Choose Your Weapon: International Trade Agreements and Exchange Rate Policy

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Choose Your WeaponInternational Trade
Agreements and Exchange Rate Policy
Mark S. CopelovitchDepartment of Political
Science La Follette School of Public
AffairsUniversity of Wisconsin - Madison
Jon C. PevehouseHarris Schoolof Public Policy
StudiesUniversity of Chicago
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Research Question

• Do governments manipulate the exchange rate to
  influence the terms of trade?
• Exchange rate protection (Corden 1982)
• Devaluing the exchange rate
• Non-intervention allowing the ER to depreciate
• Intervening in markets to prevent currency
  appreciation
• Are countries that have tied hands on trade
  policy through preferential trade agreements
  (PTAs) more or less likely to engage in exchange
  rate protection

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Exchange Rate Policy - How Do Countries Choose?

• Economic factors
• Country size/trade openness
• Vulnerability to shocks
• Correlation of income/shocks with other
  countries/regions
• Macroeconomic factors (inflation, growth, balance
  of payments)
• Political factors
• Societal interests
• Domestic political institutions (central bank
  independence, veto players)
• International cooperation/institutions (IMF, EU)
• No single regime is right for all countries (or
  times) (Frankel 1999)
• Ultimately, ER regime choice is a political
  decision!

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The Trade Implications of Exchange Rates

• Exchange rate stability
• Eliminates currency risk, facilitates
  international exchange
• Level of the exchange rate
• Depreciation/devaluation improves exporters
  competitiveness
• 10 devaluation 10 tariff 10 export subsidy
• Many examples
• Classical and interwar gold standards (Simmons
  1994, Eichengreen 1992)
• Collapse of Bretton Woods (Odell 1982, Gowa 1983)
• China, US, and global imbalances (Chinn 2005,
  Eichengreen 2006)

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Trade and Exchange RatesParallel Literatures in
International Political Economy

• Political economy of trade
• Domestic trade policies (tariffs, NTBs)
• International agreements (GATT/WTO, PTAs)
• Political economy of exchange rates
• Regime choice (fixed vs. floating vs.
  intermediate)
• Variation within fixing (monetary unions,
  dollarization, pegs)
• Similar models and variables influence both
  policies
• But, relatively little research on their
  relationship

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Research Question

• Exchange rate protection (ERP)
• Do governments manipulate the exchange rate to
  influence the terms of trade?
• Active/tacit devaluation
• Preventing appreciation through market
  intervention
• Role of international trade agreements
• Are countries that have tied hands on trade
  policy through preferential trade agreements
  (PTAs) more or less likely to engage in ERP?

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Trade and Exchange Rate Policies Two Hypotheses

• Complements
• H1 More trade cooperation, less ERP
• Key goal of fixed rates is to reduce currency
  risk and facilitate international trade
• Substitutes
• H2 More trade cooperation, more ERP
• Trade policy usually requires domestic
  legislation
• Real appreciation harms exporters
  competitiveness
• PTAs restrict ability to use trade protection

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Observable Implications

• Correlation between exchange rate regime choice
  and membership in international trade agreements
• De jure regime choice (words)
• Governments stated policy commitments
• De facto regime choice (deeds)
• Reserve movements
• Nominal exchange rate volatility
• Correlation between exchange rate movements
  (depreciation) and international trade
  agreements
• Nominal/real effective exchange rates (BIS)

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Empirical Analysis

• Data
• 21 OECD countries, 1975-1999
• Results robust to inclusion of post-EMU years
• Dependent variables
• Annual change in nominal effective exchange
  rate (?NEER)
• De jure exchange rate regime choice (IMF)
• De facto regime choice (RR, LYS, Shambaugh)
• Explanatory variables
• Macroeconomic GDP, GDP per capita, inflation,
  current account/GDP, capital account openness
  (Chinn-Ito), trade/GDP, GDP growth
• Political institutions veto players (log),
  central bank independence
• Societal interests manufactured exporters, size
  of financial sector
• International trade commitments number of PTAs,
  number of PTA partners

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Empirical Analysis (cont.)

• Baseline specification
• ERPOLICYi,t ?0 ?1TradeGDP,t-1 ?2nPTAi,t-1
  ?3Capital Openi,t-1 ?4GDPi,t-1
  ?5pcGDPi,t-1 ?6Growth ?7Inflationi,t-1
  ?8Curr Accounti, t-1 ?9Checksi,t-1
  ?10CBIi,t-1 ?11Mfg Exportsi, t-1 ?
• Interaction terms
• Number of PTAsTrade/GDP
• Number of PTA partnersTrade/GDP
• Logic pressure for ERP may increase with trade
  openness
• Models
• ?NEER OLS, panel-corrected standard errors, LDV
• Regime choice Logit, robust standard errors,
  temporal splines

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Exchange Rate Commitments

• de jure ?Nominal ER
• Trade Openi, t-1 0.050 0.055 0.017
  0.018
• (0.010) (0.010) (0.014) (0.013)
• nPTAi, t-1 0.051 --.-- -0.057 --.--
• (0.020) (0.034)
• nPartnersi, t-1 --.-- 0.022 --.--
  -0.058
• (0.014) (0.023)

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First Differences De Jure Regime Choice ?NEER
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De facto ER Regimes I

• Reinhart/Rogoff LYS Shambaugh
• Trade Openi, t-1 0.008 -0.001 0.010
• (0.012) (0.004) (0.010)
• nPTAi, t-1 0.096 0.027 0.052
• (0.025) (0.011) (0.020)

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First Differences De Facto Regime Choice
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De facto ER Regimes II

• Reinhart/Rogoff LYS Shambaugh ?NEER
• Trade Openi, t-1 0.038 0.045 0.056 0.074
  
• (0.027) (0.010) (0.022) (0.033)
• nPTAi, t-1 0.180 0.150 0.188 0.078
• (0.075) (0.029) (0.069) (0.081)
• nPTA x Tr Open -0.001 -0.002 -0.002 -0.003
  
• (0.001) (0.000) (0.001) (0.001)

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Marginal Effect of Number of PTAs on Probability
of De Facto Fixed Exchange Rates
(Rogoff-Reinhart) as Trade/GDP Changes
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Marginal Effect of Number of PTAs on Probability
of De Facto Fixed Exchange Rates (LYS) as
Trade/GDP Changes
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Marginal Effect of Number of PTAs on Nominal
Effective Exchange Rate (NEER) as Trade/GDP
Changes
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Summary Findings

• In general, PTAs and fixed exchange rates are
  complements
• More PTAs, greater probability of fixing (de jure
  and de facto)
• But, some evidence of substitution/exchange rate
  protection
• More PTAs correlated with depreciation of NEER
• Propensity to fix based on PTA commitments
  disappears/reverses at high levels of trade
  integration
• Policy implications
• ER volatility as unintended consequence of trade
  integration?
• PTAs/WTO commitments potentially severe problem
  for developing countries prone to currency crises