Exchange rate sensitivity of Japan’s bilateral trade flows

What is it about?

The traditional way of assessing the impact of currency depreciation on the trade balance has been to estimate the elasticity of trade volume to relative prices. To this end, most previous studies used aggregate trade data. To shy away from problems associated with using aggregate data, recent studies have relied on bilateral trade data. Since import and export price data is not available on bilateral level, this study proposes an alternative way of assessing the impact of currency depreciation on bilateral trade flows. The models are applied between Japan and her nine largest trading partners using recent advances in time-series modeling.

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Why is it important?

In assessing the impact of currency depreciation on the external account of a country, researchers have followed different paths. First, some have followed standard textbook prescription by estimating the well-known ML condition. The condition states that devaluation improves a country’s trade balance if sum of the price elasticities of that country’s import and export demands add up to more than unity. Second, some have argued that estimating the ML condition is an indirect approach. Thus, they have adhered to a direct method of establishing a link between the trade balance and exchange rate (as well as other determinants) following a reduced-form modeling approach. In both the first and the second approaches, researchers have mostly used aggregate data and provided mixed results. Recently, a few studies have concentrated on employing disaggregated data. While the disaggregated approach on a bilateral basis is applicable to reduced-form trade-balance models, it cannot be applied to estimate the trade flow elasticities or the ML condition. This is due to the fact that import and export prices are not available on a bilateral basis to obtain bilateral trade volumes. The remedy here is to establish a direct link between a country’s inpayments (value of exports) and outpayments (value of imports) and real exchange rate on a bilateral basis. Thus, in this paper we outline the long-run relationships between Japan’s inpayments and real exchange rate in one relation and her outpayments and real exchange rate in another relation. Using the ARDL approach, we estimate each model between Japan and her nine major trading partners that include Australia, Canada, France, Germany, Italy, The Netherlands, Switzerland, UK, and the US. The results reveal that when trade flows are measured in terms of foreign currency or reserve currency, Japan’s exports are not sensitive to real exchange rate in most cases. However, her imports are very sensitive or elastic. The fact that Japan’s exports are not sensitive to exchange rate changes provides empirical support for the argument that Japanese exporters have offset increases in their export prices by squeezing their profit margin to prevent decline in their export share. This practice has been followed not only against the US market, but also against most other major export markets. However, this seems not to be the case for Japan’s imports.

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