4.2 Do exchange rate fluctuations impact negatively on exporters?
4.2.1 Theoretical and empirical evidence
A high level of the exchange rate can act to the detriment of the tradable sector in that it lowers the New Zealand dollar revenues that exporters receive. A low exchange rate level raises the receipts that exporters receive. In other words, a fluctuating exchange rate directly impacts both positively and negatively on export receipts. The key concern when discussing the impact of fluctuations in the exchange rate is the uncertainty created for the tradable sector about the future level of the exchange rate over a multi-year horizon. It is this that can negatively affect trend growth.
Exchange rate fluctuations might impact negatively on exporters and trend economic growth by discouraging firms from undertaking investment, innovation and trade. It may also deter firms from entering into export markets (OECD, 2007). Large fluctuations in the exchange rate can also impose adjustment costs on the economy as resources keep shifting between the tradable and non-tradable sectors. This could permanently shift resources to the non-tradable sector if firms are put off entering, or staying in, export markets due to high exchange rate variability.
What is likely to be most damaging to exporters is sustained periods of overvaluation in the New Zealand dollar. While not the key focus of this paper, the impacts of this in the recent New Zealand case will be discussed later in this section.
The effects of exchange rate fluctuations may be more costly for New Zealand than for other countries, as New Zealand has a relatively small domestic market. Because of this, firms need to become exporters at a relatively early stage in their development if they are to grow. Given that New Zealand only has a few large exporting firms (e.g. Air New Zealand), its exporting industry in general looks quite different from that of Australia. Australia has many large, multinational mining companies able to diversify against the impacts of fluctuations in the Australian dollar.
Empirical evidence is inconclusive on whether fluctuations in the exchange rate hinder economic growth via the tradable sector. Theoretical evidence finds some more support for a negative impact. It is difficult to isolate the impact of the exchange rate, as there are many factors that affect exporters. Due to the availability of short-term hedging to mitigate short-term volatility, this paper is mainly focused on medium-term variability (box 1).[10] Unfortunately, data is limited for medium-term studies as New Zealand has only experienced a limited number of cycles since the exchange rate was floated in 1985. Because of this, most studies completed to date have focused on short-term volatility. Of these, studies using aggregate data mostly find no evidence of a link, and most of the few studies that do, only find a small negative effect.[11]
Some recent work does find a link between short-term volatility and exporting for New Zealand. Sanderson (2009) summarises some recent work from the Reserve Bank of New Zealand (RBNZ) and finds that short-term (i.e. month-on-month) volatility reduces both the number of exporting firms per market and the value of exports per exporting firm. Countries with a 10% higher level of exchange rate volatility after hedging is accounted for receive on average 6% less exports by value per exporting firm. However, no significant impact was found at the aggregate level because the composition of firms exporting to each market shifts towards larger firms, thereby increasing the average level of export receipts per firm.
The recent RBNZ work also examined longer-term fluctuations in the exchange rate and the impact on exporters. They find some evidence that a higher exchange rate (relative to average over the past three years) reduces the volume of trade in a firm-level export relationship, although no impact is found on aggregate trade. More work is needed to determine whether this effect reflects a reduction in the value of exports per firm, or whether firms are shifting exports between markets (Sanderson, 2009).
Box 1: Hedging practices of New Zealand Firms
One way for firms to limit their exposure to exchange rate fluctuations is by hedging currency exposures. The cost of hedging and the extent to which firms hedge is relevant to thinking about the costs of exchange rate volatility faced by exporters and import-competing firms.
There are a number of studies looking at the use of hedging by New Zealand firms.[1] Some of the findings from these studies include:
- Most firms that hedge use forward exchange contracts; these are not generally considered expensive
- Hedging patterns vary considerably by firm characteristic, such as:
- Larger firms hedge more than smaller firms; however, Fabling and Grimes (2008a) find that smaller exporting firms hedge more than medium-sized exporting firms2
- Hedging practices vary by sector/industry
- Firms with the highest export intensities have higher hedging ratios than firms with the lowest export intensities
- A relatively low proportion (around 3%) of Australian dollar transactions are hedged compared with between 60 to 70% of transactions denominated in United States dollars and other currencies (Fabling and Grimes)
- There is evidence of selective hedging, particularly for Australian dollar exposures and larger exporters (Fabling and Grimes, 2008a)
Most hedging is very short term. Fabling and Grimes (2008) find that most hedging is taken out approximately one month (on average) prior to the transaction. A greater use of hedging over short time periods is not surprising given that hedging over long periods (e.g. over 24 months) can be problematic in the following ways (Brookes et al, 2000):
- It removes the ability of a firm to benefit from any future favourable movement in the exchange rate
- There is uncertainty around forward orders, and it would be risky to lock in cover for orders that might not materialise
- Production costs may change over time due to unexpected inflation, which means the hedged export revenue may not be enough to cover expenses
- Forward contracts can impose an indirect cost by utilising credit lines
A forward exchange option (which gives the right but not the obligation to buy or sell a given amount of a given currency at a future date at an agreed exchange rate) can overcome some of the problems of hedging over longer periods. However, forward exchange options are generally more expensive than forward exchange contracts, more so over longer time periods. Instead, it is cheaper for firms to structure their business in a way that creates a natural hedge to help limit exposure to currency fluctuations over the medium term.
[1] For example, Berkman and Bradbury (1996), Berkman et al. (1997), Brookes et al. (2000), Prevost and Rose (2000), Fabling and Grimes (2008a and 2008b).
[2] Fabling and Grimes (2008b) find that once prior hedging experience is controlled for, firm size has no effect on the hedging propensity of exporting firms.
Notes
- [10]Hedging is a method of reducing the impact of price fluctuations.
- [11]See for example Clark, Tamirisa and Wei (2004) for a literature review on the effects of exchange rate volatility on trade. See Dekle and Ryoo (2007), Greenaway and Kneller (2007) and Fung (2004) for international studies. For New Zealand centred studies see Davis (2007), Smith (2004), and Buckle, Hyslop and Law (2007).
