Global Value Chains and Exchange Rates

From VoxEU.org (excerpt):

The age of global value chains

João Amador, Filippo di Mauro 09 September 2015

There is an urgent need for policymakers to fully acknowledge the extent to which conventional indicators related to gross trade are severely flawed as policy benchmarks because they fail to take into account the existence of global value chains and their increasing role in shaping the global economy. This column, which introduces a new Vox eBook, urges academics to start proposing workable indicators that are systematically produced and readily available.

The importance of global value chains (GVCs) has been steadily increasing in the last decades and, as reported in UNCTAD’s World Investment Report 2013, about 60% of global trade consists of trade in intermediate goods and services, which are then incorporated at different stages of production (UNCTAD 2013). The prevalence of GVCs in the world economy impacts strongly on trade and labour markets, but also on issues such as inequality, poverty and the environment.

This notwithstanding, the measures that usually inform the policy debate, such as bilateral trade balances, export market shares or real exchange rates, continue to be used with little indication of the caveats that affect severely their accurateness.

In a recent VOX eBook we have collected relevant research by scholars directly or indirectly associated with CompNet, the Competitiveness Research Network of the EU System of Central Banks.

You can download the ebook here.

It’s not terribly clear what they’re really talking about, so here’s my notes from a recent presentation I gave:

• Global production is fragmented
• Finished products are made up of many components from many different countries
• Each component is also the sum of parts from many different countries
• An example
• Company has (FX-denominated) imported inputs
• Processing (domestic value-added)
• Company has (FX denominated) exported outputs
• Implications:
• Impact of FX movements is ONLY on domestic value added
• High domestic value-added = high impact and vice versa
• Exports and imports move together
• Export and import prices ALSO move together
• Consequences
• Devaluation/depreciation has smaller impact on competitiveness i.e. don’t expect an export boost
• FX impact diminishes downstream but remains large upstream
• Findings
• Weaker currencies vis-à-vis USD protecting domestic margins
• Weak commodity prices = weak import prices = weak export prices
• Trade pricing suggestive of Sraffian/Post-Keynesian model, not Neo-classical
• Nevertheless, indicative of lack of pricing power

Most commentators and policy makers still think in terms of gross trade values and finished goods. What I mean by that is, a depreciation helps boost exports because our export prices in foreign currency terms would be cheaper. Since demand curves slope downwards (volume demanded increases as prices decrease), we should see export volumes increase as the exchange rate depreciates (export prices might also rise at the same time). By the same token, a depreciation causes import prices to rise and import demand to drop. What that does to import volumes depends on the price elasticity of demand for imports – inelastic demand (say, energy related) would cause the overall import bill to rise, but elastic demand should see import volumes drop.

But the underlying implicit assumption here is that demand for both exports and imports are final (goods are assumed to be “finished” and consumed in the country of destination), and that these export goods have no imported components (100% domestic value-added). Even as early as the 1970s though (i.e. right at the beginning of the floating rate era), it was found that exchange rates did NOT pass through wholly into export and import prices. Exchange rate pass through has progressively decreased over the decades, as global trade boomed and production shifted based not on comparative advantage of the finished good, but based on comparative advantage of each stage of the production process.

For example, if domestic value added was just 20%, a 10% drop in the exchange rate would improve export competitiveness by just 2%. The full impact of exchange rate fluctuations would only be found in the countries of final destination, not in those countries within the (internationalised) production process.

That’s why countries experiencing large depreciations of their exchange rates in recent times, have only seen marginal improvement in export volumes (export receipts are another matter).

The bottom line here is that, with production of goods really fragmented across many different countries, the whole notion of “competitive devaluations” has lost much of its force. You can no longer really boost exports via exchange rate adjustments. By the same token, import price sensitivity to exchange rates have been equally muted (i.e. imported inflation is losing much of its power too).

The exception would be in countries at the beginning or end of the production process. Even here though, corporate pricing policies are increasingly geared towards a globalised market – the difference in prices of many consumer electronics items are virtually the same world-wide, once you account for differences in shipping costs and local taxes. There’s little opportunity for arbitrage.

It’s all about the value-added.