2000-29

September 29, 2000

Does Pegging Increase International trade?

Pacific Basin Notes. This series appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies within the FRBSF’s Economic Research Department.

The currency crises of the 1990s appeared to reinforce the view that, in the long run, all currency pegs are unsustainable. And yet, pegged regimes maintain their attraction. For example, Calvo and Reinhart (2000) find evidence that many countries intervene to smooth fluctuations in the exchange rate even while they claim to be floating. At times, some countries, such as Malaysia, have preferred to impose capital controls rather than give up exchange rate stability. Others have gone even further, maintaining currency board style arrangements that limit the freedom of monetary authorities to print money (Hong Kong, Argentina), or giving up their national currencies in favor of a common currency (Europe). The desire for exchange rate stability is reflected in the ongoing interest in dollarization in Latin America and in common exchange rate arrangements in Southeast Asia.

Economists offer a number of explanations for the appeal of a pegged exchange rate, and key among them is the argument that pegging may enhance international trade and investment by reducing the uncertainty associated with exchange rate fluctuations. This Economic Letter reviews what is known about the effects of pegging on uncertainty and trade and highlights some possible interpretations of the recent literature.

Volatility and trade

Traditional analyses of the trade advantages of pegging focus on the fact that exchange rate volatility exposes producers to currency risk. To illustrate, suppose a California exporter sells a $100,000 piece of equipment to a Latin American country, payable in pesos at today’s exchange rate upon delivery in three months. If the peso depreciates, the payment received in three months will be lower when converted into dollars, thus cutting into profits. If the peso appreciates, the payment received in dollars will be higher. Even if payment is expected to average $100,000, a risk-averse exporter will raise the price to compensate for the risk. The higher price will lower demand for the product, cutting the volume of sales. Volatility may have analogous effects on imports if importers pay in foreign currency, as is the case in many emerging markets, that is, importers may reduce demand as they take into account the effects of assuming currency risk.

Figure 1 illustrates the sharp increases in exchange rate volatility that have occurred since the collapse of the Bretton Woods system of fixed exchange rates in the early 1970s. Specifically, it plots approximate percentage changes (monthly log differences annualized by multiplying by 1200) in the deutschemark-dollar exchange rates from January 1960 to December 1999 (I use the euro-dollar exchange rate for 1999). Measuring the volatility by ten-year standard deviations of monthly changes shows that it roughly quadrupled from an average of 2.4 in the 1960s to 10 in the 1970s, rising further to 12 in the 1980s before falling to 10 in the 1990s. The dollar-deutschemark example overstates the case somewhat for other currencies because the float has been relatively clean since the 1970s. Still, the tendency for currency volatility to increase sharply after the 1960s reflects the experience of many countries.

To the surprise of many observers, the effects of these sharp increases in volatility on international trade do not appear to be very large, after controlling for other factors. International trade has grown faster than income since the early 1970s, just the opposite of what we would expect if rising exchange rate volatility deterred trade. More systematic empirical studies confirm that the effects of exchange rate volatility on trade are small or statistically insignificant. For example, a time series study by Koray and Lastrapes (1989) suggests that increases in volatility explain only 4% of the variance in U.S. imports. A simulation analysis by Gagnon (1993) estimates that the large increase in real exchange rate volatility post-Bretton Woods reduced trade volumes by 1% to 3%. Frankel and Wei (1993) use cross-section data for 63 countries to test the effects of nominal and real exchange rate volatility in a gravity model of bilateral trade; in gravity models, trade depends on distance and size. They find that doubling exchange rate volatility in Europe would reduce intra-European trade volume by only 0.7%. Some studies even find that higher exchange rate volatility is associated with more, rather than less, international trade (Kroner and Lastrapes 1993). Additional evidence along these lines is discussed by Côté (1994), who surveys the results of 17 empirical studies.

Why are volatility effects small?

If exchange rate volatility is so high, why doesn’t it seem to hinder international trade? One explanation is that traditional, or partial equilibrium, analyses focus only on the direct effects of exchange rate volatility on trade and hence are too limited in scope. As suggested by the empirical estimates of Koray and Lastrapes (1989), exchange rate volatility does not occur in a vacuum; it typically reflects the impact of macroeconomic disturbances of various kinds. Such disturbances, as well as the decision to adopt a floating regime, may be associated with changes in demand and supply conditions that enhance, rather than discourage, international trade. For example, monetary stimulus in the United States may hurt Mexican exports by appreciating the peso, but the overall increase in U.S. demand (which is often ignored in assessing the effects of exchange rate volatility on trade) offsets this effect. Monetary shocks also can lead to uncertainty about wage payments that in turn influence the relative desirability of international trade. Bacchetta and van Wincoop (forthcoming) develop a general equilibrium model in which these various effects are taken into account and conclude that–depending on the circumstances–international trade may be the same, lower, or higher under pegging as under floating. Similar ambiguities in the effects of volatility on trade arise in another general equilibrium model by Secu and Uppal (2000).

A second explanation is that measures of exchange rate volatility are not necessarily the best proxies for exchange rate uncertainty. For example, the relative stability of the Thai baht against the U.S. dollar from 1995 to mid-1997 did not insulate the Thai economy from the effects of the high volatility of the yen against the dollar or the devaluation of the Chinese renminbi against the U.S. dollar in 1994, both of which contributed to pressure on the baht to depreciate. Under these conditions, Thai importers required to pay in U.S. dollars might have been just as dissuaded from trading by the fear of a sudden collapse in the Thai baht as they might have been by the prospect of smaller unanticipated price changes had the Thai baht been floating freely. The implication is that exchange rate uncertainty can be high whether exchange rate volatility is high or low or whether the currency is pegged or floating.

Are pegged regimes in fact so vulnerable to sudden collapses as to deter trade? Apparently they are. Flood and Marion (1997) estimate that the mean duration of pegs in countries in Latin America is about 10 months. Obstfeld and Rogoff (1995) find that only six economies with open capital markets (including Thailand, whose peg collapsed in 1997) in addition to a number of very small economies maintained fixed exchange rate for five years or more. The perception that exchange rate pegs are vulnerable has been reinforced by the spate of currency crises in both industrial and emerging market economies in the 1990s (Europe in 1992-1993, Mexico in 1994, East Asia in 1997-1998, Russia in 1998, Brazil in 1999), and it partly accounts for the interest in forming common currency areas, or dollarization in Latin America.

If uncertainty about the sustainability of a peg does deter trade, we would expect that trade would be larger within a common currency area, where exchange rate uncertainty is completely eliminated, than outside such an area. Suggestive evidence consistent with this view is provided by recent studies on economic geography that show that trade eliminates price differentials most effectively among regions sharing a common currency. Engel and Rogers (1996) use price data for U.S. and Canadian cities over the period June 1978-December 1994 and find that while distance explains a large amount of the variation in the prices of similar goods in different cities, the variation in prices is much higher for two cities located in different countries than for two cities the same distance apart in the same country. According to their estimates, the border accounts for 32% of the cross-border dispersion between pairs of cities, and crossing the border is equivalent to nearly 1,800 miles of distance between cities. While this market segmentation partly reflects trade barriers, the border effects are so large that currency effects also may play an important role.

Rose (forthcoming) implements a more direct test of the impact of a common currency on trade. He studies a panel dataset of 186 countries for five years spanning 1970 through 1990. The dataset includes over 100 country pairings and 300 observations in which both countries use the same currency. Using a gravity model of trade, he finds that two countries that share the same currency trade three times as much as they would with different currencies. Rose also finds a small negative effect of exchange rate volatility on trade.

Conclusion

There is little evidence that conventional currency pegs increase international trade, as the sharp increases in exchange rate volatility since the early 1970s appear to have had few or no adverse effects on trade volumes. One possible explanation for this is that traditional analyses focus only on the direct effects of exchange rate volatility on trade, without taking into account offsetting effects that may be identified in a broader general equilibrium framework. Another explanation is that conventional pegs do not completely eliminate exchange rate uncertainty. More research is needed to measure the importance of offsetting effects suggested by general equilibrium models. However, research showing that common currency areas increase trade suggest that the full elimination of exchange rate uncertainty also may play a role.

Ramon Moreno
Senior Economist


References

Bacchetta, Philippe, and Eric van Wincoop. Forthcoming. “Does Exchange Rate Stability Increase Trade and Welfare?” American Economic Review.

Calvo, Guillermo, and Carmen Reinhart. 2000. “Fear of Floating.” Revised unpublished manuscript, University of Maryland (May).

Côté, Agathe. 1994. “Exchange Rate Volatility and Trade: A Survey.” Bank of Canada Working Paper 94-5.

Engel, Charles M., and John H. Rogers. 1996. “How Wide Is the Border?” American Economic Review 86(5) pp. 1,112-1,125.

Flood, Robert, and Nancy Marion. 1997. “The Size and Timing of Devaluations in Capital-Controlled Economies.” Journal of Development Economics 54, pp. 123-147.

Frankel, Jeffrey, and Shang-Jin Wei. 1993. “Trade Blocs and Currency Blocs.” NBER Working Paper No. 4335.

Gagnon, Joseph. 1993. “Exchange Rate Variability and the Level of International Trade.” Journal of International Economics 34, pp. 269-287.

Koray, Faik, and William D. Lastrapes. 1989. “Real Exchange Rate Volatility and U.S. Bilateral Trade: A VAR Approach.” Review of Economics and Statistics 71, pp. 708-712.

Kroner, Kenneth F., and William D. Lastrapes. 1993. “The Impact of Exchange Rate Volatility on International Trade: Reduced Form Estimates using the GARCH-in-mean Model.” Journal of International Money and Finance 12, pp. 298-318.

Obstfeld, Maurice, and Kenneth Rogoff. 1995. “The Mirage of Fixed Exchange Rates.” Journal of Economic Perspectives 9, pp. 73-96.

Rose, Andrew K. Forthcoming. “One Money, One Market: Estimating the Effect of Common Currencies on Trade.” Economic Policy.

Secu, Piet, and Raman Uppal. 2000. Exchange Rate Volatility, Trade, and Capital Flows under Alternative Exchange Rate Regimes. Cambridge and New York: Cambridge University Press.

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