Exchange rates and trade
Naoyuki Yoshino, DeanPornpinun Chantapacdepong, Research Fellow
Matthias Helble, Research Fellow
Asian Development Bank Institute
ADBI-JIIA International Symposium on current global trade
governance: toward the next agenda, Plaza Hall, Tokyo, Japan
November 10th, 2015

Contents
1. Trade and exchange rates: An endogenous
relationship
2. Exchange rates matter for Asia’s trade and TPP
members.
3. How are exchange rates and trade addressed inTPP?

1. Trade and exchange rates:
An endogenous relationshipExchangerate

Trade

1. Trade rules limit governments ability to use traditional trade policy measure,which creates the temptation to use currency depreciation as substitute fortrade measure.
2. A currency devaluation is equivalent to a uniform ad valorem export subsidy
on all export goods and an import tariff on all imported goods.
3. Early TPP negotiations assumed exchange rates to be exogenous.

Example
Yen – US Dollar vs. Japan-US Tariffs (2014)
Importer

ExporterTariff
TypeJapan
United States MFN
United States Japan
MFN

Source: Bloomberg, UNTRAINS (2015)

SimpleAverage
2.92 %
3.29 %

WeightedAverage
1.93 %
1.19 %

1. Trade and exchange rates: An endogenous relationship
Exogeneity test of exchange rate in Trade equation:•Davidson and MacKinnon (1993) suggested an augmented regression test (DurbinWu-Hausman test). (See Ravankaｒ and Yoshino (1990, RES, Weak exogeneity test)

Structural Equations
Current Account/GDP = α+β(Terms of Trade)+δ(FDI/GDP)+uCA
Exchange rate = a + b(financial account/GDP)+c(financial uncertainty)+d(expected currency appreciation)+e(interest differential)+uEX
Reduced Form Equation
Exchange rate = all exogenous variables + Ue Exogeneity Test E(Ue, UCA ) = 0 or Not-> Current Account/GDP = α+β(Terms of Trade)+δ(FDI/GDP)+hxUe+UCA
It can be easily formed by including the residuals of each endogenous right hand side
variable, as a function of all exogenous variables, in a regression of the original model.

2.1 Basic econometric exercise shows that the exchange
rate is endogenously determined by the current accountbalance•

We used quarterly data from 2000Q1 to 2015Q1, for 9 out of 12 economies in TPP free trade
pact (AU, CA, JP, MY, US, VN, SG, NZ) and Asian countries (HK,IN, ID, KR, PH, TH, and PRC)
and (EU).

Simultaneous equation:

Equation 1:
Log(Exchange Rate𝑖𝑖) =3.30+0.08(financial account/GDP𝑖𝑖)-0.02log(global financial(9.27)***(1.10)(-1.81)*

uncertainty𝑖𝑖)+0.01log(expected currency appreciation𝑖𝑖)+0.01(interest differential𝑖𝑖)

Equation 2:(3.91)****(2.37)***

Current account/GDP𝑖𝑖 = 0.04+0.06log(term of trade𝑖𝑖)+0.0(FDI/GDP𝑖𝑖)(10.3)***(3.44)***(-1.34)+0.05(residual from Exchange Rate Regression𝑖𝑖)(2.56)****

If the coefficient in front of the residual from FX regression is statistically different from zero,then OLS is not consistent. The test implies endogeneity of the foreign exchange rate equation.

Note: t value in the parenthesis, fixed effect regression with overall r-square=0.36, number of observation = 563
Note: Using augmented regression test (Durbin-Wu-Hausman test) suggested by Davidson and MacKinnon (1993). It can be easily
formed by including the residuals of each endogenous right hand side variable, as a function of all exogenous variables, in aregression of the original model.

2.2 Equilibrium in foreign exchange market
Purchasing power parity (PPP):••Over the long term, exchange rates must have some relationship to the buying power ofthe currency in terms of goods that are internationally traded.
If at a certain exchange rate it was much cheaper to buy internationally traded goods(oil, steel, cars, etc.)—in one country than in another country, businesses would startbuying in the cheap country, selling in other countries, and earns profits.

119122Yen/Dollar• In the end, arbitrage process will force prices and exchange
rates to align so that the price of internationally traded goods
S of Dollar is similar in all countries.
(export, capital inflow)• The exchange rate that equalizes the prices of internationallytraded goods across countries is called the purchasing power
E1parity (PPP) exchange rate
• In PPP, exchange rate changes are induced by changes
E0in relative price levels between two currencies• Future work: Behavioral equilibrium exchange rate, which
D for Dollar
1. Consider influence of capital flows on the exchange rate,(import, capital outflow) such as relative interest return, net foreign asset position, FDI,5
6 7 8
foreign debt, shocks, etc.
Quantity of US Dollars traded for Yen(billions)
2. Consider factor determining current account in detail,such as relative term of trade, fiscal stance, productivity, etc.

Source: https://courses.candelalearning.com/macroecon/chapter/demand-and-supply-shifts-in-foreign-exchange-markets/#m48785-CNX_Econ_C29_022

How to determine over- and undervaluation?
Calculation of currency overvaluation index:
1. The real exchange rate (RER) is defined as:ln(𝑅𝑅𝑅𝑅𝑅) = ln(𝑋𝑋𝑋𝑋𝑖𝑖/𝑃𝑃𝑃𝑃𝑡)(3)
Where 𝑅𝑅𝑅𝑖𝑖 is the real exchange rate, 𝑋𝑋𝑋𝑋𝑖𝑖 is the nominal exchange rate and𝑃𝑃𝑃𝑖𝑖 is purchasing power parity conversion factors. All are expressed as national
currency per unit of USD, and are averaged over 5 years.
2. Balassa-Samuelson adjusted RER is defined by the regression of:ln(𝑅𝑅𝑅_ℎ𝑎𝑎𝑎𝑎) = 5.124 − 0.353 ln 𝑅𝑅𝑅𝑅𝑅𝑅𝑖𝑖 − 0.002(𝑡𝑡𝑡𝑡_𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒) (4)(19.29)***(-9.24)***(-0.72)
Balassa-Samuelson effects means non-tradable goods are cheaper in poorer
countries). We regress RER on GDP per capita (RGDPCH) here. This implies
that when income rises by 10 percent, the real exchange rate falls by around 3.5
percent.
3. Index of undervaluation is defined as:ln 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑖𝑖 = ln(𝑅𝑅𝑅𝑅𝑅) − ln(𝑅𝑅𝑅_ℎ𝑎𝑎𝑎𝑎)(5)Where ln 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑖𝑖 >0 implies currency undervaluation, (<0 is currency overvaluation)
Note: We followed the methodology of Rodrik (2008) which based on price comparison using the long runequilibrium concept, instead of definition that relates to external balance . BASED ON TRADE.

Which economies have undervalued currencies?

+ sign means currency
undervaluationln 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑖𝑖

32.5
21.5
10.5
0-0.5

Indonesia

JapanPRC

Hong Kong

Australia

Mexico𝒍𝒍 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝒊𝒊 >0indicates currency
undervaluation (led by
Mexico, Japan and HongKong). The exchange rate isset such that goods
produced at home are
relatively cheap in dollar
terms.

Note: the index of currency overvaluation is a measure of domestic price level adjusted for the Balassa-Samuelson effect. Thisindex has the advantage of comparable across countries as well as over time. This is the calculation of the equilibrium exchange
rate using the long run concept. We followed the methodology of Rodrik (2008)

Which economies have overvalued currencies?

- sign means currency overvaluation
0ln 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑖𝑖

𝒍𝒍 𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝑼𝒊𝒊 <0indicates currency
overvaluation (led by
Malaysia, Singapore
India and Canada).

-0.5
-1

-1.5
-2
Malaysia

Singapore

Thailand

Vietnam

Korea

Philippines

India

New ZealandCanadaEurozone

Note: the index of currency overvaluation is a measure of domestic price level adjusted for the Balassa-Samuelson effect. This index
has the advantage of comparable across countries as well as over time. This is the calculation of the equilibrium exchange rate using
the long run concept. We followed the methodology of Rodrik (2008)

3.1. Gravity Estimation••

Research question: Does undervaluation promote exports?
Main variables:– Dependent variable: Yearly bilateral trade flows– Independent variable: Distance, GDP, nominal exchange rate/USD,undervaluation measure••••17 economies included: Australia; Canada; Eurozone; HongKong, China; India; Indonesia; Japan; Republic of Korea;
Malaysia; Mexico; New Zealand; Philippines; Singapore;
Thailand; PRC; Viet Nam; USAYears covered: 2000-2014
Nbr. of obs.: 4080 (17*16*15) bilateral relations
Basic gravity equation (Anderson and van Wincoop, 2003):
log(trade)ijt = a0 + a1ln(GDP)it + a2ln(GDP)jt + a3ln(tradecosts)ijt+a4ln(undervaluation)ijt + a5(Exporter multilateral resistance)it +a6ln(Importermultilateral resistance)jt+εijt

3.2. Undervaluation provides an advantage
for exporters...
Gravity equation results for exports 2000-2014:(5)
All Trade-0.706***(0.0189)(6)
TPP-1.161***(0.0526)0.101***

0.0765*0.171**

3.253***(0.0113)(0.0194)(0.0451)(0.0728)(0.530)(0.911)

Observations
4,044
1,064
4,014
R-squared
0.634
0.829
0.646
Year FE
YES
YES
YES
ImpYearFE & ExpYearFENONONOCountry-pair FE
NONONO
Robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1

1,064
0.835
YESNONO

4,044
0.917
YESYESNO1,080
4,044
0.940 Not reported
YES
YES
YES
YESNO
YES

1,080
Not reported
YES
YES
YES

Log (Distance)

Log (GDP Exporter)

Log (GDP Importer)
Log (GDP per capitaExporter)
Log (GDP per capita
Importer)Log (Exchange Rate to
USD Exp.)
Log (Exchange Rate to
USD Imp.)
Undervaluation(1)
All Trade-0.836***(0.0272)(2)
TPP-1.270***(0.0646)(3)
All Trade-0.838***(0.0266)(4)
TPP-1.270***(0.0644)0.304***

0.608***

0.307***

0.664***(0.00712)(0.0240)(0.00755)(0.0254)0.296***

0.743***

0.294***

0.686***(0.00786)(0.0250)(0.00742)(0.0243)

0.177***

0.0998**0.218***

0.103**(0.0163)(0.0486)(0.0171)(0.0462)

0.248***

0.00898

0.208***

0.00595(0.0166)(0.0497)(0.0167)(0.0503)

0.00312-0.000417

0.0203**0.0195(0.00780)(0.0161)(0.00796)(0.0155)-0.0348***-0.0703***-0.0526***-0.0902***(0.00801)(0.0172)(0.00806)(0.0194)

0.123***(7)
All Trade(8)TPP

4.139***

Note: Several bilateral variables are not reported, such as common language, shared border or RTA.

3.3. Undervaluation continues to matter for
trade...
0.2

Persistent effect ofundervaluation!

02000-2002 2003-2005 2006-2008 2009-2011 2012-2014
-0.2
-0.4
-0.6
-0.8

Distance Coefficient
Undervaluation

Falling trade costs!

-1-1.2
Note: Coefficients estimated for three consecutive years using specification:log(trade)ijt = a0 + a1ln(GDP)it + a2ln(GDP)jt + a3ln(tradecosts)ijt +a4ln(undervaluation)ijt + a5(Exportermultilateral resistance)it +a6ln(Importer multilateral resistance)jt+εijt

4. JOINT DECLARATION OF THE MACROECONOMIC POLICYAUTHORITIES OF TPP COUNTRIESIn their joint declaration the TPP countries commit:
1. to foster an exchange rate system that reflects economic fundamentals and torefrain from competitive devaluation.
2. to release publicly a range of macroeconomic information and data to support
dialogue and improve transparency.
3. to set up regular dialogue on macroeconomic and exchange rate policy issues,
with the aim of sharing information and understanding the impact of policies onother countries.

First time that unfair currency practices are adressed in free-trade agreement.
Source: Reserve Bank of New Zealand, available at http://www.rbnz.govt.nz/news/2015/tpp-exchange-rate-agreement.html andJoint Declaration of the Macroeconomic Policy Authorities of Trans-Pacific Partnership Countries, available at
http://www.treasury.govt.nz/publications/media-speeches/media/06nov15p/TPP-joint-macroeconomic-declaration-6nov2015.pdf

4.1. Joint Declaration of the Macroeconomic Policy
Authorities of Trans-Pacific Partnership Countries
Preamble
Macroeconomic policy authorities of the TPP Members:… “recognize the importance of orienting our fiscal and monetary policies towardmeeting domestic objectives, with due regard for the effects of our policies onother TPP countries.”…. “recognize that allowing real exchange rates to adjust in line with economic
fundamentals facilitates smooth macroeconomic adjustment, helps to avoid
prolonged external imbalances, and promotes strong, sustainable, and balanced
global growth.”

Pledge not officially part of TPP.
Source: Joint Declaration of the Macroeconomic Policy Authorities of Trans-Pacific Partnership Countries, available at
http://www.treasury.govt.nz/publications/media-speeches/media/06nov15p/TPP-joint-macroeconomic-declaration-6nov2015.pdf

Joint Declaration of the Macroeconomic Policy
Authorities of Trans-Pacific Partnership Countries
I. Exchange Rate Policies“Each Authority confirms that its country is bound under the Articles ofAgreement of the International Monetary Fund (IMF) to avoid manipulatingexchange rates or the international monetary system in order to prevent effectivebalance of payments adjustment or to gain an unfair competitive advantage.
Each Authority is to take policy actions to foster an exchange rate system thatreflects underlying economic fundamentals, and avoid persistent exchange rate
misalignments.
Each Authority will refrain from competitive devaluation and will not target its
country’s exchange rate for competitive purposes.”

TPP members will not be subject to any trade sanction.
Source: Joint Declaration of the Macroeconomic Policy Authorities of Trans-Pacific Partnership Countries, available at
http://www.treasury.govt.nz/publications/media-speeches/media/06nov15p/TPP-joint-macroeconomic-declaration-6nov2015.pdf

4.2. Joint Declaration of the Macroeconomic Policy
Authorities of Trans-Pacific Partnership Countries
II. Transparency and Reporting
Each Authority will disclose publicly:(a) Each country’s IMF Article IV Staff Report, including exchange rate assessment;(b) Foreign-exchange reserves data including forward positions (monthly);(c) Intervention in spot and forward foreign exchange markets (at least quarterly);(d) Balance of payments portfolio capital flows (quarterly);(e) “Broad” money stock (quarterly);(f) Exports and imports (quarterly);(g) Confirmation that it is participating in the IMF Currency Composition of Official
Foreign Exchange Reserves (“COFER”) database.

Similar transparency commitments compared to those by IMF.
Source: Joint Declaration of the Macroeconomic Policy Authorities of Trans-Pacific Partnership Countries, available at
http://www.treasury.govt.nz/publications/media-speeches/media/06nov15p/TPP-joint-macroeconomic-declaration-6nov2015.pdf

4.3. Joint Declaration of the Macroeconomic Policy
Authorities of Trans-Pacific Partnership Countries
III. Macroeconomic Policy Consultations
1. Multilateral dialogue . To establish a Group of TPP Macroeconomic Officials(the “Group”) to meet at least annually.
2. The Group will consider the macroeconomic and exchange rate policies ofeach TPP country, especially the effects of such policies on other TPPcountries; issues or challenges with respect to transparency or reporting;and the policy responses which address imbalances.
3. The Group is to prepare and publish reports, communiques, or otherdocuments regarding the meeting and any conclusions that reflect thecollective views of the Group

Source: Joint Declaration of the Macroeconomic Policy Authorities of Trans-Pacific Partnership Countries, available at
http://www.treasury.govt.nz/publications/media-speeches/media/06nov15p/TPP-joint-macroeconomic-declaration-6nov2015.pdf

5. Conclusion
1. When TPP negotiated, exchange rate assumed tobe exogneous. Paper shows that exchange rate is
endogenously determined.
2. CA and FX equations have to be estimatedsimultanously.
3. Gravity equation results confirms that exchange
rate plays role in trade, especially among TPP
members.
4. Joint Declaration important step to address
exchange rate issue.
5. However, joint declaration is separate documentand «misbehavior» cannot lead to trade sanctions.

THANK YOU VERY MUCH
FOR YOUR ATTENTION

nyoshino@adbi.org
pchantapacdepong@adbi.org
mhelble@adbi.org

Big Mac index shows consistent results:
••

••

••

•

•

THE Big Mac index was invented by The Economist in
1986 as a lighthearted guide to whether currencies areat their “correct” level.
It is based on the theory of purchasing-power parity(PPP), the notion that in the long run exchange rates
should move towards the rate that would equalise theprices of an identical basket of goods and services (inthis case, a burger) in any two countries.
For example, the average price of a Big Mac in America
in July 2015 was $4.79; in China it was only $2.74 atmarket exchange rates. So the "raw" Big Mac index
says that the yuan was undervalued by 43% at thattime.
Burgernomics was never intended as a precise gaugeof currency misalignment, merely a tool to makeexchange-rate theory more digestible.
This adjusted index addresses the criticism that youwould expect average burger prices to be cheaper inpoor countries than in rich ones because labour costs
are lower.
PPP signals where exchange rates should be headingin the long run, as a country like China gets richer,but it says little about today's equilibrium rate.
The relationship between prices and GDP per person
may be a better guide to the current fair value of acurrency.
The adjusted index uses the “line of best fit” between
Big Mac prices and GDP per person for 48 countries(plus the euro area).
Source: The economist