community, which had negotiated substantial reductions in border protection when the Gold Exchange Standard determined exchange rates, were particularly strong. At the request of the then Director-General of the GATT, the IMF examined the effects of greater exchange rate volatility on global trade. While arguing that there are several channels through which exchange rates could affect trade, the IMF (1984) highlighted the role of exchange rate risk. This was in line with the early (1970s and 1980s) theoretical analyses of the relationship between exchange rates and international trade. These studies focused primarily on the commercial risk involved in conducting international transactions and the uncertainty generated by short-term or longer-term volatility. The question of how this uncertainty affected the decision to trade, its expected profitability, and eventually the allocation of resources between tradable and non-tradable goods and services was, then, the main target of attention.
Below, we review the literature on exchange rate uncertainty and trade, starting from the earlier contributions and following the evolution of the academic debate. We first analyze the theoretical arguments on how currency risks may affect trade flows in Subsection 2.1 and then focus on the empirical evidence in Subsection 2.2. Lastly, Subsection 2.3 is dedicated to two recent debates in the policy and academic communities: the sectoral effects of exchange rate volatility and the trade impact of currency unions.
Theoretical work: exchange rate risks and trade
A simple explanation of how exchange rates affect trading firms is provided in a seminal paper by Clark (Reference Clark1973). The author describes the hypothetical case of a firm operating under perfect competition that produces a single product, which contains no imported input, for sale in export markets. The firm is paid only in foreign currency; hence, the proceeds of its exports in domestic currency depend on the (unpredictable) level of the exchange rate. In the model, the firm is assumed to be small and to have limited access to currency hedging. In addition, because of the high cost of adjusting its levels of production to factors other than demand, it is also assumed that its output will not change in reaction to favourable or unfavourable changes in the profitability of its exports deriving from exchange rate shifts. Uncertainty about future exchange rates directly translates into uncertainty about future receipts in domestic currency. Thus, the firm in question must determine a level of exports that incorporates this uncertainty. If one considers that the firm maximizes its profit and is risk-averse, a prime condition for this firm to produce is that its marginal revenue exceeds its marginal cost to compensate for the exchange risk it bears. Hence, in this situation where the variability of the firm's profits depends only on the exchange rate, the greater volatility of the exchange rate (with no change necessarily in its average level) results in a reduction of output and exports, reflecting reduced exposure to exchange rate risk. In other words, this basic model, later refined by Hooper and Kohlhagen (Reference Hooper and Kohlhagen1978), establishes a negative relationship between exchange rate volatility and international trade.
The view that an increase in exchange rate volatility will have adverse effects on the volume of international trade is relatively widespread in studies conducted throughout the 1970s and 1980s (in addition to the works of Clark and Hooper and Kohlagen, see also, inter alia, Baron, Reference Baron1976; Cushman, Reference Cushman1983; De Grauwe and Verfaille, Reference De Grauwe, Verfaille and Marston1988; Giovannini, Reference Giovannini1988; Bini-Smaghi, Reference Bini-Smaghi1991). However, these conclusions rest on relatively stringent assumptions, which have been scrutinized and relaxed by other authors – notably the assumption of perfect competition, the large role of the invoicing currency, the absence of imported inputs, the high aversion to risk, and the absence of exchange rate hedging financial instruments. This scrutiny leads the way to more sophisticated models, in which the relationship between exchange rates, the supply of goods, and the decision to trade became more ambiguous.
For example, in the presence of imported inputs, the contraction in the supply of exports is smaller, as acknowledged by Clark himself, because when an exporter imports inputs from a country whose currency depreciates, there is some offsetting effect on declining export revenues in the form of lower input costs. One may also take into account the possibility of firms hedging effectively against short-term fluctuations, and the likelihood of larger firms evolving in a multi-currency environment, in which the effect of fluctuations in one or the other direction on total profitability cancel out. The extent to which firms can allocate their output between the domestic and international market (and among international markets), as well as the risk aversion of firms towards price uncertainty, also matters. These factors suggest that the link between greater exchange rate volatility and reduced trade flows is less robust than initially presumed. However, the notion that exchange rate volatility affects trade cannot be entirely dismissed. Rather, this relationship appeared to be more significant in certain specific cases and less relevant in others, leading to more nuanced results.
In a first set of models, the effect of increased volatility of exchange rates on trade depends heavily on the level of risk aversion of traders (De Grauwe, Reference De Grauwe1988; Dellas and Zilberfarb, Reference Dellas and Zilberfarb1993). Risk-neutral traders are unlikely to be affected by exchange rate uncertainty but risk-averse ones will be, albeit to different degrees. Paradoxically, for very risk-averse traders, exporting more to compensate for the expected fall in revenue per exported unit could be a reasonable response to increased volatility. As indicated by De Grauwe (Reference De Grauwe1988), while ‘exporters are universally made unhappy by the volatility of exchange rates, some may decide that they will be better off exporting more’. In this particular case, De Grauwe stresses that the dominance of income effects over substitution effects results in a positive relationship between exchange rate fluctuations and the volume of trade.Footnote 1 The existence of a positive relationship between exchange rate volatility and exports is confirmed theoretically by Broll and Eckwert (Reference Broll and Eckwert1999), but only for firms that are able to react flexibly to changes in exchange rates and re-allocate their products among markets accordingly. Such action is likely to optimize the gains from trade in an environment of increased volatility but would work only if the firms in question have large domestic markets at their disposal. As indicated by the authors, ‘the export strategy is like an option because the domestic market is certain whatever the realized exchange rate turns out to be. The domestic price is the ‘strike’ price of the real export option.’ A more volatile exchange rate, however, also implies a higher risk of exposure for international firms – with this effect working in the opposite direction. In this context, the authors find that the net effect of exchange rate uncertainty on production and exports depends on the degree of relative risk aversion of the firm.Footnote 2
A second set of studies accounts for the possibility of firms hedging against exchange rate risks. The availability of financial hedging, for instance through forward exchange markets, helps reduce the uncertainty generated by fluctuations of nominal exchange rates. Firms, however, have unequal access to hedging facilities and may display different behaviours according to which side of the hedging position they stand. While Baron (Reference Baron1976) argues that, in a world in which the only source of uncertainty is linked to exchange rates fluctuations, perfect forward markets neutralize the effects of exchange rate volatility on the volume of trade, Viaene and de Vries (Reference Viaene and de Vries1992) nuance this conclusion by suggesting that forward markets create ‘losers’ and ‘winners’ among exporters and importers which are on the opposite sides of the forward transactions. Besides, as noted by the IMF (1984), foreign exchange hedging contracts are not necessarily available in all countries and to all categories of firms. In addition, contracts typically have high fees and only cover a limited share of possible fluctuations during the proposed maturities – as by definition it is hard to anticipate the magnitude of such fluctuations. Hence, it is generally accepted that larger exporting firms are in a better position than smaller firms to benefit from exchange rate hedging. Caporale and Doroodian (Reference Caporale and Doroodian1994) confirm that hedging is available but generates costs and difficulties related to the firms' lack of foresight as to the timing and volume of foreign exchange transactions. Obstfeld and Rogoff (Reference Obstfeld and Rogoff1998) study the hedging behaviour of firms in relation to their risk aversion. They find that risk-averse firms hedge against exchange rate movements, but hedging costs translate into higher export prices, which will have a negative impact on (world) output and trade.
A third extension of the literature focuses on adjustment costs. The assumption that exchange rates affect trade because firms cannot adjust production and factor inputs according to exchange rate fluctuations has also been relaxed by several authors. De Grauwe (Reference De Grauwe and De Grauwe1992) works with a wider spectrum of cases than those described by Clark. If firms can adjust factors of production upwards and downwards according to world prices, they are indeed likely to sell more when international prices in foreign currency are high (with a limit set by the production capacity of the ‘flexible’ factor) and less when the prices are low. However, this depends on risk aversion towards profit uncertainty. The more risk-averse the firms are, the less likely they will export more in light of higher profit variance from exchange rate volatility. On the other hand, the less risk-averse firms will sell more even with profit uncertainty because the opportunity from price variability can offset the uncertainty.
A fourth set of studies analyses the effect of exchange rate volatility on the composition of trade rather than on the gross volume of trade. Some models focus on the extensive rather than the intensive margin of trade (i.e. the number of products traded rather than the volume of trade of a given number of products). Specifically, models of hysteresis in global trade show that the high variability of exchange rates and associated uncertainty can influence the decision to enter or exit foreign markets in the presence of sunk costs (in particular, Dixit, Reference Dixit1989; Krugman, Reference Krugman1986; Franke, Reference Franke1991). Sunk costs are incurred when setting up networks for export-oriented products, marketing tools, and distribution infrastructures. In the presence of such costs, firms tend to be less reactive to short-term fluctuations in exchange rates. However, the deeper and longer these fluctuations, the greater the incentive to stay out of international markets for firms that have not come in yet, and the incentive to stay in for firms having already entered the market.
Finally, the last group of works removes the assumption that exchange rate uncertainty is exogenous and takes instead a general equilibrium approach. In partial equilibrium models, the direct effect of exchange rate changes can only be tested on another variable (level of trade) regardless of whether volatility affects the other variables that influence trade. In particular, Bacchetta and Van Wincoop (Reference Baccheta and Van Wincoop2000) use a general equilibrium model, in which exchange rate uncertainty arises from monetary and fiscal policy, to examine the impact of volatility on the levels of trade and welfare in a context of both fixed and flexible arrangements. One interesting outcome, illustrating the complexity of the exchange rate–trade relationship, is that monetary stimulus in a country that leads to the depreciation of its exchange rate may not have much effect on trade. This is because the depreciation of the exchange rate reduces imports but the increase in domestic demand linked to the monetary stimulus may boost imports in an offsetting movement. Of course, the net effect will depend on a whole set of variables from demand elasticities for imports to supply-side factors, such as the desire or ability of domestic producers to adjust prices to the depreciation of the currency.
2.2 Empirical work: does exchange rate volatility hinder trade?
Reflecting the relatively mixed state of theoretical models regarding the effects of exchange rate variability on trade, the vast empirical works conducted by academics and policy-oriented economists in support of theoretical considerations are no less ambiguous. This point is made in a series of overviews of the empirical literature. As indicated by Taglioni (Reference Taglioni2002), ‘it is customarily presumed that the adverse effect of exchange rate volatility (on trade flows), if it exists, is certainly not large’. Similarly, Coric and Pugh (Reference Coric and Pugh2010) conclude that: ‘on average, exchange rate variability exerts a negative effect on international trade. Yet … this result is highly conditional … [A]verage trade effects are not sufficiently robust to generalize across countries.’ All in all, they found 33 studies emphasizing a negative relationship between exchange rate variability and trade volume and 25 studies leading to the opposite conclusion.Footnote 3
In IMF (2004), an attempt is made to obtain more conclusive empirical findings. First, the IMF looked at the time paths of the exchange rate volatility and trade and found no obvious (negative) association. World trade increased steadily between 1970 and 2000, while the path of exchange rate volatility was less smooth. Exchange rate volatility showed an upward trend from the early 1970s through the end of the 1980s, before moderating, with strong regional bulges such as in the case of transition economies in Eastern Europe in 1990–1994 and of the Asian crisis in 1997–1998. As indicated in the study, negative associations in such cases may not reflect a causal relationship, but rather are the manifestation of the effects of a common set of factors that both raise currency volatility and reduce trade. In order to estimate the specific impact of exchange rates on trade flows, the IMF used a gravity model which controls for the determinants of trade patterns other than exchange rates, such as distance/geographical positions, GDP (or demand), and many other factors that may affect transaction costs relevant to bilateral trade.Footnote 4 IMF estimates suggest that, if the volatility of exchangerates were to rise by one standard deviation, trade would fall by 7%. However, the authors do not find the relationship to be robust.Footnote 5 The IMF (2004) also finds little evidence to show that exchange rate variability affects differentiated or homogeneous products differently, thus providing little support to earlier theoretical findings. Finally, the proposition that the trade impact of exchange rate variability differs across country groups (i.e. developed versus developing) is also not supported by the IMF analysis.
Results of recent studies confirm on aggregate those of the IMF (2004) (i.e. volatility decreases trade, although the effect is small and the results are not entirely robust to changes in specifications), even if there are some differences depending on the periods and countries of interest. Rahman and Serletis (Reference Rahman and Serletis2009) found that exchange rate uncertainty has had a generally negative and significant effect on recent US exports, but that exports respond asymmetrically to positive and negative exchange rate shocks. In a gravity model using 25 years of quarterly data and co-integration techniques, Chit et al. (Reference Chit, Rizov and Willenbockel2010) examine the real exports of five emerging East Asian economies among themselves, as well as to 13 industrialised countries. The paper provides strong evidence that exchange rate volatility has had a statistically significant negative impact on the exports of those emerging East Asian economies. They also test the impact of exchange rate volatility from third countries to establish whether a rise in exchange rate volatility between the importing country and other exporting countries encourages bilateral exports between two trading partners. Their findings tend to confirm that not only absolute volatility but also relative volatility is important for the bilateral export flows of emerging East Asian economies. They conclude that exchange rate volatility in East Asian economies has a significant negative impact on export flows to the world market. Ozturk and Kalyoncu (Reference Ozturk and Kalyoncu2009) apply similar techniques to another six countries, and find that, over the period 1980–2005, exchange rate uncertainty exerts a significant negative effect on trade for the Republic of Korea, Pakistan, Poland, and South Africa, but a positive effect for Turkey and Hungary. Arize et al. (Reference Arize, Osang and Slottje2000) focus on the impact of exchange rate volatility on export demand to least developed countries, and find a negative relationship between volatility and exports both in the short- and long-run. Volatility seems to be felt by least-developed countries even more as forward markets are not accessible to many of them, limiting their ability to hedge against the main currency's movements and increasing their traders' risk aversion. Using data on 1,000 country pairs, Wei (Reference Wei1998) empirically tests the hypothesis according to which the difficulty in finding large and negative effects of exchange rate volatility on trade is due to the availability of hedging instruments. He finds that there is no evidence in the data to support the validity of the hedging hypothesis, and that for country pairs with large trade potential, exchange rate volatility deters goods trade to an extent larger than typically documented in the literature (generally between 5% and 10% in the volume of bilateral trade).
On the other hand, other authors have failed to find any robust, negative relationship between exchange rates and aggregate trade. This is, for instance, the case with Hondroyiannis et al. (Reference Hondroyiannis, Swamy, Tavlas and Ulan2008). They use a sample of 12 industrialized countries, for which they fail to find a significant effect over the period 1977–2003. They conclude that ‘the finding of a significant and negative impact of volatility is attributable to specification biases’. Boug and Fagereng (Reference Boug and Fagereng2010) find no evidence suggesting that export performance of Norwegian firms has been significantly affected by exchange rate uncertainty. Tenreyro (Reference Tenreyro2007) uses an estimation approach to address the reverse causality problem in estimating the effect of nominal exchange rate volatility on trade flows, finding no significant impact. Some recent studies incorporating exchange rate volatility in a gravity equation setting do not find a robust impact of exchange rate volatility (e.g. Eicher and Henn, Reference Eicher and Henn2009). Baum and Caglayan (Reference Baum and Caglayan2010) also conclude that exchange rate volatility does not have an impact on the level of trade, but they do find a robust link to the volatility of bilateral trade flows.
The reasons for these mixed conclusions often relate to the use of different samples (e.g. more or less disaggregated data, more or less developed economies), different measures of volatility (e.g. short- and long-run, real and nominal) and the diverse approaches to address econometric problems, such as the reverse causality of trade and exchange rate fluctuations. However, one can only acknowledge that several empirical questions in this area are still open.
2.3 Recent debates: sectoral effects and currency unions
Even though the literature on the trade effects of exchange rate volatility is quite broad, two issues seem to stand out in recent debates. The first concerns sectoral effects and the second relates to currency unions. On the first issue, the literature on the effects of exchange rate volatility is taking into account the progress in sectoral analysis, with a view to eliminating the aggregation biases deriving from the use of total exports data. The literature on currency unions acknowledges that a permanent commitment to a fixed exchange rate, by eliminating uncertainty, may have a large impact on trade. The extent to which this can be shown to be empirically true, however, depends on the ability of the empirical analyses of solving a complex reverse causality problem.
Generally, studies using disaggregated data tend to find a more robust negative relationship between exchange rate volatility and trade flows, albeit not systemically, neither for all sectors nor for all countries. This is particularly the case in Peridy (Reference Peridy2003), who shows that the impact of exchange rate volatility on exports of G-7 countries varies considerably depending on the industry covered and the destination market. He finds mostly negative effects for exchange rate volatility, but for several countries and sectors these are not statistically significant. Bryne et al. (Reference Byrne, Darby and MacDonald2008) consider the impact of exchange rate volatility on the volume of bilateral US trade (both exports and imports) using sectoral data. They find that separating trade into differentiated goods and homogeneous goods results in the most appropriate sectoral division. Thus, exchange rate volatility is found to have a robust and significantly negative effect across sectors, although it is strongest for exports of differentiated goods. Bahmani-Oskooee and Hegerty (Reference Bahmani-Oskooee and Hegerty2008) looked at the impact of increased exchange rate volatility since 1973 on US–Japan bilateral trade. They used disaggregated data for 117 Japanese industries from 1973 to 2006. They find that in the short-run some industries are influenced by exchange rate volatility, although this effect is often ambiguous. In the long-run, trade shares of most industries are relatively unaffected by exchange rate uncertainty, while some industries experience a relative shift in their proportion of overall trade. Bahmani-Oskooee and Hanafiah (Reference Bahmani-Oskooee and Hanafiah2011) have conducted similar work for all the largest US trading partners, arriving at similar results (strong suspicion of short-term effects, more ambiguous results in the long-run). Caglayan and Di (2010) examine the effect of real exchange rate volatility and sectoral trade between the United States and its top 13 trading partners. Unlike most of the previously mentioned studies, they conclude that exchange rate volatility does not systematically affect sectoral trade flows. Furthermore, any negative effects of exchange rate volatility, where they occur, often tend to be offset by opposite impacts of income volatility. Finally, a series of studies focuses specifically on agricultural trade. Wang et al. (Reference Wang, Barrett and Fawson2002) have noted that ‘temporal aggregation necessarily dampens exchange rate variability, which may make identifying any true trade-risk relationship more difficult’. This problem may be particularly severe when one estimates the effect of exchange rate volatility on agricultural trade. Correcting for these weaknesses, Wang and Barrett (Reference Wang and Barrett2007) look at the effects of exchange rate volatility on trade in eight sectors between the United States and Chinese Taipei over the period 1989–1998, and find that volatility affected agricultural flows, but not in other sectors. The hypothesis under which agricultural trade is more sensitive to long-run exchange rate uncertainty than other sectors is confirmed by Cho et al. (Reference Cho, Sheldon and McCorriston2002) who use a panel of ten OECD countries over the period 1974–1995.
A second topic where recent academic and policy debate has been particularly lively is the trade effects of currency unions. Early studies find that adopting a single currency has rather strong and positive effects on trade flows. Dell'Ariccia (Reference Dell'Ariccia1999) looks at the impact of exchange rate volatility on the bilateral trade of the EU 15 Members and Switzerland over 20 years, from the mid-1970s to the mid-1990s. Depending on the measures of variability, he finds a negative association between exchange rates and trade, and that trade would increase by 3–13% if this variability were brought down to zero. Rose's (Reference Rose2000) seminal paper on the effects of monetary unions on trade finds that sharing a currency increases bilateral trade between countries by over 200%.Footnote 6 Rose (Reference Rose2000) and Rose's subsequent work with co-author provide extensive sensitivity analysis, including different specifications of the gravity model, changes in the sample, and use of instrumental variables to control for reverse causality. Rose and van Wincoop (Reference Rose and van Wincoop2001) conclude that, while smaller than initially found, the effect of currency unions on trade remains large and significant throughout.Footnote 7
A large number of other studies, surveyed in Baldwin (Reference Baldwin2006), Eicher and Henn (Reference Eicher and Henn2009), and Santos Silva and Tenreyro (Reference Santos-Silva and Tenreyro2010), however, further qualify this initial result. The key empirical issue consists precisely in isolating the impact of currency unions on trade. Mundell's (Reference Mundell1961) optimal currency hypothesis itself suggests a reverse causality, whereby trade flows stabilize real exchange rate fluctuations, thus reducing the cost of forming a currency union. More broadly, the question is whether there are some omitted factors that drive countries to participate in a currency union and to trade. Broda and Romalis (Reference Broda, Romalis, Ito and Rose2010) present the problem as follows: ‘Most of the existing studies have focused on the effects of exchange rate regimes or volatility on trade by assuming that the exchange rate process is driven by exogenous shocks and is unaffected by other variables. By definition, this implies that the effect of trade on volatility is inexistent rather than jointly estimated with the effect of volatility on trade. This is not a benign assumption.’Footnote 8 The authors argue that ignoring the causal effect of trade on volatility results in overestimates of the true impact of exchange rate volatility on trade. Their evidence confirms that deeper bilateral trading relations dampen real exchange rate volatility and are more likely to lead to a currency union. Controlling for that reverse causality, they conclude that currency unions enhance trade by 10–25%. Santos Silva and Tenreyro (Reference Santos-Silva and Tenreyro2010) have a more pessimistic view of this relationship. In particular, their analysis (as a substantial part of the literature on currency unions) focuses on the trade effects of the euro, finding that the single currency in Europe had a trade impact close to zero. Intuitively, they argue that the discrepancy between their results and previous findings lies in the fact that members of the euro-area historically traded intensively with each other and the introduction of the euro had a small differential effect on trade when compared with other developed countries outside the euro-area.Footnote 9 While not conclusive, this provides a word of caution on the trade effects of currency unions.
3. Exchange rate misalignments and trade
A harsh debate about exchange rates and their impact on trade re-opened with the build-up of large external imbalances in the first decade of the twenty-first century and, even more forcefully, in the aftermath of the Great Recession. Concerns about unemployment and slow recovery strengthened the sensitivity and vigilance towards those countries suspected of ‘exporting’ their way out of the crisis at the expense of their trading partners. The policy and academic debate shifted somewhat at this time away from the effects on trade of exchange volatility towards the effects of sustained exchange rate depreciations/appreciations and currency misalignments.Footnote 10 This means that the emphasis falls less on the effects of variability and more on the level of the exchange rate.
Exchange rates can differ from their equilibrium level for two reasons. First, differences can be a result of government intervention directly aimed at altering the real exchange rate (currency manipulation). In this respect, governments and/or central banks possess a number of policy instruments that can affect the real value of the exchange rate, including the introduction of capital controls or targeted intervention in foreign exchange markets. Second, misalignments can be the unintended side effect of macroeconomic policies aimed at achieving domestic objectives, or can be a result of distortions in the international financial architecture or in domestic structural conditions. An important question in the debate on currency misalignments is whether the real exchange rate is a variable that authorities can influence (see, for instance, Eichengreen, Reference Eichengreen2007; Rodrik, Reference Rodrik, Elmendorf, Mankiw and Summers2008). The consensus is that the real exchange rate, being the relative price of non-traded goods, is not under the direct control of policy-makers. However, its level can be influenced by policy in the short or medium term.Footnote 11 Eichengreen (Reference Eichengreen2007) illustrates this point with the historical experience of Korea in the 1960s, where a nominal depreciation was associated with a fiscal consolidation in order to maintain an undervalued level of the real exchange rate.
The ensuing discussion will abstract from the cause (policy or not) of misalignments and will, instead, deal with their trade effects. How do currency misalignments affect international trade? Two broad ‘direct’ channels can be at work. The first is through price signals that may have an immediate impact on trade patterns. The second may materialize if a currency misalignment changes investment decisions and causes shifts in resources between the non-tradable and the tradable sector in the economy. As we review in the first subsection below, these direct effects depend on a number of circumstances that economic theory has helped spell out. The second subsection reviews the recent empirical evidence on the impact of exchange rate depreciations on export growth. Finally, the third subsection evaluates three areas of recent academic debate on the trade impact of currency misalignments: when firms are heterogeneous and face sunk export costs, when production chains span different countries and monetary areas, and when a misalignment generates pressure for compensating trade restrictions in the trading partners' economy.
3.1 Theoretical work: transitory or permanent effects?
Standard economic theory defines the long-run as the period in which all prices are fully flexible. Put differently, in the long-run prices have the time to adjust to any policy change (or other shock). In this context, money is like a veil to the real economy, an intuition that dates back at least to David Hume's essays on money and the balance of trade. In particular, when markets have no distortions, an exchange rate misalignment, such as the undervaluation of the currency, has no long-run effect on trade flows or on real economic activity because it does not change relative prices. The short-run, on the other hand, can be different. The reason is that, if some prices in the economy take time to adjust (i.e. are ‘sticky’), movements in nominal exchange rates can alter relative prices and affect both the allocation of resources between non-tradable and tradable sectors and international trade flows.
Textbook open-economy macroeconomic models embed these short-term effects of exchange rate misalignments (e.g. Krugman and Obstfeld, Reference Krugman and Obstfeld2003; Feenstra and Taylor, Reference Feenstra and Taylor2008). Specifically, when prices are sticky a nominal depreciation of the home currency causes a real depreciation of the exchange rate, which signifies that foreign goods become more expensive than domestic goods. The result of this short-run change in relative prices is expenditure switching: the home economy will import less, as home consumers switch to buying domestic products, and will export more, as foreign consumers switch to less expensive home goods. This implies that, in standard macroeconomic models, the trade balance (i.e. exports minus imports) is predicted to be an increasing function of the exchange rate in the short-run.Footnote 12 This implication assumes that two mechanisms are at play. First, nominal exchange rate depreciation causes a real depreciation, thus raising the price of foreign imports relative to home exports. The second mechanism at play is that such a change in relative prices has an immediate impact on imports and exports, and therefore on the trade balance. The short- run trade effects of exchange rate misalignments, however, are more complex as each of these mechanisms may be subject to questions, depending on the circumstances.
On the first mechanism, recent macroeconomic literature shows that the short-run impact of exchange rate depreciations on trade depends, among other things, on the currency in which domestic producers invoice their products. This is because the currency of denomination affects the extent to which a nominal depreciation causes a real depreciation. For instance, if producers set their price in the home currency (as implicitly assumed in standard trade models), there is perfect ‘pass-through’ from changes in the nominal exchange rate to the real exchange rate, and an unanticipated depreciation lowers the price of domestic goods relative to foreign goods, as discussed above. This case, which has been much debated in policy circles in recent times, has similarities (even if it is not perfectly equivalent) to the imposition of a combination of export subsidy and import tariff on all goods – an argument first made by Keynes in 1931.Footnote 13 However, the trade effect of a depreciation would be different if domestic producers were to set their price in the buyers' currency or in a vehicle currency, such as the US dollar or the euro.Footnote 14 This is because the pass-through would be less than perfect in these cases. For instance, when firms set prices in a vehicle currency, the theory suggests that a depreciation would still have real effects. However, such consequences would not be equivalent to export promotion, but rather to import restrictions, as shown in Staiger and Sykes (Reference Staiger and Sykes2010).
The second mechanism assumed in standard macro models (i.e. the immediate impact of a real currency misalignment on exports and imports) is also questionable. The depreciation of the real exchange rate can be associated with a deterioration of the trade balance on impact and a subsequent improvement (the so-called J-curve effect).Footnote 15 This is because at the time of an unexpected depreciation, most import and export orders are fixed as they are placed several months in advance. The value of the pre-contracted level of imports rises, which implies that there is an initial fall in the trade balance. The increase in import prices may be partly or fully offset by the substitution, if available, of imported goods by domestic goods, but this consumption switching may require time and adjustment. When these changes have taken place, a real exchange rate depreciation will improve the trade balance relative to its pre-depreciation level. In brief, understanding the impact of exchange rate depreciation on trade flows in the short- and medium-run is conceptually more difficult than it may appear at first sight.
The above discussion abstracts from the possibility of failures in the domestic market or the presence of entry costs into export markets. For instance, in the presence of information problems (e.g. the quality of export goods is unknown to foreign consumers), it has been argued that the level of exports may be inefficiently low (Bagwell and Staiger, Reference Bagwell and Staiger1989; Bagwell, Reference Bagwell1992). A high-quality exporter may need to signal quality, which is costly. Firms may also have common uncertainty about the profitability of exporting, and such common uncertainty suggests the existence of a coordination problem (see, in particular, the study by Freund and Pierola (Reference Freund and Pierola2010) on exports from Peru). A number of papers (e.g. Baldwin, Reference Baldwin1988; Baldwin and Krugman, Reference Baldwin and Krugman1989) study the trade effects of a currency misalignment when the entry costs into the foreign market are sunk. In this context, the undervaluation of the exchange rate may have long-run effects if it allows exporters to enter foreign markets, and thus overcome the initial information inefficiency or the cost of entry. Specifically, if this logic is correct, one would expect that currency depreciation is associated with entry into new markets and new product lines (i.e. the extensive margin of trade), and that it is not (or not completely) undone in the long-run when prices adjust. Moreover, as market failures and entry costs are considered to play a more prominent role in developing economies as opposed to developed economies, one should expect that these long-run effects are weaker for the latter group.
A related literature analyses the relationship between the exchange rate and income growth through its effect on exports. Economists have long known that avoiding overvaluation of the currency is an important factor for a country's economic performance (Rodrik, Reference Rodrik, Elmendorf, Mankiw and Summers2008). While economic models have rarely formalized the association between overvaluation and slow growth, most accounts link it to macroeconomic instability (Fischer, Reference Fischer1993; Easterly, Reference Easterly, Aghion and Durlauf2005). More recently, attention has focused on the ‘export-led’ growth process. The broad question is whether the undervaluation of the currency can have benign effects on a country's aggregate performance by improving its export performance. A series of recent papers by Hausman et al. (Reference Hausmann, Pritchett and Rodrik2005), Eichengreen (Reference Eichengreen2007), Rodrik (Reference Rodrik1986, Reference Rodrik, Elmendorf, Mankiw and Summers2008), Korinek and Serven (Reference Korinek and Serven2010), Di Nino et al. (Reference Di Nino, Eichengreen and Sbracia2011) show different mechanisms through which a depreciation can play an important part in the growth process, particularly for developing countries, by promoting exports. In general, the logic is still related to the possibility of market failures. Specifically, these models assume that market imperfections (e.g. learning externalities, product market failures, poor institutions for contract intensive activities) are more prominent in the tradable sector relative to the non-tradable. As a result, undervaluation has a positive impact on growth precisely because it alleviates the economic costs of market distortions by promoting the expansion of the tradable activities. In other words, it is the growth in exports promoted by the undervalued real exchange rate that underpins income growth in these models.Footnote 16
This argument appears to differ dramatically from the so-called ‘Washington Consensus’ view (Williamson, Reference Williamson and Williamson1990). As Berg and Miao (Reference Berg and Miao2010) point out, in this view any real exchange rate misalignment implies some sort of macroeconomic disequilibrium, which in itself is bad for economic growth. Specifically, an economic argument can be made that an exchange rate undervaluation or overvaluation can hamper growth by providing a wrong signal to economic agents, which may lead to factors misallocation. Hence, while the conventional wisdom embedded in the Washington Consensus supports the view that a real exchange rate undervaluation can be an effective instrument to promote exports, it is its long-run impact on economic growth that is questioned. Differently put, the view expressed by Rodrik (Reference Rodrik, Elmendorf, Mankiw and Summers2008) and other economists and the view of the Washington Consensus seem to differ on the importance of market imperfections in the tradable sector more than on the trade impact of exchange rate misalignments.
Ultimately, whether exchange rates undervaluation can have an effect on trade (and on other variables) in the short- and or the long-run is an empirical question that we address below. Specifically, one would argue that such long-run effects materialize if the market failures discussed above are empirically important. Whatever the answer to these questions, however, economic theory suggests three important caveats. First, according to the so-called ‘targeting principle’ in economics, policies that target directly market failures are efficient (i.e. first-best). Therefore, changes in the level of the exchange rate can at most be second-best (among others, Rodrik, Reference Rodrik, Elmendorf, Mankiw and Summers2008). Specifically, a real undervaluation creates unnecessary distortions by imposing a consumption tax on tradable goods. The second caveat is that a currency misalignment will likely have a negative spillover effect on other exporters. This is because exchange rate movements in one country will affect its competitors in third markets. Mattoo et al. (Reference Mattoo, Mishra and Subramanian2012) provide evidence of this effect for developing countries that compete with China in export markets. Finally, and related to the above point, the extent to which currency undervaluation is expected to have trade (or growth) effects depends on what other countries will do. Even if one takes the view that an exchange rate undervaluation has a positive long-run effect on exports and growth, this policy would clearly be ineffective if all countries attempted to undervalue at once (among others, Blair Henry, Reference Blair Henry, Elmendorf, Mankiw and Summers2008).
3.2 Empirical work: depreciation and export growth
The measurement of misalignments is a complex issue. There are roughly two approaches in the literature. The first attempts to estimate the level of the equilibrium real exchange rate, that is the level at which an economy would be simultaneously in internal and external balance. A misalignment is then the deviation of the actual level from this equilibrium exchange rate (e.g. Razin and Collins, Reference Razin, Collins, Razin and Sadka1999; Lee et al., Reference Lee, Milesi-Ferretti, Ostry, Prati and Ricci2008). The second approach is first to regress the real exchange rate at purchasing power parity (PPP) on real per-capita GDP (to control for the Balassa-Samuelson effect). Then the extent of misalignment is measured as the difference between the log of the real exchange rate at PPP and the log of the fitted value from the first regression (e.g. Rodrik, Reference Rodrik, Elmendorf, Mankiw and Summers2008; Freund and Pierola, Reference Freund and Pierola2012). Both approaches have merits. The first is founded in the theoretical concept of an equilibrium real exchange rate; the latter is more straightforward and may be preferable for reasons of comparability over time. Independently of these measurement issues, however, empirical results of different studies show some common patterns in the relationship between exchange rate misalignments and the growth of exports. Below we review the main recent contributions.
First, a number of papers have looked at the empirical relationship between exchange rate depreciation and export surges, defined as an acceleration of export growth. A series of studies have focused on the specific experience of certain countries and/or regions. For instance, Fang et al. (Reference Fang, Hao and Miller2006) analyse the effect of exchange rate depreciation on exports for eight Asian economies (Malaysia, Philippines, Indonesia, Japan, Singapore, Chinese Taipei, Republic of Korea, and Thailand). They find that a depreciation encourages exports for most countries, but its contribution to export growth is weak and varies across countries. They argue that the reason for this finding is that a depreciation raises exports, but the associated exchange rate risk (variability) has an offsetting effect. Bernard and Jensen (Reference Bernard and Jensen2004) focus on the US between 1987 and 1992. In analysing the sources of manufacturing export booms, they find that changes in exchange rates are an important determinant of export increases. Most of the increase in exports is on the intensive rather than the extensive margin (i.e. increasing export intensity among existing exporters rather than from new entry into exporting), a finding that is at odds with later papers discussed in the next subsection. Finally, Arslan and van Wijnbergen (Reference Arslan and van Wijnbergen1993) study the export boom of Turkey in the 1980s and assess the relative contribution of different factors, such as export subsidies, import growth in the Middle East, and exchange rate depreciation. They find that the steady real depreciation of the Turkish lira played an important role in the surge in exports.
Three recent studies focus on a cross-country analysis. Freund and Pierola (Reference Freund and Pierola2012) examine the determinants of 92 episodes of export surges, which they define as annual increases in manufacturing exports of at least 6% that last for a period of seven years or longer. They find that large depreciations of the real exchange rate have been an important determinant of export surges for developing countries. Specifically, an undervalued exchange rate has a positive effect by facilitating entry of new export products and new markets. These new products and markets account for 25% of export growth on average during the surge in developing countries. Haddad and Pancaro (Reference Haddad and Pancaro2010) provide further evidence of the links between the real exchange rate and export expansion. They find a positive association between the two variables, but only for low per capita income countries. Specifically, in developing economies with per capita income below 2,500 US dollars, an increase by 50% in real undervaluation is associated with an annual 1.8% increase in exports over GDP in the corresponding five-year period. However, they find that in the long-run the effect of a real exchange rate undervaluation on exports becomes statistically insignificant for all income levels. In another recent study, Nicita (Reference Nicita2012) investigates the impact of misalignments on trade estimating fixed effect models on a panel dataset comprising 100 countries for the years 2000–2009. This study finds that a currency undervaluation promotes exports and restricts imports and conversely for an overvaluation. The author argues that misalignments across currencies have a diversion effect quantifiable at about 1% of world trade.
Finally, the literature on exchange rate misalignments and economic growth has devoted substantial attention to the trade effects of currencies. Several recent studies have found that an undervaluation of the exchange rate boosts economic growth (Razin and Collins, Reference Razin, Collins, Razin and Sadka1999; Johnson et al., Reference Johnson, Ostry and Subramanian2007; Rajan and Subramanian, Reference Rajan and Subramanian2011; Gala, Reference Gala2008; Berg and Miao, Reference Berg and Miao2010).Footnote 17 Recent empirical results indicate that the effects of the real exchange rate on growth operate at least in part through an expansion of exports, particularly of industrial goods (Rodrik, Reference Rodrik, Elmendorf, Mankiw and Summers2008; Di Nino et al., Reference Di Nino, Eichengreen and Sbracia2011). Importantly, these studies find that the positive relationship between undervaluation and export growth is strong for developing countries and weak for advanced economies. This supports the view that the channel through which a currency undervaluation affects export and income growth is indeed by addressing market failures in the tradable sector, which are likely to be more relevant for developing countries as opposed to advanced economies.
3.3 Recent debates: heterogeneous firms, global production, and trade policy
The recent academic and policy debate on exchange rate misalignments and trade has taken three main directions. The first set of studies looks more closely at how sectors and firms react to a depreciation or an appreciation of the exchange rate. The second question is how misalignments affect trade in a world where production chains span several borders. Finally, recent studies revisit the issue of how exchange rate misalignments may have an indirect effect on trade flows by triggering a trade policy response.
Until the mid-2000s most of the literature looked at the impact of exchange rate changes on aggregate imports and exports. These estimations have problems because aggregate trade flows may have feedback effects on exchange rates. Focusing on firms, rather than aggregate variables, is a way to address this endogeneity problem. This is because individual firms' export choices are likely to be influenced by the level of the exchange rate, but not to directly influence its value. Therefore, this approach provides a better identification of the impact of exchange rate misalignments on trade (even if causality problems may persist when there are common shocks). In addition, a firm-level analysis has the advantage of disaggregating the impact of exchange rate changes on different firms. Adopting this approach, Berman et al. (Reference Berman, Martin and Mayer2012) examine how high- and low-performance firms react to exchange rate changes. When faced with a change in the exchange rate, exporters (or potential exporters) can react in different ways. First, they can change export volumes, but not their price. This is the case of 100% pass-through of the exchange rate discussed earlier, where the price in destination countries changes one-to-one with the exchange rate. The opposite situation is one of zero pass-through. In this case, exporters' mark-ups fully absorb the change in the exchange rate and there is no impact on trade volumes. Both these situations (and the cases in between) focus on the intensive margin of trade. The third impact of an exchange rate change is to alter the extensive margin of trade. Specifically, a depreciation can lead firms to start exporting or to expand the product scope of their exports, while an appreciation may have the opposite effect. In this setting, the authors show that, following a depreciation of the exchange rate, the high-performing firms are more likely to (partially) ‘absorb’ the exchange rate movement in their mark-ups, rather than increase their export volumes. Low-performing firms tend to adopt the inverse strategy, i.e. they do not change export prices according to exchange rates shifts. This behaviour is explained by the difference in firms' market power. Since the highest performing firms are the largest exporters, the authors conclude that the prices of tradable goods should be relatively insensitive to exchange rate movements. Put differently, exchange rates have only a limited effect on import prices and trade volumes as a result of the ‘natural’ selection process of exporting.
Berman et al. (Reference Berman, Martin and Mayer2012) test this theory with detailed data on French firms. Two recent papers follow a similar methodology with exporters from China and Brazil (Chatterjee et al., Reference Chatterjee, Dix-Carneiro and Vichyanond2012; Tang and Zhang, Reference Tang and Zhang2012). This evidence shows that larger and more productive firms react to a depreciation with an increase in mark-ups, while smaller and less productive exporters react by changing the import price with the exchange rate. Since the group of large exporters account for the dominant share of trade flows, aggregate trade is not very responsive to exchange rate movements, as predicted by the theory. On average, following a 10% depreciation of the currency vis-à-vis a trading partner, firms increase their export quantities to that market by 4–7%. The extensive margin of trade is also found to be affected by the exchange rate movement. The probability of entering an export market (or of expanding the product scope in that market) increases by 1–2% in the year following a currency depreciation of 10 percentage points. The overall volume of trade (the sum of old and new products) increases in the short-run by 10% (unit elasticity). The firm-level analysis of Taglioni (Reference Taglioni2012), however, provides a more pessimistic result of the direct negative link between an exchange rate appreciation and export growth, even in the short-run. She argues that the trade impact of a currency appreciation differs in important ways across the intensive and the extensive margin of trade. In particular, there can be important pro-competitive effects associated with a strong currency that materialize through the extensive margin of trade. This channel is particularly strong for middle-income economies that try to diversify their export base and improve the sophistication of their exports. Importantly, this channel may offset the more traditional negative impact that a currency appreciation has on the intensive margin of trade. The author finds supporting evidence of the offsetting effects of a change in the exchange rate on the different margins of trade using firm-level data from Chile, Macedonia, Pakistan, and Turkey. These results seem to suggest that a currency depreciation may promote export volumes but at the expenses of export diversification, at least for middle-income economies.
The second consideration that emerges from the recent academic and policy debate is that the relationship between exchange rates and trade is not an immutable one. As recently as 30 years ago, products were assembled in one country, mostly using inputs from that same country. The emergence of global supply chains in recent decades has radically changed the structure of international trade. In this environment, the relationship between exchange rates and trade flows may be substantially different. For example, when the competitiveness of national exports depends upon the availability of imported components, or when the final goods imported have a large national content that is reimported after processing abroad, then an exchange rate depreciation may have a negative short-run impact on national export industries.Footnote 18
The effects of exchange rate appreciation on trade in the context of global supply chains are addressed in several recent country studies. For instance, the IMF Spillover Report on China (IMF, 2011) analyses the main factors of concern for a large set of countries following a shock originating in China. An issue taken up in the report is the impact that a potential RMB appreciation would have on the world economy. The report finds that, in the absence of other structural reforms (such as financial sector reforms), an appreciation would lead to lower output in China and lower Chinese demand for intermediate goods from other Asian countries. As a consequence, a RMB appreciation would benefit final goods producers such as Japan and the Republic of Korea, but it may (initially) hurt intermediate goods producers in emerging Asia. A second study is by Arunachalaramanan and Golait (Reference Arunachalaramanan and Golait2011) who examine the effect of an appreciation of the Chinese RMB on India's bilateral trade balance with China. They find that an appreciation of the RMB against the Rupee would not improve the bilateral trade balance from the Indian perspective. The authors argue that this is in part due to the fact that Chinese electronics and machinery goods, which represent up to 40% of total imports from China, are very important for domestic production in India. Therefore, an appreciation of the RMB would raise the cost of intermediate products that are not easily substitutable in the short-run.Footnote 19
The third question that is at the forefront of recent research is how exchange rate misalignments may affect trade, not directly but through their impact on trade policy. The issue is whether tensions in the domain of exchange rate policy, as the ones created by persistent currency misalignments, may lead to trade policy responses. The risk is that currency undervaluation and trade restrictions can escalate in a vicious cycle and that this escalation will result in long-term trade effects. In fact, while we lack definitive evidence on the comparison of exchange rate changes and tariff changes, it is widely perceived by economists that tariffs have a stronger and more persistent impact on trade flows.Footnote 20 If this argument is correct, one important feedback channel of currencies on trade is precisely through the impact on trade policy changes. This motivates the question: are trade measures responsive to exchange rate developments?
A first set of studies looks at this question from a historical perspective. Eichengreen and Irwin (Reference Eichengreen and Irwin2010) and Irwin (Reference Irwin2012) focus on the trade policy choices of the 1930s. Their argument relates to the basic ‘trilemma’ in open economies that stable exchange rates, stable internal prices, and open trade are incompatible policy objectives (as they cannot be achieved all at the same time). Specifically, in this view the inability of a country to use the exchange rate as a policy instrument may create an incentive to impose protectionist measures. The authors find that during the Great Depression, those countries that maintained the gold standard resorted to restrictive trade policies to a greater extent than those countries that abandoned the gold standard and let their currencies fluctuate. A second historical example is the 10% import surcharge on all imported goods imposed by President Nixon in 1971. The trade measure was imposed by the US to force other countries to revalue their currency vis-à-vis the dollar, which was considered to be largely overvalued. This historical episode seems to support the view that an overvalued currency may trigger a protectionist reaction. As Irwin (Reference Irwin2013) argues, however, whether the import surcharge was successful in imposing a revaluation of major currencies against the dollar is at best controversial.
A large literature in trade policy studies how protectionism varies with the business cycle. As Bagwell and Staiger (Reference Bagwell and Staiger2003) point out, the theory and substantial empirical evidence find that trade barriers are countercyclical.Footnote 21 The broad idea is that governments may revert to use trade policy in the face of adverse macroeconomic shocks, such as the rise in unemployment associated to a downturn in economic activity. Recent empirical work has shown that one such macroeconomic shock that may trigger the rise in protectionism is an exchange rate appreciation (Bown and Crowley, Reference Bown and Crowley2012). While advanced economies have low applied import tariffs that are bound under the WTO, they may use contingent protection (e.g. antidumping duties, countervailing duties, and safeguards) to implement any new barrier when hit by a macroeconomic shock. Using quarterly data for the US, the EU and three other industrialized countries from 1980 to 2010, Bown and Crowley (Reference Bown and Crowley2012) find that real appreciations in bilateral exchange rates lead to substantial increases in the use of these contingent measures.Footnote 22 A second study by Nicita (Reference Nicita2012) also looks at the relationship between trade policy and currency misalignments. In a panel of 100 countries between 2000 and 2009, he finds that countries with overvalued exchange rates are less likely to pursue trade liberalization, but the coefficient in the regressions is small and only marginally significant. On the other hand, the results indicate that periods of exchange rate appreciations are strongly related to the number of antidumping investigations, confirming for this larger panel of countries that contingent measures are the main trade policy means of response to exchange rate shocks.Footnote 23 Finally, a third study looks at the determinants of protectionist legislation in the United States (Broz and Werfel, Reference Broz and Werfel2011). They find that there is a positive association between exchange rate appreciation and the demand for trade protection, where the latter is measured by the initiation of trade restrictive legislation in the US parliament. In brief, while details of these studies differ in a number of dimensions, they all suggest that countries may use trade measures as a form of policy substitute to an appreciating currency.
4. Conclusion
Following the end of the Bretton-Woods system of fixed but adjustable exchange rates four decades ago, the bulk of economic literature on the relationship between exchange rates and trade has dealt with the effect of increased variability (volatility) of exchange rates on trade. This was the main issue covered in the well-known survey by the IMF (2004). This genre of the literature has continued until the present, incorporating improvements derived from theoretical refinements (the ‘new–new’ trade theory) and new statistical information (firm-level data). However, since the mid-2000s, following the build-up of large global imbalances and the outbreak of the financial crisis, the focus of the academic community has also turned towards the relationship between the level (misalignment) of exchange rates and trade.
On the question of the effects of exchange rate volatility on trade, the considerable array of theoretical and empirical literature remains somewhat ambiguous. The presumption is that exchange rate volatility has a negative impact on trade flows. The evidence, however, suggests that this effect is generally not large and that its existence is highly conditional. Results are conditional for a variety of reasons. While exporting firms might in principle be more sensitive than domestic firms to exchange rate fluctuations, their sensitivity is likely to be reduced by a number of factors such as the existence of hedging instruments, the presence of imported inputs (which offset the effect of exchange rate changes on the pricing of exports), the presence of firms on global markets (where upwards and downwards movements of various exchange rates cancel out), the possibility of invoicing in local currency, and the capacity to absorb losses due to exchange rates changes and other factors in profit margins. The most vulnerable firms may not be the large ones, but rather the smaller ones. In addition, empirical studies tend to find a significant effect mainly in the case of trade with close neighbors, in particular in the case of very integrated economies.
On the issue of currency misalignments, theoretical and empirical studies over the years show that the relationship between the level of the exchange rate and trade is a complex one. Economic theory suggests that, when markets are free of distortions, an exchange rate misalignment has no long-run effect on trade flows because it does not change relative prices. But long-run effects are predicted in models that assume market distortions, such as information problems or product market failures. In the short-run, when some prices in the economy are sticky, movements in nominal exchange rates can alter relative prices and affect international trade flows. These short-run trade effects, however, are not straightforward, as they are likely to depend on specific characteristics of the economy, including the currency in which domestic producers invoice their products and the structure of trade (for example, the prominence of global production networks and the characteristics of firms). Moreover, an insidious way through which exchange rates may affect trade is an indirect one, as trading partners may react to a misaligned currency with tariff protection. On the empirical side, a currency undervaluation is generally found to have a positive short-term impact on exports, but the persistence of these effects appears to be limited to developing countries. Empirical studies also broadly confirm that contingent trade measures are used in response to trading partners' currency depreciation.
