Currency devaluation and international trade
By the early s, however, US and Japanese trade balances had adjusted, largely in line with the predictions of conventional models Krugman The question is whether this time will be different, or whether the relationship between exchange rates and trade remains strong. We use data for more than 50 advanced and emerging market and developing economies over the past three decades.
The growing importance of emerging markets in world trade justifies this broad country coverage, which goes beyond the group of countries typically examined in related studies. Our estimation approach employs both standard trade equations following the pricing-to-market literature recently reviewed in Burstein and Gopinath and an event analysis of historical episodes of large exchange rate depreciations.
This allows us to measure the strength of the links between exchange rates and the relative prices of exports and imports, as well as the links between these relative trade prices changes and movements in export and import volumes. This impact varies widely across economies Figure 1.
Much, though not all of the adjustment, occurs within a year. Our analysis of historically large exchange rate movements, which include, for example, economies affected by the European Exchange Rate Mechanism crisis, or the devaluation of the Chinese yuan in , further supports the notion that exchange rate depreciations raise exports. It also suggests that, among economies experiencing currency depreciation, the rise in exports is greatest for those with slack in the domestic economy and with financial systems operating normally.
Figure shows long-term effect on level of net exports in percent of GDP based on country-specific import- and export-to-GDP ratios and average cross-country trade elasticities. We also find little evidence of a general disconnect in the relationship between exchange rates and exports and imports over time.
This finding is especially relevant for economies that have substantially increased their participation in global value chains, such as, for example, Hungary and Romania.
It is also consistent with the findings of Ahmed et al. But it is important to keep this result in perspective. Global value chain-related trade has generally increased only gradually through the decades and appears to have slowed in recent years Constantinescu et al. Furthermore, other developments, including declining barriers to trade movements, may have strengthened the effects of exchange rates on exports and imports.
And it is worth recalling that even a decline in trade elasticities could, at least in principle, be consistent with greater economic significance of exchange rate movements, given the rising size of exports and imports in percent of GDP. Solid lines denote the average. Dashed lines denote 25th and 75th percentiles. When we test the stability of the relationship between exchange rates and total trade, we find little evidence of the links weakening over time.
Rolling regressions and structural break tests do not support the notion of a general disconnect for different country groups. As for the puzzling weakness of exports in Japan, our analysis suggests that this reflects a number of Japan-specific factors. Export growth has been weaker than could be expected based on exchange rate and trading partner growth developments. The study by Ahmed et al.
When we replicate the analysis for the economies examined in that study, we find that the evidence of a drop in the effectiveness of exchange rate movements over time is fragile. The estimated drop largely disappears after controlling for a small number of influential outlier observations. The same applies after computing real exports by deflating nominal exports using export prices rather than the CPI as in the study. The argument is based on the apparent lack of a correlation between exports and US dollar exchange rates for emerging markets since However, since the cross-section scatter plots presented there do not control for other factors that drive exports, including shifts in trading partner demand, they are affected by omitted variables and reverse-causality problems.
And since the study only considers years since , it cannot shed light on whether the links between exchange rates and exports have weakened over time.
Overall, we conclude that the relation between exchange rates and trade remains strong and that reports of a disconnect have been overstated. Our evidence suggests that recent currency movements imply a substantial redistribution of real net exports across economies, from the US and economies whose currencies move with the dollar to economies whose currencies have depreciated. Essentially, the Marshall—Lerner condition is an extension of Marshall's theory of the price elasticity of demand to foreign trade.
Formally, the condition states that, for a currency devaluation to have a positive impact on the trade balance , the sum of the price elasticities of exports and imports in absolute value must be greater than 1. The net effect on the trade balance will depend on price elasticities. If goods exported are elastic with respect to price, their quantity demanded will increase proportionately more than the decrease in price, and total export revenue will increase.
Similarly, if goods imported are price elastic, total import expenditure will decrease. Both will improve the trade balance. Empirically, it has been found that trade in goods tends to be inelastic in the short term, as it takes time to change consuming patterns and trade contracts.
In the long term, consumers will adjust to the new prices, and the trade balance will improve. This effect is called the J-curve effect. For example, assume a country is a net importer of oil and a net producer of ships. Initially, the devaluation immediately increases the price of oil, and as consumption patterns remain the same in the short term, an increased sum is spent on imported oil, worsening the deficit on the import side. Meanwhile, it takes some time for the shipbuilder's sales department to exploit the lower price and secure new contracts.
Only the funds acquired from previously agreed contracts, now devalued by the currency devaluation, are immediately available, again worsening the deficit on the export side.