Mar 14, 1984

EXCHANGE RATE VARIABILITY AND ITS EFFECTS.

GENEVA, MARCH 13 (IFDA/CHAKRAVARTHI RAGHAVAN) -- Both short-term and long-term exchange rate variability have increased sharply since 1970’S, but empirical studies have failed to establish a "systematic significant link" between this variability and the volume of international trade.-

This is one of the conclusions of an IMF study on "exchange rate volatility and world trade", due to be published shortly.-

The study, presented to the GATT Council, however notes that "the failure to establish a statistically significant link between exchange rate variability and trade does not, of course, prove that a causal link does not exist".-

The study was requested by the GATT Contracting Parties at their 1982 Ministerial session.-

Underlining its "rather indefinite conclusions", the study says that "the only clear conclusion is that uncertainty inhibits economic activity".-

Short-term instability in nominal exchange rates is relevant for traders undertaking individual transactions.-

But such transactions are the exception rather than the rule in international trade, and the uncertainty can be hedged against in forward markets at relatively low cost.-

But for those engaged in longer term commitments in international trade relationships, it may be divergence of the exchange rate for its underlying trend, rather than the movement from one period to the next, that is the most significant source of uncertainty.-

The study shows that both short-term and long-term exchange rate variability have increased sharply following the move to more flexible exchange rates at the beginning of the 1970’s.-

The variability is significantly more noticeable in case of the nominal than real exchange rates.-

In the 1960’s (when there was the fixed exchange rate system), the nominal rates tended to be more stable than the real rates.-

But since the move to generalised floating, both measures reveal a similar degree of variability.-

This suggests that inflation differentials explain only a relatively small part of exchange rate shifts, at least over the short-to-medium term.-

No clear tendency is apparent for the variability in exchange rates to decline as experience with floating arrangements accumulates.-

All the major currencies have diverged from the medium-term trend in their real effective exchange by at least ten percent during the past decade, and in some cases, including that of the U.S.A., the divergence has reached 20 percent.-

The large majority of empirical studies are unable to establish a systematically significant link between the measured exchange rate variability and the volume of international trade, whether at an aggregated or bilateral basis.-

But the failure to establish a statistically significant link between exchange rate variability and trade does not, of course, prove that a causal link does not exist.-

It may well be that the measures of variability used are inadequate measures of uncertainty, that other factors overwhelm the impact of variability in the estimating equations, or that the presence of statistical problems interferes with the effectiveness of statistical tests.-

It may be the case that the lags with which greater variability in exchange rate regime affect trade flows are longer and more variable than imagined by previous investigators.-

The study says that the indirect effects of exchange rate variability on the structure of domestic output, and thereby on the level and pattern of international trade are extremely difficult to trace.-

Exchange rate uncertainty is only one relatively minor consideration among many others in each individual decision to invest at home or abroad, expand output, merge with another enterprise, etc.-

Empirical work would thus not reveal statistically significant relationships between such phenomenon and the level of exchange rate variability.-

The continuing tendency in recent years towards growing size of enterprises and increased international investments is consistent with what might be expected as a rational reaction to increased uncertainty about relative factor and product prices in different markets.-

But this phenomenon stretches back beyond the period of greater exchange rate variability, and could just as easily be attributed to effects of greater international integration of markets and impact of technological progress on the nature of production processes.-

The study finds that the volume of business fixed investments in relation to GDP does not appear to have declined in recent years, as might have been expected on the basis of theoretical considerations about the effect of uncertainty.-

However, it is possible that the adverse effects of uncertainty were outweighed by the need to invest in energy conservation and exploration, following the large rise in relative price of energy.-

As for the effect of exchange rate instability on government macro-economic policy, the study says neither theoretical reasoning nor empirical evidence is conclusive in establishing a link between the exchange rate variability and inflation.-

On the view that the exchange rate instability has generated greater pressures for protectionism on the part of industries vulnerable to sudden shifts in external competitiveness, the study says that evidence on this matter is "somewhat anecdotal", since it is difficult to say what lies behind pressure by a particular industry for protection.-

Many of the current protectionist measures have been sector- or country-specific, rather than across-the-board, and influenced by more fundamental and long-lasting shifts in competitiveness arising from factors other than exchange rate shifts.-

The restrictions in the textiles and clothing sector, for example, have been directed specifically against developing countries with a comparative cost advantage in this sector, and have persisted for over a quarter of century during which they have become progressively more severe, irrespective of the abandonment of the par value system and swings in exchange rates among currencies during this period.-

The protectionism in steel, in the U.S.A. and the EEC, the entrenched protection in agriculture in all Industrial countries, and the protection in the automobile sector (against Japan) could also be explained by factors other than exchange rate variability.-

"In any case it is not the pressure that produces protection, but the response of the policy authorities to the sum of these responses that determines the stance of trade policy.-

"But what can be said is that the recent period of more turbulent exchange rates has seen a reversal of the generally liberal trend of trade policy that prevailed of the post-war period.-

"Doubtless, many factors contributed to such a change in trend, but the existence of volatile exchange rates has given one additional reason for interest groups to offer when they seek protection, and a further factor for authorities to cite when granting it"-