Exchange Rate Volatility, Financial Constraints, and Trade: Empirical Evidence from Chinese Firms

Exchange rate volatility, financial constraints and trade... The increasing volatility of exchange rates after the fall of Bretton Woods agreements has been a source of concerns for both policymakers and academics. An increasing number of countries, both emerging (e.g., China) and developed (e.g., euro area members) have chosen more or less fixed exchange rate systems as a way to protect themselves from the effects of an excessive volatility, especially on trade. Surprisingly, macroeconomic evidence of the effect of exchange rate volatility on trade has been quite mixed, either small or insignificant. However, both an aggregation bias and an excessive focus on richer countries with highly developed financial markets could explain this counterintuitive outcome, since much more substantial negative effects of the exchange rate volatility on trade are found for developing countries. There is still a strong lack of firm-level evidence on both the impact of exchange rate volatility on exporting behavior, and the way this relationship may be influenced by financial constraints, likely to be much stronger and more binding in developing countries. In this paper, we investigate both the impact of real exchange rate volatility on the exporting behavior and the way financial constraints, together with financial development, shape this relationship at the firm level. Our empirical estimations rely on export data for more than 100,000 Chinese exporters over the period 2000-2006. China is a highly relevant case for several reasons. First, the exchange rate volatility is expected to rise substantially in the future, along with a greater flexibility of the yuan. Second, the export rate is particularly high related to the size of China, leading to substantial exposure to exchange rate fluctuations. Finally, China is interesting because it is characterized by low financial development but rather high regional heterogeneity on that ground. More specifically, we assess whether firms reallocate their export away from partners characterized by higher exchange rate volatility, and more important, we investigate the presence of a non-linear effect of exchange rate volatility on performance depending on the level of financial constraints, in the Chinese context. The latter is apprehended through two complementary dimensions. First, we infer firm-level financial vulnerability from the financial dependence of their activities. This approach has been shown to be a robust methodology to detect credit constraints and assess their evolution. Second, we exploit Chinese cross-provincial heterogeneity to study how financial development may mitigate both credit constraints and exchange rate volatility. Doing …