The Effects of Exchange-Rate Volatility on Commodity Trade between the United States and Mexico

[Author Affiliation]Mohsen Bahmani-Oskooee, Department of Economics, P.O. Box 413, Bolton Hall 822, University of Wisconsin-Milwaukee, Milwaukee, WI 53201, USA; Bahmani@uwm.edu; corresponding authorScott W Hegerty, Department of Economics, P.O. Box 413, University of Wisconsin-Milwaukee, Milwaukee, WI 53201, USA; hegertys@beloit.edu[Acknowledgment]We would like to thank our anonymous referees for their valuable comments. Any error, however, is ours.1. IntroductionWith the breakdown of the Bretton Woods system in 1973, real exchange rates began to fluctuate greatly. As volatility increased, exporters and importers could no longer be as certain of the real prices of their goods. This increased risk would affect their expected profits, and thus influence their decision to trade. Exchange rate uncertainty has been shown to have affected trade flows between countries and across sectors, but it has had both positive and negative effects in different studies. Increased volatility has had important implications in assessing the costs and benefits of various exchange rate regimes, as well as of exchange rate controls. In this study, we assess the effect of this volatility on trade between the United States and Mexico based on the exports and imports of 102 industries from 1962 to 2004, and we find that it plays a role only for a small number of individual industries.1Intuitively, one might surmise that uncertainty toward the real price of traded goods may reduce trade flows, as risk-averse buyers and sellers face possible losses due to exchange rate fluctuations, and thus choose not to partake in risky dealings. On the other hand, it has been hypothesized that exchange rate risk can actually increase trade flows, as importers and exporters opt to increase the volume of trade to attain a certain income, making up for a decrease in the per-unit value of a good by increasing the number of units bought or sold. The bulk of the literature points to the former conclusion, as reviewed by McKenzie (1999) and more recently by Bahmani-Oskooee and Hegerty (2007).The trading relationship between Mexico and the United States is an important one. More than 70% of Mexico's exports go to the United States; likewise, Mexico is still the second-largest market for U.S. exports (after Canada). Mexico has taken advantage of its relatively inexpensive labor to attract U.S. manufacturing firms and expand its exports. Mexico imports automobile parts from the United States, for example, and then exports completed automobiles. Assembly-line factories, known as maquiladoras , have attracted much attention, but with the growth of China and competition from its even less expensive labor, this sector has actually declined. In addition, the United States is Mexico's main trading partner for agricultural products. Thus, the two countries share important trade flows across a wide variety of sectors.Table 1 shows a breakdown of Mexico's top 15 export and import industries, in order of largest to smallest dollar value (or trade share), of the 102 industries that we analyze in our study. The rankings are given for the year 1980, in order to capture the preliberalization trade structure, and for the year 2004, to capture flows in the years after Mexico joined the General Agreement on Tarifs and Trade (GATT) and the North American Free Trade Agreement (NAFTA).2Table 1 Top 15 Industries (by Dollar Value of Trade) (Table omitted. See article image.)The most striking observation in Table 1 is that the same manufacturing industries occupy top spots for both exports and imports. Road motor vehicles, exports of which have grown in importance since 1980, were also the top Mexican import in both 1980 and 2004. Likewise, such manufacturing industry categories as Telecommunications apparatus, Other electrical machinery, Machinery and appliances-non electrical, and Office machines make up a large part of both export and import flows. …