Exchange Rates and Trade Flows in Asia

A bit more on shifting trade flows following the 1997 Asian Crisis.

Enno Schroeder, whose decomposition  of European trade flows I’ve mentioned here before, was kind enough to do a similar exercise for the four Asian crisis countries. His results are here; below I present them in graphical form below.

The conventional story, as we all know, is that relative prices drive trade flows. The Asian countries, in this view, moved from deficits to surpluses after 1997 because abandoning their currency pegs and devaluing made their exports cheaper and their imports more expensive. I’ve been suggesting a different story: Relative prices were relatively unimportant in the post-1997 move to surpluses, with the improved trade balance mostly or entirely a matter of lower imports resulting from the deep fall in income in the crisis. Looking at the picture in more detail suggests a more complex but in some ways even stronger version of my earlier story.

Some context: Suppose a country reduces its total import bill. As a matter of accounting, this reduction can be broken up into some mix of lower total quantity of goods bought, a smaller fraction of those goods being imports, and a lower price of the imported goods. Similarly for exports, any increase can be broken up into higher incomes in a country’s export markets, a greater market share there for our exports, and higher export prices. So the overall trade balance — here expressed as the ratio of total export value to total import value — can be decomposed into the change in relative expenditure growth, the expenditure switch between the home country’s goods and the rest of the world’s; and the change in the relative price of home goods compared with foreign ones. (Note that relative price presumably affects trade volumes, but it also affects trade value directly — for given trade volumes, if a country’s imports are more expensive it will spend more on imports.) The cumulative contribution of each of these components is shown in the figures below, along with the nominal exchange rate. (The exchange rate is the nominal rate for July of each year, from the BIS.)

The heavy black line is the actual trade balance. Again, since the balance here is expressed as the ratio of exports to imports, a value of 1 means balanced trade. The other three solid lines show the cumulative contributions of each component to the changes in trade flows after 1996; the values represent how the trade ratio would have changed from that factor alone. Yellow is expenditure switch, from the rest of the world’s goods to the home country’s; this includes both home country switch from imports to domestic goods, and foreign country shift toward the home country’s exports. Green is income growth in the country’s trade partners relative to the home country. The solid red line is the terms of trade. The dotted red line shows the cumulative change in the nominal exchange rate; this isn’t directly a contribution to the change in trade flows, but it’s useful to know how closely the change in the terms of trade tracks the exchange rate.

It’s convenient to think of the difference between the black line and the green line as the change in competitiveness.

The immediate effect of a devaluation is to make the home country’s goods cheaper in the rest of the world, and the rest of the world’s goods more expensive in the home country. The direct effect of this is to move the trade balance further toward deficit — a descending red line in the figures below. But in the conventional story, the change in price leads to a more than proportionate change in quantity — a rise in exports and/or a fall in imports — so that the overall trade balance improves. This should show up here as a rise in the yellow line steeper than the fall in the red one. Income growth doesn’t really come into the conventional story, so the green line should be flat.

This is not what we see. Even in terms of this simple decomposition, the post-crisis experience of each of the four Asian NICs was different, but none of them fit the standard story. Devaluations don’t reliably translate into changes in the terms of trade, and changes in the terms of trade don’t reliably translate into changes in trade flows. The income-trade balance link, on the other hand, looks quite reliable. In terms of the debate taking place elsewhere in econ blog land, this is a case where “hydraulic Keynesianism” looks pretty good.

Thailand is the clearest picture.

In the 1997 devaluation, the baht lost about a third of its value; the fall in the terms of trade — the price of Thai exports relative to imports — was less than proportionate, but still substantial. You can see this in the red lines at the bottom. But there was no expenditure switch at all. The flat yellow line shows that expenditure on foreign goods out of a given Thai income, and expenditure on Thai goods out of a given income elsewhere, did not change at all in the ten years after the crisis. (More precisely, expenditure in Thailand shifted toward domestic goods, while Thailand lost ground in its export markets; the two effects approximately canceled out.) Given that Thai goods were getting cheaper relative to foreign goods, the lack of net expenditure switch toward Thai goods should have led to deeper deficits. The only reason Thailand moved from deficit to surplus, is the decline in expenditure in Thailand relative to expenditure in its trading partners. The close match between the black and the green line in the figure, means that essentially the whole change in Thailand’s trade balance is explained by the change in relative growth rates; there was no net switch toward Thai goods from foreign goods.

Indonesia is in some ways even a starker example:

Here we see a very deep devaluation, but again only a moderate change in the terms of trade, and an even smaller response of trade volumes. As in Thailand, the trade balance basically tracks relative income growth. The difference between these two cases is where the devaluation-trade flows link fails. In Thailand, the devaluation did reduce the price of exports relative to imports, but demand was not price-elastic enough for the change in prices to improve the trade balance. (In other words, the Marshall-Lerner-Robinson condition appears not to have been satisfied.) In Indonesia, the even larger devaluation — the rupiah lost almost 80 percent of its value — failed to change relative prices of traded goods, so demand elasticities did not come into play. This is partly because of high inflation in Indonesia following the devaluation, but not entirely – the rupiah fell by nearly half in real terms. But there was no change in the price of Indonesia’s exports relative to its imports. If you want an example of a devaluation not working, this is a good one.

Korea, by contrast, looks superficially like the devaluation success story.

As I mentioned in the previous post, Korea was the only one of these countries where export growth in the decade after 1997 was as fast as in the decade before. And as the figure here shows, there was a substantial shift expenditure toward Korean goods following the crisis; alone among the four countries, Korea achieved its immediate post-crisis improvement in trade balance mainly through favorable expenditure switch rather than solely through a fall in income (though that contributed too.) But over time, Korea’s terms of trade continued to deteriorate, without any further favorable expenditure switch; meanwhile, Korean growth slowed relative to its trade partners. By 2007, expenditure shares were back at 1997 levels; to the extent that Korea’s trade balance was more favorable, it was only because spending was lower relative to its trade partners. Of course the surpluses it had run in the meantime had allowed the accumulation of substantial foreign exchange reserves. But if the goal is to use a lower exchange rate to achieve a permanent shift in trade balances, Korea post-1997 cannot be considered a success.

I should emphasize here: Slower relative expenditure growth in Korea does not mean slow growth in absolute terms. In fact, Korea (and, to varying degrees, the other three) did enjoy strong post-crisis recoveries. But because by far the largest trading partner for these countries is China — taking about 25% of their exports — even fairly strong growth translated into low relative growth. In other words, rapid growth in China implied growing exports in the NICs even in the absence of any competitiveness gains.

Finally, the one country that did achieve a lasting improvement in competitiveness, Malaysia.

In the immediate crisis period, Malaysia looks like Thailand and Indonesia: A deep devaluation fails to pass through to the relative prices of traded goods, and there is no expenditure switching; instead, the entire burden of raising the trade balance falls on slower growth in domestic expenditure. In the case of Malaysia, domestic expenditure fell by an astonishing 28 percent in 1997, a collapse in economic activity that has few precedents — neither the US in the 1930s nor any Euro-crisis country comes close. But in the case of Malaysia, unlike the other three countries, growth subsequently accelerated relative to its trade partners, reflected in the downward sloping green line; at the same time, there was a continued expenditure switch in favor of Malaysian goods, reflected in the upward slope of the yellow line. What’s especially striking about this competitiveness success story is that the favorable expenditure switch happened despite a rising price of of Malaysia’s exports relative to its imports.

To continue with this analysis properly, one would want to disaggregate imports and exports by sector or industry. And would want to study, for each country, the institutional and legal changes that influenced trade flows in the decade after 1997. But failing that, it’s at least worth understanding what the aggregate numbers are saying. It seems to me that they are saying this:

Even a very deep devaluation, as in Indonesia, is not guaranteed to change the relative prices of a country’s imports and exports.

Even if a devaluation is passed through to relative prices, as in Thailand, price elasticities may not be large enough to produce a favorable change in the trade balance.

Even if a devaluation moves relative prices, and demand is price-elastic enough for the price change to move the trade balance in the right direction, as in Korea, a short-term improvement in competitiveness may not persist.

When countries do achieve a long-term improvement in competitiveness, like Malaysia, they don’t necessarily do so through a relative cheapening of exports compared to imports. On the contrary: If the Marshall-Lerner condition is not satisfied, then a relative increase in the price of a country’s exports will raise export earnings. In the case of Malaysia, improved terms of trade (that is, a rise in the price of its exports relative to its imports) account for about half the long-run improvement in its trade balance.

The Asian precedent does not make a Greek (or Spanish, or Portuguese, or Irish) devaluation look like an obviously good idea.


One other thing, if even real exchange rate changes are not passed through to traded-good prices in the destination country, then they must be showing up as changes in exporter profit margins. This shifts the focus from demand responses to supply responses, which I would argue are  more institutionally mediated. As you can tell if you’ve read this far, I am sympathetic to the “elasticity-pessimist” strand of Post Keynesian thought. But on the other side Robert Blecker has a strong argument for a strong effect of exchange rate changes, focusing on the role of export-industry profits in financing investment. Blecker’s paper, in my opinion, is more convincing the straightforward “prices matter” view of exchange rate changes. But it also suggests a certain asymmetry: low profits induce exit from tradable sectors, especially for countries with Anglo-American market-based financial systems, more reliably than high profits encourage entry.

UPDATE: The fact that even large exchange rate changes produce relatively small movements in the relative prices of traded goods is well-known in the empirical trade literature. See for example here. I should have made this clearer.

Do Prices Matter? EU Edition

The Euro crisis. One thing sensible people agree on is that the crisis has little or nothing to do with fiscal deficits  (government borrowing), and everything to do with current account deficits (international borrowing, whether public or private.) And one thing sensible people do not agree on, is how much those current account deficits are due to relative costs, or competitiveness.

A thorough dissection of competitiveness in the European context is here; Merijn Knibbe has some good posts critiquing it at the Real World Economics Review. Krugman, on the other hand, defends the competitiveness story, suggesting that the alternative to believing that relative prices drive trade flows, is believing in the “doctrine of immaculate transfer.” What he means is, the accounting identity that net capital flows equal net trade flows doesn’t in itself provide the mechanism by which trade adjusts to financial flows. A country with an increasing net financial inflow must, in an accounting sense, experience an increasing current account deficit; but you still need a story about why people choose to buy more from, or are able to sell less to, abroad.
So far, one can’t disagree; but the problem is, Krugman assumes the story has to be about relative prices. It’s not the case, though, that relative prices are the only thing that drive trade flows. At the least, incomes do too. If German wages fall, German goods may become more cost-competitive; but in any case, German workers will buy less of everything, including vacations in Greece. Similarly, if Greek wages rise, Greek goods may be priced out of international markets; but in any case Greek workers will buy more of everything, including manufactured goods from Germany. Estimating the respective impacts of relative prices and incomes on trade flows, or the elasticities approach, is one of the lost treasures of the economics of 1978. Both income and price elasticities solve the immaculate transfer problem, since capital flows from northern to southern Europe were associated with faster growth of both income and prices in the south. But their implications for policy going forward are quite different. If the problem is relative prices, a devaluation will fix it; this is what Krugman believes. If the problem is income elasticities, on the other hand, then balanced trade within Europe will require some mix of structural reforms (easier said than done), permanently faster growth in the north than the south, or — blasphemy! — restrictions on trade.
Let’s pose two alternatives, understanding that the truth, presumably, is somewhere in between. In the one case, EU current account imbalances are due entirely to countries’ over- or undervalued currencies. In the other case, current account imbalances are due entirely to differences in growth rates. One thing we do know: In the short run — a year or two — the latter is approximately true. In the short run, the Marshall-Lerner-Robinson condition is almost certainly not satisfied, so a change in prices will have the “wrong” effect on foreign exchange earnings, or at best — if the country’s imports and exports are both priced in foreign currency — have no effect. In the long run, it’s less clear. Do prices or incomes matter more? Hard to say.
So what is the evidence one way or the other? One simple suggestive strand of evidence is the intra- and extra-European trade balances of various countries in the EU. To the extent that trade flows have been driven by price, the deficit countries should have seen larger deficits with other EU countries than with other countries, and the surplus countries similarly should have seen larger surpluses within the union than outside it. Those countries whose currencies would otherwise, presumably, have appreciated relative to other EU members should have shifted their net exports towards Europe; those countries whose currencies would otherwise have depreciated should have shifted their net exports away. Is that what we see?
As is often the case with empirical work, the answer is: Yes and no. From Eurostat, here are trade balances as percent of GDP, within and outside the currency union, for selected countries and selected years.
Intra-EU Trade Balance
1999 2007-2008 2011
Germany  2.0% 4.8% 2.1%
Ireland 19.0% 7.4% 12.6%
Greece -10.0% -9.6% -5.3%
Spain -2.9% -4.0% -0.6%
France -0.3% -3.1% -4.3%
Italy 0.5% 0.5% -0.2%
Netherlands 14.8% 24.5% 27.9%
Austria -3.9% -3.0% -5.0%
Extra-EU Trade Balance
1999 2007-2008 2011
Germany  1.2% 2.8% 4.0%
Ireland 6.1% 7.8% 15.1%
Greece -3.9% -9.1% -4.4%
Spain -2.1% -5.1% -3.8%
France 1.0% -0.1% 0.0%
Italy 0.8% -1.2% -1.4%
Netherlands -11.8% -17.5% -20.5%
Austria 1.4% 2.7% 1.9%
What we see here is sort of consistent with the competitiveness story, and sort of not. Germany did increase its intra-EU net exports about twice as much as its extra-EU net exports over the pre-crisis decade, just as a story centered on relative prices would predict. And on the flipside, the fall in Irish net exports over the pre-crisis decade was entirely with other EU countries, again consistent with the Krugman story. 
But for the other countries, it’s not so simple. The increase of the Euro-era Greek deficit, for instance, was entirely the result of increased imports from non-Euro countries. Euro-area trade, and non-Euro exports, were approximately constant in the ten years from 1999. This is more consistent with a story of rapid Greek income growth, than uncompetitively high Greek prices. Similarly, the movement toward current account deficit of Spain was mostly, and of Italy entirely, a matter of trade with non-EU countries. This is not consistent with the relative-price story, which predicts that intra-EU trade imbalances should have grown relative to extra-EU imbalances. Note also that today, Germany’s net exports to the rest of the EU area are no higher than when the Euro was created, while Greece and Spain have substantially improved their intra-EU balances; but all three countries have moved further toward imbalance with extra-EU countries. This, again, is not consistent with a story in which trade imbalances are driven primarily by the relative price distortions created by the single currency.
Conclusion: Krugman is right that how much relative prices have contributed to intra-European current account imbalances, is a question on which reasonable people can disagree. But as a doctrinaire Keynesian, I remain an elasticity pessimist. It seems to me that we should at least seriously consider a story in which European current account imbalances are due to relatively rapid income growth in the periphery, and slow income growth in Germany, as opposed to changes in competitiveness. A story, in other words, in which a Greek exit from the Euro and devaluation will not do much good.
UPDATE: While I was writing this, Merijn Knibbe had more or less the same thought.