Exchange Rate Volatility, Heterogeneous Firms and Market Concentration

• Author: Xiaofen Tan,Bing Lu,Yaqi Wang
• Published date: 01 July 2020
• DOI: http://doi.org/10.1111/cwe.12326
• Date: 01 July 2020

©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 51–75, Vol. 28, No. 4, 2020

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*Bing Lu, PhD Candidate, PBC School of Finance, Tsinghua University, China. Email: lub.16@pbcsf.

tsinghua.edu.cn; Yaqi Wang (corresponding author), Associate Professor, Researcher in International Finance

Center, School of Finance, Central University of Finance and Economics, China. Email: yakisunny@126.

com; Xiaofen Tan, Professor, School of Finance, Central University of Finance and Economics, China.

Email: xiaofent@163.com. Bing Lu acknowledges nancial support from Center for International Finance

and Economic Research, PBC School of Finance, Tsinghua University. Yaqi Wang acknowledges nancial

support from the National Natural Science Foundation Youth Project (No. 71703078) and the Young Talent

(Qingnian Yingcai) Program (No. QYP2002) of Central University of Finance and Economics. Xiaofen Tan

acknowledges financial support from the National Natural Science Foundation Emergency Management

Project (No. 71850005).

Exchange Rate Volatility, Heterogeneous Firms

and Market Concentration

Bing Lu, Yaqi Wang, Xiaofen Tan*

Abstract

With the gradual promotion of market-oriented reform of the RMB exchange rate, the

uctuation range of the RMB exchange rate is increasing. How to deal with the impact

of exchange rate volatility on Chinese exports is an important challenge faced by China.

This paper nds that although exchange rate volatility, as a whole, has a negative impact

on exports, high-productivity exporters are less prone to exchange rate volatility shock

in both intensive and extensive margins. As high-productivity firms are less affected

by exchange rate risk, they account for larger market shares. This paper, from a new

perspective, provides evidence that increasing productivity helps mitigate the negative

impact of exchange volatility on exports.

Key words: exchange rate volatility, export quantity, export value, firm performance,

market concentration

JEL codes: F10, F31, L25

I. Introduction

The market mechanism is the most effective means of resource allocation. Forming

a market-oriented exchange rate determination mechanism and reducing government

intervention in exchange rate in emerging economies have long been encouraged by

the International Monetary Fund (IMF). It has also been an important goal of market-

oriented exchange rate reform in China. The IMF has repeatedly pointed out that the

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©2020 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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exchange rate marketization mechanism is in line with China’s interest.1 With the

deepening of market-oriented reform of the RMB exchange rate, the volatility of the

RMB exchange rate has been increasing. Since 1994, the People’s Bank of China has

adjusted the fluctuation range of the RMB exchange rate four times. The fluctuation

range of the RMB exchange rate was 0.3 percent in 1994, 0.5 percent in 2007, 1 percent

in 2012 and then was further adjusted to 2 percent in 2014. The increasing exibility

of the RMB exchange rate is one of the objectives in the marketization of the RMB

exchange rate pricing mechanism.

How to avoid the possible negative impact of exchange rate fluctuations on

China’s exports and economy has been a topic of great concern to both policymakers

and academics in China. Exchange rate fluctuations may have a negative impact on

exports. Under the assumption of risk-averse preference, excessive exchange rate risk

reduces the utility and the intention to export of an exporter. However, no consensus

has been reached among academic research on the effects of exchange rate volatility

on trade. In the early theoretical research, Clark (1973) found a negative relationship

between exchange rate volatility and trade with the strict assumptions such as perfect

competition, risk aversion and so on. Other researchers also came to a similar conclusion

(Hooper and Kohlhagen, 1978; Cushman, 1983; De Grauwe and Verfaille, 1988). When

some scholars relaxed the assumptions, however, the relationship between volatility

and trade was mixed (McKenzie, 1999; Clark et al., 2004). For empirical studies, the

relationship between volatility and trade was also ambiguous (Hondroyiannis et al.,

2008; Baum and Caglayan, 2010; Boug and Fagereng, 2010).

A novel finding of our paper is vast firm heterogeneity in response towards

exchange rate volatility. We find efficient firms are less vulnerable to exchange rate

volatility. Our theoretical analytic framework is an extension of Melitz and Ottiviano

(2008). We nd that exchange rate volatility has a negative impact on export quantity

and export value. Such effects are dampened for high-productivity rms. In other words,

better performing rms are less sensitive to exchange rate volatility, and these efcient

rms account for larger market shares. Industries’ market concentration thus increases,

causing the resource reallocation effects of exchange rate volatility.

To empirically test our hypothesis, we then use the merged data sets of Chinese

transaction level customs data and the annual production data of industrial firms

during 2000–2007. To our knowledge, our paper is the first to exploit such detailed

data to document the real impact of exchange rate volatility on industrial market

concentration through the channel of firm heterogeneity. We find that exchange rate

1See http://money.163.com/10/1012/17/6IQHF2ED00254JKB.html for detailed information.