Disentangling the exchange rate risk, sectoral export flows and financial development nexus

Abstract

Since the breakdown of the Bretton Woods system in 1973 there has been an increasing number of monetary authorities that have reviewed their exchange rate regimes. In this regard, a number of countries abandoned policies of fixed exchange rates and set about adopting regimes that were largely embracing of a freely floating exchange rate arrangement. The empirical literature examining the effect that the abandonment of fixed exchange rate regimes and subsequent exchange rate volatility would have on international trade flows has yielded ambiguous results. A large array of variations exist in the methodologies implemented in examining the underlying effects that exchange rate risk is hypothesised to have on the level of export flows. The main objective of this dissertation is to examine the hypothesised differential impact the exchange rate risk exerts on sectoral export flows, and the role of financial development in this relationship specifically for emerging market economies. This dissertation is characterised by several novel additions to its methodology which differentiates it from existing volatility-trade research. For one, the sectoral export flows of emerging market economies were analysed in this dissertation. Additionally, the conjectured role that financial development has to play in mitigating exchange rate risk receives attention, since this issue has not received adequate focus in the empirical literature. In accomplishing its main objective of disentangling the nexus among exchange rate risk, sectoral export flows and financial development, this dissertation analysed several emerging market economies - Brazil, Bulgaria, Hungary, Indonesia, Malaysia, Mexico, Poland, Romania, South Africa, and Turkey - over the nine year period extending from 2007Q1 to 2015Q4. The results generate when three panel data estimators were employed - the fixed effects estimator, the random effects estimator, and the Generalised method of moments (GMM) estimator with instrumental variables (IV), and the Generalised method of moments (GMM) estimator with instrumental variables (IV), and the panel dynamic ordinary Least Squares (PDOLS) - largely confirms expectations that product lines which are populated with more differentiated goods are more susceptible to exchange rate risk. However, this effect is not uniform across all differentiated goods sectors. In addition, financial development does not exert as a significant impact on export flows after accounting for endogeneity, which is attributed to the intermediate levels of financial development in emerging market economies. Therefore, this dissertation concludes that during periods of stress, it would be wise for the policymakers of countries specialising in the manufacturing and export of product lines more susceptible to exchange rate risk to better manage the level of exchange rates and extend support to these sectors.