ERIA Disc ussion Paper S eries
The Effect of Exchange Rate Volatility
on International Trade in East Asia
Inter-Disciplinary Studies Center, Institute of Developing Economies, Japan
Faculty of Economics, Keio University, Japan
Economic Research Institute for ASEAN and East Asia, Indonesia
Abstract: In this paper, we empirically investigate the relationship between exchange
rate volatility and international trade, focusing on East Asia. Our findings are
summarized as follows: first, intra-East Asian trade is discouraged by exchange rate
volatility more seriously than trade in other regions. Second, one important source for
the discouragement is that intermediate goods trade in international production
networks, which is quite sensitive to exchange rate volatility compared with other types
of trade, occupies a significant fraction of East Asian trade. Third, the negative effect
of the volatility is greater than that of tariffs and smaller than that of distance-related
costs in East Asia.
Keywords: Exchange rate volatility; Trade; East Asia
JEL Classification: F10; F31; N75
Since the Asian currency crisis in 1997, the debate on the exchange rate regime has
taken center stage in East Asia. Because the rigid dollar-pegged rate regime was alleged
to be a direct cause of the crisis, East Asian countries began to fear an excessive
dependency on the US dollar. At the same time, exchange rate stability came to be
seen as a key issue. Particularly in East Asia, international production/distribution
networks in machinery industries have developed vigorously and have established their
significance in each economy with extensive country coverage and structural
sophistication. This development of international networks has led to a rise in the
share of intra-regional trade in East Asia and has necessitated a stable exchange rate
environment. One of the natural consequences of this has been the commencement of
vigorous discussion on the possibility of a basket currency among East Asian countries.
The academic literature neither theoretically nor empirically concludes whether the
stability of the exchange market enhances international trade or not. There are a large
number of theoretical and empirical studies that analyze the relationship between
exchange rate volatility and international trade (see, for example, McKenzie, 1999;
Clark et al., 2004). As presented in McKenzie (1999), there are theoretical models
supporting both negative and positive relationships between them. Empirical studies
do not provide clear-cut results, either. Most of the empirical results present a negative
relationship, but this relationship is not always robust. The studies often find
insignificant negative or positive relationships when employing other estimation
methods such as instrument variable estimation or the introduction of fixed country
Previous empirical studies have investigated various hypotheses and subjected them
to robustness checks. Some of the studies perform long-time series analyses and
employ samples involving a large number of countries. Various kinds of volatility
measures are employed in the literature, and furthermore the volatility is sometimes
decomposed into its anticipated part and unanticipated part by using a GARCH model.
The endogeneity between exchange rate volatility and trade is addressed in the use of
instruments. The studies also compare the impact of volatility on trade among
developed countries with that among developing countries. These studies aim to
examine the differences in the currency/exchange system, or the availability of hedging
instruments across countries, through investigating the impact of exchange rate
volatility on international trade. Recently, moreover, Clark et al. (2004)1
The fourth element is especially important in the context of East Asia. The
seminal paper in the fragmentation theory, Jones and Kierzkowski (1990), illustrates the
mechanics of fragmentation in a static setting. It claims that fragmentation of
production processes takes place when (i) production cost per se in fragmented
production blocks can be substantially reduced and (ii) service link cost for connecting
remotely located production blocks is not prohibitively high. If a reduction in
production cost by fragmentation overweighs service link cost incurred thereby, the firm
breaks apart some of its production blocks to other remote locations, so as to attain a
total cost reduction. In dynamic consideration, however, we must explicitly take into
account the cost of network set-ups and network restructuring. Apart from pure
spot-market-type transactions, transactions in production networks are relation-specific.
the impact of volatility on trade in differentiated goods with that in homogenous goods.
Our study intends to contribute to the literature by clarifying differences in the
impact of exchange rate volatility among traded products or across trade structures.
Particularly in the context of East Asia, we conduct the following analysis: Firstly, we
examine whether volatility has a greater discouraging impact on trade in East Asia than
in other regions. Secondly, we try to quantify the degree to which volatility impedes
international trade in East Asia compared with tariffs and distance-related costs (e.g.,
transportation costs). Thirdly, we construct an unanticipated volatility measure
different from those used in previous literature and examine its impact on international
trade. Different from the volatility measures employed in the previous studies, this
unanticipated volatility measure is constructed by using not only the past exchange rates
but also the prospect of countries held by exchange market players (bankers). Fourthly,
we examine whether machinery parts trade is more sensitive to volatility than finished
1 Their finding of a larger impact on differentiated goods trade indicates that exchange rate volatility
occupies a significant fraction of fixed entry costs since, from the theoretical point of view,
differentiated goods trade is more sensitive to such costs.
Only a slight defect or delay of one single part may cause a serious malfunctioning of
the whole production system, and thus firms carefully select credible business partners
hooked up with reliable service links. Exchanges rates are one of the crucial elements
that generate uncertainty in the competitiveness of business partners as well as service
link costs. As a consequence, firms or production plants located in countries with high
volatility in exchange rates are less likely to be incorporated with production networks.
Indeed, some Japanese firms report that exchange rate stability is essential for
back-and-forth transactions of intermediate goods in international production networks
(Ito et al., 2008)2. On the other side of the coin, once production networks are in place,
transactions become stable, which suggests the existence of network restructuring cost.3
2 The Research Institute of Economy, Trade and Industry (RIETI) conducted hearings on strategies
for exchange risk management with a number of Japanese machinery firms as a part of their project
on “The Optimal Exchange Rate Regime for East Asia”. Ito et al. (2008) summarizes their results.
3 Obashi (2008) rigorously verifies that machinery parts and components trade in East Asia are more
stable over time than machinery finished products by employing the method of the survival analysis.
There are also the previous studies with special attention on East Asia: for example,
Bénassy-Quéré and Lahrèche-Révil (2003), Poon et al. (2005), Chit el al. (2008), and
Thorbecke (2008). While these paper employs different approaches such as an
error-correction model and panel data techniques, different sample period, and different
sample countries, all these papers found the negative relationship between exports and
exchange rate volatility in East Asia. Our paper is in particular closely related to
Thorbecke (2008). He investigates how exchange rate volatility affects electronic
parts and components exports within East Asia and finds that the volatility does reduce
trade in electronic parts and components within the region. On the other hand, this
paper examines whether there are differences in the impacts of the volatility between
finished machinery goods and machinery parts. This investigation contributes to
enhancing our understanding on the mechanics of international production/distribution
The reminder of this paper is organized as follows: Section 2 explains our empirical
methodology and an overview of our volatility measure. Section 3 reports on our
regression results, and Section 4 concludes our argument.
Appendix. Sample Countries
AfricaAlgeria, Ghana, Kenya, Madagascar, Mauritius, Morocco, Senegal, Seychelles
East Asia China, Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Thailand
Austria, Denmark, Finland, France, Greece, Hungary, Iceland, Italy, Malta, Netherlands, Norway,
Portugal, Spain, Sweden, Switzerland, United Kingdom
Argentina, Barbados, Bolivia, Brazil, Chile, Colombia, Costa Rica, El Salvador, Guatemala,
Honduras, Jamaica, Mexico, Panama, Paraguay, St.Lucia, Trinidad and Tobago
Canada, United States, Fiji, Cyprus, India, Israel, Jordan, Nepal, Pakistan, Saudi Arabia, Sri
Ando, M., Kimura, F., 2005. The formation of international production and distribution
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Bénassy-Quéré, A., Lahrèche-Révil, A., 2003. Trade linkages and exchange rates in
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Chit, M., Rizov, M., Willenbockel, D, 2008. Exchange rate volatility and exports: New
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Clark, P., Tamirisa, N., Wei, S., Sadikov, A., Zeng, L., 2004. A new look at exchange
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Ito, T., Koibuchi, S., Sasaki, Y., Sato, K., Shimizu, J., Hayakawa, K., Yoshimi, T., 2008.
Choice of invoice currency and exchange risk management: Case studies of
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McKenzie, M., 1999. The impact of exchange rate volatility on international trade flows.
Journal of Economic Surveys 13(1), 71-106.
Obashi, A., 2008. Stability of production networks in East Asia: duration and survival of
Poon, W., Choong, C., M. Habibullah, M., 2005. Exchange rate volatility and export for
selected East Asian countries: Evidence from error-correction model. ASEAN
Economic Bulletin 22(2), 144–159.
Rose, A., 2000. One money, one market: The effect of common currencies on trade.
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Thorbecke, W., 2008. The effect of exchange rate volatility on fragmentation in East
Asia: Evidence from the electronics industry. Journal of the Japanese and
International Economies 22(4), 535-544.
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