A weak dollar and a record low US interest rate are regarded as good news by US exporters but worry European manufacturers. Export industry representatives and governments fear real appreciations for their potential negative influence on profitability and employment.
But real appreciations may also bring some good news for industries by fostering restructuring and laying the ground for renewed productivity growth. In other words, do real exchange rate shocks have cleansing effects similar to recessions? Related to this is also the question whether central banks should keep strictly to their inflation targets, or if they also should keep an eye on exchange rates.
The Norwegian experience
As we discuss in a recent paper, the sharp appreciation of the Norwegian Krone in the early 2000s lends itself as a natural experiment to study the causal impact of real exchange rate shocks on employment and manufacturing restructuring.
The central bank of Norway adopted inflation targeting in March 2001. This was followed by very high wage settlements. In order to comply with the inflation target, the central bank increased the interest rate, creating a large gap vis-à-vis foreign rates. This gap was further enlarged as the Federal Reserve and European Central Bank lowered their interest rates as the dot com bubble burst. As a consequence, the Norwegian Krone appreciated sharply.
Prior to 2000, the real exchange rate had been rather stable, but between 2000 and 2002 the real exchange rate rose by around 17%. By the end of 2004, around 32,000 manufacturing jobs had been eliminated, reducing manufacturing employment by 11% from its 2000 level. The Norwegian central bank was widely criticized for not paying enough attention to the exchange rate in this period and was blamed for the sharp decline in manufacturing employment. Amongst the critical voices was the OECD, which noted in its annual country report of Norway in 2004 that "the monetary policy stayed too tight for too long".
To what extent was actually the central bank to blame, and was the result of the proceeding restructuring all that bad?
There is mounting evidence that firms’ exposure to trade varies significantly even within narrowly defined export industries. This implies that firms may be hit very differently by a real exchange rate shock. However, previous empirical analyses of the impact of real exchange rate fluctuations on employment and economic performance have failed to account for heterogeneity in exports as well as imports. As a result, the effects may not have been correctly estimated. Using a new and extensive micro data set for Norwegian manufacturing firms, we are able to calculate precise, firm-specific measures of trade exposure.
Firm heterogeneity and exchange rate shocks
We exploit the fact that firms had very heterogeneous exposure to foreign markets before the real exchange rate shock. Specifically, the most exposed were ex ante more likely to be affected by the shock. We examine growth performance for these firms before and after the shock and compare them to a group of firms that were ex ante less exposed. Several strong conclusions emerge from our analysis.
First, the real exchange rate shock was associated with substantial employment losses. One-seventh of the total decline in manufacturing employment over the period under study can be attributed to the real appreciation.
Second, the shock led to productivity gains at the firm level, indicating that the most exposed firms were able to improve efficiency in a period of tougher foreign market conditions. One-fifth of the productivity improvement over the same time span can also be attributed to the real appreciation. Somewhat surprisingly, we do not find evidence of market reallocation effects; the real appreciation does not seem to have been associated with a reallocation of resources from low-productivity to high-productivity firms.
Third, firms responded to the real appreciation by offshoring (Ekholm and Ulltveit-Moe 2007), thereby purchasing a larger share of their intermediate inputs from abroad. For the manufacturing industry as a whole, the real appreciation increased the import share of intermediates by about 1.5%.
If the central bank was to blame for loss in manufacturing employment, it should also receive credit for its contribution to the productivity boost.