The exchange rate susceptibility of European core industries, 1995–2010

• Author: David Leuwer,Bernd Süssmuth
• Date: 01 February 2018
• DOI: http://doi.org/10.1111/twec.12541
• Published date: 01 February 2018

ORIGINAL ARTICLE

The exchange rate susceptibility of European core

industries, 1995–2010

David Leuwer

1

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Bernd S€

ussmuth

1,2

1

Institute for Empirical Research in Economics, University of Leipzig, Leipzig, Germany

2

CESifo, Munich, Germany

The Euro should not fluctuate according to the mood of the markets. A monetary zone

must have an exchange rate policy... If not, we are insisting on countries making

efforts to be competitive which are destroyed by the rising value of the Euro.

Francois Hollande (February 2013)

1

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INTRODUCTION

Throughout the post-war period, it is in particular the German economy that is widely regarded as

depending on its exports. Public opinion sees exports as driving German—and ultimately also Euro-

pean—economic growth. Following this line of reasoning, key sectors such as the automobile and

mechanical engineering industries are perceived as being especially susceptible to an appreciation of

the euro. On the other hand, they arguably profit from a depreciating euro. In this context, the EUR/

US$ exchange rate is one of the most intensely observed relationships. In 2003, for example, the US

business of German companies is said to have been decreasing by 10% due to a weak dollar (Belke,

G€

ocke, & G€

unther, 2013). As of the second half of the first decade of the 2000s, it became popular

to talk about a “pain threshold”for European companies with regard to the EUR/US$ exchange rate.

Prominently the term is used referring to a suffering of German and/or French export industries from

a strengthening of the euro beyond a certain threshold. Recently, even terms such as “strategic depre-

ciation”and “currency wars”are used to refer to the fear of European industries to lose grounds in

competitiveness against the backdrop of devaluating competitor countries; see the above quote of

former French president Francois Hollande. However, with regard to stock market returns, Griffi n

and Stulz (2001), for example, find that common shocks to industries across countries are substan-

tially more important than competitive shocks due to changes in exchange rates. According to their

findings, weekly exchange rate shocks explain but a tiny fraction of the relative performance of

industries and, in particular, also of sectors that produce internationally traded goods.

In our reading of the existing literature, the question of the existence and dimension of the

exchange rate susceptibility of European core industries has not been satisfyingly answered. Sev-

eral studies investigate the EUR/US$ exchange rate dynamics in general at the level of a nation or

supranation. See, among others Belke et al. (2013), Fratzscher (2008) and Sinn and Westermann

(2001). Another strand of literature analyses the issue of exchange rate susceptibility at the level of

DOI: 10.1111/twec.12541

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:358–392.

the firm or industry. Griffin and Stulz (2001), for example, investigate different sectors in the US,

Canada, the UK, France, Germany and Japan. As mentioned above, their results suggest that

exchange rates play, if at all, only a minor role in determining sectoral performance. Contrar y to

Bodnar and Gentry (1993), Griffin and Stulz (2001) find significant exposure to exchange rate

movements for industries in the US, Canada and Japan. Williamson (2001) is a study that explic-

itly investigates the automobile industry finding, in general, significant exchange rate exposure for

this sector. However, due to “lack of competition”Williamson excludes the German automobile

industry from his analysis. Finally, Greenaway, Kneller, and Zhang (2010) emphasise the effects

of exchange rate changes at a firm’s cost side by noting that appreciation may have offsetting

effects through relatively cheaper imported intermediate goods. Their empirical results for the UK

manufacturing sector indicate that exchange rate dynamics might not have a significant effect at all

once effects at the cost side are considered. Overall, there is no coherent picture of the EUR/US$

exchange rate susceptibility of key exporting sectors of the core EU economies in the literature to

back up the vast narrative evidence on the issue.

Here, we take a different route and define susceptibility more directly as an aggravation of both

the sectoral order-book indicators and of the business climate in the automobile and mechanical

engineering industries. These two sectors account, for example, in the case of Germany for about

one-third of its total exports in 2011. Our central empirical strategy consists of estimating trivariate

VAR models incorporating the real exchange rate, the volume index of exports from the two key

exporting sectors and sectoral confidence indicators using monthly data from 1995 to 2010.

Against this backdrop, our study seeks to analyse three fundamental hypotheses:

•The popular belief of a profound exchange rate susceptibility of the core sectors, that is, the

automobile and mechanical engineering industries. [H1]

•The Williamson hypothesis according to which the German economy and its key sector, the

automobile industry, stand out (Williamson, 2001). [H2]

•The Frankel–Rose–Melitz hypothesis according to which currency union members get immu-

nised as the union fosters intra-Eurozone trade counteracting exchange rate exposure (Frankel &

Rose, 2002; Melitz, 2003). [H3]

To address the first point, we focus on the German economy as our benchmark case. Compar-

ing our results to estimates obtained from French sectoral series then allows us to assess a possibly

exceptional reaction of German key sectors. Finally, considering the GBP/US$ exchange rate along

with UK sectoral series, we analyse whether the two currency union members witnessed some

change in their response to exchange rate shocks over time. Overall, our focus is on (foreign)

demand-side effects of exchange rates, considering both realised demand, that is, exports, as well

as expected demand, that is, export order-book assessments and business confidence.

The remainder of the paper is organised as follows: Section 2 discusses sources of imperfect

pass-through in the European context. In Section 3, we use German time series to estimate a refer-

ence case. Section 4 extends our reference case to French and UK time series. In Section 5, we

look at the sectoral response to an exchange rate shock over time. Finally, Section 6 concludes.

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SOURCES OF IMPERFECT PASS-THROUGH

In a stylised model world, the reaction of exports and ultimately also of the business climate and

other confidence indicators to changes in the real exchange rate in the exporting sectors is

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clear-cut. Both, in traditional Mundell–Fleming–Dornbusch type models (Dornbusch, 1976) and in

more recent open-economy models (Lane, 2001; Svenson, 2000), an appreciation (a depreciation)

decreases (increases) the demand for domestically produced export goods by increasing (reducing)

their relative price. However, in a world of differentiated export goods supplied by firms producing

with imported intermediate goods on segmented markets, characterised by imperfect competition

and different shades of exposure to trade, the unambiguousness of this relationship gets lost. We

will discuss four central sources of imperfect pass-through in the follow ing: imported intermediate

goods relating to [H1], imperfect competition relating to [H2], strategic firm behaviour relating to

[H1] and [H2] and exposure to trade relating to [H3].

A straightforward implication of an appreciation of the domestic currency for firms producing

with imported intermediate goods is reduced cost of such inputs. This can be seen as particularly

important for European companies when it comes to paying the bill for energy used in the produc-

tion of automobiles and machinery as neither the UK (making <3% of the world’s oil production

through North sea oil drilling over our sample period) nor Germany and France are among the

major oil producing economies in the world. Ultimately, this might fully counteract the pass-

through for these industries (Greenaway et al., 2010).

In general, a full pass-through requires perfectly competitive markets. Incomplete competition

implies incomplete and inert price adjustments. For less than fully competitive markets, a pass-

through will typically be incomplete, referred to as pricing-to-market (PTM) in the literature (Krug-

man, 1986). Accordingly, companies set their export price to P¼ð1þpÞMC, that is, due to some

market power they mark-up price their products.

1

Pricing-to-market can be a possibility to preserve

foreign market shares as it allows the exporter to stabilise supply prices in foreign currency by

reacting to exchange rate movements with changes in the mark-up. PTM may also help to avoid

menu cost in case of exchange rate changes which are only transitory in nature. Additionally, it

might serve as a “war chest,”whenever firms believe that regaining forgone market shares is more

costly than transitory losses from foregone profits. Several empirical studies have found evidence

for PTM on the side of exporters in general (Falk & Falk, 2000; Knetter, 1993) and for companies

in the automobile and mechanical-engineering industry in particular (Belke et al., 2013). Ulti-

mately, the extent of exchange rate pass-through and PTM is an empirical question hinged on the

price elasticity of exports. PTM may help to cushion negative externalities of an appreciation on

the demand side, although it will always go at the cost of firms’profits. Certainly, the extent of

the latter depends on the price elasticity of exports. For example, according to Deutsche Bundes-

bank (2008), German exports, in particular, to non-European economies, react rather weakly to

exchange rate changes.

2

If, for instance, the domestic currency appreciates by 1%, real exports are

estimated to fall by only about 0.25%. This is often ascribed to relative price-inelastic goods, for

example, individualised investment goods such as specific machinery, making up a considerable

share of German exports. Foreign customers may also stick to their supplier even though the value

of foreign currency increases because of switching cost being even higher. As German companies

are highly specialised in certain industries, “foreign consumers are ‘caught’in their relation to Ger-

man suppliers”(Belke et al., 2013).

3

An alternative to cope with exchange rate risk from the firm perspective is to shift production

abroad. This so-called “natural hedging”has been widely practiced by the German automobile

1

This mark-up (price discrimination) may vary among export destinations.

2

For the following arguments and figures, see Belke et al. (2013)

3

However, Chen, Milesi-Ferretti, and Tressel (2012) recently find no evidence that German exporters, in general, benefit

from a demand elasticity advantage over other Eurozone countries.

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