The effect of the exchange rate on industry-level trade flows in Czechia

Abstract

This paper is the fi rst study to use the disaggregated data of the Czech foreign trade to examine the effect of exchange rate levels and volatility on trade fl ows. Czechia is the appropriate economy to study this phenomenon because it is heavily involved in foreign trade predominantly owned by international investors and has been applying a fl oating exchange rate arrangement for many years. We analyze the period from 1993 to 2013 and disaggregate the data according to trading partner and product category. While the effect of exchange rate level is examined by a modifi ed vector error correction model the effect of exchange rate volatility is analyzed through an extended gravity model. The detailed results obtained from empirical estimations clearly show that the relationship between exchange rates and foreign trade in Czechia does not completely correspond with the theoretical assumptions. We revealed that domestic currency depreciation worsens in the long-term trade balance in substantial parts of the Czech foreign trade, such as in the trade of machinery and transport equipment with Germany, Austria and France. The classical J-curve effect was confi rmed only for the trading of beverages and tobacco with Italy and for the trading of manufactured goods with Slovakia. We also found that an increased exchange rate volatility does not necessarily reduce foreign trade turnover, as the results for crude materials, fuels, chemical and manufactured products indicate. By contrast, the theoretical expectation of negative impact of volatility was validated for machinery, transport equipment, food and animals. Therefore, although Czechia is a small, open economy, the exchange rate effects on foreign trade signifi cantly differ in magnitude and direction across the trading partners and product groups.