Long-Run Movements in Real Exchange Rates

Although it is extremely difficult to predict or explain short-run movements in exchange rates, there is strong evidence that long-run movements in nominal exchange rates can be explained to a very significant extent by inflation differentials. There is only a limited understanding, however, of the substantial changes over the long run that many countries have experienced in their real exchange rates, defined as nominal exchange rates adjusted by relative national price levels. Particular interest has been attracted by the substantial real appreciation of the Japanese yen against the U.S. dollar over the past four decades, both before and after the shift from a fixed to a floating nominal exchange rate regime in the early 1970s.²

The usual explanation for the real appreciation of the yen is the so-called Balassa-Samuelson hypothesis. Simply put, this hypothesis states that relatively rapid output growth tends to be associated with more rapid productivity growth in the tradable goods sector than in the nontradables sector, putting upward pressure on the price of nontradables relative to the price of tradables. Under conditions in which the relative price of tradable goods across countries remains approximately constant, such a rise in the relative price of nontradables would lead in turn to real exchange rate appreciation.

The question whether rapid output growth tends to be associated with real exchange rate appreciation in general—that is, whether Japan’s experience extends to other economies—has been an important topic of investigation in conceptual and empirical research on the long-run behavior of exchange rates. Section II addresses this question for the APEC region. The relationship between changes in real exchange rates and per capita GDP for fast-growing APEC economies shows a wide range of experiences over the past two decades (see Figure 2-5). Like Japan, Korea and Taiwan Province of China have shown strong positive correlations between per capita growth and real exchange rate changes. By contrast, Hong Kong, Singapore, and Thailand have experienced high economic growth rates with virtually constant real exchange rates; Indonesia and Malaysia have experienced high growth rates with moderate real depreciations; and China has exhibited rapid growth accompanied by a large real depreciation.

These different combinations of growth and real exchange rate outcomes appear puzzling, but the puzzle can be resolved in terms of two different phenomena. First, the experiences of several APEC economies do not conform to the hypothesis that rapid output growth is associated with an upward trend in the relative price of nontradables to tradables. In particular, while the experiences of most APEC members since the early 1970s are consistent with a positively sloped relationship between the change in the relative price of nontradables and the growth rate of per capita GDP, for Singapore, Malaysia, Thailand, and Indonesia rapid output growth has not been associated with an increase in the relative price of nontradables (see Figure 2-6).³

A second reason that relatively rapid output growth has not always been associated with real exchange rate appreciation is that the relative prices of tradable goods across countries have not been constant over time but, rather, have exhibited long-term trends. The trends in the relative prices of tradable goods may reflect three different phenomena. First, the composition of tradable goods across countries tends to change over time. As economies develop, their production activities generally shift toward more sophisticated technologies and higher-quality products. Thus, to the extent that price indices for tradable goods are constructed from unit-value data or are not fully adjusted for quality changes, the influence of economic development on the composition of tradable goods is likely to be reflected in gradual trends in the relative prices of tradables across countries. Second, trends in the relative prices of tradables across countries may also reflect trends in the terms of trade among different categories of tradable goods interacting with cross-country differences in price-index weights. Third, changes may have occurred over time in the costs of “goods arbitrage,” reflecting the liberalization of trade and foreign exchange restrictions, reductions in transportation costs, or changes in other components of the costs of market penetration.⁴ In this regard, the liberalization of trade and payments restrictions has been an important phenomenon for several APEC members during recent decades.

Empirical analysis suggests that policy-related questions about long-run equilibrium exchange rates do not have simple answers. To begin with, the evidence of trends in the relative prices of tradable goods across countries—presumably related in large part to permanent changes in the composition of tradable goods or persistent changes in the terms of trade between different tradable goods—suggests that the notion of a long-run equilibrium exchange rate cannot reasonably be defined in terms of a constant purchasing-power-parity (PPP) level for tradable goods. Second, even if aggregate price indices for tradable goods behaved in a manner broadly consistent with long-run PPP, the notion that equilibrium real exchange rates are related to per capita GDP levels in a stable manner would be undermined by evidence of the widely different patterns of change that rapidly growing APEC members have experienced in the relative domestic prices of their nontradable goods.

Questions about appropriate exchange rates in the short-to-medium run, which are also difficult to answer, are not addressed in this study. It is worth emphasizing, however, that—despite the wide range of real exchange rate experiences among the rapidly growing APEC members over the past two decades—it is generally true that rapidly growing economies may often encounter circumstances in which, over a short-to medium-run horizon, policies of allowing greater upward flexibility in nominal and real exchange rates are conducive to preserving or achieving the macroeconomic objectives of internal and external balance.

In addition, in its analysis of the long-run behavior of real exchange rates, Section II abstracts from the possible influences of government policies on the relative domestic price of nontradables and the relative price of tradables across countries. It is clear that such relative prices are affected by changes in the composition of government demand and other fiscal policies, changes in the stances of monetary and exchange rate policies, and various external and internal liberalization measures.

International Trade and Real Exchange Rates

The rapid growth of a number of APEC economies has been widely associated with export expansion and a shift of factors of production into the tradable goods sector. The real exchange rate is a key relative price associated with these structural changes. Section III focuses on the effects of both day-to-day exchange rate volatility and more persistent movements in the real exchange rate on foreign trade flows in the APEC region.

Over the past twenty years, the volume of trade of APEC members as a whole has grown at least one and one-half times as much as the volume of trade in the world in general. This growth was particularly rapid in many of the East Asian economies, while most of the slower rates of growth have been experienced in the more mature economies, paralleling the behavior of real output growth. The type of goods traded also varies significantly among APEC members (see Figure 3-1). Several economies have trade that is heavily concentrated in primary goods (Australia, Chile, New Zealand, and Papua New Guinea). By contrast, the exports of China, Hong Kong, Japan, Korea, Taiwan Province of China, and the United States are highly specialized in manufactured goods. A number of economies, including much of East Asia, fall into an intermediate category, in which exports were predominantly primary goods in the early 1970s but have become more heavily concentrated in manufactured goods over time.

The openness of the various economies in the region to trade (measured as the ratio of the average of nominal merchandise exports and imports to domestic output) also varies widely among APEC members (see Figure 3-3). The two most open economies are Hong Kong and Singapore, which are centers of reexporting to other markets, as is clearly indicated by the fact that average levels of trade often exceed domestic output. At the opposite end of the scale, the shares of trade in output are lowest for Japan and the United States, the two largest economies in the region. In some other economies the ratios increase rapidly over a limited period, possibly reflecting the impact of trade liberalization; a striking example of this phenomenon is the expansion of trade in China in the 1980s.

There are also important trends within the region regarding intraregional trade. In 1993 approximately two-thirds of all merchandise trade from the APEC region (excluding China, Papua New Guinea, and Brunei Darussalam, where appropriate historical data were not available) went to other economies in this area, up from just over half in 1974. The increase in intra-APEC trade largely reflects the rapid economic expansion of many of the Asian members. The proportion of regional merchandise exports coming from East Asia increased from around 20 percent in 1974 to over 30 percent in 1993. With the important exception of Japan, the East Asian countries have also generally increased the proportions of their imports that they receive from APEC. The most striking feature of these data, however, is the increase in APEC exports going to the United States during the mid-1980s, as the dollar appreciated, and the subsequent reversal of this increase (see Figure 3-4). The appreciation of the U.S. dollar clearly had a significant, if temporary, impact on regional trade patterns.

Bilateral trade patterns also show some interesting features, largely revolving around the United States and Japan (see Figure 3-5). Japan’s export share is significantly larger than Japan’s import share in trade with both the United States and the newly industrializing Asian economies (NIEs)—Hong Kong, Korea, Singapore, and Taiwan Province of China—a pattern that is repeated for the NIEs in trade with the United States. Hence, the NIEs generally have a triangular trading relationship, being net importers from Japan and net exporters to the United States. A similar, although less strong, pattern is true of other Asian economies as a bloc.⁵ By contrast, the South Pacific economies⁶ have the opposite triangular arrangement, being net importers from the United States and net exporters to Japan. Finally, the other American economies⁷ have trade that is dominated by bilateral ties with the United States.

The triangular trading relationship of the NIEs, other Asian, and Pacific economies makes their economies particularly susceptible to changes in the yen-dollar exchange rate. For example, an appreciation of the yen against the dollar (compared with trend) tends to generate a rise in the prices of imports compared with prices of exports for those countries that are net importers from Japan and net exporters to the United States (a depreciation of the yen against the dollar has the opposite effect). The effects of these movements in the terms of trade, however, could be mitigated by these countries’ competition against Japanese goods in the U.S. market. In any case, changes in the yen-dollar exchange rate can have important economic implications for other countries in the region.

The level of the exchange rate has played a central role in empirical work on trade, where volumes of exports and imports are usually related to changes in relative prices and to changes in real activity either at home (for imports) or abroad (for exports). Such equations have proven to be highly successful empirically, and they have consistently been used in policy work and macroeconomic models. Some new empirical estimates of real exchange rate elasticities for the APEC economies are reported in Section III. They indicate that the standard empirical model of trade appears to work fairly well for the APEC region, a conclusion that is supported by similar work on the region by others. More specifically, the results indicate that, for the average APEC economy, a sustained 1 percent depreciation in the real exchange rate reduces import volumes by about ½ of 1 percent and raises real exports by about ¾ of 1 percent.

These responses are sufficiently large to ensure that the nominal trade balance improves. The improvement in the trade balance, however, may become apparent only after a year or two. This is because the impact of a change in the real exchange rate on trade volumes increases significantly over time, which is a standard empirical result.

Given the large differences in openness and the importance of trilateral trading relationships in the APEC region, it is of interest to consider the likely effects on trade of changes in the real exchange rate between the dollar and the yen, the two key currencies in the region. Highly stylized estimates of the impact of bilateral changes between the U.S. dollar and the yen on the one hand and other regional currencies on the other indicate that the economies of the region can be divided into three categories. Canada and Mexico are relatively sensitive to changes in the real value of the U.S. dollar while being fairly insulated from movements in the yen. The extremely open economies of Hong Kong and Singapore are highly sensitive to changes in the real values of both the U.S. dollar and the yen, as is Malaysia. Finally, the vast majority of economies in the region are also dependent on both exchange rates, but to a rather lesser extent than Hong Kong, Malaysia, and Singapore.

Apart from analyzing the effects of sustained changes in the value of the exchange rate, a number of studies have looked at the connection between the day-to-day volatility of the exchange rate and the level of trade. The results from these studies have varied quite widely—with a few finding significant effects from volatility, but with most finding little or no impact. The latter result is particularly true in some of the more recent work using larger data sets. Overall, the evidence appears to point to a small direct effect of exchange rate volatility on trade volumes.

This observation appears at odds with concerns often expressed by business people about floating exchange rates. One explanation may be that higher short-term volatility has been associated with larger, and more persistent, exchange rate misalignments. Such misalignments clearly involve substantial economic costs; for example, an appreciation of a currency can produce significant dislocation for both exporters and import-competing sectors and can increase protectionist pressures. Another explanation could be that in many cases floating exchange rates may have been associated with more unstable macroeconomic policies. Such indirect influences, which are unlikely to be captured in econometric studies that relate exchange rate volatility to trade volumes, may also help to explain the dichotomy between the empirical evidence and the widespread concerns about exchange rate volatility among policymakers.

To summarize the main policy conclusions of Section III, day-to-day volatility of exchange rates does not appear to be a major direct impediment to trade in the APEC region. More sustained movements in exchange rates from year to year, however, do have a significant impact on trade volumes and on the nominal trade balance, although in the latter case the effect may only become apparent after a year or two. Given the joint importance of the United States and Japan in the trade patterns of most other countries in the region, movements in either of the major regional currencies can have a significant impact on trade and activity of the other APEC economies. Finally, the trilateral trading pattern of many of the APEC economies further complicates this situation, as movements in the bilateral rate of the U.S. dollar against the yen also create changes in the relative prices of exports and imports. Changes in the yen-dollar exchange rate can therefore have important implications for the economic welfare of other countries in the region.

Foreign Direct Investment and the Exchange Rate

FDI has become an important source of fixed investment in developing countries and technological transfers from industrial to developing countries. Unlike portfolio investment, which may be withdrawn quickly, FDI is thought to involve a long-term commitment from investors and to be unambiguously beneficial to host countries, contributing to higher rates of long-run growth.

Section IV focuses on FDI and its sensitivity to the exchange rate in the APEC economies. FDI represents the foreign acquisition of a controlling claim on domestic enterprises or land, or further investment in an enterprise that is controlled.⁸ It is the word “controlling” that distinguishes FDI from foreign portfolio investment, the other subcategory of private foreign investment.⁹ World FDI has grown more rapidly than that of world output or world trade during the past two decades, making it an increasingly important economic link among countries. Several of the APEC economies have been among the fastest-growing hosts of worldwide FDI.

The APEC economies have had varied experiences with inflows and outflows of FDI (see Figure 4-1). In many of the developing economies there has been a clear underlying increase in inward flows of FDI over time, reflecting factors such as high potential returns caused by long-term shifts in productivity, policies of capital account liberalization, and long-term movements in real exchange rates. By contrast, industrial countries such as Canada, Australia, and New Zealand show no clear trend, presumably reflecting their long tradition of foreign ownership and open capital accounts associated with exploitation of their natural resources. The evidence also shows that there has been significant year-to-year variability of FDI inflows around their underlying trends. Inflows to the United States, for example, rose significantly in the mid-to-late 1980s but fell in the early 1990s. FDI outflows show a similar level of variability. A detailed look at FDI outflows from the United States and Japan, the two most important providers of FDI to the APEC region, further reinforces this conclusion.

These patterns point to the need to explore the role of cyclical factors, such as changes in the exchange rate, as determinants of FDI. Before doing so, however, it is useful to consider the underlying determinants of FDI more generally. The main task involved is explaining why investors need to acquire a controlling interest in a foreign country, rather than simply holding a passive claim—a portfolio share—on that country’s output or supplying the market through international trade. One explanation is that multinational firms find it cheaper to expand directly in a foreign country because many of their cost and product advantages rely on internal, indivisible assets such as organizational and technological know-how. Government policies are another major explanation for FDI. Tariffs, quotas, taxes, and subsidies can all create conditions under which it is more (or less) profitable to produce in—rather than export to—a foreign country, a motivation for FDI that is often labeled “tariff-jumping.” Empirical evidence supporting these factors as determinants of FDI is ample. The relationship between FDI and trade has also received some attention. Sometimes FDI is seen as a substitute for exports, with local assembly replacing foreign-produced goods, while in other cases FDI is viewed as a complement to exports through its role in building local distribution networks and other facilities in host economies. However, none of these theories is particularly helpful in explaining the behavior of FDI over shorter horizons or across countries that exhibit similar characteristics. Exchange rates, as main determinants of the relative price of domestic and foreign goods and production factors, are prime candidates for this task.

Among the suggested links between the real exchange rate and FDI, the effect of exchange rate changes on domestic costs and asset prices has received the greatest attention. An exchange rate depreciation lowers the cost of domestic production and assets, making investment in the domestic economy more attractive to foreign investors. In addition, a depreciation of the real exchange rate also increases the relative wealth of foreign firms, making it easier for foreign firms to use cheaper internal financing to buy domestic assets. When considering the effect of exchange rate changes on FDI coming through government policy, an opposite relationship with regard to the real exchange rate can emerge. To the extent that exchange rate depreciations improve a country’s trade balance, they may soften protectionist policies and, with it, reduce the incentive for tariff jumping. Further ambiguities arise when going beyond the examination of the effects on FDI of exogenous shocks that cause exchange rates to fall below their long-run trend. Indeed, exchange rates are themselves endogenous variables that respond to a variety of shocks.

Despite these sources of potential ambiguity, several studies (largely on industrial countries) have provided empirical evidence that exchange rate depreciations boost FDI inflows. New empirical work presented in Section IV, which focuses specifically on the APEC region, supports this hypothesis. More specifically, the results indicate that in the average APEC economy a 10 percent appreciation in the real effective exchange rate lowers inflows of FDI by almost ¼ of 1 percent of GDP, a significant proportion of the underlying inflows into most economies. Results are also reported that differentiate flows of FDI from the United States and from Japan to other members of APEC. They provide some preliminary evidence that FDI flows from these two economies may behave somewhat differently with respect to the real exchange rate, with investment from the United States being less dependent on changes in the real exchange rate than the corresponding flows from Japan. This suggests that the factors behind U.S. and Japanese FDI to the rest of the APEC region could be rather different, although more research would be required to sustain such a conclusion.

Attention has also been devoted in the current empirical literature to the effects of greater exchange rate volatility on FDI. Empirical evidence on the link between exchange rate volatility and FDI is limited, but it tends to favor a positive link between exchange rate volatility and FDI inflows. In response to greater exchange rate risk, multinationals appear to increase foreign investment in a country and to reduce exports somewhat.

FDI has increased rapidly over the recent past, and it now represents an important international linkage between members of APEC. Most of the factors affecting underlying levels of FDI flows are strategic, as befits an activity that is long term in nature. This does not mean, however, that short-term factors such as exchange rate fluctuations have no role. As in the case of international trade, there is considerable evidence that changes in the real exchange rate significantly influence movements of FDI compared with trend, with depreciations being associated with increased inflows. Real exchange rate variability may well also increase FDI, although the empirical relationship is less firmly established.

Concluding Perspectives

This Occasional Paper sheds new light on the connection between the dynamism of the APEC economies (in terms of growth in output, trade, and investment) and the behavior of exchange rates. The direction of causality between the exchange rate and economic performance, however, is notoriously difficult to identify; accordingly, care should be taken in using the findings presented here to make policy recommendations. Nevertheless, some general conclusions emerge.

First, countries that have experienced long-term trend appreciations without balance of payments problems have been successful economically, implying that such appreciations are one possible sign of economic success. The converse, however, does not generally hold. In particular, the assumption that high economic growth is associated with long-term real exchange rate appreciations, as high productivity growth in the traded goods sector causes a rise in the price of nontraded goods in comparison with that of traded ones, is found not to be generally true for the APEC region.

Second, for economies facing long-term exchange rate appreciations, it appears unwise to resist the associated nominal exchange rate pressures because the real appreciation will then simply come through higher domestic inflation, with potentially detrimental effects on trade, investment, and growth.

Third, the level of the exchange rate is clearly important for trade and FDI. To the extent that macro-economic policies and the choice of nominal exchange regime influence the real exchange rate, such policies should ensure that the exchange rate is not allowed to become misaligned.

The diverse levels in economic development among the APEC economies provide a useful sample for looking at the macroeconomic role of exchange rates. Beyond the parameters of the present study, there are various issues that could be examined further, such as identifying the structural characteristics associated with long-term real exchange rate trends and the extent to which the behavior of FDI differs among economies, in particular between the United States and Japan. These tasks are left for future research.