The extent to which exchange-rate fluctuations affect international prices-so-called ‘exchange-rate pass-through’-has been extensively studied, first for high-income countries and, in the last decade, also for emerging markets such as India and China. Exporters absorb exchange rate changes in their profit mark-up, depending on the degree of competition they face in a destination market which in turn will determine the extent of pass-through of exchange rate ranges into buyers’ (importers’) prices.
Why do we care so much about exchange-rate pass-through by Indian and Chinese exporters? At the general level, emerging markets matter because they have been the growth engines for the world economy during the recent economic downturn. At the specific level, the comparison between India and China is particularly fascinating for economists as these two countries have followed very different paths of integration into world value chains and have maintained different exchange-rate regimes. On the one side, China has a fixed exchange-rate regime and a great deal of outward processing trade, while on the other side, India has a flexible exchange-rate regime with predominantly arms-length trade.
What pass through?
For years, researchers have documented the low degree of exchange-rate pass-through both at the individual price level and for aggregate price indices. The explanations often provided are based on the existence of ‘pricing to market’ by imperfectly competitive firms. In recent research (Mallick and Marques, 2013), we start out from that point of view, but introduce into the analysis a number of key elements that have been missing until now.
The destination market
First, it is important to consider demand in the destination market along with demand in the exporting country, which can be crucial in the price setting behaviour of an exporter. Until now there has been little focus on considering the role of demand-side factors of both exporting and importing countries in explaining price variation across markets. In other words, ‘pricing to market’ as a response to an exchange-rate shock can be conditional on the size of demand in the exporting and importing countries, as measured by their per capita income. The degree of exchange-rate pass-through may also be correlated with the extent of outward processing trade that fosters transfer pricing. In general, transfer pricing can make the exporter’s price vary in the same direction as the exchange rate, amplifying exchange-rate changes instead of dampening them.
In or out?
Second, in the last decade the issue of firms with different productivity has been introduced into trade literature. According to that line of research, not all firms export and beyond that, not all firms export to all markets. Typically, only the highest productivity firms will export to high-income markets, whereas firms which are sufficiently productive to export but not enough to get into high-income markets may just export to low-income markets. This selection effect may be associated with the kind of products they export; so we incorporate the selection of firms in terms of product-market pairs. We argue that the decision to stay in or out of an export market for a particular product may be correlated with the ‘pricing to market’ decision. If this correlation exists but it is not taken into account, the exchange-rate pass-through estimates will be biased.
Third, there are significant differences in the variability of macroeconomic aggregates, namely gross domestic product (GDP) per capita and inflation, under fixed and flexible exchange-rate regimes. International price discrimination causes exchange-rate pass-through to be incomplete in both the short and the long run with high exchange-rate volatility. Assessing the impact of exchange-rate uncertainty or fluctuation on prices can help uncover the extent to which exporters in different countries respond to currency risks. Intuitively, exporters may tend to trade more under an uncertain environment by adjusting prices so as to increase their current revenues when faced with an expected decline in future revenues. This suggests that we can expect either a positive or a negative effect of exchange-rate uncertainty on export prices, depending on the source country and export market characteristics. In this context, considering those two key emerging market exporters, where exchange-rate fluctuations are respectively fully and partially managed by their monetary authorities, reveals whether exchange-rate volatility tends to increase price discrimination and thereby reduce the degree of pass-through.
Comparing exchange-rate pass-through
We investigate these issues by comparing the extent of exchange-rate pass-through of the rupee and the yuan in response to changes in their NEER (Nominal Effective Exchange Rate), using product-level data across high- and low-income export destinations over the period 1994-2007.
First, exchange-rate pass-through is incomplete in India’s exports to high-income markets. There is full exchange-rate pass-through in the remaining cases. This is because Indian exporters absorb changes in the Indian rupee by changing export prices in their own currency in the opposite direction to that of the exchange-rate change, but the opposite happens in the case of the Chinese yuan. The amplification effect of exchange-rate changes to price changes in the case of China may be a sign of the existence of transfer pricing, which does not exist in the case of India.
Second, we uncover the existence of a selection bias in exports to high-income markets, where the decision to export to a certain product-market pair is correlated to the pricing decision. However, the pricing of exports to low-income markets is independent of the decision to export.
Third, Indian exporters have changed their mark-ups in response to the rupee’s volatility, while Chinese exporters do not react to currency volatility given a fixed exchange-rate system with a narrow band. This suggests that Indian exporters exercise market power to obtain price premia when their currency experiences volatility with respect to the importer’s currency. There is a strong positive relationship between volatility and prices in the case of a (relatively) flexible currency system implying low exchange-rate pass-through (as in India), while high exchange-rate pass-through occurs in the case of a fixed exchange-rate regime (as in China).
Over the coming decades the BRICS (Brazil, Russia, India, China and South Africa) countries will become the largest economic group in the world and the influence of their trade patterns on the global economy will be immense. These countries are already large enough in some of their export markets to behave as price-makers. One possibility is that they can manipulate the price of their exports in their own currency to remain competitive abroad when facing adverse exchange rate changes or that the exporters can increase their profits when exchange rate changes are favourable. To sum up, the pricing behaviour of exporters in emerging markets confirms that the already well-reported decline in exchange rate sensitivity of import prices is due to export prices becoming more sensitive to exchange rate changes.
Sushanta Mallick is a professor of International Finance at the School of Business and Management, Queen Mary, University of London, UK.
Helena Marques is associate professor at the Department of Applied Economics of the University of the Balearic Islands (Spain).