Exchange rate volatility and trade: The role of credit constraints

• Published in: Review of economic dynamics Vol. 30; pp. 203 - 222
• Main Authors: Lin, Shu, Shi, Kang, Ye, Haichun
• Format: Journal Article
• Language: English
• Published: Elsevier Inc 01-10-2018
• Subjects: Credit constraints; Exchange rate volatility; Sectoral heterogeneity; Trade; Exchange rate volatility; Trade; Credit constraints; G20; F31; F14; Sectoral heterogeneity
• ISSN: 1094-2025; 1096-6099
• DOI: 10.1016/j.red.2018.05.002

This study examines the role of credit constraints in determining the trade effect of exchange rate volatility. We first develop a small open economy general equilibrium model with credit constraints. In our model, constrained firms respond to real depreciations and appreciations in an asymmetric way, and exchange rate volatility reduces their exports on average. The effect of exchange rate volatility on unconstrained firms' exports, however, is ambiguous. Overall, exchange rate volatility has a more negative impact on constrained firms. In a large sector-level bilateral trade dataset, we find robust empirical evidence supporting the predictions of the model. We show that financially more constrained sectors have a more negative exposure of their trade volumes to exchange rate volatility. Moreover, the estimated trade effects of exchange rate volatility vary substantially across sectors and can be either positive or negative depending on the degree of credit constraints.
•The role of credit constraints play an important role in determining the trade effect of exchange rate volatility.•A theoretical model illustrates how constrained and unconstrained firms respond to changes of exchange rate volatility.•Financially more constrained sectors have a more negative trade exposure to exchange rate volatility in theory and empirics.•The estimated trade effects of exchange rate volatility vary substantially across sectors.