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Exchange Rates, International Trade and Trade Policies

Article by Alessandro Nicita, 2013

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This paper analyses the impact that exchange rate volatility and misalignment have on trade and whether exchange rate misalignments affect governments’ decisions on trade policies. It also shows that trade policy is used to compensate for some of the consequences of an overvalued currency, especially anti-dumping.

U n i t e d n at i o n s C o n f e r e n C e o n t r a d e a n d d e v e l o p m e n t


EXCHANGE RATES, INTERNATIONAL TRADE
AND TRADE POLICIES


POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES
STUDY SERIES No. 56




UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT












POLICY ISSUES IN INTERNATIONAL TRADE AND COMMODITIES


STUDY SERIES No. 56






EXCHANGE RATES, INTERNATIONAL TRADE


AND TRADE POLICIES








by



Alessandro Nicita
UNCTAD, Geneva















UNITED NATIONS
New York and Geneva, 2013





ii


Note


The purpose of this series of studies is to analyse policy issues and to stimulate discussions
in the area of international trade and development. The series includes studies by UNCTAD staff
and by distinguished researchers from academia. This paper represents the personal views of the
authors only and not the views of the UNCTAD secretariat or its member States.


The designations employed and the presentation of the material do not imply the
expression of any opinion on the part of the United Nations concerning the legal status of any
country, territory, city or area, or of authorities or concerning the delimitation of its frontiers or
boundaries.




This publication has not been formally edited.


Material in this publication may be freely quoted or reprinted, but acknowledgement is
requested, together with a copy of the publication containing the quotation or reprint to be sent to
the UNCTAD secretariat at the following address:




Chief
Trade Analysis Branch


Division on International Trade in Goods and Services, and Commodities
United Nations Conference on Trade and Development


Palais des Nations
CH-1211 Geneva


















Series Editor:
Victor Ognivtsev


Officer-in-Charge, Trade Analysis Branch








UNCTAD/ITCD/TAB/57








UNITED NATIONS PUBLICATION


ISSN 1607-8291








© Copyright United Nations 2013
All rights reserved





iii


Abstract




The exchange rate plays an important role in a country’s trade performance. Whether
determined by exogenous shocks or by policy, the relative valuations of currencies and their
volatility often have important repercussions on international trade, the balance of payments and
overall economic performance. This paper investigates the importance of exchange rates on
international trade by analysing the impact that exchange rate volatility and misalignment have on
trade and then by exploring whether exchange rate misalignments affect governments’ decisions
regarding trade policies. The methodology consists of estimating fixed effects models on a detailed
panel dataset comprising about 100 countries and covering 10 years (2000-2009). The findings of
this study are generally in line with those of the recent literature in supporting the importance of
exchange rate misalignment while disregarding that of exchange rate volatility. In magnitude,
exchange rate misalignments result in trade diversion quantifiable in about one per cent of world
trade. This paper also shows evidence supporting the argument that trade policy is used to
compensate for some of the consequences of an overvalued currency, especially with regard to
anti-dumping interventions. The findings of this research carry three broad policy implications.
First, policymakers need to pay attention to the exchange rates of their countries and those of other
countries as the effect of currency misalignments on international trade is considerable. Second, the
relative valuation of currencies can explain only a small part of global trade imbalances.
Adjustments in exchange rates can be only part of the solution for global rebalancing and need to
be accompanied by other policy actions. Finally, strategies to avoid the resurgence of protectionist
measures should include multilateral cooperation related to the stabilization of exchange rates
towards their equilibrium level.










Keywords: Trade policy, international trade, exchange rate


JEL Classification: F13, F14, F31













iv






Acknowledgements






The author wishes to thank Chad Bown, Valentina Rollo, Michele Ruta and
Ugo Panizza for useful comments and discussion. The author is also grateful to
participants at meetings in UNCTAD. Any mistakes or errors remain the author's own.










v


Contents




1 Introduction .......................................................................................................................... 1


2 Empirical strategy ................................................................................................................ 3


2.1 Measurement of exchange rate and trade policy variables .......................................... 3
2.2 Estimating frameworks ................................................................................................ 5


3 Results ................................................................................................................................... 7


3.1 Descriptive statistics .................................................................................................... 7
3.2 Econometric results .................................................................................................... 10




4 Conclusions and policy implications ................................................................................. 14


References .................................................................................................................................... 15





vi


List of figures


Figures 1a and 1b. Exchange rate volatility, distributions by year and by country ............................ 7
Figures 2a and 2b. Currency misalignments, distributions by year and by country ........................... 8
Figures 3a and 3b. Tariff trade restrictiveness index, distributions by year and by country .............. 8
Figures 4a and 4b. Exchange rate volatility and international trade ................................................... 9
Figures 5a and 5b. Exchange rate misalignment and international trade .......................................... 10
Figures 6a and 6b. Exchange rate misalignment and trade policy .................................................... 10
Figure 7. Overall trade diversion effect of exchange rate misalignments ......................................... 12






List of tables


Table 1. Exchange rates and trade flows .................................................................................... 11
Table 2. Exchange rate misalignment and trade policy ............................................................... 13








1


1. Introduction




The recent debate on persistent trade imbalances and on the resurgence of non-traditional
trade restrictive measures has led to a renewed interest in better understanding the effect of
exchange rates on international trade. In spite of the increasing number of studies on the topic, the
actual effect of exchange rates on international trade is still an open and controversial question.
The theoretical literature on the issue provides little guidance as the presumption that exchange
rates directly affect trade depends on a number of specific assumptions which do not hold in all
cases.


This paper contributes to understanding the relationship between exchange rates and
international trade by investigating the effect of exchange rate volatility and misalignment on
international trade and by exploring whether exchange rate misalignment affects trade policy
decisions. The methodological framework consists of fixed effects regressions estimated on a
detailed panel dataset comprising about 100 countries and covering 10 years (2000-2009).


The first aspect of the relationship between exchange rates and trade relates to exchange
rate volatility. The basic argument for which an increase in exchange rate volatility would result in
lower international trade is that there are risks and transaction costs associated with variability in
the exchange rate, and these reduce the incentives to trade. The findings of the economic literature
on this issue have evolved in the last few decades. While early studies found adverse effects of
exchange rate volatility on trade (Ethier, 1973; Clark 1973; Baron, 1976; Cushman, 1983; Peree
and Steinherr, 1989) subsequent studies report very small impacts (Franke, 1991; Sercu and
Vanhulle, 1992). More recently, the use of refined quantitative methods resulted in more
scepticism about causality of short-term exchange rate volatility on international trade (Clark,
Tamirisa and Wei, 2004; Teneyro, 2006). In summary, the relationship between the two variables
is most likely driven by underlining long-term policy credibility rather than the short-term causality
(Klein and Shambaugh, 2006; Qureshi and Tsangarides, 2010).1 In addition, any relation between
volatility and international trade could be driven by reverse causality, in which trade flows help
stabilize real exchange rate fluctuations, thus reducing exchange rate volatility (Broda and
Romalis, 2010). In any case, there are several reasons why volatility is often not a critical issue for
international trade. One particularly compelling argument is that the risks associated with volatile
exchange rates are softened by the increasing number of financial instruments available (e.g.
forward contract and currency options) that allow firms to hedge against these risks (Ethier, 1973).
Another critique is related to the presence of sunk cost in exporting (Krugman, 1989; Franke
1991). The higher the fixed costs of exports are, the less responsive firms (and therefore
international trade) are to exchange rate volatility. All this makes exchange rate volatility less of a
critical issue for international trade. In modern cross-border transactions firms often decide to
hedge against the risk in the exchange rate or to bear the cost associated with possible exchange
rate fluctuations as part of their export strategy.


The second aspect of the relationship between exchange rates and international trade
pertains to currency misalignments. The influence of currency misalignment on international trade
is largely driven by its impact on relative import prices (Mussa, 1984; Dornbusch, 1996).2 An
undervalued currency, whether determined by exogenous shocks or by policy, increases the
competitiveness of the export- and import-competing sectors at the expense of consumers and the




1
Ozrurk (2006) provides a review of the literature on volatility. A more recent review on volatility and


misalignment is provided in Auboin and Ruta (2011).
2
Relative prices respond to exchange rate movements at least in the short run. In the long run, with no


market distortions, relative prices return to their equilibrium level and thus the exchange rate has no effect on
international trade or any other economic variable. However, this is largely a theoretical proposition as in
practice there are many distortions which may hinder the adjustment of relative prices.





2


non-tradable sector (Frieden and Broz, 2006). In this regard, the effects of misaligned currency on
prices are similar to those of an export subsidy and import tax. The literature on the topic provides
a great amount of evidence on how responsive trade flows are to changes in relative prices
consequent to movements in exchange rates (Hooper and Marquez, 1995; Bernard and Jensen,
2004). Still, as in the case of volatility, there are a number of issues that greatly complicate the
relationship between exchange rate misalignment and international trade (Staiger and Skyes, 2010).
Of particular importance is the issue that part of the undervaluation or overvaluation of the
exchange rate is often absorbed by firms which do not fully adjust their price in the destination
country (Goldberg and Knetter, 1997). Related to this is the presence of irreversible sunken costs
of entry which act as powerful incentives for firms to stay in the market even when there is
substantial undervaluation of the importer currency (Baldwin, 1988; Froot and Kemperer, 1989).
Finally, vertical integration and the role of production networks (the presence of a large share of
imported inputs) make currency misalignment less important (Zhao and Xing, 2006).3


The final issue on the relationship between exchange rates and trade explored here regards
the effect of exchange rate misalignments on trade policy. The rationale is that the stance of the
exchange rate may indirectly affect governments’ decisions regarding other policies, especially
those affecting international trade.4 The recent literature on this topic is more limited and largely
focused on contingency measures. Most of the studies find that long periods of overvalued
exchange rates are often associated with an increase in the use of protectionist trade policies,
especially anti-dumping (Frieden, 1997; Knetter and Prusa, 2003; Irwin, 2005; Oatley, 2010).5
Trade policy may be used to compensate for some of the effects of an overvalued currency.
Domestic firms that lose competitiveness as a result of a real exchange rate appreciation may lobby
for restrictive trade policies. In practice, disputes over exchange rate policies among trading
partners could foster an increase in domestic political pressures and unilateral action on trade
(Copelovitch and Pevehouse, 2010). In more general terms, countries may also be using trade
policy as a substitute for exchange rate overvaluation, so as to deal with persistent disequilibria in
the trade balance.


The main findings of this paper can be summarized as follows. First, exchange rate
volatility does not affect international trade except in the occurrence of currency unions and
pegged exchange rates. That is, any relationship between the volatility and trade variables is most
likely driven by the underlining long-term policy credibility provided by currency unions and
pegged exchange rates rather than short-term volatility itself. The second finding is that exchange
rate misalignments do affect international trade flows in a substantial manner. Currency
undervaluation is found to promote exports and restrict imports and conversely in the case of
overvaluation. In magnitudes, misalignments across currencies result in trade diversion
quantifiable in about one per cent of world trade. Finally, this paper finds some evidence
supporting the argument that trade policy is used to compensate for some of the repercussions of an
overvalued currency. However, the policy response seems to be largely restricted to anti-dumping
interventions. The evidence of a response in terms of slower overall tariff liberalization in periods
of currency overvaluation is small.


3
A large number of studies have also focused on the relationship between exchange rate misalignments and


international trade in terms of competitive devaluation. The empirical literature is generally supportive in
finding evidence of the effects of exchange rate misalignments on economic growth. On one hand, an
overvalued currency is generally found to hamper economic growth (Gala 2008; Rajan and Subramanian,
2009). On the other hand, an undervalued currency is often found to stimulate economic growth (Rodrik,
2008; Berg and Miao, 2010, Korinek and Serven, 2010).
4
For example, Eichengreen and Irwin (2009) suggest that protectionism in the early 1930s was at least as


much a consequence of governments’ exchange rate policies as a result of the collapse of aggregate demand.
5
Fernández-Arias, Panizza and Stein (2003) examine the relationship between exchange rates and trade


policy in a regional agreement context.








3


The remainder of this paper is organized as follows. Section 2 presents the empirical
approach while section 3 presents some descriptive statistics and the econometric results. Section 4
concludes.




2. Empirical strategy




In investigating the three aspects of the relationship between exchange rates and trade, the
empirical strategy takes advantage of a detailed bilateral dataset comprising trade, trade policies,
and exchange rate data. Bilateral trade data originate from the United Nations COMTRADE, while
primary tariff data are from UNCTAD TRAINS.6 Data on anti-dumping are from the World Bank
Temporary Trade Barriers Database (Bown, 2010), while the data utilized for the construction of
exchange rate indices originate from the Penn World Tables and OANDA.7


The estimating framework for assessing the effect of exchange rate volatility and
misalignment consists of an econometric model where a set of fixed effects controls for all the
determinants of trade flows normally included in gravity model specifications. The relationship
between exchange rate appreciation and trade policy is similarly explored with a fixed effects
model. Before entering into the details of the estimating frameworks some discussion on the
variables of interest is in order.




2.1 Measurement of exchange rate and trade policy variables


Although there is voluminous literature on exchange rate volatility, there is no consensus
on how to measure it. Volatility measures vary from simple deviations from an average level, to
more sophisticated econometric estimations following co-integration methods (Lothian and Taylor,
1997).8 This paper utilizes the commonly used measure where bilateral exchange rate volatility is
measured as the standard deviation of the first difference of the monthly exchange rate.9 More
formally, exchange rate volatility between countries k and j in year t is given by:


)]ln().[ln(. 1,, −−= mkjtmkjtkjt ERERdevstdERvol


where ER is the nominal exchange rate and m denotes months.10 A value of kjtERvol equal to zero
implies no volatility as in the case of a fixed exchange rate regime. The standard deviation is
calculated over a one-year period so as to measure short-run volatility. The aggregated volatility at
the country level is simply the trade weighted average of bilateral volatility. This indicator is
commonly referred to as the effective volatility of a country’s exchange rate.


As with volatility, there are several methods to measure exchange rate misalignment. Since
misalignment is simply the difference between the observed exchange rate and its estimated


6
Both trade and tariff data are available through the WITS portal (wits.worldbank.org)


7
Historical data on nominal exchange rates are available at www.oanda.com.


8
Moreover, exchange rates may be endogenous as central banks may try to stabilize the exchange rate


against main trading partners. To correct for this endogenous element, some of the measures of volatility use
a conditional variance approach which allows for more information than the simple standard deviation
method (Karolyi, 1995).
9
Rose (2000) and Tenreyro (2003).


10
Often volatility is estimated in real rather than nominal terms. Empirically, it does not make much of a


difference whether using real or nominal exchange rates as the measures are highly correlated in the short
term.





4


equilibrium level, the key issue is how to calculate the equilibrium exchange rate. Measures of the
equilibrium exchange rate vary from simple approximations to complex estimates which take into
account various possible determinants. The simplest measure of misalignment consists of the
percentage difference of the observed level of the currency to its level in a reference period. This
measure is clearly subject to the choice of the reference period and thus is more appropriate to
measure appreciation or depreciation trends rather than misalignment itself. More common
measures of misalignment utilize currency deviations from its purchasing power parity (PPP)
value. The PPP approach can be refined to various degrees as in the case of the fundamental
equilibrium real exchange rate (FEER).11 In general, the measurement of exchange rate
misalignment is a controversial issue. Even the more sophisticated estimates are subject to
critiques, as any estimate would depend on the estimating period and the included set of
determinants.12


For the purpose of this paper, the measure of exchange rate misalignment follows a
relatively simple PPP approach (Rodrik, 2008). This method consists of three steps. First, the real
exchange rate term is computed as the nominal exchange rate divided by the PPP conversion
factor. In more formal terms:


)/ln()ln( ktktkt PPPERRER =
where as before k denotes the country and t is time. When the RER exceeds one, it implies that the
currency is valued below what is indicated by its purchasing power parity. Second, to calculate the
level of misalignment the RER needs to be confronted with the fact that price levels of non-traded
goods are correlated with the country’s level of development (the Balassa-Samuelson effect). This
is taken into account by regressing the RER on per capita GDP (GDPPC), or more formally:


ittitit uGDPPCRER +++= φβα )ln()ln(
where tφ is time-fixed effects and u is an error term. Then, the measure of misalignment is given
by the difference between the observed exchange rate and the exchange rate adjusted for the
Balassa-Samuelson effect. The level of undervaluation or overvaluation between two countries is
then approximated simply by adding the respective levels of misalignments.13 This variable is
labelled kjtEXrateMis _ .


In regard to trade policy variables, this paper utilizes two variables for capturing trade
policy changes. The first variable is change in the level of the overall tariff structure. The argument
for linking this variable to the exchange rate is that countries whose currency is appreciating would
be less inclined to pursue trade liberalization as the overvalued currency already exposes domestic
industries to increased foreign competition. The overall level of tariffs is measured by the tariff
trade restrictiveness index (TTRI) calculated by Fugazza and Nicita (2011) and based on the work
of Kee, Nicita and Olarreaga (2008 and 2009).14 In the construction of the TTRI, the aggregation
across products uses import demand elasticities to take into account the fact that the imports of


11
The FEER approach is the method favoured by the IMF. However, their statistics on misalignment are


strictly confidential and not publicly available.
12


Determinants in the estimation of the FEER often include terms of trade, output per worker, government
spending, net foreign assets and openness (Froot and Rogoff, 1995).
13


In the calculation of exchange rates the reference currency is the United States dollar.
14


The authors show that the calculation of the MTRI can be greatly simplified in a partial equilibrium setting
so as to take into account only own price effects, while ignoring cross price effects on import demand
(Feenstra, 1995). In doing so, the OTRI can be calculated as a weighted average of the levels of protection
(tariff and non-tariff measures) across products where the weights are functions of import shares and import
demand elasticities.







5


some goods may be more responsive to an overvalued exchange rate.15 In formal terms, the TTRI
faced by country j in exporting to country k is:





=


hs
hsjkhsjkt


hsjkt
hs


hsjkhsjkt


jkt


T
TTRI


,,


,,,


ε


ε


x


x




where x indicates exports from country j to country k, ε is the bilateral import demand elasticity, T
is the bilateral applied tariff, and hs are HS 6-digit categories. The TTRI reflects any preferential
tariff imposed and faced by each country.


The second measure of trade policy is related to anti-dumping (AD). The hypothesis is that
firms may lobby a government to initiate an anti-dumping investigation to counteract some of the
effect of a trading partner’s undervalued currency. In such cases, one would expect an increase of
anti-dumping investigations when the misalignment between two currencies increases. The trade
policy variable thus consists of the number of anti-dumping cases initiated during the year.16 This
variable is labelled jktADPolicy .




2.2 Estimating frameworks


In order to test the relationship between exchange rates and trade, this paper employs a
simple panel analysis on a dataset covering 95 countries from 2000 to 2009. The estimating
framework applies two models. The first model is suited to explain the impact of the exchange rate
on the level of trade, while the second model measures the impact of the exchange rate on trade
policy.17


The relationship between trade and exchange rate volatility and misalignment is measured
by a panel gravity model where a set of fixed effects controls for all the determinants of trade flows
normally included in the standard gravity model specifications. More formally, the estimation of
the effect on trade due to changes in the exchange rate is based on the following specification:


jktkjtkjjktjtjktjktjkt MRGDPTTRIxrateX φθςψωβββββ ++++++++++= 43210 )1ln(ln


where the subscript j denotes exporters, k denotes importers and t denotes year, and where X is the
value of total exports, xrate denotes the variables capturing volatility ( kjtERvol ) and misalignment
( kjtEXrateMis _ ). The TTRI controls for changes in bilateral trade policies, tkjkj ςθψω ,,, , are a
set of fixed effects and jktφ is an error term. Multilateral resistance (Anderson and Van Wincoop,
2003) is proxied by adding multilateral resistance variables as in Baier and Bergstrand (2009) and


15
Intuitively, products where imports are less sensitive to prices (inelastic) should be given less weight


because an overvalued exchange rate would have a lesser effect on the overall volumes of trade.
16


By using changes instead of levels, the variable accounts for the fact the some countries may be more
assiduous users of AD than others.
17


Although these two models could possibly be more efficiently estimated in a simultaneous equation model
context, that is beyond the purpose of this paper. In addition, by estimating the system in two separate
equations the estimates may be not efficient but are still consistent, and any misspecifications in one of the
equations will not affect the results of the other.






6


Baier, Bergstrand and Mariutto (2010). This methodology produces consistent estimates and,
contrary to using country-time effects, allows the estimation of the impact of time-varying country
specific factors such as exchange rates. The model is also estimated within a specification where
country-pair fixed effects are replaced by standard bilateral gravity variables (distance, contiguity,
language and colonial links). This accounts for the effect of pegged currencies which otherwise
would be fully captured by country-pair fixed effects.


The second model tests the hypothesis that the choice and pace of trade liberalization may
also be affected by exchange rates. This model empirically explores whether exchange rate
misalignment has an effect on trade policy response in terms of tariffs and anti-dumping
investigations. The general estimating equation is:


jktkjtjjtjktjktjkt GDPXEXrateMisytradepolic φθφωββββ +++++++= 3210 _


where the subscripts are defined as above. This equation is estimated in a series of specifications


where tradepolicy is measured by the TTRI ( jktcyTariffPoli ) or by the number of anti-dumping
investigations ( jktADPolicy ).18 Two additional variables, import growth ( jktX ) and GDP, control
for other factors that may influence the demand for protection (e.g. a sudden increase in imports or
a decline in GDP). Country fixed effects ( jω ) control for time-unvarying country specific
characteristics and time fixed effects ( tφ ) control for global macroeconomic shocks. Country-pair
fixed effects ( kjθ ) control for any time-unvarying bilateral factors such as PTA that may influence
bilateral trade policy.






18
As count data are generally not normally distributed, the anti-dumping specification is estimated using a


negative binomial regression.







7


3. Results




This section first presents some descriptive statistics related to the variables of interest.
Then, it discusses the econometric results on the relationships between exchange rate and
international trade and trade policy.




3.1 Descriptive statistics


Figures 1a and 1b show the distribution of effective short-term exchange rate volatility19
for each of the years between 2000 and 2009 and then for each currency across years.20 As monthly
exchange rate data are not always available the volatility variable is calculated only for 68
countries. Overall volatility bottomed during the period of 2004-2006 to sharply increase at the
onset of the financial crisis. In just a few months at the end of 2008 some currencies oscillated 20
per cent or more in relation to the major reserve currencies.




Figures 1a and 1b. Exchange rate volatility, distributions by year and by country


0
.


02
.


04
.


06
.


08
vo


la
tili


ty


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


0
.


02
.


04
.


06
.


08
vo


la
tili


ty


by country - sorted by st.dev of volatility






Figure 1b shows that volatility is not a common problem to all currencies, but tends to be
concentrated in about half of the currencies in the sample. That is, while about half of the
currencies are more or less aligned with those of their trading partners (for example, because of
managed or pegged exchange rates), the other half fluctuates more widely. Currency fluctuation
may be detrimental to international trade as it increases the risk of cross-border transactions.


In regard to currency misalignments, figures 2a and 2b illustrate their distribution for each
year during the period of analysis and for each country. For the purpose of this graph, the
misalignment is not bilateral but is computed as a trade-weighted average as in the case of effective
volatility. The graphs report the distribution of the average misalignment faced by the currency vis-
à-vis a basket of currencies whose weight is determined by their trade importance. A value of
misalignment above zero implies overall overvaluation.






19
Short-term effective volatility is the average intra-year volatility of a currency versus all other currencies


weighted by imports.
20


For every year the box plot includes all values between the twenty-fifth and seventy-fifth percentiles, while
the bar represents the median. The interval between the lines outside the box comprises observations between
plus and minus 1.5 times the interquartile range which is normally used as a boundary to identify outliers.





8


Figures 2a and 2b. Currency misalignments, distributions by year and by country


-
1


-
.


5
0


.
5


m
isa


lig
m


en
t


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


-
1


-
.


5
0


.
5


m
is


al
ig


m
en


t


by country - sorted by level of misaligment






The first insight regarding misalignment is that currencies are generally not very aligned to
their respective purchasing power parity level (especially in 2003, 2004 and the last two years of
the analysis). A second insight is that while in the earliest years the majority of currencies were
undervalued, the latest years show a trend towards a more fair valuation.21 A third insight is that
between 2000 and 2009 only a limited number of currencies maintained a relatively stable, but not
necessarily aligned, valuation. For most currencies, their levels of valuation fluctuated substantially
during the period of analysis. For about half of the currencies analysed here, their valuation
alternated between overvaluation and undervaluation. About 30 per cent of currencies remained
within undervalued levels, while about 20 per cent remained constantly overvalued.


In relation to trade policy, figures 3a and 3b illustrate the distribution of the TTRI for each
year and then for each country. Tariff restrictions have been progressively reduced during the
period of analysis. The average TTRI across countries went from about 5 per cent for 2000 to
about 3 per cent for 2009. Such liberalization has been the result both of unilateral reductions of
MFN tariffs as well as the increasing number of bilateral and regional trade agreements. At the
country level, tariff liberalization has occurred in most of the countries in the analysis, especially in
those where tariffs were higher to start with.




Figures 3a and 3b. Tariff trade restrictiveness index, distributions by year and by country


0
.


05
.


1
.


15
.


2
.


25
TT


R
I


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009


0
.


1
.


2
.


3
TT


R
I


by country - sorted by average TTRI








21
Given the economic turmoil of 2008 and 2009, this may seem surprising. However, this trend is largely a


result of the progressive depreciation of the United States dollar.







9


With regard to anti-dumping, the analysis is based on data available for 33 countries (with
the European Union counting as one). The average number of anti-dumping investigations initiated
each year is about 255. The use of anti-dumping was more frequent in the early years of the
analysis and bottomed out in 2008, to later rebound in 2009. Although the use of anti-dumping
procedures has spread, it is largely concentrated in a few countries. The 5 most intensive users
account for more than half of the initiations, while 10 countries account for more than three
quarters.


Next are some simple figures on the cross-country correlation between exchange rate
variables and import, export and trade policy. As a cautionary note, the analysis presented in this
section is purely illustrative as it does not control for other determinants that may influence the
exchange rate and/or trade. More compelling evidence on causality is presented in the discussion of
the econometric results.


To start with exchange rate volatility and trade, it should be recalled that effective
volatility provides an indication of the stability of a currency with respect to the currencies of
trading partners. One would expect that countries whose currencies are more volatile would engage
in less trade because volatility increases trade costs. However, the cross-country correlation
between effective volatility and the export or import growth in figures 4a and 4b does not seem to
support this hypothesis. In practice, countries whose currencies have been more volatile do not
seem to have had lower rates of growth both in terms of imports and exports.




Figures 4a and 4b. Exchange rate volatility and international trade


0
.


02
.


04
.


06
Vo


la
tili


ty


(pe
rio


d
av


e
ra


ge
)


0 1 2 3 4
% Change in Exports (2000-2009)


0
.


02
.


04
.


06
a


ve
ra


ge


vo
la


tili
ty


0 2 4 6
% Change in Imports (2000-2009)






With regard to misalignment, its effect on international trade is related to the impact of the
exchange rate on relative prices or tradable and non-tradable goods. Conceptually, an undervalued
currency favours domestically produced tradable goods and thus protects domestic firms from
imports and gives them an incentive to export. According to this principle, countries with
undervalued currencies would have relatively higher exports and lower imports. The cross-country
evidence illustrated in figure 5a seems to support the argument that undervalued currencies
promote exports, because exports have grown relatively more in countries whose currencies have
remained undervalued. On the other hand, figure 5b suggests a weaker but still positive
relationship between undervaluation and import growth. This is counterintuitive, as one would
expect a negative correlation because undervaluation is expected to act as a tax on import, and thus
lower imports rather than raise them. One possible explanation is that the positive correlation
between exports and undervaluation pass spreads also on imports because increases in exports have
to be supported by increases in intermediate inputs. Although this argument may not be relevant to
all countries, it may be sufficient to explain the weaker positive correlation in figure 5b.






10


Figures 5a and 5b. Exchange rate misalignment and international trade
-


.
6


-
.


4
-


.
2


0
.


2
.


4
M


isa
lig


m
en


t (p
e


rio
d


av
e


ra
ge


)


0 1 2 3 4 5
% Change in Exports (2000-2009)


-
.


6
-


.
4


-
.


2
0


.
2


.
4


M
isa


lig
m


en
t (p


e
rio


d
av


e
ra


ge
)


0 2 4 6
% Change in Imports (2000-2009)






With regard to the relationship between exchange rates and trade policy, figures 6a and 6b
plot the average misalignment against the TTRI and the number of anti-dumping investigations.
Countries with overvalued currencies may find it more difficult to pursue trade liberalization. The
rationale is that some countries may resist trade liberalization in order to counteract the surge in
imports caused by an overvalued currency. This argument is supported by figure 6a, which shows
that countries with overvalued currencies have liberalized tariffs relatively less.




Figures 6a and 6b. Exchange rate misalignment and trade policy


-
.


6
-


.
4


-
.


2
0


.
2


.
4


M
isa


lig
m


en
t (p


e
rio


d
av


e
ra


ge
)


-.2 -.15 -.1 -.05 0 .05
Tariff Trade Restricitiveness (changes 2000-2009)


-
.


6
-


.
4


-
.


2
0


.
2


.
4


M
is


a
lig


m
e


nt


(pe
rio


d
av


e
ra


ge
)


0 10 20 30 40
Anti Dumping Cases (yearly average)






With regard to anti-dumping, the argument is similar to that of tariffs. Countries with an
overvalued currency may be more willing to use anti-dumping procedures to defend their domestic
industries. This argument is not substantiated by the raw data of figure 4b in which the weak
negative correlation is largely driven by two outliers. There is no conclusive evidence that
countries with undervalued or overvalued currencies are keener to use anti-dumping to counteract
the effect of currency misalignment.




3.2 Econometric results


Although informative, the relationships between exchange rates and trade presented in
section 3.1 are primarily for illustrative and preliminary purposes rather than for establishing
causality. To better infer the effects of exchange rates on international trade and trade policy, one
needs to control for the multitude of determinants that may influence the variables of interest. This
is done here by econometrically estimating the relationship between the exchange rate and







11


international trade according to the models presented in section 2.3. The purpose of the
econometric estimation is to explore whether bilateral trade is affected by changes in the volatility
and misalignment between two currencies once all other determinants of trade have been
adequately controlled for. In practice, what matters for better assessing causality is not so much the
cross-country evidence but rather to what extent periods of exchange rate overvaluation or
volatility – within each country – are associated to lower trade or slower trade liberalization.


Table 1 reports a series of specifications where the level of bilateral trade is regressed
against the policy variables discussed above. These specifications are quite accurate in isolating the
effects of exchange rate variables on international trade as a series of fixed effects control for
cross-country variations, time-specific factors and time-unvarying bilateral factors that could
influence the level of trade. The change in trade policy is controlled for by the TTRI variable.
Fixed effects also control for the endogenous nature of the exchange rate to trade (a country may
be willing to pursue a more stable exchange rate with a major trading partner). This empirical
approach provides an identification strategy to measure the effects of exchange rates on trade.


Specifications (1), (2) and (3) report the results where the level of trade (exports) is
regressed on the two exchange rate variables (bilateral volatility and bilateral misalignment),
controlled for trade policy, multilateral resistance and a full set of fixed effects (importer, exporter,
time and country pair). The results indicate that short-term volatility does not have a significant
impact on trade, while misalignment does. The negative coefficient on the misalignment term
implies that exports decline when currencies become more overvalued. The results remain
qualitatively similar when the two variables are used simultaneously. Note that the level of
misalignment matters even when the model is estimated on the much smaller sample for which the
volatility variable could be computed. This suggests that the significant effect of misalignment on
trade is not driven by minor currencies.


Table 1. Exchange rates and trade flows
dependent variable - log of exports


(1) (2) (3) (4) (5) (6)


Log Gdp Importer 0.776*** 0.770*** 0.783*** 0.676*** 0.703*** 0.684***
(0.069) (0.057) (0.069) (0.081) (0.066) (0.081)


Log Gdp Exporter 0.671*** 0.562*** 0.666*** 0.588*** 0.509*** 0.583***
(0.097) (0.071) (0.097) (0.105) (0.080) (0.105)


Log distance -1.176*** -1.290*** -1.176***
(0.010) (0.008) (0.010)


Common Border 0.0439 0.319*** 0.044
(0.036) (0.035) (0.036)


Colonial Links 0.482*** 0.478*** 0.482***
(0.032) (0.030) (0.032)


Common Language 0.565*** 0.631*** 0.565***
(0.023) (0.020) (0.023)


Misaligment -0.101*** -0.0781** -0.104*** -0.0767**
(0.027) (0.032) (0.028) (0.031)


Volatility -0.377 -0.381 -1.797*** -1.802***
(0.318) (0.317) (0.459) (0.459)


Log (1+TTRI) -1.084*** -0.917*** -1.080*** -1.517*** -1.466*** -1.514***
(0.237) (0.183) (0.237) (0.143) (0.103) (0.143)


Observations 38318 64770 38318 38318 64770 38318
Adjusted R 2 0.427 0.355 0.427 0.858 0.826 0.858
Standard errors in parentheses
* p < 0.10, ** p < 0.05, *** p < 0.01






12


Specifications (4), (5) and (6) report the same model but with the country pair fixed effects
replaced by the four standard gravity variables (distance, shared border, colonial links and common
language). Although these variables cannot control as well as fixed effects for bilateral trade
determinants (and for the possible endogenous nature of the exchange rate variables to trade), it is
important to also estimate the model in this manner. The main reason is that the use of country pair
fixed effects cancels the effect of perfectly aligned exchange rates (currency unions and fully
pegged exchange rates that were in force during the entire period of analysis). Thus, removing
country pair fixed effects allows unvarying exchange rates to weigh in the estimation of the
coefficients. While the results on misalignment remain virtually unchanged, the econometric
results point to a strong significance of the volatility term. This suggests that volatility is important
only when there is none, as in the case of currency unions or completely pegged exchange rates.
However, this strong result is more likely driven by long-term policy commitments related to
currency union and pegged exchange rates rather than by short-term volatility. In practice, the
actual effect of volatility on trade is that of specification (3), which indicates no significant
causality. The model of table 1 is estimated on exports. Symmetric results for misalignment are
found when the model is estimated on level of imports. In this case, misalignment is positively
correlated with imports. All in all, the results are supportive that currency overvaluation results in
higher imports and lower exports. The opposite is true for undervalued currencies.


These econometric results can be used to provide an approximation of the aggregate
impact of exchange rate misalignment on trade diversion. The overall impact of misalignment on
world trade is measured by multiplying for each country pair the measure of misalignment, the
respective level of trade and the relevant coefficient. The figures are based on the results of
specification (3) of table 1. The impact is illustrated in figure 7 which shows the effect of overall
currency misalignments on international trade for each year. In practice, the figure is to be
interpreted as the value of world exports that is diverted from countries with overvalued currencies
to countries with undervalued currencies. Note that this is an incomplete approximation of the
overall effect of misalignments on world trade as it does not take into account trade disruption (part
of the effect of misalignment on trade is not diverted but internalized by the domestic economy).


Figure 7. Overall trade diversion effect of exchange rate misalignments


0
50


10
0


Bi
llio


n


US
D


2000 2001 2002 2003 2004 2005 2006 2007 2008 2009








13


The trade diversion effect of misalignment is quantified in slightly less than 1 per cent of
world trade and varies between US$50 billion in the 2000-2002 period to almost US$120 billion in
2008. In other words, a completely aligned exchange rate system would shift about US$120 billion
of exports from countries with undervalued currencies to ones with overvalued currencies.


Table 2 reports the results on the relationship between trade policy and exchange rate
misalignment. Specifications (1) to (2) report the results testing for the hypothesis that a misaligned
exchange rate may affect trade policy. Specifications (3) and (4) report the results of exchange rate
misalignment on anti-dumping.






Table 2. Exchange rate misalignment and trade policy


dependent variable - Log (1+TTRI)
(1) (2) (3) (4)


Log Trade Value -0.0025*** 0.0101***
-(0.0002) (0.0035)


Log Gdp Importer -0.0202*** -0.0387
(0.0020) (0.0534)


Misalignment 0.0016* 0.0016* 0.16*** 0.17***
(0.0009) (0.0009) (0.0264) (0.0265)


Observations 65068 65068 18466 18466


Adjusted R 2 0.629 0.632 0.262 0.275
Standard errors in parentheses
* p < 0.10, ** p < 0.05, *** p < 0.01






In specification (1) the TTRI is regressed on misalignment and a series of fixed effects.
Country and time fixed effects control for country characteristics and global economic shocks.
Country pair fixed effects control for bilateral factors which may affect trade policy (e.g. RTAs and
import composition). The coefficient on misalignment has a positive sign, indicating that periods of
overvaluation are associated with less tariff liberalization. However, the effect of misalignment is
relatively small and only marginally significant. Specification (2) shows substantially unaffected
coefficients when two specific control variables (trade and GDP) are added. The signs on these
variables are as expected. Trade and GDP are negatively correlated with the level of tariffs. This
implies that tariff liberalization has happened relatively more slowly when trade or GDP has
declined. In summary, the results suggest that exchange rate overvaluation is related to less tariff
liberalization; however this evidence is not very strong. In magnitude, the average impact in terms
of slower tariff liberalization is about 0.1 per cent.


Specifications (3) and (4) report the results on the effect of exchange rate misalignment on
the number of anti-dumping investigations initiated. As this is a count variable, the relationship
between the two variables is estimated with a negative binomial model. The results indicate a
strong relationship between misalignment and anti-dumping. Periods of exchange rate appreciation
are positively related to the number of anti-dumping investigations. This outcome remains
unchanged when the two control variables are added in specification (4). As expected, the number
of anti-dumping investigations is also found to increase with imports but not with GDP.


On the whole, there is evidence that exchange rate overvaluation impacts the choice and
the pace of trade policy. However, its effect seems to be largely restricted to anti-dumping. The
effect of overvaluation on tariff liberalization is more muted.






14


4. Conclusions and policy implications




This paper investigates the extent to which the exchange rate affects international trade and
trade policy. The analysis is based on the econometric estimation of fixed effects models utilizing a
bilateral dataset of trade flows, exchange rates and trade policy for about 100 countries comprising
a period of 10 years.


The findings of this paper are generally in line with those of the recent literature supporting
the importance of exchange rate misalignment while disregarding that of exchange rate volatility.
In more detail, the results indicate that exchange rate misalignments do affect international trade
flows in a substantial manner. Currency undervaluation is found to promote exports and restrict
imports, while the converse holds in the case of overvaluation. In magnitude, misalignments across
currencies result in trade diversion quantifiable in about 1 per cent of world trade.


With regard to volatility, the analysis indicates that exchange rate volatility is probably not
a major policy concern. From the perspective of enhancing trade, the effects of lower volatility are
indirect, and originate from long-term exchange rate commitments such as currency unions and
pegged exchange rates rather than short-term exchange rate fluctuation. The limited importance of
exchange rate volatility is possibly related to the increasing availability of financial instruments to
hedge against exchange rate risks (e.g. forward contract and currency options) and to the increasing
share of intra-industry trade.


This study also finds evidence supporting the argument that trade policy is used to
compensate for the effect of an overvalued currency. However, the policy response seems to be
largely restricted to anti-dumping interventions. The evidence of a response in terms of a slower
pace in tariff liberalization is more muted. Although this correlation should be better investigated,
if confirmed it may have repercussions for the multilateral trade liberalization process, as large
exchange rate misalignments may reduce the incentives to remove existing trade barriers. Of
greater concern is that those results imply that persistent exchange rates misalignments may
increase incentives to recur to non-traditional protectionist policies.


More generally, this research carries three broader policy implications. First, whether
determined by exogenous shocks or by policy, policymakers need to pay attention to exchange
rates of their countries and those of other countries as the effect of currency misalignments on
international trade is considerable. This implies that countries should monitor their exchange rate
relative not only to that of their trading partners but also in relation to that of their competitors.
Second, exchange rate misalignments cannot explain the full extent of global imbalances.
Therefore, exchange rate adjustment can be only part of the solution for global rebalancing and
needs to be accompanied by other policy actions. Finally, strategies to avoid the resurgence of
trade protectionist measures should include multilateral cooperation related to the stabilization of
exchange rates towards their equilibrium level.




















15


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19


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No. 46 Marco Fugazza and Ana Cristina Molina, On the determinants of exports survival,
2011, 40 p.




No. 47 Alessandro Nicita, Measuring the relative strength of preferential market access,
2011, 30 p.




No. 48 Sudip Ranjan Basu and Monica Das, Export structure and economic performance in
developing countries: Evidence from nonparametric methodology, 2011, 58 p.




No. 49 Alessandro Nicita and Bolormaa Tumurchudur-Klok, New and traditional trade flows
and the economic crisis, 2011, 22 p.




No. 50 Marco Fugazza and Alessandro Nicita, On the importance of market access for trade,
2011, 35 p.




No. 51 Marco Fugazza and Frédéric Robert-Nicoud, The 'Emulator Effect' of the Uruguay
round on United States regionalism, 2011, 45 p.








22


No. 52 Sudip Ranjan Basu, Hiroaki Kuwahara and Fabien Dumesnil, Evolution of non-tariff
measures: Emerging cases from selected developing countries, 2012, 38p.




No. 53 Alessandro Nicita and Julien Gourdon, A preliminary analysis on newly collected data
on non-tariff measures, 2013, 31 p.




No. 54 Alessandro Nicita, Miho Shirotori and Bolormaa Tumurchudur Klok, Survival analysis
of the exports of least developed countries: The role of comparative advantage,
2013, 25 p.




No. 55 Alessandro Nicita, Victor Ognivtsev and Miho Shirotori, Global supply chains: Trade
and Economic policies for developing countries, 2013, 33 p.




No. 56 Alessandro Nicita, Exchange rates, international trade and trade policies, 2013, 29 p.






























































Copies of UNCTAD Study series on Policy Issues in International Trade and Commodities may be
obtained from the Publications Assistant, Trade Analysis Branch (TAB), Division on International
Trade in Goods and Services and Commodities (DITC), United Nations Conference on Trade and
Development, Palais des Nations, CH-1211 Geneva 10, Switzerland (Tel: +41 22 917 4644).
These studies are accessible on the website at http://www.unctad.org/tab.




Since 1999, the Trade Analysis Branch of the Division on International Trade in Goods and
Services, and Commodities of UNCTAD has been carrying out policy-oriented analytical work
aimed at improving the understanding of current and emerging issues in international trade and
development. In order to improve the quality of the work of the Branch, it would be useful to
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UNCTAD Study series on


POLICY ISSUES IN INTERNATIONAL TRADE


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(Study series no. 56: Exchange rates, international trade and trade policies)


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