The increasing volatility of exchange rates after the fall of the Bretton Woods agreements has been a constant source of concern for both policymakers and academics. Developed countries fought hard in the 1980s to limit US dollar fluctuation (one thinks of the Plaza and Louvre’s agreements, respectively in 1985 and 1987), and some European countries took an even more radical decision by giving up their national currency for the euro in 1999.
The underlying intuition is simple: exchange-rate risk increases transaction costs and reduces the gains to international trade. Surprisingly, macroeconomic evidence of the effect of exchange-rate volatility on trade, and more generally on growth, has been quite mixed, pointing to very small or insignificant effects. In that context, it seems quite puzzling to see a number of countries, especially the emerging economies, adopting more or less fixed exchange-rate systems, especially when one remembers the painful collapses of south-east Asian fixed pegs or of the Argentinian currency board at the turn of the century.
However, more recent work has emphasised that these results could be due both to an aggregation bias (Broda and Romalis 2010) and an excessive focus on richer countries with highly developed financial markets, since much more substantial negative effects of the exchange-rate volatility on trade (Grier and Smallwood 2007) and growth (Aghion et al. 2009) are found for developing countries. This column provides support for both claims, arguing that there is indeed a negative impact of exchange-rate volatility on firms’ exporting behaviour, magnified for financially vulnerable firms, and dampened by financial development.
Exchange-rate volatility, financial dependence and firm-level trade
Several mechanisms can generate a negative impact of exchange-rate volatility on trade, proportionally stronger for financially vulnerable firms – and consequently weaker with high levels of financial development. One can think of exchange-rate risk, which creates uncertainty for the exporter's earnings. The existence of well-developed financial markets should allow agents to hedge exchange-rate risk, thus dampening or eliminating its negative effects on trade. But this effect is not clearly established, either empirically or theoretically. In that sense, mitigation of exchange-rate risk is unlikely to be the main sources of the growth-enhancing effect of financial development found in the literature.
Keeping in mind that sunk costs of exports are similar to investments in intangible capital, such research and development (Berman and Héricourt 2010), and that exchange-rate movements also give rise to sunk costs (Greenaway and Kneller 2007), the negative impact of exchange-rate volatility on exports can be rationalised through the asymmetry of adjustment costs leading to investment irreversibility. Fixed start-up costs for entering the export market include costs of gathering information on foreign markets, establishing a distribution system and, more generally, adapting products to foreign tastes and environments. When facing a real depreciation of its own currency, the current earnings of a firm rise. The firm may use this additional income to fund the sunk costs of entering new markets. But once these investments are made, it will be very difficult, and most of the time impossible, to back out and recover the cost of those investments even in the case of an abrupt subsequent currency appreciation. If firms are credit constrained, they will face additional difficulties to fund new investments, and will be even more reluctant to take the chance of engaging in exports to markets characterised by highly volatile exchange rates.
Lessons from China
In our recent paper (Héricourt and Poncet 2012), we find support for this kind of mechanism using a panel of Chinese firms. In this study, we investigate both the impact of real exchange-rate volatility on the exporting behaviour and the way financial constraints, together with financial development, shape this relationship at the firm level. Our empirical estimations rely on export data for more than 100,000 Chinese exporters over the period 2000-06. We have access to information on firms’ foreign sales as well as on the structure of their exports, including the products and destinations they serve. We also infer firm-level financial vulnerability from the financial dependence of their activities. Using this detailed information, we identify the impact of exchange-rate volatility (defined as the yearly standard deviation of monthly log differences in the real exchange rate, the latter being computed as the ratio of nominal exchange rate of the yuan with respect to the partner's currency divided by the partner's price level) on different measures of intensive and extensive margins, depending on the level of financial constraints.
We find that that firms tend to export less and fewer products to destinations with higher exchange-rate volatility. It also appears that the magnitude of this export-deterring effect depends on the extent of firms’ financial vulnerability. To illustrate these results, we can compare the reduction in the export performance due to real-exchange-rate volatility for strongly and weakly credit-constrained firms. Regarding the strongly constrained firms, our results suggest that a two percentage point (i.e. one standard deviation) increase in yearly real-exchange-rate volatility would reduce the export value by 3%, and the number of exported products by 0.85%. The effect is lower, but still present, for weakly constrained firms: for them, the same 2% increase in yearly real-exchange-rate volatility cuts the export value by 0.24%, and the number of exported products by 0.07%. Tough non-negligible, the effects appear therefore quantitatively less important for the extensive margin of trade than for the intensive margin.
Mitigating role of financial development
We subsequently exploit Chinese cross-provincial heterogeneity to study how financial development (measured as the share of total credit over GDP in the province) may mitigate both credit constraints and exchange-rate volatility. We do find that financial development directly (that is, independently of the level of financial dependence) dampens the negative impact of real-exchange-rate volatility, but our results also point to an even stronger relaxation effect when sectoral financial dependence increases, especially on the intensive margin of export. Quantitatively, this second type of effect is much stronger than the direct one, with a range from one to ten.
These results are directly in line with recent macroeconomic literature emphasising that financial development tends to reduce the impact of exchange-rate volatility on economic performance (see Aghion et al. 2009). Doing so, we provide a microfounded investigation of this effect, and propose a potential channel for it (through exports).
Our results emphasise that the magnitude of the negative impact of real-exchange-rate volatility depends mainly on the extent of financial constraints, and therefore, on the level of financial development. These findings in the Chinese context are especially interesting, because China appears as a typical case for analysing issues raised by exchange-rate volatility for developing countries. First, as the country is progressively giving up its relatively rigid exchange-rate system, the exchange-rate volatility is expected to substantially rise in the future, due to progressive removal of trading restrictions on the yuan, with a goal of having a basically convertible currency by 2015. Second, the export rate is particularly high related to the economic size of China, leading to substantial exposure to exchange-rate fluctuations. Finally, the high heterogeneity in terms of both (regional) financial development and (sectoral) financial dependence enlightens that credit constraints are key in determining to what extent the exchange-rate volatility will be harmful to trade.
There are a couple of lessons to draw from our research:
- The development of credit markets is crucial to help firms to overcome the additional export sunk cost related to real-exchange-rate volatility.
Better access to external finance would support the expansion of firms' exports, particularly to those destinations characterised by real-exchange rate-related uncertainty.
- More generally, our study emphasises that emerging countries should be careful when relaxing their exchange-rate regime.
Hard fixed pegs for developing countries are certainly not always a panacea, but moving to a fully floating regime without the adequate level of financial development could also prove to be very hazardous for trade performance.
Aghion Philippe, Philippe Bacchetta, Romain Rancière and Kenneth Rogoff (2009), “Exchange rate volatility and productivity growth: The role of financial development”, Journal of Monetary Economics, 56, 494-513.
Berman Nicolas and Jérôme Héricourt (2010), “Financial Factors and the Margins of Trade: Evidence from Cross-Country Firm-Level Data”, Journal of Development Economics 93(2), 206-217.
Broda Christian and John Romalis (2010), “Identifying the Relationship Between Trade and Exchange Rate Volatility”, NBER Chapters in “Commodity Prices and Markets”, East Asia Seminar on Economics 20, 79-110, National Bureau of Economic Research, Inc.
Greenaway David and Richard Kneller (2007), “Firm heterogeneity, exporting and foreign direct investment”, Economic Journal, 117(517), 134-161.
Grier Kevin B and Aaron D Smallwood (2007), “Uncertainty and Export Performance: Evidence from 18 Countries”, Journal of Money, Credit and Banking 39(4), Blackwell Publishing, 965-979.
Héricourt Jérôme and Sandra Poncet (2012), “Exchange rate volatility, financial constraints and trade: empirical evidence from Chinese firms”, CEPII Discussion Paper 2012-35, December.