Does real exchange rate depreciation increase productivity? Analysis using Korean firm‐level data

• Author: Ju Hyun Pyun,Bo‐Young Choi
• Date: 01 February 2018
• DOI: http://doi.org/10.1111/twec.12532
• Published date: 01 February 2018

ORIGINAL ARTICLE

Does real exchange rate depreciation increase

productivity? Analysis using Korean firm-level data

Bo-Young Choi

1

|

Ju Hyun Pyun

2

1

Department of Northeast Asian Economies, Korea Institute for International Economic Policy, Sejong, Korea

2

Business School, Korea University, Seoul, Korea

1

|

INTRODUCTION

The literature has for long debated whether changes in real exchange rate (RER)―a measure for

international price competitiveness―affect a country’s total factor productivity (TFP) and further

economic growth. While one strand shows the positive effect of RER depreciation on productivity,

another focuses on its negative consequences. The positive effect of RER depreciation on TFP

implies that currency depreciation is like a positive demand shock to the economy that results in

higher productivity growth via increased factor utilisation, learning-by-doing effects or increasing

returns to scale (IRS) (Verdoorn, 1993).

1

Previous studies such as Eichengreen (2007) and Rodrik

(2008) point out that currency undervaluation stimulates economic growth, particularly in develop-

ing countries.

2

However, some studies emphasise the negative effect of RER depreciation on TFP. For

instance, Porter (1990) argues that it is, in fact, counterproductive for governments to intervene in

factor and currency markets hoping that the devaluation would help domestic firms to compete

more effectively in international markets. This is because such intervention would discourage firms

to search for more sustainable competitive advantage. In short, costs as well as benefits exist in

keeping the RER low, especially if the RER depreciation persists.

This study attempts to find the RER depreciation effects on firm-level productivity and examine

the mechanism leading to such effects using rich South Korean firm-level data for 2006–13. The

effect of external RER shocks on productivity is particularly important for Korea, because as a

small open economy, a change in RER can greatly affect the profitability of many firms.

3

Further-

more, we exploit the sharp and persistent depreciation of the Korean Won during 2007–09 as a

1

Verdoorn’s law implies a stable and positive causal relationship between output growth and productivity growth in manu-

facturing firms in the long run. Faster growth in output from higher demand increases productivity due to IRS, where the

intuition is learning by doing (Verdoorn, 1993).

2

Eichengreen (2007) argues that first Japan, then Hong Kong, Singapore, South Korea and Taiwan, and now China have

gained economic growth through exchange rate undervaluation.

3

For example, Korea’s trade dependence on international markets is high: the total trade volume of gross domestic product

was 109.9% in 2012.

DOI: 10.1111/twec.12532

604

|

©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:604–633.

natural experiment to study the exogenous RER depreciation effects on firm productivity (see Fig-

ure 1).

In the literature, RER changes are generally believed to affect the price of products or firm

assets and this price effect has been thoroughly investigated (Berman, Martin, & Mayer, 2012; Li,

Ma, & Xu, 2015). In this study, however, we elucidate that the impact of RER changes is more

than that of price changes and assess the channels through which RERs affect firm productivity.

We also identify the heterogeneous effects of a common RER shock on productivity base on firms’

exposure to international trade.

Our year-by-year analysis finds the positive effect of RER depreciation on productivity. This

positive effect is more pronounced for firms with higher export exposure. However, we find that

the significant productivity gain in response to immediate RER depreciation disappears when RER

depreciation “persists”over time. More importantly, we dissect the channels that RERs influence

productivity differently. The immediate RER effect on productivity is greater for firms (industries)

exhibiting IRS, which suggests that RER depreciation increases the TFP through the economies of

scale. Yet, the nullifying effect of “persistent”depreciation is particularly observed for firms with

a negative R&D growth. This implies that the persistent depreciation slackens innovation effort

and discourages firms from allocating resources more efficiently, thereby reducing productivity.

Several robustness checks strongly support our results.

Previous studies show that RER affects firm performance. Baggs, Beaulieu, and Fung (2009)

find that appreciations of Canadian currency decrease the probability of Canadian firms’survival,

and this effect is less pronounced for more productive firms. Tomlin (2014), using dynamic struc-

tural parameter estimates, confirms the negative effect of RER appreciation on the probability of

firm survival in the market. While the previous findings of the RER effect on firm survival are

quite consistent, the literature on how RER affects firm productivity has shown mixed results.

Fung, Baggs, and Beaulieu (2011) find that RER appreciation led Canadian plants in the manufac-

turing industry to decrease their shipments, resulting in lower productivity, but Ekholm, Moxnes,

and Ulltveit-Moe (2012) find that a sharp and persistent RER appreciation increased Norwegian

firms’productivity through labour shedding.

70

75

80

85

90

95

100

105

110

2006 2007 2008 2009 2010 2011 2012 2013

Real Effective Exchan

g

e Rate (2005 = 100)

FIGURE 1 Real effective exchange rate in Korea

Note: A decrease in RER index indicates currency depreciation. [Colour figure can be viewed at

wileyonlinelibrary.com]

CHOI AND PYUN

|

605