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Impact Of Exchange Rate Fluctuations On International Trade Finance Essay

The demise of Breton wood system was one event of history that opened the gates for freely floating exchange rates. But the effects of the decision are not limited to the theoretical stadium of exchange rate regimes. The freely floating system brought paramount uncertainty into the world financial system. The implications spread to almost all the areas of economic and financial world and are significantly deep rooted.

One of those areas is international trade. Exports and imports of a country are greatly affected by the fluctuations in exchange rate of the respective currency. Moreover, exponential increase in globalization and advancements in communication and transportation have made international trade increasingly essential. MNCs are growing in number and so is the value of international trade.

In short, companies and countries are unable to resist the pressure for going international and participating in the international markets. This gave overwhelming importance to the foreign exchange market since all the trade is to be settled through this market.

Developed countries started working on this very long ago and now they are in a position to reap the benefits of foreign exchange market despite allowing there currencies to float on the basis of market dynamics. There economies are more documented and efficient market hypothesis apply to these markets to a greater degree than the developing world.

Developing countries on the other hand are new to the system and there cultural and deep rooted sentiments didn’t allowed them to work on this issue and leave there currencies un-managed. Effects of exchange rate fluctuations on international Trade of these currencies, is an area where more research is required.

Moreover a comparison to highlight the basic differences in this regard of developed and developing world will be very useful in understanding the issue and will help the developing world to move up the ladder and be called developed world.

Rational for research

Motivation for research problem

The basic motivation for this research is the interest of the researcher in empirical and comparative studies and significance of the issue in today’s world.

Importance of proposed work

Proposed work has its importance in the theoretical as well as empirical areas of the literature. It will be useful for the government policy makers, economists, analysts as well as the MNCs who deal in international transactions. In addition to that, those MNCs who operate in both developed and developing world may find it valuable to understand the theoretical and empirical implications of the issue and the increased knowledge of basic differences will help in managing the funds better which will result in greater profitability.

Literature review

Exchange rates among currencies have been very volatile after the demise of Bretton-woods system. A central question was to identify the impact of such volatile exchange rates system on international trade (Augustine, Thomas and Daniel 2000)1. Since then many researchers investigated the relationship on both the avenues (theoretical and empirical).

The theoretical debate found a general acceptance that exchange rate volatility has a negative impact on trade i.e. it reduces trade flows. Reports from the G-242 and G-103 summits suggests that the major weakness of freely floating exchange rate system is that it ‘discouraged’ international trade. This argument found considerable support in academic literature as well. Artus (1983)4 and Brodsky (1984)5 argued that exchange rate volatility creates an additional risk in front of risk averse traders and ultimately the volume of trade suffers. Demers (1991)6 guided the literature into another perspective where he suggested that this negative hypothesis is not necessary to prove the negative affect of exchange rate fluctuations on international trade. He suggested that price levels and demand should be taken into account as exchange rate fluctuations change the prices of international products so any fixed investment in such a business may suffer due to increased price, lowered production and hence trade. Broll (1994)7 identified the importance of multinationals instead of single trading firm. In his research he developed model to find out the effects of exchange rate fluctuations on an MNC. His results showed that if the MNC is dealing in an economy where there are sufficient tools available to hedge and manage exchange rate risk such as forwards futures and options market then the effects of exchange rate fluctuations are not significant enough. But in those economies where such tools are not developed, the exchange rate fluctuations pose a significant threat on international trade.

Empirical analysts and researchers were also trying to find out the relationship with there tools and techniques. Many empirical models were developed and tested on a wide variety of samples to present interesting results. One of the most basic issues faced by researchers in this area was that there was no generally accepted measure of volatility available. So researchers developed various models to estimate volatility and carry on with the relationship. Thursby and Thursby (1985)8 used model of absolute percentage change of exchange rate i.e. Vt = | (et - et-1 ) | / et-1

Many other researchers developed other models to estimate volatility but to date there is no generally accepted model for the estimation of volatility. The results of empirical studies were both ways. Some like Akhtar and Spence-Hilton (1991)9 said that exchange rate fluctuations have strong negative relationship with trade and some other like K lein (1990)10 denied the significance of the relationship.

The vast variation into the results may be attributed to a number of factors such as countries analyzed, time period, scope of study, monthly, quarterly or annual data etc. But despite all there research the topic seems to be incomplete and more research is required to fully understand the relationship and its impact.

Research question (problem statement)

What is the relationship of Exchange Rate Fluctuations with International Trade in Developed and Developing Economies?

Research objectives

The objective of this research is to find out the implications of foreign exchange fluctuations on international trade of the country. Moreover the aim of this study is also to compare these implications between developed and developing countries and sought differences in results.

Research design

The research is aimed to examine the effects of exchange rate volatility on international trade. For this purpose, the determinants of trade according to international trade theory will be analyzed. International trade theory suggests that trade is a function of domestic and foreign income, level of real exchange rate and volatility. The research design for this study is developed accordingly.

Data of exchange rates, income levels and international trade will be gathered from reliable sources. This data will then be used in the model to derive results.

Research methodology

Primarily the research will be based on secondary data which will be collected from reliable sources and then used to find the results.

The sample for this study will consist of the data from seven countries. Three out of the seven countries will be from the developed world and another three from the developing world. All these six sets of data will be compared against the US data.

This study analyses the effect of exchange rate volatility on trade flows. The model used in this study relies on the determinants of trade proposed by international trade theory. That is, trade is a function of income, prices, the level of the exchange rate and volatility, i.e.:

Xst / PtS =f[YtUS / PtUS, YtS / PtS, etUS*(PtS / PtUS ), Vt ] (1)

Mst / PtS =f[YtUS / PtUS, YtS / PtS, etUS*(PtS / PtUS ), Vt] (2)

Where Xst represents Sample country’s exports to the US in period t and Mst is Sample country’s imports from the US; Y is the level of GDP in Sample country and the US in period t; P represents Sample country and US price levels in period t; e is the nominal level of the US-Sample exchange rate in period t; and V is the exchange rate volatility indicator, also in period t.

Expected Outcomes

It is expected that level of trade between US and Sample countries to increase as incomes rose, on the other hand an increase in domestic prices would raise the level of volume of the more competitively priced imports but reducing trade in the less competitive exports. Exchange rate depreciation would lead to an increase in exports and a decrease in imports due to the relative price effect. Finally, exchange rate volatility could impact positively on trade flows.

Timelines

Four months of extensive research and analysis will be able to complete this thesis.


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