To What Extent Do Exchange Rates and their Volatility Affect Trade?

Figure 3. Trade balance between pair countries 
(in billion euros
) 
Figure 3.a. Trade balance in agriculture 
Figure 3.b. Trade balance in manufacturing
Source
: Comext, OECD, USDA. 
Although China shows a strong trade surplus with both the United States and the Euro 
area, particularly in the manufacturing sector, it should be kept in mind that some Chinese 
exports comprise little Chinese value added. China imports many intermediate products, 
in particular from South-East Asian neighbours and re-exports finished products towards 
the rest of the world. In addition, China opened its market considerably during its 
accession process to the WTO (China became a member of the WTO in 2001). The 
simple average Chinese tariff rate was reduced from 42.9% in 1992 to 16.6% in 2001 and 
to 9.8% after accession (OECD, 2006). This reduction in tariffs has undoubtedly 
contributed to the increase in China’s integration in the world economy and its strong 
growth in trade. 
China’s strong trade surplus with some of its partners has enabled it to accumulate 
exchange reserves; half of its reserves are held in US Treasury bills and therefore 
finances US debt. China is thus holding many of its assets in dollars which would decline 
in value if the dollar depreciates. There is therefore a strong interdependency between the 
three large economies in terms of levels of trade in goods and cross-border capital flows. 
V. 
Impact of exchange rates and their volatility on trade flows 
Econometric model specification 
In order to model the impact of exchange rates and their volatility on imports and 
exports in the three geographical areas, an autoregressive distributed lag (ARDL) model 
has been constructed with cointegration in the vein of Bahmani-Oskooee and Ardalani 
(2006) and Baek and Koo (2009). Import and export values are estimated in two separate 
equations including as determinants a proxy for income, the exchange rate and exchange 
rate volatility. This methodology was chosen for a number of reasons, both econometric 
and economic. In particular, it takes into account the mathematical properties of the 

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 TO WHAT EXTENT DO EXCHANGE RATES AND THEIR VOLATILITY AFFECT TRADE – 
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OECD TRADE POLICY WORKING PAPER NO. 119 © OECD 2011 
series, i.e. the stationarity
12
or non stationarity of the variables. In order to do this, 
variables were checked for cointegration
13
properties in the model. This enables 
measurement of both short-run and long-run effects, which is important here due to delay 
in trade transaction and associated risks. 
Import and export functions are formulated as follows with exchange rates included 
both in terms of levels and volatility. 
t
t
t
t
country
t
i
vol
d
ER
c
Y
b
a
M






ln
ln
ln
ln
,
,
(1) 
t
t
t
t