This paper investigates the importance of exchange rates on international trade by analyzing 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 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 finding that short term exchange rate volatility is generally not a serious concern. 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 antidumping interventions.
1. Introduction
The recent debate on persistent trade imbalances and the resurgence of non-traditional trade restrictive measures has led to a renewed interest in 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 (misalignment and volatility) 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.
The most studied aspect of the relationship between the exchange rate 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 the variability of 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; Cushman, 1983; Peree and Steinherr, 1989) subsequent studies report very small impacts (Huchet-Bourdon and Korinek, 2011), or effects only limited to developing countries (Arize et al., 2000). Moreover, the use of refined quantitative methods resulted in more skepticism about the causality of short term exchange rate volatility on international trade (Taglioni, 2002; Clark, 2004; Tenreyro, 2007). In summary, the relationship between the two variables is likely driven by underlining long term policy credibility rather than the short term causality (Klein and Shambaugh, 2006).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.
4. Conclusions
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 finding that short term exchange rate volatility is generally not a serious concern. More in 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. In magnitude, misalignments across currencies result in trade diversion quantifiable in about one percent of world trade.
