Exchange Ratesand External Adjustment*

Peterson Institute for International EconomicsSeptember 11, 2019

*2019 External Sector Report—Chapter 2 (Gustavo Adler, Carolina Osorio Buitron and Sergii Meleshchuk) 1

Gustavo AdlerInternational Monetary Fund

Overview

2019 External Sector Report revisits role of exchange rate in external adjustment, with focus on:

o Currency of invoicing Use of third-country (dominant) currencies in bilateral trade

Bilateral exchange rates become less relevant to trade volumes

o Global value chains (GVC) Use of imported intermediate goods in production of goods for exports

Third-party (upstream and downstream) exchange rate movements become important Production costs move in tandem with prices

Special attention to Short- and Medium-term implications

Work builds on growing literature: Boz et al (2018), Gopinath et al (2018); October 2015 WEO; Leigh et al (2017); Amiti et al (2014); Bayoumi et al (2018); Bayoumi et al (2019); Bems (2014); Borin and Mancini (2019), Cheng et al (2016); De Soyres et al (2018).

Ongoing debate about the role of exchange rates in facilitating external adjustment

2

Currency of invoicing

3

Country A Country B

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑩𝑩

𝑷𝑷𝑴𝑴𝑩𝑩 = 𝒆𝒆𝑨𝑨,𝑩𝑩 ∗ 𝑷𝑷𝑷𝑷𝑨𝑨

Firms set prices inown currency 𝑷𝑷𝑷𝑷𝑨𝑨

Firms set prices in own currency 𝑷𝑷𝑷𝑷𝑩𝑩

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑨𝑨

𝑷𝑷𝑴𝑴𝑨𝑨 =𝑷𝑷𝑷𝑷𝑩𝑩

𝒆𝒆𝑨𝑨,𝑩𝑩

Export vol

Import vol

Traditional View (mostly) producer currency pricing (PCP)

Traditional view of external adjustment

Currency of invoicing

4

A depreciation of country A’s currency 𝒆𝒆𝑨𝑨,𝑩𝑩

Country B

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑩𝑩

𝑷𝑷𝑴𝑴𝑩𝑩 = 𝒆𝒆𝑨𝑨,𝑩𝑩 ∗ 𝑷𝑷𝑷𝑷𝑨𝑨

Firms set prices inown currency 𝑷𝑷𝑷𝑷𝑨𝑨

Firms set prices in own currency 𝑷𝑷𝑷𝑷𝑩𝑩

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑨𝑨

𝑷𝑷𝑴𝑴𝑨𝑨 =𝑷𝑷𝑷𝑷𝑩𝑩

𝒆𝒆𝑨𝑨,𝑩𝑩

Export vol

Import vol

Expenditure-switching through exports and imports

Country A

Balanced external adjustment through exports and imports

Currency of invoicing

5

Country A Country B

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑩𝑩

𝑷𝑷𝑴𝑴𝑩𝑩 = 𝒆𝒆𝑩𝑩,𝑼𝑼𝑼𝑼𝑼 ∗ 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Firms set prices indominant currency 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Firms set prices in dominant currency 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑨𝑨

𝑷𝑷𝑴𝑴𝑨𝑨 =𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

𝒆𝒆𝑨𝑨,𝑼𝑼𝑼𝑼𝑼

Export vol

Import vol

Bilateral exchange rates less relevant. Prices depend on exchange rate vis-à-vis dominant currency (US$) in the near term

Dominant currencies alter external adjustment mechanisms

Currency of invoicing

6

Country A Country B

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑩𝑩

𝑷𝑷𝑴𝑴𝑩𝑩 = 𝒆𝒆𝑩𝑩,𝑼𝑼𝑼𝑼𝑼 ∗ 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Firms set prices indominant currency 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Firms set prices in dominant currency 𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

Demand 𝑫𝑫 𝑷𝑷𝑴𝑴𝑨𝑨

𝑷𝑷𝑴𝑴𝑨𝑨 =𝑷𝑷𝑷𝑷𝑼𝑼𝑼𝑼𝑼

𝒆𝒆𝑨𝑨,𝑼𝑼𝑼𝑼𝑼

A depreciation of country A’s currency vis-à-vis all currencies:

Export vol

Import vol

Expenditure-switching mainly through imports

𝒆𝒆𝑨𝑨,𝑩𝑩 = 𝒆𝒆𝑨𝑨,𝑼𝑼𝑼𝑼𝑼 𝒆𝒆𝑩𝑩,𝑼𝑼𝑼𝑼𝑼

∆≈ 𝟎𝟎

∆≈ 𝟎𝟎

One-legged external adjustment

Currency of invoicing

TUR

IDN CHN

IND

ROU

HUN

POL

BRA

DNK

GBR

CZE

NOR

AUS

JPN

KOR

SWE

CAN

CHE

FRASVN

GRCESP

IRL

LTU

FIN

AUTITA

SVK

0

0.2

0.4

0.6

0.8

1

0 0.2 0.4 0.6 0.8 1

Shar

e of

exp

orts

invo

iced

in U

SD

(pos

t-19

99 a

vera

ge)

Share of exports to US (2001-15 average)

EMDEsnon-EA AEsEA

Exports

HypotheticalLCP line

Sources: Gopinath (2015), WIOD 2016 and IMF staff calculations

BRA

CHN

TUR

IND

IDN

POLHUN

ROU

GBR

CAN

CZE

JPN

CHE

AUS

KOR

EST

LTU

SVKLUX

FINGRC

IRL

AUT

BEL

NLD

FRA

0

0.2

0.4

0.6

0.8

1

0 0.2 0.4 0.6 0.8 1

Shar

e of

impo

rts i

nvoi

ced

in U

SD(p

ost-

1999

ave

rage

) Share of imports from US (2001-15 average)

Imports

HypotheticalPCP line

7

Trade with US and trade invoiced in US Dollars(share of total exports/imports)

USD dominates trade invoicing

Currency of invoicing

8

Bilateral Trade Prices / Volumes

Bilateral Exchange Rate

Exchange Rate vis-à-vis US Dollar

Controls for Bilateral and Global Demand/Supply shocks

Analysis of bilateral manufacturing trade prices and quantities based on and Gopinath and others (forthcoming). 37 advanced and emerging market economies Period 1990-2014

Short-term (same year of shock) and medium-term (3 years after) effectsTrade balance(share of GDP)

Trade openness

ERPT and Volume elasticities

Empirical Analysis

9

Currency of invoicing Exchange Rate Pass-Throughreflects USD dominance

Exchange Rate Pass-through (ERPT) to Export Prices(to prices in exporter currency, weighted regressions)

Sources: IMF staff estimates based on dataset from Gopinath and others (2018). An increase in either exchange rate implies a depreciation of the domestic currency. The figure reports point estimates and 95 percent confidence bands.

0

0.2

0.4

0.6

0.8

1

Bilateral US$ Bilateral US$

Short term Medium term

Export prices

1. Average Effects

US dollardominance

PCP PCP=LCP

LCP

0

0.2

0.4

0.6

0.8

1

Bilateral US$ Bilateral US$

Short term Medium term

Export prices

No USD invoicing

High USD invoicing

2. Effects by Degree of USD Invoicing

10Sources: IMF staff estimates based on data sets from Gopinath and others (2018) and Boz and others (forthcoming).1/ Contributions of export and import volumes to change in trade balance, in percent of GDP, in response to 10 percent depreciation vis-à-vis all currencies. Computed for median export- and import-to-GDP ratio.

Currency of invoicing USD dominance alters short-term adjustment

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

Short term Medium term

Export volumes

Import volumes

Total effect on trade balance (includes prices)

Contribution of trade volumes to change in trade balance 1/(response to 10% depreciation vis-à-vis all currencies, for median country, in %GDP)

Muted export response

More balanced adjustment

1. Average effects

-0.6

-0.2

0.2

0.6

1.0

1.4

1.8

1 2 3 4 5

Low High

Short term Medium term

ExportVolumes

ImportVolumes

Low High

2. Effects by degree of USD invoicing

Global Value Chains

Upstream supplier

(backward)

Downstream buyer

(forward)

GVC integration reduces (increases) the relevance of bilateral (third-party) ERs

11

Trade with GVC integration:

Traditional view of trade:

GVC measuresBackward: ∑𝑐𝑐𝜔𝜔𝑐𝑐,𝑎𝑎𝑎𝑎

𝐵𝐵 𝑑𝑑𝑒𝑒𝑎𝑎𝑐𝑐ω𝑐𝑐,𝑎𝑎𝑎𝑎𝐵𝐵 import content of c

in exports from a to b

Forward: ∑𝑑𝑑𝜔𝜔𝑑𝑑,𝑎𝑎𝑎𝑎𝐹𝐹 𝑑𝑑𝑒𝑒𝑎𝑎𝑑𝑑

𝜔𝜔𝑑𝑑,𝑎𝑎𝑎𝑎𝐹𝐹 share of exports

from 𝑎𝑎 to 𝑏𝑏 reexported to 𝑑𝑑

CountryA

CountryB

𝑒𝑒𝐴𝐴𝐵𝐵

CountryA

CountryB𝑒𝑒𝐴𝐴𝐵𝐵

CountryD

𝑒𝑒𝐵𝐵𝐵𝐵Country

C

𝑒𝑒𝐴𝐴𝐴𝐴

Intermediate good Final good

Global Value Chains

Sources: WIOD 2016 and IMF staff calculations1/ Trade weighted average of bilateral GVC measures. 12

Multilateral Measures of Global Value Chain Integration in Manufacturing 1/

AUS

AUT

BEL

BRA

CANCHE

CHN

CZE

DEUDNK

ESP

EST

FIN

FRA

GBR

GRC

HUN

IDNIND

IRL

ITA

JPNKOR

LTU

LUX

MEX

NLD

NOR

POLPRT

ROU

RUS

SVK

SVN

SWETUR

USA

0

0.1

0.2

0.3

0.4

0.5

0.6

0 0.2 0.4 0.6

2014

2001

Backward Integration(Share of exports)

45°

AUS

AUT

BEL

BRA

CAN

CHECHN

CZE

DEU

DNKESP

EST

FINFRA

GBR

GRC

HUN

IDN

INDIRLITA

JPN

KOR

LTULUX

MEX

NLD

NOR

POLPRT

ROU

RUS

SVK

SVN

SWE

TUR

TWN

USA

0

0.1

0.2

0.3

0.4

0.5

0.6

0 0.1 0.2 0.3 0.4 0.5 0.6

2014

2001

Forward Integration(Share of imports)

45°

Cross-section heterogeneitybut limited change since early 2000s

Global Value Chains

13

Stand-alone/direct

Exchange Rate vis-à-vis USD (stand-alone/direct)

Controls for Bilateral and Global Demand/Supply shocks

Analysis of bilateral manufacturing trade prices and quantities;

Through backward GVC linkages

Through forward GVC linkages

37 advanced and emerging market economies Period 2001-14

Global input-output tables (WIOD 2016).

Bilateral Exchange Rate (stand-alone/direct)

Stand-alone/direct

Through backward GVC linkages

Through forward GVC linkages

Bilateral Trade Prices / Volumes

Trade balance(share of GDP)

Trade openness

ERPT and Volume elasticities

Empirical framework

Global Value Chains GVC integration lowers gross tradeelasticities but increases trade flows

14

0.0

0.5

1.0

1.5

2.0

Short term Medium term Short term Medium term

Varying GVC integration¹ Varying openness²

Economy with median GVCintegration and trade openness

25th pctile

75th pctile

25th pctile

75th pctile

Sources: IMF staff estimates based on dataset from Gopinath and others (2018), WIOD 2016.1Openness fixed at the level of the median economy. 2Backward and forward GVC integration fixed at the level of the median economy.

Impact of GVC and Trade Openness on Trade Balance Response(Response to a 10 percent depreciation vis-à-vis all currencies)

-0.2

-0.1

0

0.1

0.2

0.3

-0.2 -0.1 0 0.1 0.2

Trad

e op

enne

ss fo

r a g

iven

leve

l of f

orw

ard

inte

grat

ion

Backward GVC integration for given level of forward integration

Correlation between GVC and Trade Openness(backward GVC integration)

Sources: IMF staff estimates.

Global Value Chains Limited changes over time

15

0.6

0.7

0.8

0.9

1.0

1.1

1.2

2000 2001-04 2005-09 2010-14

At constant GVC integration(Effect of changing trade openness)

At constant trade openness(Effect of changing GVC integration)

Net effect

Evolution of Trade Balance Response for Average Economy 1/(Response to 10 percent depreciation vis-à-vis all currencies, %GDP)

Sources: IMF staff estimates based on dataset from Gopinath and others (2018), WIOD 2016.1/ Response of the average economy in the sample, with time-varying GVC integration or trade openness (i.e., one at the time) or both (net effect).

0.0

0.1

0.2

0.3

0.4

0.5

-1 0 1 2 3 4 5 6

2001 2014

Distribution of Trade Balance Responses, 2001 and 2014 1/(Response to a 10 percent depreciation vis-à-vis all currencies, %GDP)

Sources: Gopinath and others (2018), WIOD 2016 and IMF staff estimations.1/Density of medium-run trade balance responses to a 10 percent depreciation vis-a-vis all currencies across all countries in the sample. Cross-section and time series differences reflect countries varying degrees of GVC integration and trade openness.

Takeaways and Policies

16

Greater GVC participation- Lower gross trade elasticities, but unchanged overall sensitivity of trade balance to ER

USD dominance in trade invoicing- Muted effects of exchange rates in the short term

(esp. on export volumes)- Less of a factor in the medium term

Short term. Where external imbalances are excessive, achieving near-term external adjustment larger ER movements —possible adverse balance sheet and inflation effects. other macroeconomic policies —complement ER flexibility or mitigate effects.

In cases with no evident external imbalances other policy tools to achieve full employment in the event of a negative shock.

Supply-side policies can help enhance exchange rate mechanisms- Access to credit; adequate transportation infrastructure

Medium term. Exchange rate flexibility remains useful to facilitate durable external adjustment

Further research. Services trade; role of balance sheet effects; etc.

Thank you!

17

Global Value Chains GVC integration dampensgross trade elasticities

18

-6

-3

0

3

6

9

Shortterm

Mediumterm

Shortterm

Mediumterm

Shortterm

Mediumterm

Shortterm

Mediumterm

Exports Imports Exports Imports

Volumes Prices

Median GVCintegration

25th pctile

75th pctile

Sources: IMF staff estimates, Gopinath and others (2018), WIOD 2016.1/ Weighted regressions.

Overall trade volume and price responses 1/(response to 10 percent depreciation vis-à-vis all currencies)

Higher ERPT(esp. for exports)

Dampening of gross trade volume elasticities