partially because of data availability and partially because it is a more representative measure of the demand for foreign goods.

# **4.2.4 Exchange rates**

Our specification includes two different controls for exchange rates: the real bilateral exchange rates _RER_ and the real effective exchange rate _REER_ . The _RER_ is computed as a product of the bilateral nominal exchange rate and the ratio of importer to exporter CPI. Both, CPI indices and bilateral exchange rates, are taken from the _IMF International Financial Statistics (IFS)_ . We derive the nominal rates using the exchange rates against the US dollar. The choice of the CPI over the PPI or other producer related indices is due to the wider data availability. The _RER_ is defined so that an increase means a depreciation, i.e., a boost in competitiveness. Hence, we can expect the overall effect of this variable on trade will be positive.

The _REER_ measure captures the real effective exchange rate of importer _d_ in relation to all the trade partners except the exporter _o_ . The effect of this variable is a priori ambiguous. An increase in this measure indicates that the real exchange rate of the importer appreciates on average towards all trade partners and competitors of exporter _o_ . This implies that their exports to market _d_ are cheaper and one could reasonably expect that if the exports from _o_ are substitutable with exports from other countries, the importer will switch to new suppliers. In this case the overall effect would be negative, to signal the substitution effect. However, the sign could also be positive and signal a wealth effect. The more favorable exchange rate could mean that importer _d_ disposes of more income to buy goods from all trade partners, including exporter _o_ . Hence, the sign of _REER_ remains largely an empirical question. A positive sign indicates that the wealth effect prevails over the substitution effect while a negative sign that the substitution dominates.

# **4.2.5 Financial controls**

Despite the fact that it is common practice to quantify uncertainty using measures of financial market volatility, there are some obvious concerns. Given the financial nature of the proxy for uncertainty, it is not possible to completely rule out an alternative story. It might well be that what depresses economic activity and demand is not uncertainty per se but a rise in financial frictions or a reduction in wealth. The uncertainty periods often occur during times of financial crises that tend to be characterized by financial frictions that make the financing of export related costs harder. To account for this possibility we augment our baseline specification by a proxy for financial constraints. The spread between the money market rate and treasury bill rate (ted) is a commonly used measure of credit crunch, however, because of data availability we use the level of the money market rate. The two measures are very highly correlated for the subsample for which we have both ted and the money market rate, allowing us to construct the spread.

In addition to financial constraints, we also control for wealth effects, which we measure as the change in the level of real stock prices. The rationale for this is that movements in stock prices can have at the same time a wealth effect as well as an uncertainty effect. In periods of lack of confidence, a drop in 14