Third World Economics No. 518 (1-15 April 2012)

WTO debates relationship between exchange rates and trade

How exchange rate movements affect trade, and what to do about it, were the subject of a WTO seminar in March. Kanaga Raja reports.

GENEVA: The WTO Working Group on Trade, Debt and Finance recently held a seminar on the relationship between exchange rates and international trade, with the working group chair saying that the debate saw a “healthy diversity of views” and raised awareness on the complexity of the issues.

The 27-28 March seminar was convened following a request by Brazil for a debate on the topic with a view to better understanding the issues involved and their implications for WTO member states.

The seminar was divided into four sessions: a private sector session and a public sector session on 27 March; and an international organizations session and an academic session on the following day.

Speaking to journalists after the conclusion of the seminar, Ambassador Roberto Azevedo of Brazil said, “We thought it was extremely useful these last two days. [We] learned a lot.”

He added that several different perspectives emerged.

“I think one positive thing is that everybody agreed that there is a relationship between trade and exchange rates. I don’t think they could reach any other conclusion,” he further said. The question is what kind of relationship it is and how deep it goes, he noted, adding that it varies a lot from country to country and from sector to sector.

“So I think that’s all expected and our hope is that this will be the basis for the continuation of our conversation, and pretty much every delegation that spoke at the end said that they found it useful to continue this conversation,” Ambassador Azevedo said, pointing out that Brazil had said that, as did the United States, the European Union and Japan.

“As far as we are concerned, mission accomplished,” said Ambassador Azevedo.

Asked if there had been a discussion to modify the General Agreement on Tariffs and Trade (GATT) to address the concerns that had been raised, the Brazilian envoy said, “That is one possible outcome as far as we see it but we are not at that point yet. We are still framing the discussion that could develop into something where we look at WTO disciplines and how adequate or inadequate they are, and whether we need to evolve. I think that’s a subsequent point in the discussions. We’re not quite there yet.”

In his concluding remarks at the end of the two-day seminar, the outgoing chairperson of the Working Group on Trade, Debt and Finance, Martin Glass of Hong Kong-China, said that the relationship between exchange rates and trade is not a new subject in the WTO but has been an area of concern since the late 1970s when the Bretton Woods system disappeared. Since then, the trade community has sought greater exchange rate stability.

The seminar saw a frank exchange of experiences and a healthy diversity of views on the impact of exchange rate volatility and misalignment on trade, he added.

The meeting raised awareness of the complexity of the issues and was held in a constructive spirit. Members are well aware that, firstly, exchange rates are part of the WTO external environment and could be seen as an irritant in trading relations, and, secondly, that every member could, at different times, be on either side of the spectrum when it comes to currency values, said the chair.

In the private sector session of the seminar, the chair said, representatives of industry from different countries spelled out the challenges they face in dealing with exchange rate volatility and misalignments. Most participants talked about the challenges facing small and medium-sized enterprises.

“Some entrepreneurs emphasized the uncertainty costs associated with volatility, while others focused on the more permanent difficulty of competing with countries  which  ‘benefit’  from  undervalued exchange rates. Some of these entrepreneurs said that in the absence of adjustment, raising tariffs would be a ‘last resort’.”

According to the chair, others said that in a strong currency environment, the solution was to be constantly ahead of the markets in terms of innovation, investment and training of workers. Companies needed, they said, to have both the best levels of productivity and the best mix of domestic production and imports. The best policies, they maintained, were those which open markets, not close them.

The public sector session discussed the policy challenges involved in dealing with exchange rate misalignments. Many members acknowledged that erratic exchange rate shifts constrained policymakers because they undermined the perceived level of protection negotiated in the WTO.

“However, they said, trade policy measures were not an appropriate response to non-trade policy concerns. They said governments had to address the root causes of exchange rate misalignments, including the management of monetary policies, the handling of short-term capital flows and the lack of structural reforms in certain countries.”

However, the chair said, countries are bound by other international obligations, including in the International Monetary Fund (IMF), not to oppose the normal adjustment of their exchange rates, which should facilitate the reduction of global imbalances at the international level.

With respect to the third session, the chair said international organizations also stated that the relationship between exchange rates and trade was not a two-way street. It came in the wider context of current efforts to rebalance the world economy towards sustainable growth, with a need to “deleverage” in developed economies and be more reliant on domestic demand in emerging economies.

The exchange rate would only be part of the adjustment, and hence a trade policy response to some of these mechanisms was clearly a second- or third-best answer – if at all – he added.

The session with academics suggested that the exchange rate channel was not the main driver of the recent turnaround of current account and trade balances, partly because exchange rates operate more through financial impact than trade. Exporting firms affected by exchange rate shock will tend to adjust export volumes rather than price, the chair said.

“On the exchange rate change versus tariff change question, the latter is more influential. But volatility of exchange rates is an important factor influencing firms’ decisions.”

Cases in which exchange rate policy is directly aimed at exporting more are rare. Should systematic trade policy responses be developed around this problem, was the final question that was dealt with during the seminar, the chair concluded.

According to trade officials, a number of members welcomed the fact that several issues had been raised and discussed within the space of the two days. The general feeling was that the whole issue of exchange rates and their relationship to trade is extremely complicated and requires very careful consideration.

Everyone acknowledged that exchange rates have some impact on trade, but there is a degree of difference as to how big that impact actually is depending on the circumstances, such as the types of company, product and tariff involved.

According to a source close to the two-day discussions, the question of whether specific countries’ currencies were deliberately being misaligned provoked a couple of heated exchanges, but by and large the seminar was held in a very positive atmosphere.

There was an exchange between China and the US on people living above their means and the need to save more and spend and consume less. The question of unfair trade practices was raised against China, said the source.

Confirming an exchange between the president of the Exim Bank of China and a US Treasury official during one of the sessions, the source said it is no secret that the US is concerned about what it perceives as China’s policies and the impact they have on the current account imbalance.

But what was seen over the last two days from a number of speakers was that it is not as simple as that but a lot more complex, the source added.

According to another source, Venezuela said that the idea of special and differential treatment should apply to macroeconomic policies, and that a country at China’s level of development which still has significant poverty should not necessarily have the same currency policy as the US.

Highly sensitive subject

Earlier, in opening the seminar on 27 March, WTO Director-General Pascal Lamy had said that for a number of reasons, members wanted this debate (on the relationship between exchange rates and trade). “I think that, from an institutional perspective, we even need it. The topic is as old as the GATT/WTO system itself, but it has not been discussed within these walls in a long time. It has to be approached, like the Working Group decided, on the basis of a rational, educative and fact-based discussion. Reality has to be distinguished from emotions that inevitably arise on this topic, as much here as in other institutions.”

“Exchange rates are, and have always been, a highly sensitive subject in the WTO. There is an emotional, cultural – if not moral – dimension attached to it by the trade community, in which the line between reality and perception can become blurry. This is in part because our community has a limited grasp of the workings of the financial system, and more widely of macroeconomic developments that determine exchange rates. This is also because, as exchange rates are exogenous to traders, some may feel that they are systematically on the receiving end of unwarranted fluctuations. I appreciate the uncertainty associated with some erratic movements of exchange rates can be not only a source of frustration, but also of asymmetric costs, which can distort international competition.”

Lamy said: “Think about the abruptness of local financial crises and how short-term capital flights may spill over into brutal adjustment of exchange rates – a phenomenon observed during the Asian financial crisis of the late 1990s. For small or medium-sized economies, these are enormous shocks to absorb. After the recent financial crisis, the sense that the financial sector adjustment in rich economies is destructive for real economies, including that of poorer countries, is very vivid in this institution. Exchange rates are perceived to have been a transmission channel of these shocks.”

According to the Director-General, these concerns have to be acknowledged, even though at times some of them may fall foul of exaggeration. “However, one should not descend into victimization or moral judgements: exchange rate adjustments are not all evil in themselves; in fact, they often correct macroeconomic, financial or current account imbalances, the persistence of which would be of even greater cost to traders. Trade also brings its well-acknowledged overall benefits to the cost of sometimes painful adjustments; and prices of tradables can be volatile in their own right too. Just consider fluctuations in commodity prices.”

Lamy said: “The raison d’etre of this seminar is to examine the subject in a rational way, and avoid finger-pointing and frustration, which can only influence ill-designed trade policy responses. As often in life, one stands where one sits. One tends to hear more complaints from industries in countries where currency appreciates than from countries where currency depreciates. In a world of global supply chains and an increasing share of imports in exports, one can guess that traditional effects of currency appreciation and depreciation are in part cushioned.

Besides, history tells us that at different times, countries may be on both sides of the currency fluctuation spectrum, appreciating at one time and depreciating at another.”

Exchange rate impact

According to Lamy, a literature survey produced by the WTO secretariat last year provides some answers to the relationship between exchange rates and trade.

The survey says that, on average, exchange rate volatility has a negative, even if not very large, impact on trade flows. Exchange rate volatility increases commercial risk, introduces uncertainty costs, and can influence the decision whether or not to enter foreign markets. In other words, volatility may affect resource allocation. The extent of these effects depends on a number of factors, including the existence of hedging instruments, the structure of production (e.g., the prevalence of small firms) and the degree of economic integration across countries. For example, it is well reported that exporting firms having access to hedging instruments might be less “sensitive” than those which are subject to external exchange rate fluctuations.

“As I have already mentioned, the impact of exchange rate fluctuations is also reduced by the presence of imported inputs, which offset the effect of exchange rate changes on the pricing of exports.”

To take this further, Lamy underlined, a firm which has only one export market and whose export earnings depend on bilateral exchange rates is likely to be more affected than firms that are present in global markets (where upward and downward movements of various exchange rates may cancel each other out). Global firms also have the possibility of invoicing in local currency, and the capacity to absorb losses due to exchange rate changes and other factors in profit margins.

All in all, he stressed, the most “sensitive” firms seem not to be the large ones, but rather the smaller ones. In addition, empirical studies tend to find a more significant effect mainly in the case of trade with close neighbours, in particular in the case of very integrated economies. For example, a 2004 IMF study clearly indicates that exchange rate volatility within the European Union, before the advent of the euro, had a significant impact on relative prices of members.

Exchange rate misalignments, i.e., sustained deviations of nominal exchange rates from their equilibrium value, are also predicted to have short-run effects in models with price rigidities.

“But the exact impact is not straightforward and depends on the specific characteristics of the economy. This includes, inter alia, the currency in which domestic producers invoice their products and the structure of trade (for example, the prominence of global production networks).

On the empirical side, the complexity of the relationship between exchange rate misalignments and trade yields has mixed findings – it is not always clear that misalignments change the system of relative prices of an economy, at least long enough and deep enough to be able to shift resources or have quantity effects. For instance, a currency undervaluation is sometimes found to have a positive impact on exports, but the presence, size and persistence of these effects are not consistent across different studies. These effects, when they exist, are predicted to disappear in the medium to long run, unless some other distortion characterizes the economy.”

Policy coherence

Lamy noted that the problem for business is one of excess volatility, when exchange rates behave in a disorderly way and do not adjust to economic fundamentals. Part of the international trading community found in the Bretton Woods era is a system of orderly adjustment of real exchange rates. The system, though not ideal, was maintained. But there was a system, providing for a sense of organized governance in the international monetary system. “This is what we lack today.”

He added that the IMF and GATT were created in response to a lack of coordination of economic policies during the Great Economic Depression; these new institutions aimed at dealing with trade and exchange rate policies as a matter of common interest, with the introduction of disciplines to avoid competitive devaluations, maintain exchange rate stability, reduce balance-of-payments crises and fight protectionism. The international monetary and trading systems were linked from the outset by a coherent set of rules aimed at the progressive liberalization of trade and payments.

Article XV of GATT required members to cooperate with the IMF on questions relating to freedom or restrictions concerning exchange and trade. Members are required not to frustrate the intent of the GATT provisions through exchange actions, nor to undermine the provisions of the IMF Articles of Agreement through trade actions. GATT provisions reflected two things: (1) the attachment of the trade community to exchange rate stability; (2) the need for that community to ensure that the trading system is not frustrated by the undisciplined use of exchange restrictions or multiple exchange rates.

“These provisions are still part of our rule book. But they have not been interpreted and thus what they mean today, in a WTO and non-Bretton Woods context, remains to be tested. However, the institutional set-up remains very much one of coherence – and not of conflict – between the two systems,” he said.

Since the end of the Bretton Woods system, Lamy underscored, the trading community has consistently asked for greater exchange rate stability and proper adjustments of balance of payments. This was already the case in the 1973 Ministerial Declaration at the opening of the GATT Tokyo Round, as much as in 1994, 20 years later, in the Ministerial Declaration on the Contribution of the WTO to Greater Coherence in Global Economic Policy Making.

Reading again the 1994 text, Lamy said that he is struck by the authors’ wisdom. It emphasizes, on the one hand, that “greater exchange rate stability, based on more orderly underlying economic and financial conditions, should contribute towards the expansion of trade, sustainable growth and development, and the correction of external imbalances”; on the other hand, the ministers “recognized, however, that difficulties the origins of which lie outside the trade field cannot be redressed through measures in the trade field alone”.

According to the Director-General, this says that an international monetary system aimed at greater exchange rate stability and correcting imbalances helps expand trade. At the same time, trade measures cannot correct policy imbalances elsewhere and be an answer to non-trade policy concerns. Tit-for-tat trade measures would be a recipe for protectionist crossfire.

Clearly, with the exception of currency traders, erratic movements of exchange rates are an irritant in today’s trading system. One must acknowledge their influence in trade policy setting, though, not least because exchange rate shifts may increase or weaken the desired or perceived level of protection of domestic operators. Maintaining multilaterally agreed levels of border protection is certainly a legitimate trade policy objective. The desired levels of protection are negotiated by members through long-term commitments – precisely because policies need to set predictable conditions of access for producers and traders.

“At the same time, one may wonder whether long-term levels of protection need to be adjusted to short-term fluctuations or even misalignments of exchange rates. As the literature survey seems to indicate, exchange rates may have an influence only in the short run, not in the long run unless there are substantial market failures. It leads to the question as to whether long-term border protection should not be considered in the light of the longer-term developments of exchange rates rather than short-term developments,” said Lamy.

“This is why the international community needs to make headway on the issue of reform of the international monetary system. Unilateral attempts to change or to retain the status quo will not work. We need an international monetary system which supports cross-border investment and a better allocation of capital across nations and which ‘facilitates international trade’ – as laid out in the aims of the International Monetary Fund.”

“What we need is a global monetary system which inspires confidence, offers stability and monitors exchange rates more efficiently. One which provides the means through which global imbalances that may risk endangering stability can be addressed,” said Lamy.

“Trade cannot become the scapegoat for the pitfalls and drawbacks of the international monetary system, or current non-system. The WTO system, its policies and rules will not be able to solve macroeconomic issues at the heart of the performance of currencies worldwide. WTO rules will not fix consumption or saving patterns at home, they will not solve competitiveness issues of domestic industries, they will not determine domestic interest rates, they will not achieve proper prudential supervision in the financial system.”

“All these issues require a mix of cooperation in the macro-financial field and proper domestic policies which lie outside the remit of the WTO. In the current volatile environment, we need to make sure that the WTO system does not crumble under the weight of excessive expectations,” the Director-General concluded.

The Brazilian experience

Meanwhile, in a presentation during the private sector session on 27 March, the CEO of Brazilian company Coteminas, Josue Gomes da Silva, told the participants that the topic “exchange rate” is a complex and polemical one. Some studies argue that, in the long run, periods of currency appreciation are offset by periods of devaluation, concluding that exchange rate fluctuations have neutral effects on economic growth over time.

Nonetheless, at the current stage of the world economy, revisiting this position is important, as trade liberalization reforms that many countries undertook during the last two decades may have triggered a different relationship between the exchange rate and economic growth in the long run.

“The increased globalization of production of industrial goods coupled with exchange rate misalignments might provoke irreversible losses in the manufacturing structure of countries with overvalued currencies. Brazil is an example of that, and our industry is at a significant risk of permanent backwardness,” he said.

“It is important to recognize that the Brazilian economy is performing relatively well, and that some sectors have even benefited from our overvalued currency. We do know that this makes our case more difficult, but a premature de-industrialization process as it is now taking place in Brazil might preclude the country from a much brighter future and impose limits to our development. Brazil is a country of 190 million inhabitants and with a continental territory. De-industrialization is not an option for us.”

He noted that the Brazilian manufacturing sector has had a somewhat erratic performance in recent years. In 2010, industrial production in Brazil recovered from the deep contraction suffered in 2009. But in 2011, the virtual stagnation of manufacturing impacted negatively the growth rate of Brazilian GDP. In 2011, the manufacturing sector suffered from a very strong and negative impact caused by competition of imports in the domestic market. Most of these imports come from countries with depreciated currencies, whereas the real, Brazil’s currency, has remained overvalued.

“Looking at the breakdown numbers of individual manufacturing sectors, we will be able to identify those that were faced with stronger competition from abroad in 2011. Sectors in which output dropped considerably were textiles, leather, office and telecoms equipment, apparel, electrical machinery and equipment, chemicals and rubber and plastics.”

Brazil’s foreign trade in commodities and semi-manufactured goods has been growing consistently and has been able to expand well beyond the pre-crisis level, said da Silva. However, when it comes to manufactured goods, the picture is quite different: exports in 2011 still did not exceed those of 2008 in value.

“Hence, the result of the balance of trade deteriorated with frightening speed and intensity. In 2011, the deficit in manufactured goods reached $92.5 billion. It should be noted that, in 2006, only six years ago, trade in manufactured goods posted a surplus of $5.1 billion,” he said.

In some segments, increases in the trade deficit were especially fast and severe. Such was the case with chemicals, oil and fuel refining, electronics and telecom equipment, machinery and equipment and automotive products. Just a few semi-manufactured industries went the opposite direction, achieving a higher trade surplus. That was the case with food, beverages and mining.

“When we look at the export coefficients and import penetration of manufactured products in Brazil, we can see clearly that the country is quickly losing several sectors of its industry. A country that used to be known for a relatively complex and integrated manufacturing base runs the risk of confronting the destruction of some industries and the disintegration of supply chains in others.”

According to da Silva, many export coefficients of different sectors have been reduced, including electronics and computer equipment, machinery and electrical equipment, automotive products and machinery and equipment. This fact shows the low competitiveness in Brazil due to, among other factors, the asymmetry of exchange rates between Brazil and its competitors.

Import penetration coefficients in Brazil show the opposite effect: in most sectors, there were higher penetration coefficients as a result of low competitiveness of Brazilian manufacturing in its own domestic market. Again, among other factors, it can be affirmed that this low competitiveness is to a large extent caused by exchange rate distortions between Brazil and its competitors, he said, noting that the most significant increases in import penetration have been in apparel, metallic products, automotive, textiles, electrical machinery and equipment, electronic and IT equipment.

“It is fair to say that problems other than exchange rate misalignments contribute to reducing the competitiveness of Brazilian products. But I can assure you, and several examples will show this, that exchange rate misalignments are at the heart of the problems faced by the industrial sector in Brazil.”

He said that the case of his company is emblematic. From 2001 through 2007, Coteminas was able to multiply its exports more than sixfold, only to have to reverse the trend and shrink its exports back to where it was five years earlier. Exports in 2011 were similar to the level in 2001. “We have relocated production to other countries.”

“In conclusion, if the double asymmetry in the exchange rate is a Brazilian problem today, it is also a systemic issue that tomorrow other nations might be confronted with. It is true that exchange rates are an area for sovereign decision by each country. It is no less true, however, that they impact trade, and the WTO should participate in the discussions. The double asymmetry problem exists. It is a critical issue. It has to be addressed, otherwise countries will create their own unilateral solutions against the distortion. Tariff wars and protectionism should be avoided by multilateral rules that can be accepted by all,” da Silva said.

It is learned that, following the conclusion of the seminar, the issue will go back to the formal meeting of the Working Group on Trade, Debt and Finance, with consultations to be held by the new chair (Ambassador Hisham Badr of Egypt) with the main actors. On the basis of these consultations, the chair is expected to convene a meeting of the working group to discuss the follow-up to the seminar. (SUNS7340/7341)