Exchange Rate Fluctuations and U.K. Manufacturing Exports


WP/94/132-EA
Exchange Rate Fluctuations and U.K. Manufacturing Exports
by Hossein Samiei

The United Kingdom's export performance since the 1970s, it has often
been argued, has reflected a tendency for U.K. exporters to use favorable
exchange rate movements to improve profit margins rather than to strengthen
their competitive position and boost foreign demand for their products.
Exports, however, also depend on supply-side performance, which, unlike
demand, is positively influenced by improved profit margins. The effect of
exchange rate fluctuations on export performance therefore depends on the
price sensitivities of both supply and demand and on the pricing policies of
exporting firms. In a competitive international market, exporting firms
follow a pricing-to-market policy, taking prices in foreign currencies as
given and offsetting the effects of exchange rate depreciation by
appropriately adjusting local currency export prices. At the opposite
extreme, setting prices based only on domestic factors, for example in order
to preserve profit margins, implies a full exchange rate pass-through to
consumer prices abroad. The former pricing policy maintains demand while
the latter sustains the firm's ability to invest and supply.

Depending on the market structure, a lack of response (or a partial
response) of export prices to sharp or sudden exchange rate fluctuations
could indicate the presence of hysteresis in the sense that a transitory
shock to the system would permanently change relative prices. Moreover,
when investment and production involve costs that are irreversible, the
supply of exported goods may manifest hysteresis that arises from the entry
and exit decisions of firms. The response of export prices to exchange rate
movements may also depend on the prevailing exchange rate regime. A
question in relation to the United Kingdom is whether this response was
influenced by sterling's membership in the ERM and its subsequent departure
from the system in September 1992. In principle, the disciplinary effects
of a credible fixed exchange rate system are likely to influence price
determination by, for example, reducing the likelihood that devaluations
will be used to improve competitiveness.

This paper examines the impact of exchange rate fluctuations on U.K.
manufacturing exports. The results indicate a recursive structure in the
long run, wherein prices influence the volume of exports demanded but are
not influenced by it. They also indicate that U.K. exporters only partially
offset the impact on foreign consumers of fluctuations in the effective
exchange rate of the pound. During the ERM period, however, the extent of
pass-through to foreign prices weakened, a process that appears to have
reversed after exit from the ERM. Hysteresis in the form of limited
exchange rate pass-through is supported by the results, but that arising
from regime switches in supply is not.