Exchange Rate Volatility and World Trade

International Monetary Fund

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1984
• eBook ISBN: 9781557750655

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Contents

Prefatory Note

I. Introduction

II. Overview of the Issues

Uncertainty Costs

Adjustment Costs

International Investment

Structure of Output

Large vs. Small Firms

Competition and Concentration of Output

Inflation

Macroeconomic Policy

Protectionism

Developing Countries

III. Measuring Exchange Rate Variability

Dimensions of Exchange Rate Variability

Nominal vs. Real Exchange Rates

Bilateral vs. Effective Exchange Rates

Time Period of Variability

Actual vs. Predicted Movements

Exchange Rate Variability, 1960–83

Volatility in Floating vs. Fixed Rate Period

Is There a “Learning” Process?

Intercountry Variations

Exchange Rates and Price Movements

Deviations from Trends

IV. Volume and Pattern of World Trade

Aggregate Relationships Between Exchange Rate Variability and Trade

Trade Flows of Individual Countries: Time-Series Analysis

Bilateral Trade Flows: Cross-Section Studies

The Evidence from Surveys

V. Structure of Output and Investment

Adjustment

Company Structure

International Specialization

Sectoral Allocation of Resources

Investment

VI. Macroeconomic Policy

Inflation

Policy Constraints

Protectionism

VII. Further Observations

VIII. Summary and Conclusions

APPENDICES

I. Measurement of Exchange Rate Variability

II. Determination of Aggregate Trade Levels

III. Inflation and Exchange Rate Variability

IV. Determination of Bilateral Trade Flows

BIBLIOGRAPHY

TABLES

Section

V.

1. Major Industrial Countries: Fluctuations in the Real Net Foreign Balance as a Proportion of Gross Domestic Product

2. Industrial Countries: Changes in Export Concentration, 1961–81

3. Major Industrial Countries: Real Nonresidential Gross Fixed Capital Formation as a Proportion of Gross Domestic Product, 1960–82

Appendices

I.

4. Major Industrial Countries: Month-to-Month Changes in Nominal Effective Exchange Rates, 1961–83

5. Major Industrial Countries: Month-to-Month Changes in Real Effective Exchange Rates, 1961–83

6. Major Industrial Countries: Quarter-to-Quarter Changes in Nominal Effective Exchange Rates, 1962–83

7. Major Industrial Countries: Quarter-to-Quarter Changes in Real Effective Exchange Rates, 1962–83

8. Major Industrial Countries: Effective Variation of Nominal Exchange Rates, 1961–83

9. Major Industrial Countries: Month-to-Month Changes in Nominal Effective Exchange Rates Relative to Trend, 1964–83

10. Major Industrial Countries: Quarter-to-Quarter Changes in Real Effective Exchange Rates Relative to Trend, 1964–83

II.

11. Equations Relating Growth to World Output and World Trade

III.

12. Major Industrial Countries: Determinants of Inflation

IV.

13. Major Industrial Countries: Determinants of Bilateral Trade Flows

CHARTS

Section

III.

1. Selected Industrial Countries: Spreads Between Buying and Selling Rates in Forward Exchange Markets, 1974–82

2. Major Industrial Countries: Deviations from Trend in Real Effective Exchange Rates, 1961–83

IV.

3. Number of Percentage Points by which World Export Growth Exceeded World Output Growth, 1955–82

4. OECD Member Countries: Relationship Between Real Import Growth and Real Gross Domestic Product Growth, 1961–82

5. Brazil: The Real Brazilian Cruzeiro/U.S. Dollar Rate, 1957–74

V.

6. Major Industrial Countries: Traded Goods Output as a Proportion of Gross Domestic Product, 1960–81

Appendices

I.

7. Major Industrial Countries: Quarterly Real Effective Exchange Rates, 1961–83

8. Major Industrial Countries: Monthly Nominal Effective Exchange Rates, 1961–83

II.

9. OECD Member Countries: Growth Rate of Non-Oil Imports, 1962–81

10. Rate of Growth of World Trade, 1959–82

The following symbols have been used throughout this paper:

… to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;

– between years or months (e.g., 1979–81 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years (e.g., 1980/81) to indicate a crop or fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

III Measuring Exchange Rate Variability

The fundamental uncertainty in business is that unforeseen fluctuations in revenues relative to costs will make a particular transaction or activity uneconomic. When revenues and costs are in different currencies, possible exchange rate movements are clearly an important dimension of this uncertainty. They are not, however, necessarily an independent source of uncertainty, nor do they affect different enterprises in the same way.

The simplest kind of international transaction is the basic trading transaction of nineteenth century textbooks, whereby a trader makes a contract to buy a fixed quantity of goods at a given price in one country, and to sell them after, say, 90 days, at a fixed price in another country. His profit is the difference between the purchase price and the selling price (less freight, insurance, and interest costs), and the only source of uncertainty is the exchange rate at which he can translate his sales revenue in foreign currency into local currency to repay his borrowing. It is the possibility that the nominal exchange rate will move by an unknown amount during the life of his contract that is the proper measure of the uncertainty he faces.

Where forward markets exist, of course, the nature of the uncertainty faced by traders is transformed. A forward market represents, in effect, a “guaranteed” forecast of the exchange rate that will prevail at the end of the contract period, which a trader can take advantage of by payment of a small margin around the forward rate. Since currency uncertainty can be removed from the short-term trading transaction by payment of this margin, the “cost” of such uncertainty cannot be higher than the cost of purchasing insurance against it.¹

Since spreads between bid and offer rates in the 3-month forward market have rarely exceeded 0.2 of 1 percent for major currencies (see Chart 1), the implicit cost of short-term exchange rate uncertainty would appear to be too small to have a significant effect on aggregate trade flows. Spreads for forward contracts of 12 months’ maturity have generally been larger, reflecting the relative “thinness” of this market. Nevertheless, spreads for the major currencies are generally well under 1 percent (so that the cost for a one-way transaction is under 1/2 of 1 percent of the central rate).

Chart 1. Selected Industrial Countries: Spreads Between Buying and Selling Rates in Forward Exchange Markets, 1974–82¹

¹ Averages of daily rates; exchange rates are U.S. dollars per unit of local currency in the New York foreign exchange market.

Most international trading activity, however, has a longer time horizon than that corresponding to the shipment of goods. It generally involves the commitment of resources, and the development of markets, for an extended period of time. During this time, domestic production costs and foreign selling prices will both change in local currency terms. The key question, therefore, is whether, and by how much, fluctuations in exchange rates offset or accentuate these uncertainty-producing movements in production costs and sales receipts. The answer to these questions requires the adjustment of nominal exchange rate relationships to take account of changes in prices and costs. This in turn presents the problem of choosing suitable indices to capture the particular costs and prices that are most relevant from the point of view of traders.

It is also relevant that the “commitment period” for resources varies widely among activities. The decision to market excess production of a homogeneous commodity with a well-developed international market (e.g., a primary commodity or raw material) can be effected at short notice, and then not repeated if market conditions change. The decision to take advantage of market conditions to sell a manufactured product for which domestic demand falls short of established production capacity requires an investment in developing market outlets that is not worthwhile unless sales are expected to continue for some time. Finally, the decision to create new production capacity to meet foreign demand may entail a commitment to investment in plant and equipment, as well as labor force training, that will continue for a period of many years.

Enough has been said so far to indicate that different kinds of uncertainty are important for different kinds of international enterprise. There is no unique measure of “exchange rate variability” that can be used as a proxy for the uncertainty and adjustment costs that traders face as a result of exchange rate movements (Lanyi and Suss, 1982). In what follows, four dimensions of variability are presented and discussed. They are then combined in various ways to produce proxies for exchange rate uncertainty. The behavior of these proxies–over time and among countries, as well as relative to the other proxies–is discussed later in the section (and in more detail in Appendix I). These measures are used in the empirical analysis presented later in the paper.

Exchange Rate Variability, 1960–83

The foregoing discussion implies that there are a large number of potential measures of variability. Several of these are presented, using data for the major industrial countries, in Appendix 1. (For another presentation and discussion of exchange rate variability, see Kenen, 1979.) The footnotes to the tables indicate the definitions that have been used in their construction. Interpretation of these results, however, requires some simplifying organizational structure. The followin...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• I. Introduction
• II. Overview of the Issues
• III. Measuring Exchange Rate Variability
• IV. Volume and Pattern of World Trade
• V. Structure of Output and Investment
• VI. Macroeconomic Policy
• VII. Further Observations
• VIII. Summary and Conclusions
• Appendices
• Bibliography
• Tables
• Footnotes