The effects of devaluation on the trade balance and the balance of payments

- - to all three objections.' Cooper shows that the impact effect of 15 of 24 devaluations is to "improve" the balance of goods and service^,^ while in 17 of 24 cases the balance of paym

The Effects of Devaluation on the

Trade Balance and the Balance of

Payments: Some New Results

R ~ i t g t i , Colltgr, Rntg<r\-Thr Stnte Lrl?r'er\rt\

This paper examines the statistical relationship between de\raluation ant1 both the trade balance and the balance of paymelits for 16 de\raluatio~lsof 14 countries in the 1960s Using several tests involv- ing both the seemingly u~lrelated and pooled cross-section time- series regression techniques, the paper tests the effect of devaluation hile sta~~dardizirlg for other variables that map affect the foreign accounts \Yhile the balance of pa)-merits does seem to improve follo\ving devaluation, no evidence is found to support the hypothe- sis that cievaluation improves the trade balance T h e paper con- cludes that the acljustment to devaluation is essentially monetary in nature, involving only a portfolio stock adjust~nent

Within the international trade literature, it is not uncommon to find arguments about lvhether devaluation will improve the trade balance

o r the balance of payments Each theoretical approach has its own set

of arguments For example, the proponents of the elasticities proach (e.g., Robinson 1947; Metzler 1948) describe the necessary and sufficient conditions for an improvement in the trade balance in terms of elasticities of demand and supply If the demand elasticities are sufficiently large and the supply elasticities sufficiently small, devaluation should improve the trade balance Proponents of the absorption approach (e.g., Alexander 1952; Johiison 1967) describe 11on devaluation nlay change the terms of trade, increase production,

ap-l ' h e author ~vouap-ld ap-like to thank Jacob Frenkel, Harr! Johnson, Arthur Laffer, Stephen Slagee, John Bilson and an anonvmous referee for helpful aclvice and corn- ments The\- should not be held responsible h o l v e ~ e r , for any remaining errors

[ J o i i r ~ i ( i l01 PoJ~IIc(I/F~orzo~riv, 1979 xol X i , no 11

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T H E ETFECTS OF DEVAI L ATION 60 1 switch expenditure from foreign to domestic goods, or have some other effect in reducing domestic absorption relative to production and thus improving the trade balance International niorletarists (e.g., Mundell 1971; Dornbusch 1973n; Frenkel and Rodriguez 1975) argue that derraluation reduces the real value of cash balaiices andlor changes the relative price of traded and nontraded goods, thus im- proving both the trade balance and the balance of payments This article, however, examines the statistical relationship between devaluation and the two foreign accounts More specifically, the arti- cle tries to determine if, on the average, devaluation improves the trade balance andior the balance of payments No attempt is niade to show the merits of one theoretical approach over another While the theoretical discussion is primarily in terms of a monetarist model, the final empirical 111odel is a reduced-form equation that is not inconsis- tent u.ith the other theoretical models If devaluation causes a significant improvement in the trade balance, this irnprovernent should he statistically observable regardless of ivhich theoretical ap- proach is used

Section I describes empirical studies of the effects of devaluation by other authors and analyzes why their approaches fail to answer the relevant questions completely Section I1 describes the functional forms used in this study and summarizes the theory behilid the model Section I11 describes the various tests and their results Finally Section I V summarizes the results and drarvs some conclusions

I Other Empirical Studies

In recent years several papers have appeared tvhich have tried to analyze empirically the effect of devaluation on the trade balance and balance of payments There are three basic objectio~is that one can niake to these previous studies: (1) They examine only the impact effects and fail to show whether any apparent improvement is tempo- rary or permanent (2) They do riot compare postdevaluation levels of the accounts with predevaluation levels It therefore cannot be de- termined if an improvement as compared with the pear of devalua- tion is also an irnproveme~it as compared with predevaluation years

(3) They have not accounted for the effects of other variables such as

the government's monetary or fiscal policy Only the improvement or

~vorsening of the raw account figures follolving devaluation is re- ported Such a procedure is equivalent to ascribing all the changes in the accounts to devaluation

TYhile all three objections do not apply to each of the previous studies, each study fBils to deal properly with at least one of them For example, the widely quoted study by Cooper (1971n, 1971b) is subject

- -

to all three objections.' Cooper shows that the impact effect of 15 of

24 devaluations is to "improve" the balance of goods and service^,^ while in 17 of 24 cases the balance of payments improves However, there is no indication if this improvement is permanent, because figures are not provided for succeeding years Nor are figures pro- vided for years prior to devaluation, so it is impossible to determine if the "improved" level is an improvement over the levels in the previous pears In fact, 10 of the 15 "improved" balances of goods and services are still negative follo~ving devaluation, while in contrast 14 of the 17 improved balances of payments are in surplus Finally, no attempt has been made to separate what portion of the improvement is due to devaluation and what portion is due to changes in other variables Connolly and Taylor (1972) partially overcome some of the shortcomings of the Cooper paper Using 16 of the devaluations in the Cooper sample, they try to relate improvements in the balance of payments (defined as net change in reserves) and rates of domestic credit creation They conclude that (1) the higher the rate of devalua- tion, the greater the improvement in the reserve position; and (2) the higher the rate of domestic credit expansion following devaluation, the smaller the improvement

Laffer (1976) eliminates the first two objections in a test of 15 postwar devaluations He examines the time path of the trade balance over 'iyears, from 3 years before devaluation until 3 years after He finds that although the trade balance "improves" in the year following devaluation for eight of the 15 cases, in one-half of those cases the trade deficit is still worse than the average balance of the 3 years prior

to clevaluation Furthermore, 10 of the 15 countries have the largest deficit of the 7-year period in the 3 years following devaluation, and two more have the largest deficit in the year of devaluation Ten of the 14 countries with data for the third year following devaluation have a larger deficit in that year than in the pear after devaluation Thus, there is little evidence of devaluation causing significant or sustained improvement in the trade balance

An analysis similar to Laffer's is performed by Salant (1976) on 101 devaluations, for both the trade balance and the balance of payments Salant finds that in about three-quarters of the cases (75 of 101) the

In this summary, I have excluded some well-known articles that attempt to explain the effect of devaluation on the percentage change in exports, imports, market shares, o1.5ome other related variables IVtlile these articles purport to explain the effect o n the trade balance (a general equilibriutn concept), their technique is to examine changes in exports or imports in isolation (a partial eq~lilibriuril concept) Since I am investigating the siniultaneous net change in exports a n d imports in this paper, I have restricted the discussion in this section to studies that have also dealt explicitly with this concept

I n each of these studies, an "improvement" is defined as any absolute reduction in a drficit or an increase in a surplus

603 THE EFFECTS OF DEVALUATIOB

average balance of payments for the 3 years following devaluation is improved as compared with the average in the 3 years preceding devaluation I n contrast in less than one-half the cases (46 of 101) does the average of the trade balance improve

T h e implication of these studies is that there is considerably more evidence for the balance of payments to improve following devalua- tion than for the trade balance to d o so But, while some of the studies overcome one or two of the previously stated objections, none takes into account all three Even more important, none of the tests fully accounts for the third objection Only the Connolly and Taylor (1972) study makes any attempt to take into account the kffects of a variable other than devaluation

T h e object of this paper is to account for each of the three objec- tions which arise from the previous studies Evidence of not only the impact but also the longer run effects of devaluation will be examined and compared with the predevaluation behavior of the accounts Furthermore, an attempt will be made to isolate the effects of devalu- ation alone by standardizing for the effects of other exogenous vari- ables

where T B i= the level of the trade balance in country i ; B p i = the level

of the balance of payments in country i ; Y i= the level of output in country i ; g i ,gR = growth rates of income in country i and the

rest-of-world R ; M i , M R = the ratio of the average level of high- powered money (where changes occur only from domestic sources) to output in country i and the rest-of-world R ; Gi, G R = the ratio of government consumption to output; and ERL = the exchange rate of country i (see the Appendix for a more detailed description of these variables)

604 J O U R N A L OF POLITICAL E C O S O h I Y Following Laffer (1969, 1975), increases in a country's growth rate

relative to the average growth rate in the rest of the world are expected to cause a deterioration in the trade balance but an im- provement in the balance of payments These anticipated relation- ships are consiste~lt with the theory that commodities such as money and goods tend to flow from areas of the ~vorld where there is excess supply to areas of excess demand An increase in the relative growth rate of a country increases demand for money and goods relative to elsewhere, increasing the flow of these con~modities into the country and causing the trade balance to Ivorsen and the balance of payments

to i m p r ~ v e ~

T h e nlonetary variable is not the usual money supply variable such

as M 1 or M 2 Rather, it represents changes in the level of the domestic portion of high-powered money, the portion of high-powered money directly under the control of the monetary authorities T h e effect of this variable on the trade balance is uncertain, depending upon se\,- era1 factors According to some theorists (Johnson 1972; Dornbusch

19730, 1975; Frenkel and Rodriguez 1 9 7 5 ) , as the government in-

creases the money supply, the level of real balances in the economy increases Individuals perceive their wealth to rise, causing the level of expenditure to increase relative to income and the trade balance to deteriorate However, a negative relationship between changes in the money supply and changes in the trade balance may not be observed for at least three reasons First, nominal money balances may be only a small fraction of total wealth In this case, a devaluation will not cause

a significant change in real wealth Second, expenditure may respond only slightly to changes in wealth Thus, even if the reduction in the real value of money significantly reduces real ~vealth, an impercepti- ble change in the trade balance will be observed Finally, money may not be perceived as net wealth by the private sector I n this case, there

"he hypothesized relationship bettveen the trade balance and growth rates ausumes that demand shocks dominate supply shocks If ari increase in the relative growth rate represents an exogenous supply shock, then output increases Inore than demand, creating an excess supply of goods and a positive relationship between changes in relative growth rates and changes in the trade balance However, if the increased relative growth is caused b\ an exogenous dernand shock, domestic demand rises by more than domestic supply, creating the negative relationship between changes in relatibe growth rates and changes in the trade balance A general equilibrium model of

h o ~ demand shocks produce the negative relationship is provided in Laffer 11975) and Laffer and hliles (1980), chap 8 Empirical cvidence that demand shocks tend to dominate is found not only in this paper but also in Laffer (1969), Laffer and Ranson (1975), and Miles (1977) A n alternative explariation of the negative relationship in terms of permanent income is found in Miles (1977) It' current economic conditions strongll irlfluerice expectatiorls about the future, a rise in the current growth rate raises the expected increase in income not only in the current year but in f l ~ t u r e years as well Permanent incomc theretor-e rises b! more than present income, causing current demand to rise by more than current supply and a worsening in the trade balance

605

T H E EFFECTS O F DEV.4LUATIOS

is no real balance effect and the trade balance does not d e t e r i ~ r a t e ~ If any of these three conditio~ls holds, the real balance effect loses its empirical relevancy

Increases in the money supply are expected to cause the balance of payments to worsen regardless of whether the real balance effect is relevant Where a real balance effect exists, increasing the money supply increases the supply of real balances relative to demand; and this excess supply ~vill be alleviated by an outflolv of money through the balance of payments 111 the absence of a real balance effect, increasing the money supply raises the ratio of money to bonds above the desired level, necessitating a portfolio adjustmeilt that occurs exclusively through a balance of payments-capital account deficit Notice that it is not just the changes in the domestic ratio of money

to output which is used as the independent variable but, rather, changes in the difference between the domestic and rest-of-world values For example, as long as there is no reserve creation in the

~ ~ o r l d ,the sum of all changes in the balance of payments must be zero

If all governments are increasing the domestic ratios of money to output, not all balances of pavments can be deteriorating Instead, the account will be expected to deteriorate in those countries where the domestic ratio increases the most

Government consunlption represents one source of direct expen- diture in the economy Thus, if the government increases the level of its corlsumption by a dollar, as long as individuals do not immediately view government expenditures as merely replacing their private con- sun~ption,total expenditure will rise Given the level of output, a rise ill total expenditure causes the trade balance to deteriorate As in the case of the monetary variable, the change in the domestic ratio rela- tive to the rest-of-~vorld ratio is used as the independent variable Since devaluation is a monetary phenomenon, the expected effects depend upon the importance of the real balance effect If the real balance effect is empirically relevant, devaluation is expected to im- prove both the trade balance and the bala~lce of pavments T h e Eeduction in real balances caused by devaluation both ;-educes expen- diture and creates an excess demand for money, ivhich has the effect

of improving both accounts Hon~ever, if the real balance effect is not empirically relevant, only the balance of payments is expected to improve T h e absence of a real balance effect means that both expen- diture and the trade balance are unaffectecl Instead devaluation

Qank-created or "inside" monev is certainly recognired not to be net wealth to the private sector T h e onlv remaining rnone! asset is fiat or high-powered mane\ Fiat monev is the liability of the guvernment, To the extent that the private sector recog- nizes that governmental liabilities represent tax liabilities on the PI-ivate sector, fiat money is si~nultaneousl\ both a private asset and liability

606 J O ~ R N A LO F POLITICAL ECONOMY

reduces the ratio of real money assets to real net bond assets below the desired level T h e necessary adjustment occurs entirely as a portfolio reacljustment, as bonds a r e exchanged for money

I n this section the functional forms of the trade balance a n d the balance of payments equations described above a r e used in several tests to try to determine if devaluation has a positive effect o n either account As an interesting by-product of the procedure, the impor- tance of the individual variables in affecting the accounts can also be measured

By regressing country equations separately using ordinary least squares (OLSs), it is implicitly assumed that the errors of the indi- vidual countr? equations a r e unrelated However, such an assumption may not be valid for the trade balance and the balance of payments For the world as a whole, the sum of all trade balances o r the sum of all balance of payments is constrained to be zero For each export in the world there must be a n equivalent import T h u s , the trade balance

a n d balance of payments errors for all countries in the world a r e not independent T h e remaining question is what effect any covariance of errors will have o n the estimated coefficients T h e effect of the covariance is measured through the use of seemingly unrelated re- gressiorls (Zellner 1962; Kmenta 1971) T h e first step of the proce-

d u r e is to estimate the individual country equations by OLSs At this stage, the equations a r e assumed unrelated However, in the second step the errors of these equations a r e used to create a variance-covariance matrix T h e final step is to use Aitken's generalized least squares to reestimate the individual regression coefficients incor-porating the information about the covariance of the errors Incor- porating the information increases the efficiency of the estimators

T h e sample of countries for the seemingly unrelated tests consists

of 14 countries O n e problem is the possible first-order autocorrela- tion of the disturbances of individual countries T o handle the au- tocorrelation, estimates of the autocorrelation coefficient p obtained from the iterative Cochrane-Orcutt technique (CORC) o n OLSs a r e used to transform the data before the present test is performed T h e transformation leaves each variable in each of the 14 countries with 17 observations for the period 1956-72

607 THE EFFECTS OF DEVALUATIOh'

T h e seemingly unrelated regressions are used for both a residuals test and a direct test of the exchange rate, both of which are described below:'

Residuals Test

This test utilizes equations (1) and (2) ~ ~ i t h o ~ i tthe exchange-rate variable Excluding the exchange rate in the estimated equation means that the residuals of the equation represent the effects of devaluation and all other variables Using a test similar to one em- ployed by Fama, Fisher, Jensen, and Roll (1969), the path of the residuals around devaluation is examined to determine if they be- have differently after devaluation occurs as compared with prior behavior

Examination of these residuals around the period of devaluation provides information about the effectiveness of devaluation For example, if devaluation causes a permanent improvement in the trade balance, there should be large positive residuals at or near the year of devaluation and only small or random residuals in subsequent years

T h e large positive residuals indicate a large positive change in the trade balance that is not explained by government monetary or con- sumption policy or by growth rates T h e subsequent small residuals would indicate little change in the trade balance in the future that is not due to the two policies or growth rates

T h e monetary approach suggests that there should be only a tem- porary improvement in the trade balance as real cash balances return

to the desired level A temporary improvement ~vould be indicated by positive residuals at or near the year of devaluation and negative residuals in subsecluent years This pattern of residuals would indicate

a positive change in the trade balance not explained 11y the stan- dardized variables, followed by eventual negative changes as the trade balance returns to its original level If the trade balance is to return to its original level, the sum of the positive residuals should approximate the sum of the negative residuals

A third possible path of' behavior is the so-called J-curve Under this hypothesis, devaluation causes the trade balance to worsen initially, due to price effects, but eventually to improve as demand for the countr-y's goods increases This hypothesis would be consistent with initially large negative residuals followed by large positive residuals If

T h i s paper reports only the results of the seemingly unrelated regression equations However, a comparison of the results for both OL.Ss and seeminglv unrelated regres- sions is reported in Miles (1978).T h e primary effect of using the seemingly unrelated technique is to increase the frequency of significant coefficients of the expected sign

In each country, the year of devaluation is called !,ear t Residuals

(divided by the standard errors) are collected for each country for the

7 years t -3 t o t + 3 T h e residuals of similar periods (~vith respect to devaluations) are then summed across countries, and average residu- als are created by dividing by the number of countries in the group

T h e resulting number represents the average residual as a fraction of the standard error for all the countries in the year of devaluation T h e procedure is repeated for the other six time periods, permitting comparison of the averages from 3 years before until 3 years after devaluation If devaluation improves the trade balance or balance of payments, the improvement will surely occur within 3 years

T h e results of this procedure are shown for the trade balance in table 1 and for the balance of payments in table 2 Both tables contain the residuals for 16 devaluations of the 14 countries, as well as the average values Examine first the results for the trade balance T h e average residuals are snlall but positive in the 2 years prior to devalu- ation This result suggests that any deterioration of the trade balance

in those years appears, on the average, to be caused by government policies and grolvth I n the year of devaluation, however, there is a very large negative residual T h e residual is larger in absolute size than the residual in any of the other 6 years I n the following 3 years,

there is a positive residual only in year t + 1 But this positive residual

is only about three-fifths the absolute size of the negative residual in the year of devaluation In other words, there is no evidence of devaluation improving the trade balance even temporarily Devalua- tion has a large negative effect in year t and continues to have a net negative effect in the follo~ving 3 years I n fact, the trade balance deteriorates even more follolving year i + 1

equation is to include deviations that are not due to just a poorl) fittecl regression equation T h e procedure is an attempt to tackle the problern of weighting outl)ing observations However, an alternative vielv might be that the residuals should not be

weighted Tlle residuals test has been performed o n both seemingly unrelated and OLSs for (i) residuals ~ e i g h t e d hy the inverse of the standard errors (ii) un\ieighted residuals, and (iii) unweighted residuals, but excluding countries ~\.ith "large" or outly- ing residuals I n each case, the results are esentiallv the same for both the trade balance and the balance of payments T h e results, therefore, d o not appear sensitive to either the weighting wheme or the tvpe of regression analysis For thc I-esults using un- weighted residuals of the OLSs equatiom, see hIiles (1078)

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