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Has the European Monetary System Led to More Exports?
Evidence from Four European Union Countries
Fountas, Stilianos
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Date
1998-10
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Fountas, S. (1998). "Has the European Monetary System Led
to More Exports? Evidence from Four European Union
Countries" (Working Paper No. 031) Department of
Economics, National University of Ireland, Galway.
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National University of Ireland, Galway
http://hdl.handle.net/10379/1432
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National University of Ireland, Galway
()//5f-o// mi hLircann, G'«.m'////;/;
Has the European Monetary System
Led to More Exports?
Evidence from Four European Union Countries
Stilianos Fountas
No. 31
Kyriacos Aristotelous
October 1998
Department of Economics
Roinn na hEacnamaiochta
Working Paper Series
http://www.ucg.ie/ecn/
Abstract
We attempt to investigate whether the ERM period has coincided with an
increase in intra-EU exports. We conclude that this has not been the case
but it is likely that the elimination of nominal exchange rate variability
arising from a single currency will boost intra-EU trade.
Keywords:
exchange rate regime, exchange rate variability, EMS
JEL Classification:
F31, F33
1
Introduction
Recently, the volume of research focusing on the determinants of export demand in industrial and developing countries alike, has grown significantly.
The increasing interest in this topic has been sparked off by, first, developments in the econometrics of non-stationary macroeconomic time series
and, second, the theoretical ambiguity that surrounds the relationship between exports and exchange rate volatility. An important issue that has
been left out of the discussion of the existing literature on this topic is the
impact of the creation of the Exchange Rate Mechanism (ERM) associated
with the set up of the European Monetary System (EMS) on the volume of
intra-European Union (EU) exports.
The launch of the EMS, a system of fixed but adjustable exchange rates,
would be expected to lead to lower long-run nominal (and real, as inflation
rates tend to converge) exchange rate variability1 and, therefore, have a direct impact on the volume of intra-EU exports. In addition, the reduction in
exchange rate uncertainty brought by the ERM would lead to higher output
and hence have an indirect impact on export growth as interest rates tend to
converge to a lower level. More specifically, lower exchange rate uncertainty
associated with a smaller exchange rate variability would increase the quality of information provided by the price mechanism of resource allocation.
The fall in risk would reduce the risk premium incorporated in the expected
return on investment projects and hence the real interest rate, thus, boosting output growth De Grauwe (1996a). The result of output growth would
be an increase in the demand for exports in foreign countries. In summary,
smaller exchange rate uncertainty would boost exports indirectly through
its effect on output growth.
On the eve of the European Monetary Union (EMU), the relationship between the exchange rate regime and the volume of exports acquires increasing significance. It is for this reason that the primary objective of this study
is to investigate whether the ERM period has coincided with an increase
in intra-EU exports. Evidence in favour of a positive association between
exchange rate stability obtained by the ERM and export volume, would
provide an indication of potentially additional benefits in terms of output
growth (the export-led growth hypothesis) as the EU member countries proceed to lock their currencies in a system of irrevocably fixed exchange rates
and eventually a single currency2 . To this end, we specifically look at the
'Gros and Thygesen (1998) report evidence of a lower nominal and real exchange rate
variability in intra-ERM exchange rates following the creation of the EMS.
2 Gros (1996) provides evidence that increases in the short-run variability of intra-ERM
exchange rates leads to higher unemployment and less job creation in a number of large
four largest EU countries, namely, France, Germany, Italy and the UK. For
each of these countries we estimate an export demand function and test for
the influence of the exchange rate regime on export volume.
The paper is organised as follows: Section 2 discusses the theoretical model,
Section 3 presents our econometric methodology and results, and Section 4
provides some concluding remarks.
2
Theoretical background
The empirical literature on the estimation of export functions uses the following long-run export function (see e.g., Arize, 1995; Chowdhury, 1993):
In Xt = 0o + 0i In Yt + 02 In Pt + 0s Vt + ut
(1)
where Xt stands for real exports, Yt for real foreign income, Pt for relative
prices (a measure of competitiveness), Vt for exchange rate volatility and ut
is the error term.
Gotur (1985) shows that Equation (1) is the long-run solution to a system of
behavioural demand and supply functions for exports. Economic theory suggests that the impact of real world income on real exports should be positive
and the impact of relative price on real exports negative. Traditional trade
theory suggests that exchange rate volatility would depress trade because
exporters would view it as an increase in the uncertainty of profits on international transactions, under the assumption of risk aversion. On the other
hand, a number of authors such as De Grauwe (1988), Franke (1991), Giovannini (1988), Sereu and Vanhulle (1992), and Viaene and de Vries (1992)
illustrate in the context of theoretical models that exchange rate volatility
might benefit trade. Hence, the sign of /?3 in Equation (1) is ambiguous
from a theoretical point of view.
The international empirical evidence on the influence of volatility on exports
is also mixed. Arize (1995), Chowdhury (1993), De Grauwe (1987), Holly
(1995), Kenen and Rodrik (1986), Koray and Lastrapes (1989), Peree and
Steinherr (1989), and Pozo (1992) find evidence of a negative relationship
between exchange rate volatility and trade. Asseery and Peel (1991) and
IMF (1984) show evidence of a positive relationship between exchange rate
volatility and trade, while Bailey, Tavlas, and Ulan (1986), Gagnon (1993),
Gotur (1985), and Peree and Steinherr (1989) were unable to find evidence of
EU countries including Germany.
any significant effect of exchange rate volatility on trade3 . Most of the above
literature uses US dollar exchange rates and hence is not directly related
with our study that concentrates on ERM exchange rates. Exceptions are
De Grauwe (1987) and Bini-Smaghi (1991) who find a significant, although
small, relationship between exchange rate variability and intra-EMS trade.
However, these two studies have not considered the effect of the exchange
rate regime on intra-EMS exports, but only the relationship between exports
and volatility. Our study purports to close this gap in the literature.
3
3.1
Econometric methodology and results
Methodology
If the variables in Equation (1) are cointegrated, then it can be shown that
the error-correction model (ECM) will be of the following form:
_
i=i
k
41
;
:l
i+et
(2)
where -Rt_i is the error-correction term (ECT) and Dt is a dummy variable
taking the value of one when the exporting country was a member of the
ERM4 .
3.2
I
_
i=i
Data and the exchange rate volatility proxy
We use quarterly data for the period 1973-1996 and our sample includes the
four largest EU countrie^, Prance, Germany, Italy and the UK. The beginning of the sample period coincides with the start of the floating exchange
rate regime following the collapse of the Bretton- Woods system.
The export variable includes each country's exports to the other three countries. Its real value is created through division by the unit export value.
Our first explanatory variable in the export function is foreign income. For
each country, this series is constructed by taking the weighted average of
3 A survey of the literature on the relation between exchange rate volatility and trade
is given in Cote (1994).
4 The dummy variable takes the value one post 1979.11 for France and Germany and
for the periods 1979.II-1992.III and 1990.IV-1992.III for Italy and the UK, respectively.
the real GDP series (nominal GDP deflated by the consumer price index)
of the other three countries. Each country's trade weights are calculated
by determining the share of bilateral trade (exports and imports) in total
trade between each country and its three trading partners. The source of the
export data is the OECD Monthly Statistics of Foreign Trade. The source
of the rest of the series is the International Financial Statistics (IFS) published by the IMF. The quarterly GDP data were converted to the domestic
currency. For this purpose, US dollar exchange rates were taken from the
IFS and were converted to exchange rates between the four EU countries.
The second right-hand side variable in Equation (1) is a measure of competitiveness. It is defined as the ratio of the exchange rate-adjusted price
of domestic country exports to the price of exports of the other three countries. Hence, it is the ratio of the domestic unit export value to the weighted
average of the unit export values of the other three countries, denominated
in the domestic currency. The weights are identical to those used in the
construction of the income variable.
Finally, as a measure of time-varying exchange rate volatility we use the
moving standard deviation of the growth rate of the nominal effective exchange rate:
/!
\ 1/2
V, = (-!>*«-.-I»**-.>')
0)
where Z is the nominal effective exchange rate and m, the order of the
moving average, is set equal to 8. The nominal effective exchange rate is
calculated by the weighted average of the exchange rates where the trade
weights are the ones used in creating foreign income and relative prices5 .
This measure of exchange rate volatility is adopted by several authors including Lastrapes and Koray (1990) and Chowdhury (1993).
3.3
Results
^
We first employed unit root tests to determine the integration properties
of each time series. The results of these tests, available upon request from
the authors, imply that all series are /(1). Then, we proceeded to test for
cointegration following the Johansen maximum likelihood approach. We
chose the lag length in the VAR using a likelihood ratio test. The results of
the trace and maximum eigenvalue tests, also available upon request from
5 Although we use nominal exchange rates to calculate our volatility measure, Chowdhury (1993), Lastrapes and Koray (1990), and Thursby and Thursby (1987) obtain similar
results using nominal and real exchange rates.
the authors, illustrate that there exists a unique cointegrating vector for
Prance, Germany, and Italy but not for the UK.
Using the cointegration vectors normalised on exports, we estimated the
ECMs and report the results in Table 1. To decide the final forms of the
ECMs, we started with the maximum lag suggested by the likelihood ratio
test for each variable included in the VAR and eliminated insignificant lags
unless this introduced serial correlation in the error term. This allowed us
to derive a parsimonious model. For the UK, the estimated regression does
not include an ECT as cointegration does not apply.
Before the results are discussed, we need to determine the adequacy of the
ECMs. For that reason, we performed a number of tests which are reported
in the last column of Table 1. These tests indicate that the ECMs are adequate for further analysis. The adjusted R2 ranges from a low 0.62 to a high
0.75. Such values compare very well with the adjusted R2 values of other
studies for regressions based on first differences in variables. The BreuschGodfrey serial correlation LM test (F-version) indicates that there is no
serial correlation in the residuals of the estimated equations at the 5 percent
level. Moreover, autoregressive conditional heteroscedasticity (ARCH) does
not seem to be a problem according to the ARCH LM test.
Having provided evidence supporting the adequacy of the estimated ECMs,
we can make a number of observations regarding the estimates presented in
Table 1. First, the ECM results show that changes in foreign income have
statistically significant short-run effects on exports. Second, the dynamics
of the ECM equations also indicate that exchange rate variability has a
negative short-run impact on export volume6 . The effect appears to be
significant for all countries except France. Third, the short-run dynamics
show that, in agreement with other studies (e.g., Arize, 1997; Chowdhury,
1993) and the results of standard trade models, the short-run response of
export volume to foreign income is larger than that to relative price changes.
Finally, and perhaps most importantly, the EMS dummy variable is not
statistically significant for any of the four countries included in the study.
Therefore, one can conclude that the creation of the ERM has not led to
an increase in intra-EU exports either directly or indirectly. This important
finding can be partially explained by a number of forces that have been
widely studied in the literature (De Grauwe, 1996b). The restrictive fiscal
policies followed by the major EMS countries, the supply side problems
of many European countries, and the slow-down in the trade integration
process within the EU since the 1960s could have been strong enough to
6This result is in agreement with the results of Bini-Smaghi (1991) and De Grauwe
(1987) obtained using classical regression analysis.
Table 1: Regression results for error-correction models
Country
Prance
lag
0
R
AX
AY
1
-0.18
(2.57*)
-0.70
(8.45**)
-0.71
(9.14**)
-0.68
(9.43**)
0.87
(2.59**)
0.82
(2.49*)
2
3
0.05
(3.29**)
3
4
-0.45
(5.51**)
-0.30
(3.58**)
-0.26
(3.16**)
0.49
(6.21**)
-0.03
(0.19)
-4.44
(2.35*)
0.75
AR
1.77
0.003
(0.14)
-0.08
(1.44)
-0.39
(4.19**)
-0.02
(2.61**)
0.86
(2.51*)
-0.56 . -0.68
(1.28)
(1.52)
3
0.5
(6.02**)
>
-0.51
(5.05**)
-0.30
(2.92**)
3
-0.27
(2.73**)
4
0.40
(4.18**)
0.63
(1.77)
0.63
ARCH
2.59
-0.01
(0.49)
1.15
(3.08**)
R"
AR
1.77
0.02
(1.77)
0.01
(1.54)
0.02
(1.95)
0
2
R2
-4.56
(3.21**)
0
1
0.7
ARCH
0.50
2
UK
R2
ARCH
= 0.96
0.53
(2.29*)
1.14
(4.86**)
5
4
Summary
statistics
AR
1.01
-0.007
(0.45)
2
1
D
0.04
(1.27)
-2.09
(1.54)
0
1
Italy
AV
-0.35
(1.27)
0.47
(1.64)
4
Germany
AF
-35.54
(2.29*)
R*
0.62
AR
1.58
ARCH
0.25
Figures in parentheses are the absolute t-statistics.
* and ** denote significance at the 5% and 1% levels, respectively.
The F-statistic versions of the LM(4) test statistic for autocorrelation (AR) and the LM(4) test
statistic for autoregressive conditional heteroscedasticity (ARCH) are reported.
swamp the possible beneficial effects of exchange rate stability resulting
from the implementation of EMS.
4
Concluding remarks
This paper attempted to primarily investigate whether the ERM period
has coincided with an increase in intra-EU exports using the techniques of
multivariate cointegration and error-correction models. The models were
estimated using quarterly data for the four largest EU member countries,
Germany, Prance, Italy, and the UK for the sample period 1973.I-1996.IV.
Our empirical estimates support two main conclusions.
First, growth in intra-EU trade seems to be relatively independent of the
exchange rate regime. Put differently, growth in intra-EU trade is influenced
by a number of factors, exchange rate regime being a relatively unimportant one. Second, the finding that changes in exchange rate volatility affects
export volume negatively could be interpreted as suggesting that the reduction in exchange rate volatility that could result from the further monetary
union within the EU would likely boost intra-EU trade. This interpretation
represents an argument in support of the proponents of monetary union in
Europe.
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Department of Economies
National University of Ireland, Galway
Working Paper Series
No. 31 October 1998 "Has the European Monetary System Led to More Ex­
ports? Evidence from Four European Union Countries," Stilianos Fountas and
Kyriacos Aristotelous.
No. 30 October 1998 "Real Interest Rate Parity under Regime Shifts: Evidence
for Industrial Countries," Jyh-lin Wu and Stilianos Fountas.
No. 29 October 1998 "Analyzing Gender-Based Differential Advantage: A Gen­
dered Model of Emerging and Constructed Opportunities," Scott R. Steele.
No. 28 September 1998 "The Impacts of Transition on the Household in the
Provinces of Kazakhstan: The Case of Aktyubinsk Oblast," Pauric Brophy.
No. 27 July 1998 "A Comparison of the Effects of Decommissioning, Catch
Quotas, and Mesh Regulation in Restoring a Depleted Fishery," J. Paul Hillis and
Vilhjalmur Wiium.
No. 26 July 1998 "The Sensitivity of UK Agricultural Employment to Macroeconomic Variables," Patrick Gaffney.
No. 25 July 1998 "The Economic and Social Costs of Alzheimer's Disease and Re­
lated Dementias in Ireland: An Aggregate Analysis," Eamon O'Shea and Siobhân
O'Reilly.
No. 24 July 1998 "Testing for Real Interest Rate Convergence in European
Countries," Stilianos Fountas and Jyh-lin Wu. (Forthcoming in the Scottish Journal
of Political Economy)
No. 23 April 1998 "Production, Information and Property Regimes: Efficiency
Implications in the Case of Qconomies of Scope," Scott R. Steele.
No. 22 April 1998 "An Empirical Analysis of Short-Run and Long-Run Irish Ex­
port Functions: Does Exchange Rate Volatility Matter?," Donal Bredin, Stilianos
Fountas, Eithne Murphy.
No. 21 April 1998 "Technology and Intermediation: the Case of Banking,"
Michael J. Keane and Stilianos Fountas.
No. 20 March 1998 "Are the US Current Account Deficits Really Sustainable?,"
Stilianos Fountas and Jyh-lin Wu. (Forthcoming in the International Economic
Journal)
10
No. 19 December 1997 "Testing for Monetary Policy Convergence in European
Countries," Donal Bredin and Stilianos Fountas. (Forthcoming in the Journal of
Economic Studies)
No. 18 September 1997 "New Fields of Employment: Problems and Possibilities
in Local and Community Economic Development," Michael J. Keane.
No. 17 September 1997 "Estimation of the Impact of CAP Reform on the
Structure of Farming in Disadvantaged Areas of Ireland," Eithne Murphy and Breda
Lally.
No. 16 May 1997 "Exchange Rate Volatility and Exports: the Case of Ireland,"
Stilianos Fountas and Donal Bredin. (Published in Applied Economics Letters, May
1998)
No. 15 May 1997 "Tests for Interest Rate Convergence and Structural Breaks
in the EMS ," Stilianos Fountas and Jyh-lin Wu. (Published in Applied Financial
Economics, April 1998)
No. 14 May 1997 "Cointegration Tests of the Profit-Maximising Equilibrium in
Greek Manufacturing 1958-1991," Theodore Lianos and Stilianos Fountas. (Pub­
lished in International Review of Applied Economics, 1997)
No. 13 April 1997 "Agriculture and the Environment in Ireland: Directions for
the Future," Eithne Murphy and Breda Lally. (Published in Administration 1998)
No. 12 March 1997 "Male Mortality Differentials by Socio-Economie Group in
Ireland," Eamon O'Shea. (Published in Social Science and Medicine, Vol.45 No.6,
1997)
No. 11 July 1996 "Testing for the Sustainability of the Current Account Deficit
in Two Industrial Countries," Jyl-Lin Wu, Stilianos Fountas and Show-Lin Chen.
(Published in Economics Letters Vol. 52, No. 2, 1996)
No. 10 April 1996 "Towards Regional Development Programmes in Russia,"
Michael Cuddy.
No. 9 April 1996 "Uncertainty in the 'General Theory' and 'A Treatise on
Probability' ," Joan O'Connell.
No. 8 December 1995 "Some Evidence on the Export-Led Growth Hypothesis
for Ireland," Stilianos Fountas.
No. 7 November 1995 "Caring and Theories of Welfare Economics," Eamon
O'Shea and Brendan Kennelly.
No. 6 September 1995 "The Relationship Between Inflation and Wage Growth
in the Irish Economy," Stilianos Fountas, Breda Lally and Jyh-Lin Wu. (Forth­
coming in Applied Economics Letters)
11
No. 5 September 1995 "Quality and Pricing in Tourist Destinations," Michael
J. Keane. (Published in Annals of Tourism Research Vol. 24, No. 1, 1997)
No. 4 September 1995 "An Empirical Analysis of Inward Foreign Direct In­
vestment Flows in the European Union with Emphasis on the Market Enlargement
Hypothesis," Kyriacos Aristotelous, Stilianos Fountas. (Published in the Journal
of Common Market Studies Vol. 30, No. 4, December 1996)
No. 3 September 1995 "The Social Integration of Old People in Ireland," Joe
Larragy and Eamon O'Shea.
No. 2 September 1995 "Caring and Disability in Long-Stay Institutions," Ea­
mon O'Shea and Peter Murray. (Published in the Economic and Social Review,
Vol. 28, No. 1, 1997)
No. 1 September 1995 "Are Greek Budget Deficits 'too large'?" Stilianos Foun­
tas and Jyh-lin Wu. (Published in Applied Economics Letters Vol. 3, No. 7, 1996).
Enquiries:
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National University of Ireland, Galway
Tel:
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12