Exchange rate bands of inaction and hysteresis in EU exports to the global economy

Abstract

Purpose The purpose of this paper is to estimate the effect of policy and exchange rate uncertainty shocks on EU countries’ exports to the world economy. The authors examine the performance of the four biggest economies, namely Germany, France, Italy and the UK, under policy and exchange rate uncertainty in exports to some of the most important global export destinations (the USA, Japan, Brazil, Russia and China). Design/methodology/approach For this purpose, the authors apply a non-linear model, where suddenly strong spurts of exports occur when changes of the exchange rate go beyond a zone of inaction, which the authors call “play” area – analogous to mechanical play. The authors implement an algorithm describing path-dependent play hysteresis into a regression framework. The hysteretic impact of real exchange rates on exports is estimated based on the period from 1995M1 to 2015M12. Findings Looking at some of the main export destinations of the selected EU member countries, the USA, Japan and some of the members of BRICS (Brazil, Russia and China), the authors identify significant hysteretic effects for a large part of the EU member countries’ exports. The authors find that their export activity is characterized by “bands of inaction” with respect to changes in the real exchange. To check for robustness, the authors estimate export equations for limited samples: excluding the recent financial crisis and excluding the period up to the burst of the dotcom bubble and September 11. In addition, the authors employ an economic policy uncertainty variable and an exchange rate uncertainty variable as determinants of the width of the area of weak reaction of exports. Research limitations/implications Overall, the authors find that those specifications which take uncertainty into account display the highest goodness of fit, with economic policy uncertainty dominating exchange rate uncertainty. In other words, the option value of waiting dominates the real exchange rate effect on the EU member countries’ exports. Practical implications The existence of “bands of inaction” (called “play”) in EU member countries’ exports should lead to a more objective discussion of peaks and troughs in those countries’ real exchange rates and, more specifically, of the relevance of internal and external devaluation and other indicators to gain international competitiveness on exports in political debates. If policy and/or exchange rate uncertainty are diminished, one may expect an earlier boost in exports, if the home currency is devaluing in real terms. Social implications The results are useful as arguments in the debate about exchange rate pain threshold vs export triggers. Originality/value The authors focus on the export performance of the four biggest economies in the European Union, namely Germany, France, Italy and the UK. The authors examine their respective export performance, as an innovation, under policy and exchange rate uncertainty and, for this purpose, look at some of the most important global export destinations (the USA, Japan and the BRICS (Brazil, Russia and China)). The authors do so, also as an innovation, by differentiating between intervals of weak and strong reaction of their exports to real exchange rate changes.