VoxEU Column International trade

Currencies and trade: Looking at the recent literature

Real exchange rates are a headache for policymakers. Sometimes they move around too much, disrupting trade and harming business, sometimes they don’t move enough, leaving economies with fewer options for growth. This column reviews the literature on the effects of exchange-rate volatility and how to deal with them.

As shown in the latest WTO Report on G20 Trade Measures, in recent months there has been a new "trend to address what is perceived as currency undervaluation through trade measures: exchange rate developments fed into requests by industries to more tailored assistance and protection from foreign competition" (WTO 2011). Throughout history, international trade and monetary relations have certainly undergone more than one period of tension, a reflection of their intertwined nature (Irwin 2011). In recent years, the focus of academic and policy interest on currencies and trade is explained by the new (and many would say more chaotic) monetary environment that emerged from the collapse of the Bretton Woods system in the 1970s.

A key element of this interaction is the effect that exchange rates have on international trade flows. In a recent paper (Auboin and Ruta 2011), we review how economists see this relationship. The bulk of the economic literature has dealt with the effect of increased variability (volatility) of exchange rates on trade. 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, the relationship between the level (misalignment) of exchange rates and trade has drawn increasingly more attention in the academic and policy community. Part of this debate focuses on the extent to which changes in the level of the exchange rate can contribute to redressing global imbalances.

Exchange rate volatility and trade

The question of the trade impact of increased exchange-rate volatility - hence the impact of increased price uncertainty linked to the exchange rate - remains somewhat ambiguous. As argued by Taglioni (2002), "it is customarily presumed that the adverse effect of exchange-rate volatility (on trade flows), if it exists, is certainly not large". Two surveys produced by the IMF (1984, 2004), at the request of both the GATT and later the WTO, come to similar conclusions. More recent studies do not alter this general picture: on average, exchange-rate variability seems to have a negative impact on international trade, but this finding is 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 rate changes and other factors in profit margins. The most sensitive 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 neighbours, in particular in the case of very integrated economies.

In short, the effects of high exchange-rate variability are likely to be felt mostly by smaller traders in smaller economies with under-developed financial systems not allowing hedging, and dependent mainly on one (large) currency/market. At the other end of the spectrum, global firms with multi-country and multi-currency operations, using a high density of inputs and financial hedging techniques, are likely to balance out the variability of exchange rates more easily.

Exchange-rate misalignments and trade

Theoretical and empirical studies over the years show that the relationship between the level of a currency and trade is so multi-faceted and complex that it is hard to extract clear lessons. Standard economic theory suggests that under perfect markets, an exchange-rate misalignment has no long-run effect on trade flows, as 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 (e.g. Korinek and Serven, 2010).

In the short run, when some prices in the economy can be sticky, movements in nominal exchange rates can (under some assumptions) alter relative prices and affect international trade flows. For instance, an unanticipated devaluation can lower the price of domestic goods relative to foreign goods. This case, which has been much debated in policy circles in recent times (e.g. Mattoo and Subrumanian, 2010), 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. 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 (Staiger and Sykes 2010) and the structure of trade, namely, the prominence of global production networks. Specifically, when exports include a high import content, a devaluation increases the price of imported components, which alters the effect predicted by standard economic models that abstract from the sophistication of modern global production structures.

On the empirical side, the complexity of the relationship between exchange-rate misalignments and trade yields mixed findings. For instance, a currency undervaluation is sometimes found to have a positive impact on exports (e.g. Freund and Pierola 2008), but the size and persistence of these effects are not consistent across different studies (e.g. Haddad and Pancaro 2010).

The importance of macroeconomic factors

The OECD has studied the trade impact in agriculture and manufacturing/mining sectors of changes in exchange rates for the world's three largest economies, namely the US, the Eurozone, and China (OECD 2011). Details of the study show that the value of trade between the US and China would be more affected by currency changes than that of the US-Eurozone or the Eurozone-China. According to model results, a hypothetical 10% depreciation of the US dollar (or a 10% appreciation of the yuan) would result in a fall in the bilateral deficit by some 13%. The OECD considers that this outcome goes in the direction of some recent academic papers (e.g. Evenett 2010) suggesting that the trade imbalance between the US and China is due to a number of factors, of which the exchange rate is (only) one – the main driver of trade flows being income/demand levels, i.e. domestic income/demand for imports and foreign income/demand in the case of exports.

Given the importance of macroeconomic factors influencing trade balances, both directly through demand and indirectly through its impact on determining the direction of exchange rates, it is important that any serious dialogue on the relationship between exchange rates and trade be based on analyses (and policy dialogue) in association with both the IMF and the WTO – as suggested by the WTO Ministerial Declaration on Coherence in Policy Making (1994).


Auboin, Marc and Michele Ruta (2011), “The Relationship between Exchange Rates and International Trade: A Review of Economic Literature”, WTO Working Paper ERSD-2011-17.

Evenett, Simon (2010), “The US-Sino Currency Dispute: New Insight from Economics, Politics and Law”, Centre for European Policy Research.

Freund, Caroline and Martha Denisse Pierola (2008), “Export Surges: The Power of a Competitive Currency”, Policy Research Working Paper Series 4750, The World Bank.

Haddad, Mona and Cosimo Pancaro (2010), “Can Real Exchange Rate Undervaluation Boost Exports and Growth in Developing Countries? Yes, But Not for Long”, VoxEU.org, 8 July.

IMF (1984), “Exchange Rate Volatility and World Trade”, IMF Occasional Paper 30.

IMF (2004), “Exchange Rate Volatility and Trade Flows - Some New Evidences”, IMF Occasional Paper 235.

Irwin, Douglas A (2011), “Esprit de Currency”, Finance & Development, 48(2), June.

Korinek, Anton and Luis Serven (2010), “Undervaluation through Foreign Reserve Accumulation: Static Losses, Dynamic Gains”, VoxEU.org, 10 May.

Mattoo, Aaditya and Arvind Subramanian (2008), “Currency Undervaluation and Sovereign Wealth Funds : A New Role for the World Trade Organization”, Working Paper 4668, World Bank.

OECD (2011), “To What Extent Do Exchange Rates and Their Volatility Affect Trade”, TAD/TC/WP(2010)21/Rev.1.

Staiger, Robert W and Alan O Sykes (2009), “Currency manipulation' and world trade: A caution”, VoxEU.org, 30 January.

Taglioni, Daria (2002), “Exchange Rate Volatility as a Barrier to Trade: New Methodologies and Recent Evidences”, Economie Internationale (CEPII), Quarter 1-2:227-259.

WTO (2011), Report on G-20 Trade Measures, October 2011.


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