> Pascal Lamy’s speeches

> Literature survey on the relationship between exchange rates and trade (WT/WGTDF/W/57)

I am happy to open this seminar which is aimed at fostering dialogue and improving members’ understanding of the economic interface between exchange rates and trade.

During these two days, WTO members will be able to explore and discuss various dimensions of that relationship seen from different angles, whether from the private sector, governments, international organizations or academia.

For a number of reasons, members wanted this debate; I think that, from an institutional perspective, we even need it. The topic is as old as the GATT/WTO system itself, but it has not been discussed within these walls in a long time.

It has to be approached, like the Working Group decided, on the basis of a rational, educative, and fact-based discussion. Reality has to be distinguished from emotions that inevitably arise on this topic, as much here as in other institutions.

In areas where trade intersects with other policies, as is the case with today’s topic, policy-makers should take advantage of our introspection to increase their awareness about the trade impact of their decisions. In this sense, this policy dialogue should lead to a more holistic reflection about how to improve the coherence of financial and trade policies, a message that this institution has carried consistently throughout its history and texts. The presence today of many representatives of non-trade institutions is important in this regard.

Let me develop a few thoughts along these lines.


Realities and perception

Exchange rates are, and have always been, a highly sensitive subject in the WTO.  There is an emotional, cultural — if not moral — dimension attached to it by the trade community, in which the line between reality and perception can become blurry.

This is in part because our community has a limited grasp of the workings of the financial system, and more widely of macroeconomic developments that determine exchange rates. This is also because, as exchange rates are exogenous to traders, some may feel that they are systematically on the receiving end of unwarranted fluctuations. I appreciate the uncertainty associated with some erratic movements of exchange rates can be not only a source of frustration, but also of asymmetric costs, which can distort international competition.

Think about the abruptness of local financial crises and how short-term capital flights may spill over into brutal adjustment of exchange rates — a phenomenon observed during the Asian financial crisis of the late 1990s. For small or medium-sized economies, these are enormous shocks to absorb.  After the recent financial crisis, the sense that the financial sector adjustment in rich economies is destructive for real economies, including that of poorer countries, is very vivid in this institution. Exchange rates are perceived to have been a transmission channel of these shocks.

These concerns have to be acknowledged, even though at times some of them may fall foul of exaggeration.  

However, one should not descend into victimization or moral judgements: exchange rate adjustments are not all evil in themselves; in fact, they often correct macroeconomic, financial or current account imbalances, the persistence of which would be of even greater cost to traders. Trade also brings its well-acknowledged overall benefits to the cost of sometimes painful adjustments; and prices of tradables can be volatile in their own right too. Just consider fluctuations in commodity prices.

So, part of our sensitivity is that the time perspective of exchange rate markets is different from that of real economy producers and traders, who tend to base their own decisions on longer-term parameters, i.e. those governing investment, product development, and exports. This time perspective means that traders have a natural preference for stability and predictability of their policy environment.

Part is also engrained in history, from the gloom and doom of pre-World War II developments, when uncooperative exchange rate depreciations were associated with unilateral protectionist responses to economic depression, mass unemployment, the rise of populism and dark political developments.


The need for a rational debate

The raison d’être of this seminar is to examine the subject in a rational way, and avoid finger-pointing and frustration, which can only influence ill-designed trade policy responses. As often in life, one stands where one sits. One tends to hear more complaints from industries in countries where currency appreciates than from countries where currency depreciates. In a world of global supply chains and an increasing share of imports in exports, one can guess that traditional effects of currency appreciation and depreciation are in part cushioned. Besides, history tells us that at different times, countries may be on both sides of the currency fluctuation spectrum, appreciating at one time and depreciating at another.

The literature survey produced by the Secretariat last year provides some answers to the relationship between exchange rates and trade.

The survey says that, on average, exchange rate volatility has a negative, even if not very large, impact on trade flows. Exchange rate volatility increases commercial risk, introduces uncertainty costs, and can influence the decision whether or not to enter foreign markets. In other words, volatility may affect resource allocation. The extent of these effects depends on a number of factors, including the existence of hedging instruments, the structure of production (e.g. the prevalence of small firms), and the degree of economic integration across countries. For example, it is well reported that exporting firms having access to hedging instruments might be less “sensitive” than those which are subject to external exchange rate fluctuations. As I have already mentioned, the impact of exchange rate fluctuations is also reduced by the presence of imported inputs, which offset the effect of exchange rate changes on the pricing of exports.

To take this further,  a firm which has only one export market and whose export earnings depend on bilateral exchange rates is likely to be more affected than firms that are present in global markets (where upwards and downwards movements of various exchange rates may cancel each other out). Global firms also have the possibility of invoicing in local currency, and the capacity to absorb losses due to exchange rate changes and other factors in profit margins.

All in all, the most “sensitive” firms seem not to be the large ones, but rather the smaller ones. In addition, empirical studies tend to find a more significant effect mainly in the case of trade with close neighbours, in particular in the case of very integrated economies. For example, the 2004 IMF study clearly indicates that exchange rate volatility within the European Union, before the advent of the euro, had a significant impact on relative prices of members.

Exchange rate misalignments, i.e. sustained deviations of nominal exchange rates from their equilibrium value, are also predicted to have short-run effects in models with price rigidities. But the exact impact is not straightforward and depends on the specific characteristics of the economy. This includes, inter alia, the currency in which domestic producers invoice their products and the structure of trade (for example, the prominence of global production networks). On the empirical side, the complexity of the relationship between exchange rate misalignments and trade yields has mixed findings — it is not always clear that misalignments change the system of relative prices of an economy, at least long enough and deep enough to be able to shift resources or have quantity effects.

For instance, a currency undervaluation is sometimes found to have a positive impact on exports, but the presence, size and persistence of these effects are not consistent across different studies. These effects, when they exist, are predicted to disappear in the medium to long-run, unless some other distortion characterizes the economy.


The policy lessons: a need for greater policy coherence

Trade needs exchange rate stability

The problem for business is one of excess volatility — i.e. when exchange rates behave in a disorderly way, and do not adjust to economic fundamentals. Part of the international trading community found in the Bretton-Woods era is a system of orderly adjustment of real exchange rates.  The system, though not ideal, was maintained. But there was a system, providing for a sense of organized governance in the international monetary system. This is what we lack today.


Exchange rates are not a new issue for the GATT/WTO

The IMF and GATT were created in response to a lack of coordination of economic policies during the Great Economic Depression — these new institutions aimed at dealing with trade and exchange rate policies as a matter of common interest, with the introduction of disciplines to avoid competitive devaluations, maintain exchange rate stability, reduce balance of payments crises, and fight protectionism. The international monetary and trading systems were linked from the outset by a coherent set of rules aimed at the progressive liberalization of trade and payments.

GATT Article XV required members to cooperate with the IMF on questions relating to freedom or restrictions concerning exchange and trade. Members are required not to frustrate the intent of the GATT provisions through exchange actions, nor to undermine the provisions of the IMF Article of Agreements through trade actions.

GATT provisions reflected two things: (1) the attachment of the trade community to exchange rate stability; (2) the need for that community to ensure that the trading system is not frustrated by the undisciplined use of exchange restrictions or multiple exchange rates.

These provisions are still part of our rule book. But they have not been interpreted and thus what they mean today, in a WTO and non-Bretton Woods context, remains to be tested. However, the institutional set-up remains very much one of coherence — and not of conflict — between the two systems.

Since the end of the Bretton Woods system, the trading community has consistently asked for greater exchange rate stability and proper adjustments of balance of payments. This was already the case in the 1973 Ministerial Declaration at the opening of the GATT Tokyo Round, as much as in 1994, 20 years later, in the Ministerial Declaration on the Contribution of the WTO to Greater Coherence in Global Economic Policy Making.


Trade policy alone cannot be the answer

Reading again the 1994 text, I am struck by the authors’ wisdom. It emphasizes on the one hand, (I quote) that “greater exchange rate stability, based on more orderly underlying economic and financial conditions, should contribute towards the expansion of trade, sustainable growth and development, and the correction of external imbalances”; on the other hand, Ministers “recognized, however, that difficulties the origins of which lie outside the trade field cannot be redressed through measures in the trade field alone”.

This says that an international monetary system aimed at greater exchange rate stability and correcting imbalances helps expand trade. At the same time, trade measures cannot correct policy imbalances elsewhere, and be an answer to non-trade policy concerns. Tit-for-tat trade measures would be a recipe for protectionist crossfire.

Clearly, with the exception of currency traders, erratic movements of exchange rates are an irritant in today’s trading system. One must acknowledge their influence in trade policy setting, though, not least because exchange rate shifts may increase or weaken the desired or perceived level of protection of domestic operators. Maintaining multilaterally agreed levels of border protection is certainly a legitimate trade policy objective. The desired levels of protection are negotiated by members through long-term commitments — precisely because policies need to set predictable conditions of access for producers and traders.

At the same time, one may wonder whether long-term levels of protection need to be adjusted to short-term fluctuations or even misalignments of exchange rates. As the literature survey seems to indicate, exchange rates may have an influence only in the short-run, not in the long-run unless there are substantial market failures. It leads to the question as to whether long-term border protection should not be considered in the light of the longer-term developments of exchange rates rather than short-term developments. 


The WTO system cannot solve it all

This is why the international community needs to make headway on the issue of reform of the international monetary system. Unilateral attempts to change or to retain the status quo will not work. We need an international monetary system which supports cross-border investment and a better allocation of capital across nations and which “facilitates international trade” — as laid out in the aims of the International Monetary Fund.

What we need is a global monetary system which inspires confidence, offers stability and monitors exchange rates more efficiently. One which provides the means through which global imbalances that may risk endangering stability can be addressed.

Trade cannot become the scapegoat for the pitfalls and drawbacks of the international monetary system, or current non-system. The WTO system, its policies and rules will not be able to solve macroeconomic issues at the heart of the performance of currencies worldwide. WTO rules will not fix consumption or saving patterns at home, they will not solve competitiveness issues of domestic industries, they will not determine domestic interest rates, they will not achieve proper prudential supervision in the financial system.

All these issues require a mix of cooperation in the macro-financial field and proper domestic policies which lie outside the remit of the WTO.  In the current volatile environment, we need to make sure that the WTO system does not crumble under the weight of excessive expectations.

Let us take the opportunity of the next two days, in a constructive and rational way, to increase our knowledge, exchange our mutual policy experiences, and understand better the borders of trade and financial policies. To achieve this through this seminar will be a step in the right direction.

Thank you for your attention.


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