FRBSF Economic Letter
2000-29; September 29, 2000
 Economic
Letter Index
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.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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