Exchange Rate And Trade An Analysis Of The Relationship For Ukraine

Discussion of the theoretical ground for connection between exchange rate and trade balance………4 2 .1 The logic of the connection between trade balance and exchange rate...4 2.2 Review of

EXCHANGE RATE AND TRADE:

AN ANALYSIS OF THE RELATIONSHIP FOR UKRAINE

by Iuliia Tarasova

A thesis submitted in partial fulfillment of the requirements

for the degree of

Kyiv School of Economics

Abstract

EXCHANGE RATE AND TRADE:

AN ANALYSIS OF THE RELATIONSHIP FOR UKRAINE

TABLE OF CONTENTS

Introduction………1

Chapter 2 Discussion of the theoretical ground for connection between exchange rate and trade balance………4

2 1 The logic of the connection between trade balance and exchange rate 4

2.2 Review of previous studies in the field 7

2.3 Theoretical model of trade flows formulation 13

2.4 Analysis of the impact of trade balance on exchange rate 17

Chapter 3 Empirical estimation of the influence of exchange rate on trade balance ……… …17

3.1 Construction of real effective exchange rate 20

3.2 Analysis of the current tendencies 23

3.3 Linear regression model 28

3.4 Simultaneous equation model 30

3.5 Co-integration analysis 33

3.6 Summary of the results 35

3.7 Discussion of the results 36

3.8 Policy recommendations 39

Chapter 4 Conclusions.………

……… 40

……… 43

Appendix 1 Detail summary statistics on variables use in the work

LIST OF TABLES

Table 1 Foreign trade by countries 21

Table 3 Import by group of goods 22 Table 4 Means and standard deviations of the export, import,

and trade

Table 5 Means and standard deviations of domestic and

Table 6. Means and standard deviations of domestic and

Table 7 Linear regression model results 29 Table 8 The results of the tests on linear regression model

29 Table 9 Results of the tests on endogeneity 30 Table 10 Simultaneous equation model estimation results 31

Table 12 KPSS test results for first differences 33 Table 13 Test for number of co-integration relationships 34

The author wishes to Iryna Lukyanenko, her adviser, for the help with problem formulation and estimations, useful comments and suggestions, as well as general support and guidance during the thesis writing

She also thanks to all the professors who read the early drafts of the work and left their invaluable comments, namely, to Tom Coupe, Serguei Maliar, Olena Nizalova, Pavlo Prokopovych and Volodymyr Vakhitov.

The author wishes to thank to Hanna Vakhitova for support and help

She is especially thankful to her colleagues, Iaroslava Suchok and Julia Gerasymenko, for support and help general help and kind during the work and to Vasylyi Zhuk for help with data collection.

C h a p t e r 1

INTRODUCTION

Exchange rate policy is considered as one of thepowerful tools of economic regulation and theregulation of the external sector in particular One

of the aims of the exchange rate policy could be toaffect the trade balance in a certain direction.However, after a century of research in the field westill do not have a sharp theory about the effect ofexchange rate depreciation and appreciation on thetrade balance (Qiao (2005) The empirical findings inthis direction are also mixed (Koray and McMillin(1998)

External trade can be stimulated by a throughseveral channels In particular, preferences,subsidies, quotas, taxes and other limitation could

be used to push the trade balance in the desireddirection However, these tools are almostunavailable after Ukraine joined the World TradeOrganization as WTO limits the possibility of usage

of such a policy in order to maintain the fare

competition in the international markets That iswhy the exchange rate policy stays almost onlypossible tool But the question is can the policyreally be used to influence trade flows? Whether wereally can say what effect on trade balance adepreciation or appreciation will have? Is theconnection between exchange rate and tradebalance is strong enough for us to be able to base apolicy on it?

To answer all the questions asked in case ofUkraine we have to know the exact relationship ofexchange rate and trade balance in Ukraine.Unfortunately, we have limited knowledge about it.However, the knowledge is highly demanded by themonetary authority of the country National Bank ofUkraine recently has announced implementing ofinflation targeting A well developed model of theeconomy, in particular, of external sector of thecountry is necessary for starting this policy Theestimation of the relationships between exchangerate and trade balance will provide informationabout external sector behaviour and create a basisfor the further developing of the economy model.That is why the main gaol the research has is to

analyze the relationship and make recommendationbased on the results of the work.

We built our analysis according following logic.First, we discuss the previous theoretical andempirical results in the field We present basicapproaches to understanding of trade balance andexchange rate interrelationship and literaturereview in the field Then we proceed with atheoretical background of chosen modelspecification After we move to construction of realeffective exchange rate and export and importdeflators, as these measures will necessary for ouranalysis In the next part we present results of ourestimations And finally, we discuss the results andmake policy recommendations

We conduct our research for Ukrainian data from

2002 (1) to 2008(2), quarterly We use data on tradeflows, inflation, exchange rate and other variablesfor Ukraine and main trade partners that is allpublicly available in official statistics of Nationalbank of Ukraine, Government Statistical Committee

of Ukraine and International Monetary Fund

The uniqueness of the work is that it is the firstanalysis of impact of real exchange rate on trade

balance for Ukraine that employs complicatedmodelling techniques Moreover, we construct thereal effective rate base on 10 main trade partnersand adjust the domestic inflation on the structure oftrade every year.

Before we move to discussion of previous studies

in the field we are going to provide some intuition ofthe impact of exchange rate on trade balance

The macroeconomic theory suggests thatexchange rate will affect trade balance but it is notclear on the issue of the channels and direction ofthe influence Moreover, exchange rate may thevariable that bring innovation into the economy, that

is the source of the shock, as well as the variablethat transmits the influence of other policies on thetrade balance In order to narrow our analysis we willlook at the case when exchange rate as the variablethat brings innovations

Various effects may be observed as a result ofexchange rate changes Let us analyze the case ofdepreciation The depreciation will reduce the foreign

currency price for the exported good However, thedomestic currency price may rise as a result ofincrease in demand for exported So, the devaluationwill have two opposite effects on price of export Onthe one hand, the price is going done due todevaluation; and, on the other, the price is going updue to increase in demand So, likely the exportedvolumes will increase but less then we expect due topure fall in foreign currency price.

The depreciation will also influence import Inparticular, it will make the import more expensive indomestic currency This will stimulate domesticconsumers to substitute for domestically producedgood So, the price again will experience twodifferent effects: decrease due to fall in demand andincrease due to devaluation

Combining together the effect of devaluation onexport and import we cannot make a clear predictionfor overall effect as the trade flows will experienceopposite effects In fact the final result will depend inthe magnitudes of the effects And it is exactly thatMarshall-Lerner condition suggest It tells that ‘thecondition for depreciation (appreciation) to improve(deteriorate) the foreign currency value of trade

balance’ is that the absolute sum of price elasticities

of export and import is greater then one (Allen,2006)

The logic presented above discuses classicalapproach to the relationship between exchange rateand trade balance It assumes that all agents canadjust immediately to the innovation in exchangerate However, further development of the theorysuggested that we should differentiate betweenshort and long run effects because in sort run someprices and volumes and production capacities arefixed which can result in different effect in short run.The theory that allows us to include timing into theeffect analysis suggests J-curve behavior of tradebalance J-curve assumption suggests that due toprice rigidities in the sort-run the appreciation(depreciation) of the domestic currency improves(deteriorates) the trade balance but worsen(improves) it in long-run (Koray and McMillin(1998) In order to explain the J-curve in moreditties we will assume that a country start withnegative trade balance and experience devaluation

at moment A (figure 1) According to J-curve theshort rune response should be negative (B) but then

the trade balance should improve until new levelwhich can be even positive.

Figure 1 J-curve

The existence of J-curve is very individual acrosscountries (Stucka (2003), but it is crucial tocountry's policy maker Moreover, as it was shown

by Mahmud (2004), the response of trade balance toexchange rate changers also depends on whether afixed or floating exchange rate regime is adopted inthe country (Gomez and Alvarez-Ude (2006) Thereason for that may be that changes in exchangerate under floating regime are fully endogenous, and

so, some of the effect of the movements, that wemay expect due to changes, happened before theobserved period and was a cause for the movementsnot the effect That is why we would expect a clearerJ-curve pattern under fixed rather under floatingexchange rate regime Also as we will discuss

further the economic situation and the speed ofdevelopment matter On average the less developedand faster developing countries are less likely tofollow J-curve

Concluding, the section presents basic approaches

to understanding of influence of exchange rate andtrade balance The discussion above tells that thedirection of the influence depends on variouschannels of the effect transmission, differentelasticities of those channels and the timing of theeffect That is why in our research we are going touse different approaches to the relationship Thenext section is dedicated to the review of work done

on the field

2.2 Review of previous studies in the field

In this section existing researches developed inthe field are overviewed The fist part of theoverview is concerned to theoretical models In thesecond part empirical results are analyzed

The issue of exchange rate impact on tradebalance has been explored for little less then acentury The literature starts a wide discussion inthe 30s of the twentieth century with the analysis of

the importance of the international trade of theeconomy and its connection to exchange rate One

of the most popular models in this direction isMundell-Fleming model that incorporate tradebalance (net export) into ISLM model and allowsanalyzing the impact of the exchange rate on theeconomy

An another popular model in the field is Lerner condition that represents so-called

Marshall-"elasticity" approach as it analyzes export andimport elasticities and compares them Thecondition suggests that if sum of price elasticities ofexport and import with respect to exchange rate inabsolute values is grater then 1 then devaluationimproves trade balance

The further theoretical model developed by Nagyand Stahl (1967) deals with more detail examination

of the reasons for demand for export and import.The main idea of the Nagy and Stahl (1967) study is

to define "irritation between optimal volume of theforeign trade and the marginal exchange rate"(Nagy and Stahl (1967) minimizing the domesticexpenditures According to the research thedevaluation of the exchange rate improves the trade

balance and decreases the domestic expenditure.

So, the findings of the model coincide with theMurshall-Lerner condition

Later researches are more likely to connect theexternal sector behaviour to the monetary sectormovements The advantage of the class of models isthat they describe monetary policy effect on theexternal sector For example, Stockman (1980)analyzes the relationship of exchange rate and tradebalance using modelling the connection betweenexchange rate and term of trades that in tern affectexports and imports The model presents "analternative equilibrium interpretation of elasticityapproach" (Stockman (1980) and concludes thatexport, import and exchange rate are determinedsimultaneously by the market as the response to realsupply and demand shocks However, the work doesnot indicate any of the variables of interest as theimpulse for another That means that it is necessary

to model the relationship with a system ofsimultaneous equations

Another wide class of theoretical literatureincludes models that describe the behaviour of tradeflows between the countries One of the central

issues of the models is currency internalization or,

in other words, the determination of the exchangerate of the countries based on the price levels andtrade flows between the countries The problem wasexamined by a big group of the researches:Krugman (1984), Zhou (1997), McKinnon (1997),Hartmann(1998) and others (Rey (2001)

So, there is a wide range of the theoreticalliterature studying the connection betweenexchange rate and trade balance Most of the worksare dedicated to the general equilibrium models andstresses the importance of the monetary sector inthe external sector functioning The most limitation

of the models is that they are hardly testable as thedata needed for the empirical estimation is poor.That is why works that test the relationship try toapply less general models in order to estimate theeffect Further we are going to overview theempirical studying in the field

The empirical studies can be grouped usingseveral criteria First we shall divide the researches

by the type of the countries studied We are going tolook at the estimation of the relationship for 1)

developed countries; 2) less developed countries; 3)CIS countries

The examination of the developed countries'external sector, especially the USA, is the widestgroup of the researches The most popular issue totest is the J-curve assumption; however, the findingdoes not give a clear support of it For example,Bahmani-Oskoee and Brook (1999) used USA versusrest of the world (RoW) model taking the six majorUSA trade partners as a proxy to the RoW They find

a support of J-curve and Marshall-Lerner condition

In contrast, Rose and Yellen (1989) did not find anyevidence of J-curve for the USA and Pesaran andShin (1997) supported only long-run part of thecurve So, there is no clear conclusion about J-curveeffect in the USA international trade

The studies for the developing countries, such asmiddle-east and north-Africa countries, find evenless evidence of J-curve behaviour Bahmani-Oskoee(2001) found only a few evidences of sort-run effectsand Upadhyaya and Dhakal (1997) out of 7 exploredcountries supported the J-curve only for Mexico.Moreover, Kale (2001) observed a negative impact

of domestic exchange rate rise in long-run and was

able to support with data only sort-run J-curvebehaviour for Turkey

The last group of studies deals with CEECcountries The findings for the group are justopposite for different countries For example,Hacker and Hatemi (2002) estimated the tradepattern between Poland, Hungary and CzechRepublic and Germany and did not find J-curve onlyfor Hungary Stucka (2001) estimated the effect ofexchange rate on the trade balance of Croatia andwas not able to find a clear J-curve behaviour

All in all, in every group of studies we may bothfind or not the evidence of negative sort-run andpositive long-run effects of devaluation on tradebalance It is more likely to find J-curve fordeveloped countries The explanation may be that indeveloped economies the market mechanism isbetter developed and the quality of the collectedinformation is higher

The second criterion to group researches is theapproach used There three biggest options are 1)analysis of a country versus RoW; 2) analysis ofbilateral model (country to country trade); and 3) apanel data analysis

Models of a county versus RoW describes thebehaviour of trade flows between a country andseveral its main trade partners that are aggregatedaccording to the size of trade and represent theRoW One of the papers that use the approachdiscusses the trade flows behaviour of Croatia(Stucka 2001) The analysis of 8 years of Croatiatrade (1994-2002) trade with 6 major trade partnersshowed that Marshall-Lerner condition hold for thecountry; however, there is no strong evidence of sortand long run effect associated with J-curvebehaviour In contrast, Noland (1989) was able tofind evidence of J-curve foe Japan in 70s and firsthalf of 80s.

The second approach is bilateral tradeestimation It allows analyzing of the trade flowsbetween the countries and the role of exchange rate

in it Most of the estimated models with thisapproach deal with USA versus another country.David Backus (1986) find J-curve pattern in Canada-USA trade in 70s Rey (2001) examines USA-GrateBritain trade and finds a significant role of moneyand financial markets in the process of tradeadjustments

The third approach is modelling of trade patterns

of several countries simultaneously This approachwas applied by IMF analytics (Allen 2006) Theanalysis includes 46 countries divided into 3 groups

It results into support of Marhall-Lerner conditionfor "most of the countries" (p 26) and generalcorroborate J-curve behavior of trade balance.However, Miles (1979) pooling 16 countries did notfind any evidence of improving of trade balance inresponse of currency devaluation

Summarizing, usage of different approach alsodoes not either show a clear evidence of positiveeffect of devaluation on trade flows no supports J-curve Moreover, the analysis of the same country indifferent time periods may did or did not result in J-curve

The last grouping factor we are going to present

is methodology used We may divide all usemethodologies into 3 groups: 1) multiple regressionestimation; 2) VAR and VEC estimation of externalsector; and 3) simultaneous modelling of externaland monetary sectors We also may name a generalequilibrium models as a forth group, but the method

is used only by large international institutions, inparticular, IMF

Multiple regression models were those startingthe literature They were based on one equationreflecting correlation between trade balance andexplanatory variables such as exchange rate,domestic and foreign income, price indexes andothers However, the major problem of those modelswas the endogeneity bias and exchange rata andtrade balance influence each other

With the developing of econometric methods VARand VEC model became popular in the field(Shirvani and Wilbratte (1997), Marwah and Klein(1996), Baharumshah (2001), Kale (2001) and others(Stucka(2003) The further analysis showed a tightconnection between external sector and monetaryvariables changers (Backus (1994), Rey (2001),Mussa (1982), Moon (1982) and others) However,the evidence of strength and the direction of therelationship between exchange rate and tradebalance is very time and country dependent

So, in our research we shall look for the connectionbetween exchange rate and trade balance using

several approaches presented above in order to useadvantages of all of them.

2.3 Theoretical model of trade flows formulation

We are going to model two-country case In ourwork we will look of Ukrainian foreign trade as tradebetween two countries: Ukraine and The rest of theworld For the purpose of our analysis we will use amodel developed by Goldstein and Kahn (1985) andRose and Yellen (1989)

The basic assumption of this model is thatexported and imported commodities have finite priceelasticities It means that they are not perfectsubstitutes for those produced domestically

Let’s assume that domestic demand for import,

ImD, and foreign demand for import (that is demandfor domestic export) ExD, are given by (1) and (2)

Im 1

Where Y and Y* are domestic and foreign incomes,

PIm and PEx are import and export deflators, P and P*

are domestic and foreign price levels, e is nominalexchange rate (in American notation) In equations

(1) and (2) import and export deflators represent theprice that domestic and foreign consumersrespectively will pay for imported or exported goods.

So, we assume the demand for import for bothdomestic and foreign markets depend on income inthe region, prices for imported goods and the pricefor domestic goods The last variable represents theprice for the region’s own production, so the price ofsubstitutes Moreover, we include exchange rate inthe equation for demand for export because weassume that all variables except indexes arecalculated in domestic currency

We need another assumption in our model Wewill assume that there are no inferior goods and theimported good do not have domestic complements.This allows us to conclude that domestic and foreignincome elasticities are positive Furthermore, cross-price demand elasticities are also positive, whileprice elasticities are negative

Im

0

D Y





D Ex

Ex P





The demand function is usually assumed to behomogeneous of degree 0 So, if we increase allindependent variable by the same factor, thedemand will not change So, we can use this property

to divide both equations by respective price level As

a result all variables will be represented in realterms We can rewrite (1) and (2) as

Im 1

Im D ( , )

r  f Y P  r r , where r Y

Y P

 and

Im Im

r

P P

Ex Y

Now we know that real price of domestic income

is the same as relative price of foreign exportadjusted to exchange rate So we may state that

*

P RER e

P

Note, for (5) and (6) we use standard Americannotation of exchange rate That is number of units offoreign currency per a unit of domestic currency.However, in our work we will stick to Europeannotation that is exchange rate is number of units ofdomestic currency per a unit of foreign one It is easy

to show that such a change of notion will notinfluence the model final result except for thederivative of the trade balance by exchange rate willhave the opposite sign

In order, to complete the model we have tointroduce supply of export and import Let’s assumethat the supplies are given by (7) and (8).

Im* * 3

Concluding, we get that real trade balancedepends positively of foreign income, negatively ondomestic income and real exchange rate Note, inthis derivation we use standard American notation ofexchange rate to stick to usual theory Further wewill work with European nation that is why in ouranalysis we expect trade balance to dependpositively on real exchange rate.

2.4 Analysis of the impact of trade balance on exchange rate

Before we were discussing influence of exchangerate on export and import and now we go into issue

of exchange rate determination We will need theconclusions when we will have a separate equationfor exchange rate

There are a number of models that can be used

to explain the process of exchange ratedetermination The two major classes of them areBalance of Payments (BoP) models and monetarymodels BoP models suggests that the main driver toexchange rate innovations is the gap betweenforeign exchange demand and supply flows.However, the imbalance between inflows ofcurrency (export) and outflow of currency (import)

can exits only in sort term The main reason for that

is that one side of the trade will be financing theincreasing consumption of the other, and with timethe other will have to repay the debt So, the flowswill be balanced That is why the main determinants

of the exchange rate are those determing BoP:domestic and foreign income and domestic andforeign interest rates Naturally, this theory modelsreal exchange rate that accounts for the price levels

It was the fist so-called "dynamic" models and itexplains simultaneous time path of nominalexchange rate, price level, interest rate and moneysupply The central idea of the framework is thatexchange rate overshooting For example, anpermanent increase in money supply in sort runresults in decrease in interest rate, this, in tern,

causes capital outflow and, through that,depreciation (as the supply of domestic currencyrises) However, in with time the price level adjustand interest rate returns to its pre-shock level Andexchange rate fall but less then initial rise The longrun result of the shock is increase in price level andexchange rate without any change in interest rate.But, during the process of adjustment the exchangerate goes higher then equilibrium level that isovershoots That allows us to conclude that we cancatch the impact of such a process on exchange rate

by changes in domestic and foreign interest rates

In our research we take Dornbush model as thebasis However, due to reasons discussed inprevious section we are going to use real exchangerate Similar approach was used by Jeffrey Frankel(1979) He developed a real interest differentialmodel that explains the behaviour of real exchangewith, real interest rate, price level and income

Finally, we will assume that real exchange ratedepends on trade balance as it creates pressure forrate movements, as it is done in the first class of themodels, and domestic and foreign interest rate assecond class of models suggest Furthermore, for

the analysis we will use an assumption that pricelevels influence exchange rate through tradebalance and interest rates This is not a badassumption as price levels influence exchange ratethrough agents’ actions which in our analysis arerepresented by foreign trade and investments

C h a p t e r 3

EMPIRICAL ESTIMATION OF THE INFLUENCE

OF EXCHANGE RATE ON TRADE BALANCE

3.1 Construction of real effective exchange rate

As the theory discussed before suggests in order

to measure the influence of exchange rate on tradebalance we need to introduce real exchange rate.There are several ways or methods how one cancalculate real effective exchange rate In thissection, we will describe and motivate themethodology of real exchange rate construction thatwas used for the porpoise of the estimation

The methodology we applied is based on thepurchasing power parity (PPP) In particular, on theassumption that absolute PPP did not hold duringthe sample period and relative PPP hold Theadequacy of the assumption can be motivated by thefact that Ukraine was using fixed rate regime untilSeptember 2008 and, obviously, the inflation rates

in the country and out of it ware different

In order to apply PPP rule we need to choose ameasure for domestic and the other party inflation

For that purpose we chose eleven Ukrainian major

trade partners: Belarus, Russian Federation,

Kazakhstan, Italy, Germany, Poland, Hungary,

France, China, Turkey, the USA, and Egypt (table 1)

The criterion for the choice was that a country has

more then 2% in export or import volumes

However, we could not find data for several years

for Egypt that is why we use only ten countries The

total share of these countries in external trade is

about 60% So, we consider the ten countries as a

good proxy for the other party in trade, in other

words, for rest of the world

Table 1 Foreign trade by countries 1

thousands USD share in totalexport thousands USDaverage, share in totalimport

Total trade 46237169,9 100,00% 55650639,2 100,00%

CIS Countries 16072505,52 34,76% 23726317,44 42,63%

Byelorussia 1414802,21 3,06% 1582955,658 2,84%Kazakhstan 1130847,393 2,45% 1416521,69 2,55%Russian

The weights that we used to construct foreign

price index are share in total export and import of

the trade partner Domestic inflation is also a

composed index of export and import deflators To

proxy export and import deflators we chose groups

of major trading goods (tables 2,3) The criterion for

the choice was that the share of the group in export

or import was more the 3% We weighted the price

indexes for those groups by there share

Table 2 Export by group of goods 2

A code and name of commodities is in obedience

to UKTZED

Average, thousands of USD

Share in total export

III 15 Fats and butters of animal or vegetable

27 power materials; oil and products of its

2 Source: site of Government Committee of Statistics http://www.ukrstat.gov.ua/

3 Over recent years its share began to rise that is why we include this group into

72 black metals 91264231,75 33,20%

73 wares are from black metals 14136410,68 5,14%

84 caldrons, machines, vehicles and mechanical

85 electric machines and equipments 10140448,01 3,69%

86 railway or tram-car locomotives, shlyakhove

Table 3 Import by group of goods *

A code and name of commodities is in obedience

to UKTZED

Average, thousands of USD

Share in total import

85 electric machines and equipments 1950263,8 5,08%

87 surface transport vehicles, except for all-rail 4009122,7 10,43%

So, the export (import) price deflator is

calculated of follows

i i i

where P is price index (deflator) of

export(import), wi is share of group i, pi is price

index of group i

So, the formula that we applied to calculate real

effective exchange rate is

P* is foreign price index For RER0 we take the valuefor nominal exchange rate between hryvna and USdollar at the beginning of the sample period.

3.2 Analysis of the current tendencies

In this section we describe the data sample andcurrent tendencies in major variables

The period analyzed in the work is from 2002(1)

to 2008(2) on quarterly bases We did not includethe previous periods are we are not able toconstruct export and import deflators for them Till

2002 Government Committee of Statistics (GSC) usedifferent classification for group of goods that is whyneither shares not price indexes on the groups wechose are not available before 2002(1) We also arenot able to include the end of 2008 and the begging

of 2009 as the statistical on country’s GDPs is notavailable jet