TWN Info Service on WTO and Trade Issues (Apr12/06)
3 April 2012
Third World Network

WTO debates relationship between exchange rates and trade
Published in SUNS #7340 dated 29 March 2012

Geneva, 28 Mar (Kanaga Raja) - The World Trade Organisation (WTO) on Tuesday began its two-day seminar on the relationship between exchange rates and international trade, which is being held in the Working Group on Trade, Debt and Finance.

In October last year, the Working Group agreed to hold the seminar, following earlier submissions by Brazil for a debate on the issue with a view to better understanding the issues involved and their implications for WTO members.

The two-day seminar has been broken up into four sessions: a private sector session and a public sector session on Tuesday; and an international organisation session and an academic session on Wednesday.

According to trade officials, the private sector session is to discuss how the private sector exporters and importers are dealing with the effects of volatility and misalignments in exchange rates, while the public sector session is to take up WTO Members' experience of exchange rate fluctuations and misalignments and their impact on trade.

Trade officials said that the international organisations session will address the views and work of these bodies on the relationship between exchange rate movements and trade, and their institutional policy experience in this area. The academics session will clarify the terms of the debate from a scientific/academic standpoint.

In a media briefing following the end of the first day of discussions, Ambassador Roberto Azevedo of Brazil noted that what was heard today (in apparent reference to the public sector session hearing WTO Members' views) was clearly divergent views about the roots and causes of exchange rate misalignments.

He said that some were of the view that the problem with exchange rate misalignments was due to more direct intervention on the exchange rate markets in trying to control the value of the currency, while others felt that the main source of the problem was fiscal and monetary policies that provoked very large flows of capital across borders (see below.)

In opening the two-day seminar on Tuesday, WTO Director-General Pascal Lamy said that for a number of reasons, members wanted this debate. "I think that, from an institutional perspective, we even need it. The topic is as old as the GATT/WTO system itself, but it has not been discussed within these walls in a long time. It has to be approached, like the Working Group decided, on the basis of a rational, educative, and fact-based discussion. Reality has to be distinguished from emotions that inevitably arise on this topic, as much here as in other institutions."

"Exchange rates are, and have always been, a highly sensitive subject in the WTO. There is an emotional, cultural - if not moral - dimension attached to it by the trade community, in which the line between reality and perception can become blurry. This is in part because our community has a limited grasp of the workings of the financial system, and more widely of macroeconomic developments that determine exchange rates. This is also because, as exchange rates are exogenous to traders, some may feel that they are systematically on the receiving end of unwarranted fluctuations. I appreciate the uncertainty associated with some erratic movements of exchange rates can be not only a source of frustration, but also of asymmetric costs, which can distort international competition."

Lamy said: "Think about the abruptness of local financial crises and how short-term capital flights may spill over into brutal adjustment of exchange rates - a phenomenon observed during the Asian financial crisis of the late 1990s. For small or medium-sized economies, these are enormous shocks to absorb. After the recent financial crisis, the sense that the financial sector adjustment in rich economies is destructive for real economies, including that of poorer countries, is very vivid in this institution. Exchange rates are perceived to have been a transmission channel of these shocks."

According to the Director-General, these concerns have to be acknowledged, even though at times some of them may fall foul of exaggeration. "However, one should not descend into victimization or moral judgements: exchange rate adjustments are not all evil in themselves; in fact, they often correct macroeconomic, financial or current account imbalances, the persistence of which would be of even greater cost to traders. Trade also brings its well-acknowledged overall benefits to the cost of sometimes painful adjustments; and prices of tradables can be volatile in their own right too. Just consider fluctuations in commodity prices."

Lamy said: "The raison d'etre of this seminar is to examine the subject in a rational way, and avoid finger-pointing and frustration, which can only influence ill-designed trade policy responses. As often in life, one stands where one sits. One tends to hear more complaints from industries in countries where currency appreciates than from countries where currency depreciates. In a world of global supply chains and an increasing share of imports in exports, one can guess that traditional effects of currency appreciation and depreciation are in part cushioned. Besides, history tells us that at different times, countries may be on both sides of the currency fluctuation spectrum, appreciating at one time and depreciating at another."

According to Lamy, the literature survey produced by the Secretariat last year provides some answers to the relationship between exchange rates and trade.

The survey says that, on average, exchange rate volatility has a negative, even if not very large, impact on trade flows. Exchange rate volatility increases commercial risk, introduces uncertainty costs, and can influence the decision whether or not to enter foreign markets. In other words, volatility may affect resource allocation. The extent of these effects depends on a number of factors, including the existence of hedging instruments, the structure of production (e.g. the prevalence of small firms), and the degree of economic integration across countries. For example, it is well reported that exporting firms having access to hedging instruments might be less "sensitive" than those which are subject to external exchange rate fluctuations.

"As I have already mentioned, the impact of exchange rate fluctuations is also reduced by the presence of imported inputs, which offset the effect of exchange rate changes on the pricing of exports."

To take this further, Lamy underlined, a firm which has only one export market and whose export earnings depend on bilateral exchange rates is likely to be more affected than firms that are present in global markets (where upwards and downwards movements of various exchange rates may cancel each other out). Global firms also have the possibility of invoicing in local currency, and the capacity to absorb losses due to exchange rate changes and other factors in profit margins.

All in all, he stressed, the most "sensitive" firms seem not to be the large ones, but rather the smaller ones. In addition, empirical studies tend to find a more significant effect mainly in the case of trade with close neighbours, in particular in the case of very integrated economies. For example, the 2004 IMF study clearly indicates that exchange rate volatility within the European Union, before the advent of the euro, had a significant impact on relative prices of members. Exchange rate misalignments, i.e. sustained deviations of nominal exchange rates from their equilibrium value, are also predicted to have short-run effects in models with price rigidities.

"But the exact impact is not straightforward and depends on the specific characteristics of the economy. This includes, inter alia, the currency in which domestic producers invoice their products and the structure of trade (for example, the prominence of global production networks). On the empirical side, the complexity of the relationship between exchange rate misalignments and trade yields has mixed findings - it is not always clear that misalignments change the system of relative prices of an economy, at least long enough and deep enough to be able to shift resources or have quantity effects. For instance, a currency undervaluation is sometimes found to have a positive impact on exports, but the presence, size and persistence of these effects are not consistent across different studies. These effects, when they exist, are predicted to disappear in the medium to long-run, unless some other distortion characterizes the economy."

Lamy noted that the problem for business is one of excess volatility - i.e. when exchange rates behave in a disorderly way, and do not adjust to economic fundamentals. Part of the international trading community found in the Bretton-Woods era is a system of orderly adjustment of real exchange rates. The system, though not ideal, was maintained. But there was a system, providing for a sense of organized governance in the international monetary system. "This is what we lack today".

He added that the IMF and GATT were created in response to a lack of coordination of economic policies during the Great Economic Depression - these new institutions aimed at dealing with trade and exchange rate policies as a matter of common interest, with the introduction of disciplines to avoid competitive devaluations, maintain exchange rate stability, reduce balance of payments crises, and fight protectionism. The international monetary and trading systems were linked from the outset by a coherent set of rules aimed at the progressive liberalization of trade and payments.

GATT Article XV required members to cooperate with the IMF on questions relating to freedom or restrictions concerning exchange and trade. Members are required not to frustrate the intent of the GATT provisions through exchange actions, nor to undermine the provisions of the IMF Article of Agreements through trade actions. GATT provisions reflected two things: (1) the attachment of the trade community to exchange rate stability; (2) the need for that community to ensure that the trading system is not frustrated by the undisciplined use of exchange restrictions or multiple exchange rates.

"These provisions are still part of our rule book. But they have not been interpreted and thus what they mean today, in a WTO and non-Bretton Woods context, remains to be tested. However, the institutional set-up remains very much one of coherence - and not of conflict - between the two systems," he said.

Since the end of the Bretton Woods system, Lamy underscored, the trading community has consistently asked for greater exchange rate stability and proper adjustments of balance of payments. This was already the case in the 1973 Ministerial Declaration at the opening of the GATT Tokyo Round, as much as in 1994, 20 years later, in the Ministerial Declaration on the Contribution of the WTO to Greater Coherence in Global Economic Policy Making.

Reading again the 1994 text, Lamy said that he is struck by the authors' wisdom. It emphasizes on the one hand, that "greater exchange rate stability, based on more orderly underlying economic and financial conditions, should contribute towards the expansion of trade, sustainable growth and development, and the correction of external imbalances"; on the other hand, Ministers "recognized, however, that difficulties the origins of which lie outside the trade field cannot be redressed through measures in the trade field alone".

According to the Director-General, this says that an international monetary system aimed at greater exchange rate stability and correcting imbalances helps expand trade. At the same time, trade measures cannot correct policy imbalances elsewhere, and be an answer to non-trade policy concerns. Tit-for-tat trade measures would be a recipe for protectionist crossfire.

Clearly, with the exception of currency traders, erratic movements of exchange rates are an irritant in today's trading system. One must acknowledge their influence in trade policy setting, though, not least because exchange rate shifts may increase or weaken the desired or perceived level of protection of domestic operators. Maintaining multilaterally agreed levels of border protection is certainly a legitimate trade policy objective. The desired levels of protection are negotiated by members through long-term commitments - precisely because policies need to set predictable conditions of access for producers and traders.

"At the same time, one may wonder whether long-term levels of protection need to be adjusted to short-term fluctuations or even misalignments of exchange rates. As the literature survey seems to indicate, exchange rates may have an influence only in the short-run, not in the long-run unless there are substantial market failures. It leads to the question as to whether long-term border protection should not be considered in the light of the longer-term developments of exchange rates rather than short-term developments," said Lamy.

"This is why the international community needs to make headway on the issue of reform of the international monetary system. Unilateral attempts to change or to retain the status quo will not work. We need an international monetary system which supports cross-border investment and a better allocation of capital across nations and which ‘facilitates international trade' - as laid out in the aims of the International Monetary Fund."

"What we need is a global monetary system which inspires confidence, offers stability and monitors exchange rates more efficiently. One which provides the means through which global imbalances that may risk endangering stability can be addressed," said Lamy.

"Trade cannot become the scapegoat for the pitfalls and drawbacks of the international monetary system, or current non-system. The WTO system, its policies and rules will not be able to solve macroeconomic issues at the heart of the performance of currencies worldwide. WTO rules will not fix consumption or saving patterns at home, they will not solve competitiveness issues of domestic industries, they will not determine domestic interest rates, they will not achieve proper prudential supervision in the financial system."

"All these issues require a mix of cooperation in the macro-financial field and proper domestic policies which lie outside the remit of the WTO. In the current volatile environment, we need to make sure that the WTO system does not crumble under the weight of excessive expectations," the Director-General concluded.

Speaking at the media briefing Tuesday evening, Ambassador Azevedo said that as far as Brazil is concerned, the seminar is beginning to give shape to a conversation which is now moving somewhat from "an abstract and conceptual dialogue" that members had in the early stages of the work programme into something that is more real and reflects more what is happening on the ground. "In other words, we are moving from concept to reality and I think that is an important step in the work programme that we envisioned."

Asked about the flavour of the discussions, the Brazilian envoy said that there were clearly at least two different issues, one was misalignments (in exchange rates) and everyone said that this was the problem at this point in time, and much more than (exchange rate) volatility.

He explained that misalignment is the difference in benchmarks or levels of exchange rates and that could have happened in the short run or long run and the fact that one has a level of exchange rate now that is significantly different from what it was before. Volatility is when there are fluctuations of a significant margin of exchange rates up and down.

There was a clear understanding that misalignment is a problem, but there was less convergence on whether volatility in itself is a problem, he said, adding that there was also a conversation on the impact of these problems on the ground. There were representatives from the private sector stating how that affected the way they did business, and how their companies were affected. (See below for a presentation by a Brazilian private sector representative.)

As to what was causing these volatilities and misalignments, Ambassador Azevedo said that some felt that the problem with the exchange rate misalignments was due to more direct intervention on the exchange rate markets and therefore trying to control the value of the currency by means of intervention in the market. Others felt that the main source of the problem was by means of fiscal and monetary policies that provoked very large flows of capital across borders.

There was a difference of views on that, he said, adding that what is important, from Brazil's perspective, is that what is causing the exchange rate fluctuations and misalignments "is obviously an important element to bear in mind but is not a WTO job. The WTO is here not to control capital flux, not to control the markets of exchange rates. We're here to talk about the trade elements that are associated with these issues, not with the causes or the roots of whatever it is that are associated with those."

Ambassador Azevedo elaborated that "the WTO is a forum where this discussion must be happening. More than that, the WTO has a contribution to give; more than that, the WTO has a contribution which does not need to be limited to a discussion, it can be more effective and more operative by developing disciplines" for example, that address the trade-related aspects of exchange rates-trade.

"That, the WTO can do," he said, adding that what it is that the WTO cannot do is that it will not solve the problems of currency misalignments, as the WTO does not have the mechanism, the expertise or the competence to do that. That is for other fora to do. The WTO is here to assess - once the misalignment exists, and assuming that it can be identified and quantified, then what is it that can be done about it from the trade perspective, he added.

Pointing to the question of whether there is a misalignment, he said, "If you can overcome that initial step which is establishing that there is a misalignment, use that as a given, and then determine what kind of action, what kind of remedy, what kind of discipline could be applicable or should be applicable in that situation..."

"Now, whether we're ready, whether we have unanimous views about what to do, how to deal with this, I would feel quite comfortable in saying that at this point in time, ‘No', I don't think at this point in time I can detect the consensus on where to go. I think most of the people are thinking about this. Most of the people are still making up their minds about this and I think that this kind of assessment on whether or not we have a chance of doing something [or] developing something new or perfecting what we have, that can only be done down the road when we actually come to that kind of conversation. We haven't had that kind of conversation yet," he added.

Responding to another question, Ambassador Azevedo said that as far as Brazil is concerned, what is important for the WTO to do is once it is established that there is a misalignment - whatever kind of misalignment - that you have the mechanisms and disciplines that are in place - either existing ones or new ones - that can address that situation, avoiding a spiral of protectionist measures.

Asked about Brazil being protectionist, Ambassador Azevedo said that "anybody who has been doing trade for as long as I have, they have given up on finding [a] non-protectionist country. Everyone protects something. If we were having this conversation in agriculture, we will be on a completely different track because everybody who wants [liberalisation] in services and in industrial goods, protect and close their markets, and heavily subsidise their agriculture. If that's not protectionism, I don't know what is."

Meanwhile, in a presentation during the private sector session Tuesday morning, the CEO of the Brazilian company Coteminas, Mr Josue Gomes da Silva, told the participants that the topic "exchange rate" is a complex and polemic one. Some studies argue that, in the long run, periods of currency appreciation are offset by periods of devaluation, concluding that exchange rate fluctuations have neutral effects on economic growth over time. Nonetheless, at the current stage of the world economy, revisiting this position is important, as trade liberalization reforms that many countries undertook during the last two decades may have triggered a different relationship between the exchange rate and economic growth in the long run.

"The increased globalization of production of industrial goods coupled with exchange rates misalignments might provoke irreversible losses in the manufacturing structure of countries with overvalued currencies. Brazil is an example of that, and our industry is at a significant risk of permanent backwardness," he said.

"It is important to recognize that the Brazilian economy is performing relatively well, and that some sectors have even benefited from our overvalued currency. We do know that this makes our case more difficult, but a premature de-industrialization process as it is now taking place in Brazil might preclude the country from a much brighter future and impose limits to our development. Brazil is a country of 190 million inhabitants and with a continental territory. De-industrialization is not an option for us."

He noted that the Brazilian manufacturing sector has had a somewhat erratic performance in recent years. In 2010, industrial production in Brazil recovered from the deep contraction suffered in 2009. But in 2011, the virtual stagnation of manufacturing impacted negatively the growth rate of Brazilian GDP. In 2011, the manufacturing sector has suffered from a very strong and negative impact caused by competition of imports in the domestic market. Most of these imports come from countries with depreciated currencies, whereas the Real, Brazil's currency, has remained overvalued.

"Looking at the breakdown numbers of individual manufacturing sectors, we will be able to identify those that were faced with stronger competition from abroad in 2011. Sectors in which output dropped considerably were textiles, leather, office and telecoms equipment, apparel, electrical machinery and equipment, chemicals and rubber and plastics."

How could the country have preserved its trade surplus since 2008 at a level around $25 billion to $30 billion, he asked, noting that commodities and favourable trade terms are at the root of this record export level. Foreign trade in commodities and semi-manufactured goods has been growing consistently and has been able to expand well beyond the pre-crisis level. However, when it comes to manufactured goods, the picture is quite different: exports in 2011 still did not exceed those of 2008 in value.

"Hence, the result of the balance of trade deteriorated with frightening speed and intensity. In 2011, the deficit in manufactured goods reached US$92.5 billion. It should be noted that, in 2006, only six years ago, trade in manufactured goods posted a surplus of US$5.1 billion," he said.

In some segments, increases in the trade deficit were especially fast and severe. Such is the case of chemicals, oil and fuels refining, electronics and telecom equipment, machinery and equipment and automotive products. Just a few semi manufactured industries pursed the opposite direction, achieving a higher trade balance surplus. That is the case of food, beverages and mining.

"When we look at the export coefficients and import penetration of manufactured products in Brazil, we can see clearly that the country is quickly losing several sectors of its industry. A country that used to be known for a relatively complex and integrated manufacturing base runs the risk of confronting the destruction of some industries and the disintegration of supply chains in others."

According to Mr Da Silva, many export coefficients of different sectors have been reduced. Such is the case of electronics and computer equipment, machinery and electrical equipment, automotive products and machinery and equipment. This fact shows the low competitiveness in Brazil due to, among other factors, the asymmetry of exchange rates between Brazil and its competitors.

Thereby, import penetration coefficients in Brazil show the opposite and reflective effect: in most sectors, there were higher penetration coefficients as a result of low competitiveness of Brazilian manufacturing in its own domestic market. Again, among other factors, it can be affirmed that this low competitiveness is to a large extent caused by exchange rate distortions between Brazil and its competitors, he said, noting that the most significant increases in import penetration have been in apparel, metallic products, automotive, textiles, electrical machinery and equipment, electronic and IT equipment.

"It is fair to say that problems other than exchange rates misalignments contribute to reducing the competitiveness of Brazilian products. But I can assure you, and several examples will show this, that exchange rate misalignments are at the heart of the problems faced by the industrial sector in Brazil."

He said that the case of his company is emblematic. From 2001 through 2007, Coteminas was able to multiply its exports more than six fold only to have to reverse the trend and shrink its exports back to where it was 5 years earlier. Exports in 2011 were similar to the ones in 2001. "We have relocated production to other countries."

"In conclusion, if the double asymmetry in the exchange rate is a Brazilian problem today, it is also a systemic issue that tomorrow other nations might be confronted with. It is true that exchange rates are an area for sovereign decision by each country. It is no less true however that they impact trade, and the WTO should participate in the discussions. The double asymmetry problem exists. It is a critical issue. It has to be addressed, otherwise countries will create their own unilateral solutions against the distortion. Tariff wars and protectionisms should be avoided by multilateral rules that can be accepted by all," Mr Da Silva said.

Meanwhile, in a press release issued Tuesday, Deputy US Trade Representative Michael Punke said: "Expanding international trade is critical to a vibrant global economy, a reduction in poverty, employment growth, and rising incomes. The work of the WTO is vital in promoting trade through rules that open markets and a dispute system that gives teeth to those rules. The success of the WTO was evident during the most recent global crisis when countries largely resisted pressures to enact protectionist measures. This seminar reminds us of the importance of exchange rates in the global trading system. Real exchange rates that are aligned with fundamentals are a necessary foundation for the global trading system."

In the same press release, Deputy Assistant Secretary of the Treasury Mark Sobel said: "A strong consensus now exists on the importance of promoting market-determined exchange rate systems, enhancing flexibility to reflect underlying economic fundamentals, avoiding persistent exchange rate misalignments and refraining from competitive currency devaluation. Exchange rate management and policies need to allow real exchange rates to better reflect fundamentals. This in turn will facilitate balanced international trade and give countries greater independence in pursuing domestic policy objectives. When trading partners believe others are allowing their exchange rates to adjust in line with fundamentals there is less pressure for protectionism and more support for trade liberalization. The IMF has a core mandate to exercise rigorous surveillance over its members' exchange rate policies and it must carry out this vital core mission."

"Strong IMF and WTO collaboration is important for the global economic and trading system," Ambassador Punke and Deputy Assistant Secretary Sobel said.