WORLD TRADE  
ORGANIZATION   
WT/WGTDF/W/65 
18 July 2012 
 (12-3908) 
Working Group on Trade, Debt 
and Finance  
 
 
THE RELATIONSHIP BETWEEN EXCHANGE  RATES AND INTERNATIONAL TRADE: 
A SHORT UPDATE OF RECENT ECONOMIC LITERATURE 
 
Note by the Secretariat 
  
 
 
  
 
  
I. INTRODUCTION 
1. This Note adds to the extensive literature re view delivered to Members in September 2011 
(WT/WGTDF/W/57). It includes a reference to a few papers produced in 2012, mostly, prepared for, 
and/or mentioned by speakers in the context of th e WGTDF Seminar held on 27 and 28 March, 2012.   
II. NEW STUDIES ON THE ECONOMICS OF THE RELATIONSHIP BETWEEN 
EXCHANGE RATES AND TRADE FLOWS 
2. Until the mid-2000s most of the literature on th e trade impact of exchange rate changes 
looked at the effect on aggregate imports and e xports. These estimations are problematic because 
aggregate trade flows may have feedback effects on  exchange rates. Focusing on firms, rather than 
aggregate variables, is a way to address this "endoge neity" problem. This is because individual firms' 
export choices are likely to be influenced by the le vel of the exchange rate, but not to directly 
influence its value. In addition, a firm-level analys is has the advantage of disaggregating the impact of 
exchange rate changes on different firms.  
3. Adopting this approach, Berman et al . (2012) examine how high- and low-performance firms 
react to exchange rate changes. When faced by a change in the ex change rate, exporters (or potential 
exporters) can react in different ways. First, they can change export volumes, but not their price. This 
is the case of 100 per cent pass-through of the exchange  rate, where the price in destination countries 
changes one-to-one with the exchange rate. The opposite  situation is one of ze ro pass-through. In this 
case, exporters' mark-ups fully absorb the change in the exchange rate and there is no impact on trade 
volumes. Both these situations (and the cases in betw een) focus on the intensiv e margin of trade. A 
third impact of an exchange rate change is to alter the extensive margin of trade. Specifically, a 
depreciation can lead firms either to export more (intensive margin) or to expand the variety of 
products exported (extensive margin), while an ap preciation may have the opposite effect. In this 
setting, the authors show that, following a depreci ation of the exchange rate, the high-performing 
firms are more likely to (partially) "absorb" the ex change rate movement in their mark-ups, rather 
than increase their export volumes. Low performing firm s tend to adopt the inverse strategy, i.e. they 
do not change export prices as a consequence of ex change rates shifts. Since the highest performing 
firms tend to be the largest exporters, the paper c oncludes that the prices of tradable goods should be This document has been prepa red under the Secretariat's own 
responsibility and without prejudice to the positions of Members 
and to their rights and obligations under the WTO WT/WGTDF/W/65 
Page 2  
 
 relatively insensitive to exchange rate movements. Put differently, exchange rates have only a limited 
effect on import prices and trade volumes as a result of the "natural" selection process of exporting activity.  4. Berman et al. (2012) test this theory with detailed data on French firms. Two recent papers 
follow a similar methodology with exporters from China and Brazil (Chatterjee et al. , 2012; Tang and 
Zhang, 2012). This evidence shows that larger and more productive firms react to a devaluation with 
an increase in mark-ups, while smaller and less pr oductive exporters react by changing the import 
price with the exchange rate. Since the group of large exporters account for the dominant share of 
trade flows, aggregate trade is not very responsive to exchange rate movements, as predicted by the 
theory. On average, following a 10 per cent depreciation of the currency vis-à-vis  a trading partner, 
firms increase their export quantities to that market by 4 to 7 per cen t. The extensive margin of trade 
is also found to be affected by the exchange ra te movement. The probability of entering an export 
market (or of expanding the product scope in th at market) increases by 1-2 per cent in the year 
following a currency devaluation of 10 percentage points. The overall volume of trade (the sum of old 
and new products) is shown to increase in the short- run by 10 per cent (unit elasticity).  The findings 
by Berman have been presented, at least partly , in the presentation by Professor Martin, at the 
WGTDF seminar on 27 and 28 March, 2012 . More work has taken place since. 
5. The firm-level analysis of Taglioni (2012), offers an interesting result regarding the direct 
negative link between an exchange rate appreciatio n and export growth, even in the short-run. She 
argues that the trade impact of a currency revalua tion differs in important ways across the intensive 
and the extensive margins of trade. In particul ar, there can be important pro-competitive effects 
associated with a strong currency that materializes through the ex tensive margin of trade. This 
channel is particularly strong for middle-income ec onomies that try to diversify their export base and 
improve the sophistication of their exports. Importan tly, this channel may offset the more traditional 
negative impact that a currency appreciation has on the intensive margin of trade. The author finds 
supporting evidence of the offsetting effects of a chan ge in the exchange rate on the different margins 
of trade using firm-level data from Chile, Macedonia,  Pakistan and Turkey. As a mirror image of the 
analysis of the effect of a currency appreciati on, these results seem to suggest that a currency 
devaluation may promote export volumes but at the expense of export diversification, at least for 
middle-income economies. Some of these findings have been presented by World Bank Vice-President Canuto, in his presentation at the WGTDF seminar.  
6. Firm-level data analysis has not completely crowded out cross-country analysis, though. In 
2012, the OECD finalized a study mentioned in the initial literature survey, and by Deputy Secretary-
General Tamaki at the seminar in his presentation.  The study (Huchet-Bour don and Korinek, 2012) 
examined the impact of exchange rate volatility on  trade in two small open economies, Chile and New 
Zealand. A companion paper has examined the sam e question in three large economies; China, the 
euro Area and the United States, using the same methodology.
1 The study finds that the two small 
economies' trade tends to be impacted more by ex change rate volatility than trade in the larger 
                                                      
1 The OECD simulated hypothetical depreciations or appreciations of 10 per cent of these countries' 
exchange rates to see their impact on their bilateral trad e with the United States, th e euro-zone and China. It 
found that, for example,  the impact of a 10 per cent depreciation of the Chilean Peso depends very much on the 
trading partner and the sector concerned. Imports from China and the euro-zone are re latively less affected than 
imports from the United States (largely as a result of the latter's high agricultural content). A 10 per cent 
appreciation of the Peso has a relatively large (positive) impact on Chile's exports to China, a large importer of 
extractive products - a result not so su rprising because of the relative inelasticity of China's imports of copper 
(Chile's main export) to international prices. The simu lations confirm the observation of the companion paper 
that many fundamentals affect the relationship between ex change rate and trade, namely, the price elasticity of 
each traded product, the country's ma rket share of the product concerned,  the product composition of exports 
and imports, the pricing strategy of importers and exporters, etc. Many of these parameters work in opposite 
directions.  WT/WGTDF/W/65 
 Page 3 
 
 
 economies - albeit that the direction of this impact can go either way (by increasing or decreasing 
trade). Smaller, open economies such as New Zealand and Chile have to bear the full adjustment of 
exchange rate changes, relative to less trade-dependent, large ec onomies because they tend to have 
less a diversified production and expor t base, and hence are less in a position to move into exports that 
have greater price elasticity when exchange rate appreciation results in potentially more costly 
exports. Also, exporters may not be able to source their needs from the domestic market when their 
exchange rate depreciates, making imports of fore ign intermediate goods more costly. The argument 
is symmetrical for depreciations, i.e. the numb er of domestic producers is smaller and hence 
insufficient to substitute for imports when prices increase. The study finds that in both countries 
exports respond less to exchange rate volatility th an do their imports, a possible reason being that 
these countries are in part commodity exporters and that their exchange ra tes track the commodity 
prices of the goods they exports. In the long-run t hough, the relationship between exchange rates and 
trade flows seems to be less certain.  The study mak es the point that exchange rate shifts are only one 
among several factors affecting trade.  
7. It has been argued that the relationship between exchange rates and trade flows may be 
affected by the changing patterns of trade, in pa rticular the emergence of global supply chains, the 
increased use of inputs and hence in the higher share of imports in exports. There are few specific papers measuring possible change in the way excha nge rates impact trade using the trade in value-
added concept, not least because data are for the time being scarce. Similarly, few studies analyse the 
trade impact of exchange rates movement on th e internationalization of production. One study 
mentioned in WTO Document WT/WGTDF/W/57 is Zh ao and Xing (2006) who analysed the effect 
of exchange rates on the outsourcing decisions of  multinational enterprises (MNEs), in particular 
exchange rate appreciation, which may have tw o consequences: appreciation may not narrow the 
wage gap enough to lead to a repatriation of the MNE to the higher cost country (supposedly the 
country of origin of the MNE); second, the overall production cost or cost structure of MNEs would 
increase. Hence, currency appreciation in a developi ng (low cost) country may well have a negative 
impact on the advanced economy, depending on the structure of global supply chains. The 2011 IMF 
Spillover Report on China (IMF, 2011) analysed th e main factors of concern for a large set of 
countries following a shock originating in China. An issue taken up in the report is the impact that a 
potential RMB revaluation would have on the world economy. The report finds that, in the absence of 
other structural reforms (such as financial sector re forms), an appreciation would lead to lower output 
in China and lower Chin ese demand for intermediate goods fro m other Asian countries, implying a 
suboptimal equilibrium. As a consequence, a RMB appreciation would benefi t final goods producers 
such as Japan and the Republic of Korea, but it may (initially) hurt intermediate goods producers in 
emerging Asia.  
  
 
    
 
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 BIBLIOGRAPHY 
 
 
 Berman, Nicolas, Philippe Martin and Thierry Ma yer (2012), How Do Different Exporters React to 
Exchange Rate Changes? Theory, Empirics and A ggregate Implications, Quarterly Journals of 
Economics, 127 Issue 1 (February): 437-492 .  Huchet-Bourdon, Maryline and Jane Korinek (2012), Trade Effects of Exchange Rates and their 
Volatility: Chile and New Zealand, OECD Trade Po licy Working Papers, No. 136, OECD Publishing. 
 
IMF (2011), People's Republic of China: Spillove r Report for the 2011 Article IV Consultation and 
Selected Issues. Country Report No. 11/193  
 Taglioni, Daria (2012), Exchange Rates and the Ex tensive Margin of Trade, mimeo, World Bank 
(available at www.worldbank.org )  
  
Zhao, Laixun and Yuqing Xing (2006), Global Pro duction and Currency Devaluation, Review of 
International Economics 14 (May): 202-211. 
 
 
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