Almost all countries outside of the U.S. have recently condoned or actively encouraged exchange rate depreciations, hoping that it would improve their economies.
Exchange rate depreciation is perhaps politically the easiest boost, followed by export subsidies. Other policies such as import restrictions and wage reductions by contrast are a tough sell in any country. Recent developments in the global economy lead many countries to surmise the necessity of defending themselves against unitary global shocks.
Samuel Brittan writes that it was a British economist named Joan Robinson who provided the classic definition of “beggar-thy-neighbour” policy. According to Brittan, she argued that,
For any one country, an induced increase in exports relative to imports leads to more jobs. In addition to the initial increase in employment, there is a secondary increase from the money spent by the newly employed workers. The snag is that an increase in the exports of one country leads to a decline in exports of other countries, “everything else being equal”. At best, it leaves the level of employment for the world as a whole unaffected” and probably reduces it.
The pound has just fallen to a seven year low against the U.S. dollar. It is the sharpest fall since the crisis of 2008. What would result from this large drop? It’s hard to tell – perhaps the IMF October 2015 paper can enlighten,
The results suggest that large depreciations substantially boost exports. By definition, the episodes studied are associated with large depreciations, and the results indicate that these depreciations average 25 percent in real effective terms over five years. Export prices in foreign currency fall by about 10 percent, with much of the adjustment occurring in the first year.
Taking the opposite view however, Buttonwood in the Economist argues that a devaluation is not something that one should rejoice. He writes,
A devaluation is a cut in a nation’s standard of living; it costs more to buy other people’s goods (or to go on holiday overseas. […] Our Big Mac index suggests the pound is undervalued, not overvalued against the dollar. There is no economic imbalance that this exchange rate move is correcting. And there may be no gain to exporters; as we recently reported, recent devaluers have seen little benefit.
In addition, from the FT,
At the annual conference of the EEF, the association for manufacturers, the benefits of more competitive exports from a sustained weak pound were offset by fears of broader economic uncertainty.
“Some of my big costs are priced in yen or Swiss francs. I am more concerned with sterling’s slide as an indicator of increased volatility in the macroeconomy, and the fact that it has jumped down that much in such a short time,” said Andrew Churchill, managing director of JJ Churchill, a precision engineer that employs 120 people in the Midlands. “Volatility is the enemy of long-term business planning. It’s the hidden brake on the upward drive to export more, to grow,” he added.
With many conflicting views on the effect of currency devaluation on trade, it is pertinent for us to ask, how does this channel work and is it really effective? To think through this question, we need to look at the following points:
One, globalisation nowadays has resulted in greater specialisation and international fragmentation of production, i.e. a good will begin its production life in one country and is finished in another country.
The global value chain is the trade in intermediate goods that serve as inputs into other economies’ exports. The trade residing in the global value chain may respond more weakly to fluctuations in exchange rates than conventional trade. According to the IMF, “export competitiveness is determined not only by the exchange rate and price level of the export destination economy, but also by the exchange rate and price level of the economy at the end of the production chain”.
Although the global value chain is on the rise, the bulk of global trade is still conventional trade.
Two, trade elasticity and hence, competitiveness is a core determinant. Trade elasticity consists of the price elasticity of imports and the price elasticity of exports. The Marshall-Lerner condition states that “for a depreciation of the domestic currency to reduce the external deficit, the sum of export and import price elasticities in absolute terms must be greater than 1”. Trade elasticities is the conventional measure that converts effective price changes into actual economic development, and therefore competitiveness.
REER is also used as a demand-based indicator of competitiveness. REER, which stands for Real Effective Exchange Rate, is the weighted average of a country’s currency relative to an index or basket of other major currencies adjusted for the effects of inflation. Below is a chart showing REER effect on real net exports.
Note: The illustrative effects of CPI-based real effective exchange rate movements from January 2013 to June 2015 on real net exports in percent of GDP are based on the average consumer price index (CPI)–based estimates of the exchange rate pass-through into export and import prices and the price elasticity of exports and imports reported in Table 3.1. These average estimates are applied to all economies. Country-specific shares of exports and imports in GDP used in the calculation are from 2012.
It is not enough to analyse the trade elasticity. We also need to examine the exchange rate pass-through. This is the extent to which firms “pass through” changes in exchange rates to prices. An interesting example given by the same IMF paper notes that, “Japanese exporters have long demonstrated pricing to-market behaviour by maintaining the stability of their export prices in overseas markets and absorbing exchange rate fluctuations through profit margins. This practice results in limited exchange rate pass-through to export prices”.
Three, the composition and clients of the exports matter, i.e. what are the exporters making and where are they selling it to. Here is the chart of the composition of the UK BoP:
UK Quarterly Current Account Balance of Payment as % of GDP
Source: Based on data from ONS series D28J, D28K, D28M, D28N, AA6H. UK, http://pearsonblog.campaignserver.co.uk/?tag=balance-of-payments
Saying that, an RBS 2014 report found that product mix does not really matter for the UK between 2008-2012,
The UK’s slower export growth was due, in roughly equal parts, to geographic focus and lower competitiveness. Of the 12.4 percentage-point shortfall, -6.7% was due to where we export, -5.6% was due to competitiveness. Product mix essentially made a neutral contribution (-0.1%).
Four, whether economic slack is present in the particular country counts too. A lot of slack means that there is spare capacity to quickly respond to increased demand, whereas a full employment economy will struggle to raise production quickly without creating inflationary pressure.
It is difficult to make the judgement, especially for policy makers, of what the interaction of these conditions will result in. Nonetheless, these are some of the points that one needs to keep in mind when looking at the relationship between exchange rates and trade. To convolute the matter, there are many more factors not mentioned here, and they all change in rank importance as world trade shifts continuously between a state of wanting to be more globalised and a state of fear-induced preference for protectionism.
Thoughts on Trade
Global merchandise trade contracted in the first half of 2015, the first time since 2009. Maybe in reaction, or as a result of that, protectionism is rising. The FT quoted Simon Evenett, a professor of economics at the University of St Gallen and head of Global Trade Alert as saying,
“People have always talked about protectionism in terms of imports, now we are talking about it as a means of boosting exports. That is new,” he says. “The scale of the export subsidies is quite worrying. I’m not sure if we have seen anything like that before.”
However, conducting protectionism through depreciation may have grown less effective. Swarnali Ahmed, Maximiliano Appendino and Michele Ruta, in their 2015 paper entitled “Depreciations without exports? Global value chains and the exchange rate elasticity of exports”, finds evidence that the elasticity of manufacturing export volumes to the real effective exchange rate has decreased over time.
According to the authors,
…as countries are more integrated in global production processes, a currency depreciation only improves the competitiveness of a fraction of the value of final goods exports. In line with this intuition, the analysis finds evidence that the rise of participation in global value chains explains on average 40 percent of the fall in the elasticity.
Trade is also a main concern in the Brexit discussion, one that I might expand on in another post (if I have the will and the time). For Britain, the concern regarding the fate of financial service if Brexit happens emphasises that composition of trade does matter. To boot, between industries, the difference is that during tough times, manufacturing can batten down the hatches and build up inventories, whereas services cannot.
On the country level, high income and low income countries may experience different outcomes from the same measures. In addition to supply chain (global value added), exchange rate pass-through (trade elasticity), product mix and geography (composition and client), as well as spare capacity (economic slack), each country might have to grapple with making unpopular decisions regarding its policies. This is where political stability, well-formed regulations and supportive institutions will be advantages that developed countries have over emerging countries.
At the same time, an ageing population, increasing incomes and a saturation of needs for industrial products are strong trends pointing towards a shift from manufacturing to the service economy. To add, some studies argue that de-globalisation is happening right now.
These two trends combined bring forth a reduction in trade growth, and indeed, this morning I woke up to the FT headline of, World Trade Records Biggest Reversal Since Crisis.
According to the article, “The value of goods that crossed international borders last year fell 13.8 per cent in dollar terms — the first contraction since 2009 — according to the Netherlands Bureau of Economic Policy Analysis’s World Trade Monitor”.
To round up, what is an economy, really? It is a system of agents, goods and services, and from there, of price and quantity. In terms of trade, it is a system of countries, also goods and services, and from there, value and volume. With the onset of de-globalisation, an increasingly removed country has fewer channels to profit from its own comparative advantage, and therefore, possesses limited levers for the growth of its economy.
At the heart of the matter is our propensity to think of this issue as a one-to-one economic effect. Simplifying, instead of facing the fact that the outcome would probably be determined by the resolution of a series of retaliatory actions. In other words, this can quickly turn into a game theory problem, and less of an econometric one.