Effect of Ukraine’s exchange rate devaluation on trade with the EU

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Effect of Ukraine's exchange rate devaluation on trade with the EU

Hellyer Mark

Director of CTA Economic & Export Analysts (UK),postgraduate student,

Kyiv National University of Trade and Economics Kyiv, , Ukraine

Abstract

This article examines the relationship between exchange rate changes and export development within the context of the free trade agreement (DCFTA) between Ukraine and the EU. It argues that the effects of the exchange rate may be a greater influence than the FTA regime itself. After examining current theory and definitions, the article looks at difference measures of exchange rate, nominal, variations of the real exchange, exchange rate volatility and equilibrium exchange rate to identify causal links to Ukraine's trade before and after the DCFTA. It shows that there is a positive causal relationship between the real exchange rate and exports with devaluations during implementation had a significant impact on Ukraine's exports, and this effect is greatest on those products that benefited from better access under the FTA.

Keywords: trade liberalization, the Deep and Comprehensive Free Trade Area, economic growth, currency regulation, currency exchange rate regime, exports, preferential trade agreements.

Аннотация

Влияние девальвации обменного курса Украины на торговлю

exchange rate trade

Хеллаер М.

В статье рассмотрена взаимосвязь между изменением валютного курса и развитием экспорта в контексте соглашения о свободной торговле (УВЗСТ) между Украиной и ЕС. Валютный курс может иметь большее влияние, чем сам режим ЗСТ. Учитывая современные теории и определения, в статье проанализированы различные подходы к определению обменного курса, номинальная стоимость, вариации реального обмена, изменчивость валютного курса и равновесный обменный курс для выявления причинно-следственных связей с торговлей Украины до и после УВЗСТ. Это свидетельствует о наличии положительной причинно-следственной связи между реальным обменным курсом и экспортом с девальвацией во время внедрения, что существенно повлияло на экспорт Украины, и этот эффект является крупнейшим для тех товаров, которые получили преимущество от лучшего доступа к ЗСТ.

Ключевые слова: либерализация торговли, углубленная и всеобъемлющая зона свободной торговли, экономический рост, регулирование валюты, режим валютного курса, экспорт, льготные торговые соглашения.

Анотація

Ефект девальвації обмінного курсу України в торгівлі з ЄС

Хеллаєр М.

Постановка проблеми. Україна у 2014 році підписала ПВЗВТ з Європейським Союзом, сподіваючись, що негайно відбудеться значне збільшення експорту України до ЄС. Однак насправді товарообіг України за 3 роки після відкриття ринку ЄС фактично зменшився. Утім, Україна перейшла з системи контрольованих обмінних курсів, що діяли до 2014року, до керованої плаваючої системи.

Аналіз останніх досліджень і публікацій. Оцінка валютного курсу України зорієнтована на попередню контрольовану систему та її недоліки й наслідки для економіки. Для проведення дослідження визначено подальший аналіз теоретичних і фактичних наслідків девальвації обмінного курсу (в результаті переходу від нерухомої до плаваючої системи).

Метою статті є дослідження впливу девальвації валюти України на експорт до ЄС у рамках ПВЗВТ, щоб побачити ступінь впливу на зміну в торгівлі внаслідок девальвації на відміну від покращених умов доступу на ринок ПВЗВТ.

Матеріали та методи. Методологічною основою статті стали методи аналізу та синтезу, статистичний аналіз і регресійне моделювання 0Ь8. Дослідження, засноване на експортних даних з Європейського Союзу на рівні продукції, показниках Світового банку щодо обмінного курсу та тексті Угоди про асоціацію між Україною та ЄС.

Результати дослідження. У статті розглянуто, як впливає номінальний курс, реальний курс і мінливість курсу на торгівлю з ЄС. За результатами аналізу визначено, що девальвація реального валютного курсу мала, як очікується, позитивний вплив на експорт України, проте номінальний курс і мінливість курсу на нього не вплинули. Проведення дослідження розділено за видами продукції, сільського господарства, несільськогосподарських товарів і продуктів, що отримали вигоду від доступу на ринок у рамках ПВЗВТ.

Висновки

Результати дослідження показують, що лібералізація гривні, що відбулася водночас із впровадженням ПВЗВТ в Україні у 2014 році має значний вплив та позитивний внесок у ефективність експорту України з ЄС. Однак набагато більший вплив спостерігався на сільськогосподарську продукцію, зокрема на основні товари з низькою доданою вартістю. Це дає змогу припустити, що інші бар'єри впливають на ці продукти з більшою доданою вартістю, які обмежують вплив, або що вони більше покладаються на імпортні вкладення, які водночас матимуть подорожчати через девальвацію.

Ключові слова: лібералізація торгівлі, поглиблена та всеосяжна зона вільної торгівлі, економічне зростання, регулювання валюти, режим валютного курсу, експорт, пільгові торговельні угоди.

Background. The economic integration of Ukraine with the EU under the AA/DCFTA seeks to provide open market entry and legislative alignment to the Single European Market through improved market access (gradually eliminating tariffs) and regulatory alignment (Ukraine adopting EU business regulations so that there is no difference in applied regulations for a Ukrainian business whether the product is sold in Ukraine or in the

EU). However, the AA/DCFTA does not address exchange rate stability whereby rates are linked so that it creates improved trade opportunities throughelimination of transaction costs and exchange rate uncertainty and increase in price transparency.Greater exchange rate stability should result in lower transaction costs and price transparency that reduce costs and thereby enhance competition and increase international competitiveness of enterprises leading to greater trade.

Moreover, in the absence of exchange rate linkages in the agreement, the relative value of the exchange rate between EU and Ukraine could affect trade and potentially negate any of the benefits derived from market access improvements. Overvalued currencies make imports relatively cheaper and exports relatively expensive encouraging imports and discouraging exports. Therefore, devaluation of a national currency would lead to a reversal of the situation and balanced trade.

The object of this Paper is to understand how the exchange rate between the UAH and the euro affected exports to the EU under the DCFTA and constrained or enhanced performance: whether at a nominal level, real exchange rate, exchange rate uncertainty and/or real exchange rate misalignment. In addition, do these effects affect different groups of Ukraine's exports in different ways and how much of Ukraine's export performance to the EU post DCFTA is affected by exchange rate changes. This is not only interesting within the context of the DCFTA policy itself, but also in terms of the Central Bank of Ukraine's policy of controlled liberalisation from dollar tracking in the post DCFTA period.

Analysis of recent research and publications. Although Ukraine's exchange rate has been studied in recent years in terms of the wider impact on the economy and a more broader discussion on the method of management of the exchange rate itself, for example see [1-5], very little analysis of the impact of Ukraine's exchange rate on trade specifically has been undertaken. Prior to 2014, both practical and theoretical literature focused on the effects of artificially maintaining the exchange rate such as Vorobyov [6] who used PPP method of real exchange rate to show that the UAH was overvalued and adversely affected the macro-economic fundamentals, including trade balance but concluded that although devaluation was necessary, social consequences may lead to further supporting currencies rather than devaluing (as in the case of Argentina and Brazil) and therefore, there is a need to study the wider effects of devaluation first before embarking on such policies.

After the devaluations experienced in Ukraine from 2014, scientific study in Ukraine also examined the effects of the volatility and fluctuations of the exchange rate on the wider economy. Didur et al [7] examines the causes of instability in the UAH exchange rate and postulates that this instability increases uncertainty and risk for business and therefore recommends control of the currency (managed floating) but provides no analysis of real effects.

Gorraya [8] showed using presentation of data and correlations, that unpredictable exchange rate fluctuations can be extremely negative on the national economy, causing inflation, growth risks of international trade and investment attraction, exacerbation of currency risk in the banking sector and currency speculation.

However, these studies have largely examinedthe theoretical framework and/or observations of trends,for determining the effects of exchange rate devaluations and volatility on exports. Thesedo not explicitly examine the effects of the exchange rate on the effectiveness exports and especially under the DCFTA provisions, so a broader analysis of literature on exchange rate effects on trade is needed.

Within the EU, Monetary Union extends to a common currency and creates one of the most advance and integrated monetary unions in the world. The trade effects of the Eurozone monetary union have been studied and have been shown to have had a mostly positive effect on EU trade. Early estimations from Micco et al. [9] found 5-10 % increase in bilateral trade but later studies for example, Bun and Klaassen [10] suggests only a 3 % increase in trade.

However, Johnson argues [11] that devaluations can only be effective if there are real devaluations; that is, if the relative price of tradeables is devalued. Johnson examined the effect on the economy, in terms of tradable (imports/exports) and non-tradeables (domestic production and consumption). He concluded that a large real devaluation could cause a nominal increase in exports and decrease in imports.

Kreinin [12] examines the «pass through» effects of real exchange rate changes on import and export prices and then the consequent impact on import and export volumes. The methodology applied by Kreinin is that of a «control» country approach' whereby the «passthrough» effect is the difference between the changes in price that actually has taken place in the country investigated and the hypothetical change that would have occurred in the absence of exchange rate devaluations (measured by a set of control countries where no exchange rate change occurred). The results of this study showed that devaluations caused a significant effect on volumes of trade in 3 of the 6 countries investigated. For example, a 10 % devaluation (with 100 % pass through to export prices) in the US, generated a 17 % increase in exports (equivalent to an estimated foreign demand elasticity for US exports of 1.7). implied foreign demand elasticities for Japanese and Canadian exports were 1.1 and 2.3 respectively.Bhagwat and Onitsuka [13] examined 22 nominal devaluations in 19 countries. Growth rates and market shares before and after the devaluation showed that most countries experienced an increase in export growth over a three-year period with even better results from an analysis of individual commodities.

Yandle and Ridler [14] developed a simplified model of world markets for commodities from developing countries to assess the impact of exchange rate changes on export growth and suggests that export responses to devaluation's is likely to be insignificant due to export supply rigidity such as low opportunity costs for capital, labour, land and technology which limits supply responses.Little et al [15] examined 18 countries and showed that there is no impact of real devaluations on traditional agricultural and mineral exports. However, there was a marked improvement in exports of non-traditional/manufactured products as a result of real exchange rate devaluations.

The aim of the article is to investigate the impact of Ukraine's currency devaluation on exports to the EU under the DCFTA to see the extent of the impact on change in trade due to devaluation as opposed to improved DCFTA market access conditions.

Materials and methods. Methods of analysis and synthesis, method of statistical analysis and OLS regression modelling are used in the article. The research based on export data from the European Union at a product level, the World Bank Indicators on Exchange rate and the European Union-Ukraine Association Agreement text.

Results. In the review of scientific literature, different measures of real exchange rate and the use of different measures has be shown to affect the results including Fleissig and Grennes's[16]; Sadoulet and Janvry [17] and Vries [18]. These have shown that different calculations of a countries' real exchange rate can lead to significantly different results. In many cases the direction of the change in real exchange rate has been shown to be opposite using differing indices, as well as differing definitions. Therefore, several authors have adopted an alternative examination of exchange rate as a policy by studying the equilibrium real exchange rate at the impact of misalignment and realignment on international trade. One of the first studies on misalignment of the real exchange rate was conducted by Edwards [19] who conclude that «disequilibrium in the real exchange rate can reduce economic efficiency, misallocate resources, undermine the agricultural sector and increase capital flight”. Misalignment theory states that if the real exchange rate is overvalued, then imports will be cheaper and exports more expensive, encouraging imports at the expense of local production and discouraging exports and a reallocation of resources to domestic industries. Although a devaluation from equilibrium should still theoretically cause an increase in exports and a decrease in imports, in developing countries, there is generally a minimum level of imports required of essential items not produced locally. In addition, exporters would be encouraged to stop exporting and produce import substituting products which are attracting higher prices. Thus, a country should aim for a policy of equilibrium real exchange in order to encourage export development.

Edwards used simple regressions of exchange rate misalignment to model the impact on growth of GDP on 12 countries. This showed that countries with large and persistent real exchange rate misalignment experienced poor economic performance relative to those with real exchange rates close to the equilibrium value.

In order to estimate the extent of misalignment of the real exchange rate, the difference between the equilibrium real exchange rate and the current real exchange rate is measured. This can be used using an elasticity approach to calculate the misalignment. The level of exports and imports generated with the Equilibrium Real Exchange Rate (ERER) can be determined through the movement from the real exchange along the supply and demand curves(Supply and Demand Movements to Equilibrium Real Exchange Rate):

where eE is the export elasticity.

where eM is the import elasticity.

According to Sadoulet and Janvry [20] an «acceptable or sustainable» level of trade deficit will generate the equilibrium real exchange rate. Therefore, E and M (the level of imports and exports for a sustainable trade deficit). Substituting E and M in the above equations for Q, and combining the simultaneous equations the following equation is produced (Calculating Real Exchange Rate):

(2)

Since, M - E is the actual deficit (D) and M*-E* is the acceptable deficit (D ), D and D can be substituted and the equation solved for ERER as follows (Equilibrium Real Exchange Rate Estimation):

Once an acceptable level of deficit has been determined, which according to Sadoulet and Janvry, is two per cent of GDP, the equilibrium real exchange rate can be calculated.

Based on the theoretical framework of the effect of the exchange rate (deliberate policy or not) this chapter explores whether the change in value of the Ukrainian hryvnia affected exports to the EU, did exchange rate uncertainty play any role and/or did the relative over or undervaluation of UAH) constrain or otherwise impact trade with EU under the DCFTA.

The economic literature demonstrated that devaluations can only be effective if there are real devaluations, that is, if the relative price of tradeables is devalued, if there were in fact no «real» devaluations, this could explain why there are positive correlations between the nominal Euro/UAH rate and some of the groups of Ukraine's exports to the EU.

In order to understand the extent to which the appreciation or depreciation in the UAH had on Ukraine's export performance, a model of trade and real exchange rate is developed. Much of the literature explains this as not only is the change in nominal exports affected by supply responses, but also by demand and exchange rate uncertainty or volatility that also impact on investment by entrepreneurs. EU demand response could explain the more positive effects seen in agricultural products that had tariff barriers or equivalent preDCFTA application showing a price elasticity effect and post 2014, there was no real exchange correlation but this group saw a positive increase in exports to EU which may mean the tariff liberalisation effect was greater on this group.

In addition to this, the contention by many economists (especially those arguing against flexible exchange rate regimes) is that an unstable exchange rate has an adverse effect on trade and investment through increasing risks. According to the IMF [21] countries exchange rate policies should avoid «jerky movements in the real exchange rate and overvaluation (...) as they have adverse effects on the tradable sector».

The World Bank [22] used a simple model to examine the impact of exchange rate changes in trade.

«Simple export equations are estimated in which the explanatory variables include the real exchange rate, uncertainty in exchange rate and world demand for exports. Exchange rate uncertainty is approximated by a two-year moving variance (...) currency devaluation encourage exports».

The World Bank's model is specified as follows:

Variables: RER - real exchange rate (1985=100);

ERU - real exchange rate uncertainty, approximated by two-year moving average variance;

WD - world demand, estimated by using OECD GDP at constant prices;

X - nominal value of exports.

In order to examine the potential role (if any) of the exchange rate in Ukraine's export performance to the EU, this the model was re-specified with a more targeted approach:

Variables: RER - real exchange rate;

ERU - real exchange rate uncertainty, approximated by two-year variance;

EUD - EU demand, estimated by using EU GDP at constant prices;

X - nominal value of exports to the EU.

Ukraine has for a long time maintained a fixed exchange rate policy with central bank and the Ministry of Finance, «tracking» and intervening in currency markets (buying and selling currency). Ukraine kept the UAH exchange rate tied to the US dollar [16] under open economy conditions, causing huge imbalances in foreign trade, financial sector, and economic motivation of citizens and companies. As a result, from 2010-2013, Ukraine used almost half of its currency reserves to maintain the exchange rate, so that in late 2013 reserves amounted to only USD 20 billion (35 % of short-term debt and 2.5 months of imports). Additional external borrowings were needed and a USD 3 billion loan ("Eurobonds") from Russia was taken. However, the situation continued to deteriorate as the National Bank of Ukraine struggled to maintain a fixed rate with gradual and small devaluations until February 2014 when it allowed the UAH to devalue in one day from 16 UAH/USD to 25 UAH/USD.

Between 2014 and 2015, the National Bank of Ukraine continued managing the exchange rate with subsequent larger depreciations of 14 % to 19.5 % monthly and then to 30 % in March 2015. At the same time, it imposed severe restrictions on the purchase of foreign currency. Therefore, since 2014, Ukraine has pursued a policy of «controlled» exchange liberalisation that has aimed at gradual devaluation whilst maintaining stability until the currency liberalisation can be fully achieved through «integration into the European economic and financial space that will allow Ukraine to become a full-fledged participant of the globalized economy» [13].

These two policy approaches can be described as «fixed» pre 2014 and «controlled liberalisation» post 2014 and this exchange rate policy shift coincides with the AA/DCFTA implementation. Therefore, this nominal «devaluation» could provide a stimulus for trade with the EU. This paper examines the effect of Ukraine's exchange rate policy on trade with the EU under the DCFTA to see if either, relative valuation of the exchange affected trade and whether the lack of exchange rate integration (either tracking or fixed) would potentially increase the trade under the agreement. This is not only important from the perspective of national exchange rate policies (fixed versus managed floating) but also in understanding whether the relatively poor performance of exports under the DCFTA has been affected, either positively or negatively by the exchange rate.

Ordinary Least Squares regression analysis was undertaken for Ukraine exports to the EU, disaggregated into total, agricultural and non- agricultural exports, and further disaggregated in above categories for preferred exports (those groups of products that gained preferences under the DCFTA and outperformed other groups).

Nominal values of export were used as the dependent variable with explanatory variables of real exchange rate against the euro, EU real GDP and real exchange rate, two year variance as a measure of exchange rate uncertainty Table 1 below summarises the results of the regressions.

Table 1

Model of Exchange Rate Impact on Ukraine's Exports to EU