Academic journal article Journal of Agricultural and Resource Economics

Estimating the Effects of Exchange Rate Volatility on Export Volumes

Academic journal article Journal of Agricultural and Resource Economics

Estimating the Effects of Exchange Rate Volatility on Export Volumes

Article excerpt

This paper takes a new empirical look at the long-standing question of the effect of exchange rate volatility on international trade flows by studying the case of Taiwan's exports to the United States from 1989-1998. In particular, we employ sectoral-level, monthly data and an innovative multivariate GARCH-M estimator with corrections for leptokurtic errors. This estimator allows for the possibility that traders' forward-looking contracting behavior might condition the way in which exchange rate movement and associated risk affect trade volumes. Change in importing country industrial production and change in the expected exchange rate are found to jointly drive the trade volumes. More strikingly, monthly exchange rate volatility affects agricultural trade flows, but not trade in other sectors. These results differ significantly from those obtained using more conventional and restrictive modeling assumptions.

Key words: agricultural trade, exchange rate, expectations, GARCH

Introduction

One of the leading conundrums in international economics concerns the relationship between exchange rate risk and international trade volumes. The widespread popular perception that greater exchange rate risk reduces trade has helped motivate monetary unification in Europe (European Union Commission, 1990) and is strongly related to currency market intervention by central banks (Bayoumi and Eichengreen, 1998). Most current microstructural theoretical models of exporter behavior predict a negative relation between exchange rate risk, reflected in the conditional variance of the exchange rate, and export volumes [see Barkoulas, Baum, and Calgayan (2002) for one good, recent example].

Yet a vast economic literature yields highly inconsistent empirical results on this issue. One common argument is that exporters can easily ensure against short-run exchange rate fluctuations through financial markets, while it is much more difficult and expensive to hedge against long-term risk. Cho, Sheldon, and McCorriston (2002), DeGrauwe and de Bellefroid (1986), Obstfeld (1995), and Peree and Steinherr (1989), for example, demonstrate that longer-run changes in exchange rates seem to have more significant impacts on trade volumes than do short-run exchange rate fluctuations that can be hedged at low cost.

On the other hand, Vianne and de Vries (1992) show that even if hedging instruments are available, short-run exchange rate volatility still affects trade because it increases the risk premium in the forward exchange rate. Doroodian (1999), Krugman (1989), Mundell (2000), and Wei (1999) argue that hedging is both imperfect and costly as a basis to avoid exchange rate risk, particularly in developing countries and for smaller firms more likely to face liquidity constraints. This leads to the conventional argument that exchange rate volatility causes revenue uncertainty which will dampen trade due to risk aversion, irreversible investment in productive capital, or both (Ethier, 1973; Demers, 1991; Sercu, 1992). DeGrauwe (1988) nicely illustrates how the relationship between exchange rate volatility, whether long run or short run, and trade flows is analytically indeterminate when one allows for sufficient flexibility in assumptions. This suggests the effects of exchange rate volatility on trade volumes remain a fundamentally empirical issue.1

The empirical literature on this topic is mixed. Several authors have found that exchange rate uncertainty may induce marginal producers and traders to shift from trade to nontraded goods, thereby dampening trade volumes (Arize, Osang, and Slottje, 2000, 2004; Broda and Romalis, 2004; Chowdhury, 1993; Pozo, 1992). In contrast, other studies have found exchange rate volatility may stimulate trade (Delias and Zillberfarb, 1993; Frankel, 1992; Sercu and Vanhulle, 1992). Finally, many empirical studies have failed to establish any significant link between measured exchange rate variability and the volume of international trade (Aristotelous, 2001; Assery and Peel, 1991; Gagnon, 1993; Tenreyro, 2004). …

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