Exchange rate and trade: A disconnect?
Exchange rate movements have been unusually large and have sparked some controversy as to their likely effect on exports and imports. Some suggest that exchange rates matter far less than they used to, and may have disconnected from trade entirely. Claims like these are not at all new—they have been around at least since the economist Fritz Machlup coined the phrase ‘elasticity pessimism’ back in 1950 (Machlup 1950).
These days, the disconnect argument is often based on the observation that production has become fragmented across countries in global value chains. Smart phones assembled in China using parts from multiple countries are one such example. A rising share of exports consists of components imported from abroad (foreign value content), and a currency depreciation should thus provide a more limited boost to exports. The puzzling weakness of Japanese exports since 2012 despite the yen’s depreciation of more than 30% in real effective terms has further fueled the disconnect debate.
A disconnect of exchange rates from trade would complicate policymaking. It would weaken a key channel for the transmission of monetary policy and make it harder to reduce trade imbalances via the adjustment of exchange rates.
Concerns that exchange rates may have disconnected from trade have been assuaged in the past. In the 1980s, the US dollar depreciated and the yen appreciated sharply after the 1985 Plaza Accord, but trade volumes were initially slow to adjust. Some commentators then suggested a disconnect between exchange rates and trade. By the early 1990s, however, US and Japanese trade balances had adjusted, largely in line with the predictions of conventional models (Krugman 1991). The question is whether this time will be different, or whether the relationship between exchange rates and trade remains strong.
New evidence on exchange rate movements and trade flows
Our analysis in chapter 3 of the IMF’s October 2015 World Economic (Leigh et al. 2015) sheds new light on this issue by taking a fresh look at the relationship between exchange rate movements and trade flows.
We use data for more than 50 advanced and emerging market and developing economies over the past three decades. The growing importance of emerging markets in world trade justifies this broad country coverage, which goes beyond the group of countries typically examined in related studies.
Our estimation approach employs both standard trade equations (following the pricing-to-market literature recently reviewed in Burstein and Gopinath 2014) and an event analysis of historical episodes of large exchange rate depreciations. This allows us to measure the strength of the links between exchange rates and the relative prices of exports and imports, as well as the links between these relative trade prices changes and movements in export and import volumes.
Contrary to the notion of disconnect, we find a strong link between exchange rates and trade.
- Overall, we estimate that 10% real effective exchange rate depreciation implies, on average, a 1.5% of GDP increase in real net exports.
This impact varies widely across economies (Figure 1). Much, though not all of the adjustment, occurs within a year.
Our analysis of historically large exchange rate movements, which include, for example, economies affected by the 1992 European Exchange Rate Mechanism crisis, or the devaluation of the Chinese yuan in 1994, further supports the notion that exchange rate depreciations raise exports. It also suggests that, among economies experiencing currency depreciation, the rise in exports is greatest for those with slack in the domestic economy and with financial systems operating normally.
Figure 1. Effect of a 10% real effective depreciation on real net exports (Percent of GDP)
Source: IMF staff calculations.
Note: Figure shows long-term effect on level of net exports in percent of GDP based on country-specific import- and export-to-GDP ratios and average cross-country trade elasticities.
Little sign of disconnect over time
We also find little evidence of a general disconnect in the relationship between exchange rates and exports and imports over time.
We find some evidence that the rise of global value chains has weakened the relationship between exchange rates and trade for some products and some economies, particularly for trade in intermediate products used as inputs into other economies’ exports. This finding is especially relevant for economies that have substantially increased their participation in global value chains, such as, for example, Hungary and Romania. (It is also consistent with the findings of Ahmed et al. 2015a and Cheng and others, forthcoming.)
But it is important to keep this result in perspective. Global value chain-related trade has generally increased only gradually through the decades and appears to have slowed in recent years (Constantinescu et al. 2015). The bulk of global trade still consists of conventional trade, with the foreign value content of exports currently averaging only about 25% across economies (Figure 2).
Furthermore, other developments, including declining barriers to trade movements, may have strengthened the effects of exchange rates on exports and imports. And it is worth recalling that even a decline in trade elasticities could, at least in principle, be consistent with greater economic significance of exchange rate movements, given the rising size of exports and imports in percent of GDP.
Figure 2. Evolution of global value chains (Foreign value added in percent of gross exports)
Source: Duval and others 2014, Johnson and Noguera 2012, and OECD
Note: Solid lines denote the average. Dashed lines denote 25th and 75th percentiles.
When we test the stability of the relationship between exchange rates and total trade, we find little evidence of the links weakening over time. Rolling regressions and structural break tests do not support the notion of a general disconnect for different country groups.
As for the puzzling weakness of exports in Japan, our analysis suggests that this reflects a number of Japan-specific factors. Export growth has been weaker than could be expected based on exchange rate and trading partner growth developments. But our analysis suggests that this largely reflects the surge in production off-shoring after the crisis and the 2011 earthquake, which coincided with and offset much of the boost to exports from the yen’s depreciation.
Relation to existing work
The study by Ahmed et al. (2015b) finds larger trade elasticities than we do for a sample of 46 economies, implying even stronger effects of exchange rates on exports. But it also argues that the responsiveness of exports to the real effective exchange rate has declined substantially over time.
When we replicate the analysis for the economies examined in that study, we find that the evidence of a drop in the effectiveness of exchange rate movements over time is fragile. The estimated drop largely disappears after controlling for a small number of influential outlier observations. Results based on ‘robust’ regressions in which observations are automatically given a lower weight in the estimation if they have excessive influence indicate little evidence of a drop in trade elasticities. The same applies after computing real exports by deflating nominal exports using export prices rather than the CPI as in the study.
A Financial Times (2015) study goes further, arguing that the “benefits of depreciation on exports may have evaporated”. The argument is based on the apparent lack of a correlation between exports and US dollar exchange rates for emerging markets since 2013. However, since the cross-section scatter plots presented there do not control for other factors that drive exports, including shifts in trading partner demand, they are affected by omitted variables and reverse-causality problems. And since the study only considers years since 2013, it cannot shed light on whether the links between exchange rates and exports have weakened over time.
Overall, we conclude that the relation between exchange rates and trade remains strong and that reports of a disconnect have been overstated.
Our evidence suggests that recent currency movements imply a substantial redistribution of real net exports across economies, from the US and economies whose currencies move with the dollar to economies whose currencies have depreciated. (Beyond these direct effects, observed changes in trade also reflect shifts in the underlying fundamentals driving exchange rates themselves.)
From a policy standpoint, our results confirm that exchange rate movements can still help to reduce trade imbalances. Exchange rate movements also continue to have a strong bearing on export and import prices, with implications for inflation dynamics and the transmission of monetary policy. However, our research does not address the desirability of any specific exchange rate change or any particular policy stance in any specific country.
Disclaimer: The views expressed in this article are the sole responsibility of the authors and should not be attributed to the International Monetary Fund, its Executive Board, or its management.
Ahmed, S, M Appendino, and M Ruta (2015a), “Depreciation without exports”, VoxEU.org, 27 August.
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