The Impact of Real Exchange Rate Movements on Service Sector Firms

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The Impact of Real Exchange Rate Movements on
Service Sector Firms
Jen BaggsSchool of Business, University of
VictoriaEugene BeaulieuDepartment of
Economics, University of CalgaryLoretta
FungDepartment of Economics, University of
Alberta
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Motivation

• Important Question
• How do large real exchange rate movements affect
  service sector firms?
• Services are becoming increasingly tradable and
  exchange rate has been identified as a key factor
  that affects service trade (Deardorff et al,
  2001).
• For services that are exposed to trade, exchange
  rate movements can influence the degree of
  competition and firm behavior.

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Motivation (cont.)

• This paper builds on two groups of literature
• Exchange rate effect on volume of service trade
• Deardorff et al, 2001, Hung and Viana, 1995, and
  Freund and Weinhold, 2002
• Impact of international competition on Canadian
  manufacturing firms, particularly, the effect of
  trade liberalization and exchange rate movements
• Trefler (2004), Baldwin and Gu (2003, 2004),
  Baggs (2005), Baggs and Brander (2006),
  LaRochelle-Côté (2007), Baggs et al (2008).

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Motivation (cont.)

• Empirical Analysis
• Between 1986 and 1997, the Canadian economy
  experienced a large currency appreciation
  followed by a large depreciation.
• Examine the exchange rate effects on firm
  profits, survival, sales and leverage using micro
  data.

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Hypotheses

• Derived from a combination of Fungs (2008) and
  Melitz and Ottavianos (forthcoming) model
• Appreciations of home currency reduce firm
  profit.
• Appreciations of home currency reduce firm
  probability of survival and this effect is less
  pronounced for more productive firms.
• When the exit rate is low, appreciations of home
  currency cause a reduction in total sales.
• Appreciations lower profits and induce firms to
  allow debt and leverage to rise.
• Home currency depreciations have opposite
  effects.

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Exchange Rate Measure

• Industry-specific trade-weighted real exchange
  rate Weighted average of normalized real
  exchange rate of Canadas top 10 trade partners.

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Longitudinal Micro-data T2-LEAP

• From T2 tax forms, and the Longitudinal
  Employment Analysis Project (LEAP)
• Every incorporated Canadian establishment that
  legally hires employees AND files a T2 from
  1984 to 1998 (we use 1986 to 1997).
• Annual data on the firms employment level,
  profit, revenues, debt, equity, assets, location,
  and industry affiliation at the 3-digit SIC level.

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T2-LEAP (Cont.)

• Focus on service industries that are exposed to
  international trade
• Construction
• Communication
• Finance and insurance
• Business services
• Other services (e.g. films and organized sports)

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T2-LEAP (Cont.)

• This data set is ideal for identifying entry/exit
  because it consists of the universe of Canadian
  firms.
• Constructing panels of survivors and exiters
• Baggs (2005) criteria
• Initial population of firms are those that
  existed in 1986.
• Augmented each year by removing exiting firms and
  adding new firms.
• A firm is removed from the sample in the year in
  which the firm files its last tax return or if it
  is the last year that the firm hires employees.
• A firm enters our sample in the first year it
  both hires employees and files a tax return.

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Table 1 Descriptive Statistics
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Empirical Evidence Firm Profits

• Firm Profits
• f firm i industry.
• lnprofit is set to 0 when profit is negative or
  0.
• ERit industry-specific trade-weighted real
  exchange rate.
• xft-1 age, size category and labour
  productivity.
• yit-1 industry concentration (CR4), industry
  sales growth, real interest rate and GDP growth
  rate.
• Also include time trend (tt) and industry fixed
  effects (at the 2-digit SIC level).
• Interaction
• lnERitlnproductivityft-1
• Model OLS and Tobit.
• Tobit deal with data truncation.

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Empirical Evidence Firm Survival

• Firms probability of survival
• surviveft 1 if firm f survived in year t 0
  otherwise.
• Model probit

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Empirical Evidence Firm Sales

• Firm Sales
• Model OLS.

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Empirical Evidence Leverage

• Firm Leverage
• Prediction Appreciations lower profits and
  induce firms to allow debt and leverage to rise.
• Models OLS and 2SLS
• OLS reduced form.
• 2SLS
• Profit is instrumented by exchange rate and
  industry sales growth.
• Regress leverage on predicted profit and other
  independent variables.

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Conclusions

• Significant exchange rate effects
• Real appreciations of home currency reduce firm
  probability of survival and this effect is less
  pronounced for more productive firms.
• Real appreciations reduce firm profits, sales and
  leverage.
• The leverage reduction induced by currency
  appreciation may result from reduced profit.
• Overall, the direction of exchange rate effects
  are the same as the empirical findings for
  Canadian manufacturing firms.

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Conclusions (cont.)

• To our knowledge, this is among the first
  empirical research on the exchange rate effects
  on service sector firms. Further investigation
  into their behavior is much needed.