Exchange rate risk, contract enforcement, and trade: A theoretical and empirical investigation

It is commonly claimed that exchange rate risk depresses international trade. However, both the theoretical and empirical contributions to the literature fail to conclusively support this assertion. The first chapter reconsiders the trade effects of exchange rate risk in a setting with imperfect contract enforcement. The theoretical analysis reconciles the seemingly contradictory findings by pointing out the key interaction between the level of contract enforcement and impact of exchange rate risk on trade, an aspect that has surprisingly been neglected so far. In particular, a clear distinction can be made among three cases. First, an increase in exchange rate risk dramatically inhibits trade when the level of enforcement is sufficiently poor. Second, an increase in exchange rate risk encourages trade for some intermediate levels of contract enforcement. Third, for sufficiently high levels of contract enforcement the impact of exchange rate risk on trade is negligible.; The second chapter subjects the theoretical conclusions of the first chapter to econometric tests using aggregate bilateral trade flows of 44 developed and developing countries. The analysis supports an interaction between the level of enforcement and impact of exchange rate risk on trade but provides only limited evidence of the kind of association suggested by the theory,; The third chapter reexamines the link between the trade effects of exchange rate risk and level of enforcement at a disaggregate level where trade data are grouped into homogenous or differentiated products. The analysis indicates an interaction between the level of enforcement and impact of exchange rate risk on trade, which is not uniform across commodities. The empirical results show that this interaction applies most strongly to differentiated products and its nature is strikingly consistent with the theoretical conclusions in the case of differentiated products. All in all, the data fit the theoretical model closely once we remove homogenous products.