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Chapter 3. Global Trade and Relative Prices: A Sectoral Elasticities Approach

Author(s):
Nagwa Riad, Luca Errico, Christian Henn, Christian Saborowski, Mika Saito, and Jarkko Turunen
Published Date:
January 2012
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A highly disaggregated sectoral level approach is used to examine the impact of relative price changes on trade flows and structures. The impact of such macroeconomic policies is often analyzed at the level of the overall economy or for highly aggregated sectors, using multicountry computable general equilibrium (CGE) models that rely on modeling complex interactions among a large number of variables in various economies. As a complement to such analysis, a simple model that combines a partial equilibrium approach with input-output table analysis is used here to analyze the response of sectoral trade flows to changes in relative prices.21 The framework models the impact of a hypothetical change in relative prices in two steps. The first step focuses on the import market of each economy. Changes in relative prices result in demand responses and shifts in the structure of trade at the product level, reflecting differences in import demand and substitution elasticities as well as the amount of imported intermediate inputs used in the production of exports.22 The second step of the analysis uses input-output tables to determine the change in the composition of import demand as a result of the shift in the structure of exports (as determined in the first step). Appendices 5 and 6 provide details on the methodology.23

The greater product detail and transparency of this modeling approach comes with a cost. Our approach offers two key advantages. First, by allowing for a high level of product detail, the aggregation bias implicit in CGE models using aggregate trade flows is avoided. The high level of sectoral detail allows reactions to relative price changes to vary across goods and countries. The model thus provides a useful framework for analyzing sectoral and supply chain linkages in international trade. Second, the model is simple and transparent in its assumptions allowing the flexibility to adjust the key parameters, including accounting for the effect of global supply chains on the response of trade flows. On the downside, each product is modeled as a separate market and in isolation from other markets, and inter-and intrasectoral linkages or economy-wide impacts of changes in relative prices that are likely to take place are not fully captured. These limitations need to be kept in mind when examining the model’s predictions at the aggregate level.

The simulations focus on the four key players in global trade. The analysis essentially focuses on the impact of a change in relative prices in China and the United States on their trade structures, by assuming an exogenous 10 percent increase in relative prices in the former and a similar decline in the latter. The increase (decrease) in relative prices can be interpreted as a real appreciation (depreciation) against all trading partner currencies. The direction of change in relative prices in each country is consistent with policy recommendations to reduce global imbalances through a lower current account surplus in China and deficit in the United States (Blanchard and Milesi-Ferretti, 2009). For purely illustrative purposes, we also assume a 10 percent relative price increase in the euro area and a similar decline in Japan. The baseline for the analysis is 2008, being a largely precrisis year.24

A. Aggregate Results

Changes in relative prices result in sizable long-term responses in trade flows and rebalancing effects. Table 6 presents a summary of the results under different assumptions of pass-through of exchange rates to import prices. Assuming full pass-through in the long run, the results suggest that a 10 percent depreciation for the United States would result in a 14 percent expansion in exports and a 7 percent contraction in imports. Together these translate into a 40 percent improvement in the trade balance and roughly a halving of the U.S. current account deficit-to-GDP ratio. These results are broadly consistent with findings by Obstfeld and Rogoff (2005) and Dekle, Eaton, and Kortum (2007), among others, suggesting that a 20 percent fall in relative prices in the United States would be sufficient to close the current account deficit. The results for China suggest that a 10 percent real exchange appreciation would lead to a 50 percent reduction in its merchandise trade surplus.25

Table 6.Simulated Long-Term Impacts of Relative Price Shocks on External Balances Based on 2008 Trade(Percent of national GDP, unless otherwise noted)
Post-shock1Simulated impact

(Percent change)
PreshockPerfect

pass-through
Imperfect

pass-through2
Perfect

pass-through
Imperfect

pass-through2
Simulation 1: China (Assumption: 10 percent appreciation)
Current Account Balance9.65.97.1
o/w Merchandise Trade Balance8.04.25.4
Exports31.728.930.0–10.9%–7.7%
Imports–23.8–24.7–24.61.7%1.3%
Simulation 2: Euro Area (Assumption: 10 percent appreciation)
Current Account Balance–1.7–4.7–3.9
o/w Merchandise Trade Balance–0.6–3.6–2.8
Exports317.015.115.7–12.7%–8.9%
Imports3–17.5–18.6–18.54.5%3.7%
Simulation 3: Japan (Assumption: 10 percent depreciation)
Current Account Balance3.26.35.6
o/w Merchandise Trade Balance0.83.93.2
Exports15.317.516.717.0%12.0%
Imports–14.5–13.5–13.5–4.5%–4.5%
Simulation 4: United States (Assumption: 10 percent depreciation)
Current Account Balance–4.7–2.4–3.3
o/w Merchandise Trade Balance–5.8–3.5–4.4
Exports9.110.29.913.7%10.4%
Imports–14.9–13.8–14.3–6.7%–2.7%
Memorandum items (in billions of U.S. dollars):
Nominal GDP4
China4,5204,417
Euro Area13,61613,374
Japan4,8874,992
United States14,36914,519
Sources: IMF, World Economic Outlook database, Direction of Trade Statistics, and staff estimates.

A downstream position in a supply chain is likely to cushion the impact of a relative price change on both exports and imports. The response of Chinese exports to a 10 percent exchange rate appreciation is smaller in absolute magnitude compared to that of Japanese exports to a 10 percent exchange rate depreciation. To a large extent, this result reflects China’s downstream position in the Asian supply chain and the relatively high share of foreign intermediates that mitigate the impact of exchange rate changes on its exports. The large foreign share in Chinese final exports also implies that import growth is relatively small: a given decline in exports leads to a larger decline in intermediate imports. On the other hand, the relatively large impact on Japanese exports is driven not only by Japan’s upstream position in the supply chain but also by its strength in exports of consumer discretionary goods such as vehicles and transport equipment with low foreign content and high price sensitivity.

Imperfect exchange rate pass-through to import prices and pricing-to-market are likely to mitigate the adjustment in trade flows to exchange rate changes.26 In reality, trading firms absorb part of the exchange rate changes rather than pass them on to importing consumers. In particular, in trading relationships with flexible exchange rate regimes, exporters may delay price adjustments given the possibility of an unwinding of the initial exchange rate shock. Exporters may also be pricing-to-market, in which case the change in relative prices would not be (fully) reflected in import prices. As shown in Table 6, accounting for less than perfect pass-through reduces the exchange rate impact on both exports and imports in all simulations significantly.27

Overall, the results for advanced economies are in line with historical responses of trade flows to exchange rate changes (Box 7).

Adjustment in trade flows is also likely to be gradual given high fixed costs in production and trade relationships. Fixed production costs and constraints to factor mobility make it burdensome and often unprofitable to move production facilities across countries once they are established. Furthermore, there is a large and growing literature outlining the high fixed costs of establishing export relationships, such as costs of establishing distribution networks or adapting to local regulations (Freund, 2009). On average, the analysis suggests that about half of the long-run adjustment in trade balances in response to a real exchange rate appreciation would materialize within the first 2 years, and 80 percent within 6 years.28

B. Sectoral Effects

An appreciation results in an increase in the share of high-technology exports in China and to a lesser extent in the euro area. In China, the share of machinery and electronics (a high-technology sector) in overall exports increases in response to the appreciation, whereas that of textiles (a low-technology sector) falls. This result reflects both limited price sensitivity of high-technology goods, which are typically more differentiated (Rauch, 1999), and the larger contribution of imported intermediate inputs (Figures 19 and 20).29 It suggests that an appreciation would support a continued upgrading of Chinese exports in terms of technology content and reduce the reliance on low-skill manufacturing. This may also lead to increasing convergence with advanced countries’ exports in terms of quality (Schott, 2004). Box 8 further illustrates the impact on the Chinese export structure under an alternative assumption that other supply chain countries also allow their currencies to appreciate. The qualitative results remain broadly unchanged. On the other hand, the response in the euro area is more muted, reflecting the lower contribution of FVA in high-technology exports.

Figure 19.Exports by Section: Percent Change and Share

Sources: UN Comtrade; and IMF staff estimates.

Figure 20.Responses of Exports by Technology Content

(Percentage point change in share)

Sources: UN Comtrade; and IMF staff estimates.

A depreciation results in important shifts in the share of medium-high-technology exports in Japan and the United States, largely driven by the auto sector. Medium-high-technology exports are generally more sensitive to relative price changes, reflecting both higher DVA and the largely discretionary consumer character of this sector, which is subject to higher income elasticities. In Japan, where the transport sector accounts for a sizable share of overall exports (23 percent in 2008), a depreciation would reinforce its comparative advantage in medium-high-technology exports. In fact, Japan’s relative specialization in the motor vehicles subsector would exceed that of France, Germany, and Spain, which had overtaken Japan after 1995 (Box 9). The response in the United States is relatively more muted given the higher FVA in its auto sector compared to Japan—26 percent versus 13 percent, respectively.

Box 7.Impact of Exchange Rate Changes and Trade Flows—A Historical Perspective

The simulation results are broadly consistent with responses observed during historical episodes of exchange rate changes. A dynamically adjusted REER (DAREER) is used to account for the gradual realization of the impact on trade flows of changes in the real exchange rate. There are several reasons why trade flows would only respond gradually to exchange rate changes. Export relationships are costly to establish and production facilities are hard to redeploy in the short run. In the case of an appreciation, exporting firms may initially attempt to maintain market share at the cost of profits until cost savings can be realized, or a hoped-for offsetting exchange rate movement takes place.

A simple autoregressive model is used to trace the dynamic adjustment of trade flows to exchange rate shifts, based on the relationship between short-run and long-run elasticities. Following Goldstein and Khan (1985) and Senhadji and Montenegro (1999), the ratio of long-run to short-run impact is in the range of 2 to 5. A midpoint of 3 as the key parameter determining the speed of adjustment is thus used as a reasonable ratio for likely outcomes. This implies that a third of the impact of 10 percent change in the REER would manifest in the first year of the shock, with the remaining impact (6.5 percent) unfolding asymptotically (Box Figure 7.1). The DAREER is thus a weighted average of realized REER shocks, with weights obtained as shown in Box Figure 7.1 and more recent shocks given higher weights.

Box Figure 7.1.Pass-Through of 10 Percent Shock in REER per Year

Source: IMF staff estimates.

Note: Chart assumes a ratio of long-run to short-run pass-through of 3 in a first-order autoregressive model.

The DAREER has historically been less volatile compared to the unadjusted REER, given that exchange rate fluctuations in proximate years often offset each other (Box Figure 7.2). The analysis focuses on the United States and Japan, given their flexible exchange rate regimes and availability of long time series, but for expositional brevity, only the results of the United States are discussed.

Box Figure 7.2.United States

Sources: IMF, Information Notice System (INS), and staff estimates.

The historical analysis confirms the negative relationship between external balances and movements in the DAREER (Box Figure 7.3). For the United States swings of 10 percent or more in the DAREER were relatively infrequent; the DAREER exhibited only two long waves of appreciation and depreciation since the 1980s, with attendant worsening and improvement in trade and current account balances.

Box Figure 7.3.US DAREER and External Balances

Sources: IMF, World Economic Outlook database, INS, and staff estimates.

The historical response of external balances to changes in the DAREER is closely aligned with the simulation results. Box Table 7.1 presents results based on peak-to-trough analysis of changes in external balances and the DAREER. Peak-to-trough analysis is based on 2-year averages because the DAREER for the United States moved only gradually. On average, the trade balance improved (deteriorated) by 0.17 percent of GDP for every percentage point depreciation (appreciation) of the DAREER. These values are close to the simulation results suggesting a 1.4 percentage point of GDP improvement in the trade balance in the United States in response to a 10 percent real depreciation (assuming partial pass-through).

Box Table 7.1.Response of External Balances to Exchange Rate Changes: Historical and Simulation
Historical episodes
United Statesfrom

to
1982–83 1986–871986–87 1991–921994–95 2000–012005–06 2008–09MeanSimulated

Scenario1
Change in dynamically adjusted REER (percent)9.7–14.610.9–7.7–10.0
Current account adjustment (percent of GDP)–2.73.0–2.41.91.4
Ratio: CA change/DAREER change–0.3–0.2–0.2–0.3–0.2–0.1
Trade balance adjustment (percent of GDP)–1.81.9–1.91.51.4
Ratio: TB change/DAREER change–0.2–0.1–0.2–0.2–0.2–0.1
Sources: IMF, World Economic Outlook database, and staff estimates.

Box 8.Appreciation within the Asian Supply Chain

Alternative simulation. Regional integration in Asia suggests that an appreciation of the Chinese nominal exchange rate is likely to result in revaluations of other regional currencies. An appreciation along the Asian supply chain would result in a further increase in prices of Chinese exports through higher costs of imported intermediate inputs, potentially contributing to lower exports and further global rebalancing.1 The alternative simulation therefore reflects the trade impact of changes in relative prices stemming from a 10 percent appreciation in the Chinese nominal exchange rate and a concurrent 5 percent appreciation of the nominal exchange rates of countries in the Asian supply chain.2 The aggregate results are presented in Box Table 8.1.

Box Table 8.1.China: Baseline and Alternative Simulations1
Simulated impact
(percent change)
BaselineAlternative
Exports–10.9–10.2
Imports1.71.3
Sources: UN Comtrade; and IMF staff estimates.

Additional effects on Chinese exports. There are three additional effects on Chinese exports compared to the baseline simulation. First, imported intermediate inputs from upstream supply chain partners become more expensive, making Chinese exports based on processing trade more expensive and contributing to lower exports. Second, Chinese exports to countries in the Asian supply chain become less expensive and therefore exports to these countries decline less. Finally, higher import prices from countries in the Asian supply chain lowers overall imports in third markets through the income effect, leading to a larger decline in exports from China, whereas substitution between importing countries results in a smaller decline in exports from China.3

Box Figure 8.1.Exports to Supply Chain Countries

(Percent change)

Sources: UN Comtrade; and IMF staff estimates.

Supply chain effects on Chinese exports. The additional appreciation amplifies the role of the region as a destination for Chinese exports (see Box Figure 8.1). Exports to the Asian supply chain countries—including Hong Kong SAR and Korea among the top 10 largest export destinations—decline substantially less compared to the baseline scenario. Despite higher export prices, the decline in Chinese exports to the rest of the world, including to Japan, is not significantly higher compared to the baseline simulation.

Box Figure 8.2.Exports by Technology Content

(Percent change)

Sources: UN Comtrade; and IMF staff estimates.

Sectoral effects. Despite the larger share of imported intermediate inputs in Chinese exports of high-technology sectors, the alternative simulation does not fundamentally change the picture of an upgrading in Chinese exports in terms of their technology content (see Box Figure 8.2). As in the baseline simulation, exports of high-technology goods decline the least, resulting in a further increase in their share in total exports (especially for machinery and electronics exports).

Aggregate effects and rebalancing. The aggregate effects on Chinese trade are somewhat smaller than in the baseline simulation (Box Table 8.1). For exports, the gain from more exports to Asian countries and relative competitiveness gains in third markets outweigh the loss from higher export prices resulting from higher prices of imported intermediate inputs. Overall, the alternative simulation suggests a 3.6 percentage point fall in the Chinese current account surplus (compared to 3.8 percent in the baseline). The smaller decline reflects less rebalancing vis-à-vis the supply chain countries, with limited additional rebalancing impact with the rest of the world. Exports to euro area countries fall somewhat more (by 12.4 percent instead of 12 percent in the baseline), whereas the impacts on Chinese exports to Japan and the United States are similar to the baseline simulation.

1Thorbecke and Smith (2010) estimate that an appreciation of the renminbi and other east Asian currencies by 10 percent would result in a decline in processed exports by 10 percent (compared to a fall of only 4 percent if the renminbi appreciates alone).2 Countries in the Asian supply chain are: Hong Kong SAR, Indonesia, Republic of Korea, Malaysia, the Philippines, Singapore, Taiwan Province of China, Thailand, and Vietnam.3 Although this box focuses on exports, imports to China can also change. First, imports from Asian supply chain countries become more expensive, resulting in a smaller increase in Chinese imports. Second, a smaller decline in Chinese exports has a smaller dampening impact on imports of both intermediate and final goods.

Imports of intermediate goods in the four economies are affected differently by a relative change in prices (Figure 21).30 In China, intermediate goods imports fall by more than 6 percent in response to the appreciation, reflecting the overall decline in exports and its downstream position in the Asian supply chain.31 Similarly, a depreciation of the yen would lead to an increase of more than 3 percent in Japan’s intermediate goods imports, reflecting the significant expansion on the export side. In the United States, however, a depreciation of the dollar would lead to a drop in imports of intermediates because exports would not react as much as in Japan. A similar effect is visible in Europe: the assumed appreciation of the euro would result in a net increase in import of intermediates because exports do not react as much as in China or Japan.

Figure 21.Import Responses by Type of Good

(Percent)

Sources: UN Comtrade; and IMF staff estimates.

Exports to supply chain partners are resilient to relative price changes but suppliers of intermediates can be impacted severely when exports fall in response to exchange rate appreciation. Figure 22 presents simulated export changes by destination as well as import changes by origin for each simulation, highlighting supply chain partners. For all four simulations, exports to supply chain partners are affected less by relative price shocks.32 This could reflect two interrelated factors. First, the cost of breaking up a trade relationship may be particularly large in a supply chain, which would express itself in lower substitution elasticities in supply chain countries.33 Second, our simulation countries are dominant players in their regional supply chains in terms of both the volume and the value of their exports going to these destinations. This makes substitution for their trading partners more difficult. It is important to bear in mind, however, that supply chain partners are more strongly affected than other trading partners to the extent that they export a high share of intermediates to the hub country. A large exchange rate shift will not only result in a significant response of exports but also of the intermediate goods imports used in their production.

Figure 22.Responses of Exports and Imports: Supply Chain vs. Rest of World

(Percent change)

Sources: UN Comtrade; and IMF staff estimates.

Note: BGR, Bulgaria; CAN, Canada; CHN, China; CZE, Czech Republic; DNK, Denmark; GBR, United Kingdom; HKG, Hong Kong SAR; HUN, Hungary; IDN, Indonesia; IND, India; JPN, Japan; KOR, Republic of Korea; LTU, Lithuania; LVA, Latvia; MEX, Mexico; MYS, Malaysia; PHL, Philippines; POL, Poland; ROM, Romania; ROW, rest of world; SGP, Singapore; SWE, Sweden; THA, Thailand; TWN, Taiwan Province of China; VNM, Vietnam.

Box 9.Revealed Comparative Advantage (RCA) Analysis in Japan

The impact of the depreciation on the transport sector can be further gauged through the RCA index. The RCA index is a complementary construct to the ESI and measures the extent to which a country specializes in a certain product relative to other countries exporting the same product. The RCA therefore gives an indication of the products/sectors in which a given country has comparative advantage (to the extent that trade patterns internalize intercountry differences in relative costs as well as noncost factors). As shown, Japan regains part of its comparative advantage after the exchange rate change, driven by changes in the motor cars subsector.

Box Figure 9.1.Impact of a 10 Percent Japanese Depreciation on the Country’s Revealed Comparative Advantage (RCA)

Sources: UN Comtrade; and IMF staff estimates.

Trade balance adjustment in response to exchange rate changes takes place mainly outside the supply chain. In response to an appreciation exports to supply chain partners fall by less than exports to the rest of the world. At the same time, imports from the supply chain countries increase less than imports from the rest of the world. Taken together, this implies that trade balance adjustment in response to a relative price change is weaker within the supply chain than outside it (Figure 23).

Figure 23.Contribution to Adjustment in Trade Balance

(Percent)

Sources: UN Comtrade; and IMF staff estimates.

Data on imports at the six-digit level is used for the full set of 162 countries available in UN Comtrade.

These exchange rate changes are assumed to be entirely exogenous without regard for the origin of the shock and any other implications this shock may have on macro variables and trade balances. The analysis also abstracts from any potential possible responses to the exogenous shock.

The model is based on two sets of micro-level trade elasticities with a high level of product detail (demand elasticity: HS six-digit; substitution elasticity: HS two-digit). For each import market and for a hypothetical increase in relative prices, the exporter substitution effect (between suppliers) quantifies the extent consumers switch demand away from country A toward countries producing the same good. The demand (income) effect then quantifies the extent to which the importing country reduces its import demand overall, given that it now faces higher international price levels. Because our country sample covers nearly all of world trade, changes in the level and the composition of every country’s export basket can be determined on the basis of changes in trading partners’ imports.

The financial crisis caused trade flows to contract disproportionately in 2009 and thus is likely to provide a distorted picture of long-run structural patterns. At the same time, earlier years such as 2006–2007 may be distorted by the oil and food price surges.

The aggregate impact on China’s exports is on the lower side of the spectrum of results typically found in the literature. Ahmed (2009) shows that exchange rate appreciation dampens Chinese export growth, both for nonprocessed and processed exports, with the estimated cumulative price elasticity being greater than unity. Thorbecke and Smith (2010), using dynamic ordinary least squares estimation and quarterly data over the 1993–2008 period, argue that a 10 percent appreciation of the renminbi alone would reduce processed exports by 14 percent.

Pass-through analysis is based on results by Campa and Goldberg (2005) estimating exchange rate pass-through to be about 0.6 in the short run and 0.75 in the long run (amidst significant cross-country variation). Interestingly, their results showed the lowest pass-through elasticity to be observed for the U.S. import market (0.25 in the short run and 0.4 in the long run), suggesting a potentially more limited impact on the U.S. trade balance from exchange rate changes.

This implies that a bigger change in the nominal exchange rate would be needed to generate a 10 percent shift in international relative prices.

Adjustment paths for external balances are derived based on the relationship between short-run and long-run elasticities suggested by the literature, which tend to vary between 2 and 5 (Goldstein and Khan, 1985; Senhadji and Montenegro, 1999).

Supply chain analysis in Chapter 2 has shown that foreign content tends to be highest in the high-technology sector.

Note that in response to an exchange rate depreciation, the demand for imports falls as a result of imports becoming more expensive (price effect). At the same time, an increase in exports leads to an increase in both GDP and the demand for imported goods, especially intermediates (demand effect). Although the price effect is substantially larger for consumer and capital goods, the demand effect has a larger impact on intermediates in China and Japan.

Goods classified as “intermediate inputs” are by “product type” and not by “use” as in input-output tables. The former is used to approximate the latter since the latter is not available at the six-digit HS commodity level.

In Japan, the difference in magnitude between the impact on exports to Asian supply chain partners compared to the rest of the world is particularly large. This is driven not only by Japan’s dominant position in the production chain but also its upstream position which results in significant high-technology exports to these partners (which tend to be less responsive).

We also carried out simulations that assume constant elasticities across products and markets. Although less pronounced in this alternative setup, exports to supply chain countries continue to be relatively less responsive to relative price changes. This suggests that in addition to the lower substitution elasticities in supply chain import markets, the dominant market position of our simulation countries is an important reason for the limited responsiveness of exports to the supply chain.

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