The Eurozone is close to slipping into a recession. The most recent OECD forecasts point to an average growth of 0.2% of GDP in volume within the EZ151 in 2012, ranging from -3% (Greece and Portugal) and -0.5% (Italy), to +0.6% (Germany) and +1% (Ireland). The synchronised poor growth performance observed in most European countries can be explained by many factors, including trade and financial linkages, in a context of high economic integration between proximate economies. On the trade side, the contraction of exports reduces GDP growth mechanically. In parallel, the high correlation of aggregate consumption between these countries is also affecting domestic sales of European firms. This column argues that, on top of this, firms’ domestic sales are also directly affected by the fall in their exports to European countries in crisis, and that this mechanism amplifies the transmission of foreign recessions to the domestic economy.
The export-domestic sales complementarity at the firm level
In most recent international trade theories (e.g. Melitz 2003), variations in foreign demand do not affect firms’ production decisions for the domestic market. There are a number of reasons to believe the opposite, however. Exports and domestic sales may, for example, compete for resources, so that a depressed foreign demand should free production capacity to serve the domestic market.2 On the other hand, a reduction in cash flow due to a fall in foreign demand may reduce firms’ capacity to invest and supply domestic consumers. In a recent paper (Berman at al. 2011), we find support for this last mechanism using a panel of French firms.
Our study relies on firm-level data from France over the period 1995-2001. We have access to information on manufacturing firms’ domestic and foreign sales, as well as on the structure of their exports, including the products and destinations they serve. Using this detailed information, we identify a number of changes in the foreign demand conditions faced by the firms, depending on the products and destinations that they served (changes in foreign demand for a given product, variations in import tariffs, etc.) We also consider large shocks, such as financial crises or civil wars. All these factors determine the sales of firms in their foreign markets, but are unlikely to be affected by firms’ production decisions.
We find that a reduction in a firm’s exports, due to adverse foreign demand conditions, tends to reduce its domestic sales. The analysis shows that this complementarity between exports and domestic sales can be observed during the same year, i.e. there is an immediate transmission from foreign sales to exports, and that it is independent from the domestic demand conditions that could also be affected by the correlation of consumption across countries. When exports decrease by 10%, domestic sales drop by 1.5- 3%. This is true whatever the source of variation in foreign demand (positive foreign shocks have a similar positive effect on domestic sales).
An illustration: The 1997-8 Asian Crisis
An example can be given using the Asian Crisis of the late 90s. The financial crisis, as well as the large currency devaluations that occurred in a number of Asian countries in 1997-8 (Thailand, Philippines, Indonesia, South Korea, and Malaysia), generated a large drop in demand for French firms exporting to these countries. We find that their exports did indeed drop, but so did their domestic sales. Figure 1 shows the domestic sales of different groups of French firms, defined according to their “exposure” to the five countries listed above. This “exposure” represents the average share of French firms’ exports to the Asian countries that were affected by the crisis, during the two years before the crisis occurred (1995 and 1996). Firms that were exposed to the Asian countries before 1997 clearly exhibit a slower growth of their domestic sales by 1997, and those firms with an exposure higher than 20% of total export sales report a drop in their domestic sales during the period of the Asian Crisis, 1997-8. This descriptive evidence is strongly supported by our econometric analysis when we control for firms’ characteristics and the evolution of the domestic demand addressed to these firms. By 1997, domestic sales are found to be 5% lower for those firms that were exposed to the crisis countries.
Figure 1. Average domestic sales of French firms
Notes: Exposure represents the average share of exports to Asian crisis countries in 1995 and 1996. Only firms present over the entire period are considered.
The role of liquidity
How are shocks affecting foreign demand transmitted to firms' domestic sales? Among other potential explanations, we show that the need for short-run liquidity may be especially relevant. More precisely, the cash flow generated by exports may be used by firms to finance domestic operations in the short term (to pay suppliers, hire workers or invest), which would generate the type of complementarity that we observe. Indeed, we find that firms belonging to sectors in which the need for short-term liquidity is higher – due to higher working-capital requirement – have domestic sales that exhibit a significantly larger response to exports through foreign demand variations. This is also true for firms with fewer tangible assets, and for the smaller ones. This clearly supports the idea that the complementarity is likely to be stronger for the most financially vulnerable firms.
Of course, other channels cannot be excluded. We tested the possibility that the complementarity could be stronger for firms that operate in sectors exhibiting increasing returns to scale. For these firms, a positive demand shock on the foreign market would increase the production scale and decrease average cost. This increase in a firm's efficiency would promote sales at home if it is (at least partially) reflected in the price of goods sold in the domestic market. The analysis that we perform for French firms does not, however, confirm that complementarities between exports and domestic sales are driven by this mechanism. We also examine a possible role of capacity constraints, the latter inducing a substitutability relationship between exports and domestic sales. We find that in sectors where inventories are large, i.e. where firms are less likely to face capacity constraints, the complementarity between exports and domestic sales is stronger. However, this complementarity is still present in sectors where firms are more subject to capacity constraints. In any case, more research is certainly needed to determine the channel of transmission that is prevalent in explaining this export-domestic sales complementarity.
Back to the Eurozone Crisis
Our results emphasise that the transmission of foreign shocks to the domestic economy can be magnified by the complementarity between exports and domestic sales within firms. This channel comes on top of the mechanical effect of exports on GDP growth, the correlation of consumption across countries that also affects domestic sales of French firms, and other factors, such as financial linkages. The exports-domestic sales complementarity is verified in the case of the Asian Crisis, although this time the situation is quite different. Many more French firms are exposed to the fall in demand in Europe through their exports, and to a much higher degree.
Given the strong integration of European economies, this research highlights that policies implemented with the objective of reducing debt and public deficits (public cuts in pensions, social expenditures, etc.) and increasing competitiveness (through the reduction of unit labour costs) in neighbouring countries will, among other transmission channels, affect the domestic sales of French firms, and may reduce economic growth. This situation may then feed back into the economic growth of neighbouring economies.
The generalisation of beggar-thy-neighbour policies in Europe is likely to drive the overall European economy into a slow-growth and high-debt trap, despite desperate efforts by European governments to tackle the latter. What follows is that the macroeconomic adjustment required in countries most affected by the crisis needs to be supported by those countries in better shape. More cooperation is critically needed in Europe.
Authors' note: This column does not reflect the views of the Banque de France.
Ball, R. J. Eaton, J. R. and M. D. Steuer (1966), “The Relationship Between United Kingdom Export Performance in Manufactures and the Internal Pressure of Demand”, The Economic Journal, Vol. 76, No. 303, pp. 501-518
Berman, N., Berthou, A. and J. Héricourt, (2011), “Export dynamics and sales at home”. CEPR Discussion Paper 8684.
Faini, R. (1994), "Export supply, capacity and relative prices," Journal of Development Economics, Elsevier, vol. 45(1), pp. 81-100.
Melitz, M. J. (2003), “The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity”, Econometrica, Econometric Society, vol. 71(6), pp. 1695-1725.
Vannoorenberghe, G. (2011), “Firm-level volatility and exports”, Journal of International Economics, forthcoming.
1 The EZ15 include only OECD countries, therefore excluding Cyprus and Malta.
2 Several papers advocate this substitutability relationship between domestic sales and exports, from Ball et al. (1966) to Faini (1994) or, much more recently, Vannoorenberghe (2011).