Export promotion through exchange rate changes: exchange rate depreciation or stabilization?

• Author: Fang, WenShwo

1. Introduction

   Exchange rate movements affect exports in two ways--rate depreciation and rate volatility (risk). The two effects have received considerable attention since the collapse of fixed exchange rates in the early 1970s. But, no research considers the net (total) effect on exports of the two potentially offsetting effects. This paper investigates the net effect for eight Asian countries with Engle's (2002) dynamic conditional correlation (DCC) bivariate GARCH-M model that simultaneously estimates time-varying correlation and exchange rate risk. The net effect relates to the goal of a foreign exchange intervention.

   Depreciation lowers the foreign currency price of exports and probably increases the quantity of exports and export revenue in domestic currency. Conditions may exist, however, where export revenue falls. Highly inelastic foreign import demand leads to failing export revenue. Ambiguity also arises if export production incorporates high import content, since the domestic cost or price of exports rises with depreciation. During periods of appreciation, exporters might price to market, lowering their domestic currency price to maintain export market share.

   Theory and empirical evidence exhibits ambiguity as to the effect of the exchange rate on exports and export revenue. Junz and Rhomberg (1973) and Wilson and Takacs (1979) find that devaluation increases exports for developed countries with fixed exchange rates, and Bahmani-Oskooee and Kara (2003) find similar results with flexible rates. In contrast, Athukorala (1991), Athukorala and Menon (1994), Abeysinghe and Yeok (1998), and Wilson and Tat (2001) find that appreciation does not lower exports in some Asian countries.

   With fluctuations in the exchange rate, exchange rate risk could, theoretically, lower exports due to profit risk as developed by Ethier (1973). De Grauwe (1988) suggests, however, that exporters might increase volume to offset potential revenue loss. Broll and Eckwert (1999) note that the value of the real option to export might increase with risk depending on the risk aversion of exporters. Klaassen (2004) argues that the effect of exchange rate risk is an empirical issue.

   The empirical evidence on the effects of exchange rate risk is also mixed. Pozo (1992) uncovers a negative effect on the United Kingdom's (UK) exports to the United States. Chowdhury (1993) and Arize (1995, 1996, 1997) find negative effects on U.S., European, and G7 exports. Weliwita, Ekanayake, and Tsujii (1999) report negative effects for Sri Lanka's exports to six developed countries. Fang, Lai, and Thompson (2006) discover negative effects for Japan, Singapore, and Taiwan. Arize, Osang, and Slottje (2000) and Arize, Malindretos, and Kasibhatla (2003) identify negative effects on less-developed countries (LDC) exports using a moving sample standard deviation model. In contrast, Asseery and Peel (1991) detect positive effects for Australia, Japan, Germany, and the United States, and a negative effect for the UK; Kroner and Lastrapes (1993) uncover positive effects for France, Germany, and Japan, but negative effects for the UK and the United States; McKenzie and Brooks (1997) uncover positive effects for Germany and the United States; Klaassen (2004) discerns no effect on monthly bilateral U.S. exports to the other G7 countries.

   These contrary results motivate the present paper, the first to examine the net effect of depreciation and exchange rate risk using the DCC bivariate GARCH-M model. Even if exchange rate depreciation positively affects exports, the associated exchange rate risk effect could offset the positive effect, leading to a negative net effect. Our empirical results address the goal of a foreign exchange intervention. That is, does intervention stimulate exports by depreciating the currency or by reducing exchange rate fluctuations? The conventional view argues that exchange rate depreciation stimulates exports. The more recent view argues that exchange rate risk hampers exports, providing the rationale to reduce exchange rate fluctuations. Both arguments appear in the present paper, which examines the net effect. Assuming a positive correlation between exchange rate depreciation and exchange rate risk, a positive net effect supports a depreciation policy, whereas a negative net effect supports reducing exchange rate fluctuation.

   To measure the net effect, we employ monthly time-series data on bilateral exports from eight Asian countries, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand, to the United States from 1979 to 2003. Strong reasons exist to examine Asian bilateral exports. First, Klaassen (2004) shows that exchange rate risk exhibits too little variability for developed countries to elicit an effect on exports and proposes studying the exchange rate risk effect using data on developing countries. Fang, Lai, and Thompson (2006) provide evidence that some Asian countries experience more volatile exchange rates than certain European Monetary System (EMS) currencies. Second, Table 1 shows that the United States accounts for a substantial portion of exports from these Asian countries. The average U.S. share of total exports during our sample period ranges from 16% for Indonesia to 34% for Philippines. The bilateral approach avoids asymmetric responses across exchange rates in highly aggregated data, bringing more focus to the net effect of the exchange rate movement. Exports in these countries respond differently to exchange rate depreciation and risk.

   Our use of the bivariate GARCH-M model differs from previous techniques in several ways. Bahmani-Oskooee and Kara (2003) and Wilson and Tat (2001) use cointegration to examine the effect of depreciation on exports and the trade balance. Arize, Osang, and Slottje (2000) show that this technique overestimates the effect of depreciation when a negative exchange rate risk effect exists. The present paper simultaneously estimates the effects of exchange rate depreciation and risk. Moving standard deviations of the exchange rate maintain the hypothesis of homoskedasticity while serving as a proxy for heteroskedastic risk in Chowdhury (1993) and Arize, Osang, and Slottje (2000). Our present method improves on those models examining the relationship between means and variances, as in Engle, Lilien, and Robins (1987) and Bollerslev, Chou, and Kroner (1992). Exchange rate risk is conditional and time varying, as shown by Hodrick and Srivastava (1984). GARCH methods allow time dependence as in Pozo (1992), McKenzie and Brooks (1997), and Weliwita, Ekanayake, and Tsujii (1999), but their two-step procedure may produce inefficient estimates as noted in Klaassen (2004). The present paper uses simultaneous bivariate estimation. The effects of exchange rate changes depend on the export adjustment speed. Time structure is an important characteristic of international trade as argued by Goldstein and Khan (1985) and Klaassen (2004). Dynamic features of our present distributed lag export model and the DCC estimator distinguish it from one-period adjustment multivariate GARCH-M models assuming a constant correlation between the exchange rate and exports over time such as Kroner and Lastrapes (1993) and Fang, Lai, and Thompson (2006). The present DCC estimator improves estimation efficiency over the constant correlation models as noted in Engle (2002), Tse and Tsui (2002), and Tsay (2002).

   The rest of this paper unfolds as follows. Section 2 specifies the elements of the DCC bivariate GARCH-M model to examine the net effect of exchange rate depreciation and its risk on exports. Section 3 describes the data, presents empirical results, and derives the net effects. Section 4 analyzes quantitatively the net effects of exchange rate changes. Section 5 summarizes the empirical findings and provides concluding remarks.

2. The DCC Bivariate GARCH-M Model and the Net Effect

   The nonstructural reduced-form export equation of Rose (1991), Pozo (1992), and Klaassen (2004) from the two-country imperfect substitute model provides the building block of our empirical analysis, which examines the net effect of exchange rate movement on Asian bilateral exports to the United States. Real export revenue (x) depends on real foreign income (y), the real exchange rate (q), and real exchange rate risk ([h.sub.q]). Real export revenue equals nominal export revenue in domestic currency deflated by the consumer price index (CPI). Our maintained hypotheses include the following. Foreign income, the U.S. industrial production index, should exhibit a positive effect on real export revenue. The real exchange rate, the domestic currency price of the U.S. dollar times the ratio of U.S. to domestic CPIs, should also exhibit a positive effect on real export revenue. The real exchange rate eliminates potential ambiguity from adjusting price levels. The effect of exchange rate risk proves uncertain theoretically and empirically.

   To capture short-run adjustments of the variables, the following eclectic dynamic conditional correlation bivariate GARCH-M model provides the framework for investigating the net exchange rate effect.

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (1)

   [DELTA]l[q.sub.t] = [s.sub.0] + [s.sub.1][[epsilon].sub.q,t-1] + [2.summation over (i=l)][[gamma].sub.i][MD.sub.i] + [[epsilon].sub.q,t] (2)

   [[epsilon].sub.t]/[[psi].sub.t-1] ~ Student-t(v) (3)

   [h.sub.x,t] = [[alpha].sub.0] + [[alpha].sub.1][[epsilon].sup.2.sub.x,t-1] + [[alpha].sub.2][h.sub.x,t-1] (4)

   [h.sub.q,t] = [[beta].sub.0] + [[beta].sub.1] [[epsilon].sup.2.sub.q,t-1] + [[beta].sub.2][h.sub.q,t-1] + [2 summation over (i)][[lambda].sub.i][VD.sub.i] (5)

   [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (6)

   [eta].sub.t] = [D.sup.-1.sub.t][[epsilon].sub.t] (7)

   [Q.sub.t] = [bar.[rho].sub.xq] (1 - [[theta].sub.1] - [[theta.sub.2]) + [[theta.sub.1] [[eta].sub.t-1] [[theta]'.sub.t-1] + [[theta].sub.2] [Q.sub.t-1] (8)

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