Trade and the Euro: effects on bystanders

ABSTRACT

This article investigates trade effects of the euro focusing on the impact on bystanders. We use data for Swedish firms and examine the impact on exporting firms’ intensive and extensive margins of trade. Our result shows an overall increase in Swedish firms’ exports to the euro area after the introduction of the single currency, indicating that the euro has decreased trade costs also for outsiders. In addition, we find important heterogeneity in the sample, suggesting that it is the large majority of small firms that has increased trade flows with the Eurozone the most.

KEYWORDS:

• Euro
• trade diversion
• exports
• heterogeneous firms

JEL CLASSIFICATION:

• F10

I. Introduction

The implementation of the euro was expected to increase the benefits from the single market through increased trade and investment. By removing costs associated with currency exchange and related transaction costs, a single currency is expected to reduce prices and lead to increased trade among member states. In addition, higher price transparency and elimination of exchange rate volatility is anticipated to increase competition and further induce positive effects on trade. A large and growing literature on the trade effects of currency unions in general, and the Eurozone in particular, tends to confirm positive trade effects of a currency union on its members.¹ The effects on nonmember countries, however, are much less explored. One risk faced by outsiders is the potential trade-diverting effect as a fall in trade costs and prices within the currency union will increase the relative cost of trading with outside countries. On the other hand, similar to inside firms, outside firms may benefit from a single currency when trading with important trading partners.

Whether the euro has induced trade diversion or trade creation with nonmembers is an empirical question. In this article, we investigate the euro’s impact on bystander firms’ exports to the Eurozone countries using firm-level data for Swedish manufacturing and wholesale firms. We consider Sweden to be an interesting case as it is a EU member country that has not adopted the euro. It is also a small economy, highly dependent on trade, with about half of its trade flows with the Eurozone.² The assessment of the trade effects follows the heterogeneous-firm model of the micro patterns of international trade and examines the impact on both firms’ intensive (the volume of export sales to each destination) and extensive (number of destinations) margins of trade. As demonstrated by, e.g. Helpman, Melitz, and Rubinstein (2008), ignoring the impact changes on the extensive margin of trade could be of major concern and lead to biased estimates. The use of firm-level data is also to be preferred in order to control for micro-economic dynamics and to understand the effect of the euro on the behaviour of exporting firms.

To our knowledge, the only studies that have addressed the effects of the euro on outsiders using firm-level data are the descriptive studies by Baldwin et al. (2008) and Fontagné, Mayer, and Ottaviano (2009). These studies find no support for trade diversion. Our micro-econometric approach where we use detailed information of firms’ geographical export patterns and evaluate the effects on both trade margins enable us to investigate this issue in a more comprehensive way.

II. Trade effects on bystanders

A common currency such as the euro is expected to affect trade by reducing various types of trade costs. In the framework by Melitz (2003), the trade creating effects from reducing trade costs may be observed on two margins: the intensive margin where trade volumes of existing exporters increase and the extensive margin where the number of trading firms increases as the productivity threshold to enter the export market is lowered. As Melitz shows, effects on the intensive margin are induced by lowering variable trade costs, while the extensive margin is affected by an increased profitability from exporting through a fall in variable and/or fixed costs of trading. Among the costs associated with trade in different currencies, the transaction costs can be viewed as variable trade costs, while costs related to lack of price transparency and exchange rate volatility is likely to involve more fixed costs of trading.

Independent of whether the euro influences variable or fixed costs of exporting, its implementation may have trade-diversion effects for outsiders. A fall in trade costs in the Eurozone implies a fall in the perceived price on these countries’ markets, which increases the relative cost of trading with outsiders. Thus, even if the absolute cost for outsiders to reach the Eurozone remains unchanged, outsiders’ exports will become relatively more expensive on the euro markets, leading to decreased demand for outsiders’ products.³ On the other hand, a currency union could lead to increased trade also with nonmembers. For one thing, the euro implies that also outside firms will benefit from using the same currency when trading with important trade partners. Hence, outsiders may experience falling absolute trade costs to the Eurozone that could counterbalance the expected trade diversion. Moreover, dynamic effects that promote competition and economic growth may increase import demand for outsiders’ products as well, especially when involving differentiated goods. In addition, higher price transparency that increases the price sensitivity of customers within the Eurozone may changes outsiders’ export pricing strategies. Thus, if outsiders respond by cutting price-cost margins, this will lower their relative prices and stimulate sales (see Baldwin et al. 2008).

III. Data and econometric strategy

Our data is provided by Statistics Sweden and consist of an unbalanced panel of 11,939 firms in the manufacturing and wholesale sector for the period 1997–2003.⁴ For all years we have detailed information on each firm’s output, factor inputs, and export volumes to each export destination. Besides the Eurozone countries, we restrict the analysis to exports to other high-income countries in order to have a relevant comparison group. A definition of the sample and the variables used can be found in Table 1.

Table 1. Data description and sources (1997–2003 period).

Characteristics	Definition (source)	Mean (min, max)
Firm level (based on all firm-year observations)
TFP	Total factor productivity defined as in Olley and Pakes (1996).	22,092 (3.21, 8,896,455)
Employees	Number of employees in full year equivalents.	54 (1, 20,091)
Destination level (based on all destination-year observations)
GDP	Gross domestic product in billions of current US$ (CEPII).	550 (0.275, 15,500)
Euro	Dummy variable taking the value of 1 from 1999 for each trade partner belonging to the Eurozone and 0 otherwise.
Sample information
Importers	The sample consists of 71 high-income OECD and non-OECD countries.
Eurozone	Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, Spain
EU	Eurozone + Denmark and UK
Exporters	In our sample, the share of exporting firms is 79% and 57% of the firms export to the Eurozone countries.
Firms	The sample of 11,939 firms excludes firms existing for less than 3 years and that have less than 10 employees throughout the whole period.

Our estimation procedure is based on a heterogeneous-firm type of the gravity model, and to assess the euro’s impact on the intensive margin of trade we estimate the following benchmark specification with several levels of fixed effects:

(1) $\begin{array}{rl}& lnx{}_{fjt}={\alpha }_0+{\alpha }_{1}Eur{o}_{jt}+{\alpha }_{2}lnGD{P}_{jt}\\ & +{\alpha }_{3}lnTF{P}_{ft}+{\alpha }_{4}lnEmploymen{t}_{ft}\\ & +{\pi }_{fj}+{\delta }_t+{\phi }_{jt}+{\epsilon }_{fjt}\end{array}$(1)

where $ln{x}_{fjt}$ is the natural logarithm of the export value of firm f to importer j at time t, $Eur{o}_{jt}$ is an indicator of Eurozone membership, $lnGD{P}_{jt}$ is the log of importer GDP, $lnTF{P}_{ft}$ is the log of total factor productivity of firm f measured as in Olley and Pakes (1996), and $lnEmploymen{t}_{ft}$is the log of the firm’s number of employees used as a measure of firm size. ${\pi }_{fj}$ and ${\delta }_t$ are fixed effects capturing firm-importer and time invariant trade costs, ${\phi }_{jt}$ is a trend at the destination level to control for the importer’s general trade development over time, and ${\epsilon }_{fjt}$is an error term.

To investigate the impact of the euro on the propensity to export to Eurozone countries, we consider the following specification of the extensive margin of trade:

(2) $\begin{array}{rl}& X_{fjt}={\alpha }_0+{\alpha }_{1}Eur{o}_{jt}+{\alpha }_{2}lnGD{P}_{jt}\\ & +{\alpha }_{3}lnTF{P}_{ft}+{\alpha }_{4}lnEmploymen{t}_{ft}\\ & +{\pi }_{fj}+{\delta }_t+{\phi }_{jt}+{\epsilon }_{fjt}\end{array}$(2)

where $X_{fjt}$ is an indicator that takes the value of 1 if the firm exports to destination j and 0 otherwise. Other variables are defined as above. Equation (2) is estimated using a linear probability model (LPM) with fixed effects as in Bastos and Silva (2012). This allows us to capture unobserved firm-importer effects without facing the problems of incidental parameters that may occur in a probit model. In addition, the LPM gives good estimates of the partial effects (Wooldridge 2002, p. 455).

IV. Empirical results

The two sets of results for the euro’s effect on Swedish firms’ intensive and extensive trade margins are presented in Table 2. For both sets of results, the positive and significant coefficients for importer GDP and for firm productivity are in line with our expectations and earlier studies. An increase in employment, on the other hand, is not associated with increased trade.

Table 2. Euro effect on bystanders, 1997–2003.

	Intensive margin				Extensive margin
	(1)	(2)	(3)	(4)	(5)	(6)	(7)	(8)
Euro	0.119***	0.124**	0.121***	0.129***	0.009*	0.009	0.009*	0.022***
	(0.001)	(0.018)	(0.001)	(0.000)	(0.129)	(0.111)	(0.087)	(0.001)
lnGDP	0.391**	0.256***	0.390**	0.391**	0.092***	0.093***	0.092***	0.092***
	(0.023)	(0.434)	(0.023)	(0.023)	(0.000)	(0.008)	(0.007)	(0.007)
lnTFP	1.100***	1.168***	1.165***	1.100***	0.145***	0.173***	0.150***	0.147***
	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)
ln Employment	−5.546***	−6.426***	−6.034***	−5.541***	−0.405***	−0.521***	−0.443***	−0.422***
	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)	(0.000)
$Euro\times Mediumfirm$				−0.0420*				−0.020**
				(0.059)				(0.000)
$Euro\times Largefirm$				0.039				−0.055***
				(0.154)				(0.000)
Sample	All dest.	EU	All dest.	All dest	All dest.	EU	All dest.	All dest
Fixed effects	Firm-dest. Trend (dest) Year	Firm-dest. Trend (dest) Year	Firm-dest. Trend (dest) Year Year-ind.	Firm-dest. Trend (dest) Year	Firm-dest. Trend (dest) Year	Firm-dest. Trend (dest) Year	Firm-dest. Trend (dest) Year Year-ind.	Firm-dest. Trend (dest) Year
Observations	352,546	193,343	352,546	352,546	864,075	451,708	864,075	864,075
R^2	0.810	0.825	0.811	0.810	0.606	0.611	0.606	0.606

Robust p-values (in parentheses) are based on SEs clustered at destination level. ***, **, and * denote statistical significance at the 1%, 5% and 10% level of significance, respectively. The estimations of the intensive margin only include firms with positive exports.

The assessment of the trade effect of the euro is captured by the treatment dummy (Euro). For our benchmark specification of the intensive margin in column 1, the result suggests that the potential trade-diverting effect of the euro has not occurred. On the contrary, exports to the euro area increase with almost 12% after the single currency is introduced. The result is upheld in column 2 where we narrow down the sample to only EU countries as control destinations, as well as in column 3 where year-industry fixed effects are included. To investigate whether the euro affects firms differently, we interact the euro dummy with different firm size categories in column 4.⁵ There are reasons to believe that smaller firms will find it harder to cover trade costs both at the intensive (e.g. trade costs related to the management of currency problems) and extensive margin (e.g. trade costs associated with sunk costs of exporting) and hence will be more affected by the euro than larger firms (see the discussion in Berthou and Fontagné 2008; and Esteve-Pérez et al. 2011). The result in column 4 indicates no difference between the base group of small firms and the group of large firms. For medium-sized firms, however, the positive impact of the euro on the intensive margin is somewhat smaller as the estimated coefficient for the interaction term is negative.

The results for the extensive margins are presented in columns 5–8. Again, the euro dummy is positive, although quite small in magnitude and not always significant. The most striking result is found in column 8 and is indicative of a clear heterogeneous effect of the euro. Thus, while the euro has a positive and highly significant effect for the benchmark of small firms, this is not the case for larger firms. In fact, medium-sized firms seem rather unaffected by the euro, and large firms actually reduce trade at the extensive margin following the introduction of the euro.⁶ The positive effect on both margins for small firms suggests that the euro is associated with a reduction in trade cost for these firms that has enabled them to cover both variable and fixed cost of exporting to the Eurozone. Larger firms – and in particular firms with more than 250 employees – appear on the other hand to have experienced some trade diversion, possibly because these firms were less affected by trade costs in the first place.

V. Conclusions

This article adds to the literature on trade effects of currency unions by addressing the issue of the effects on bystanders, using firm-level data. An understanding of the impact of a single currency on outside firms’ engagement on export markets is essential from a policy perspective as it points to the possible costs of remaining outside. The results from our micro-econometric approach indicate an overall positive effect of the euro on both the intensive and extensive margin of trade. Thus, the main impact of the euro for Swedish firms seems to have been a decrease in trade costs with the Eurozone countries. This is an important finding since it suggests that Swedish firms did not lose in competitiveness within the Eurozone as a whole, and supports previous descriptive studies of no trade-diverting effects of the euro. In addition, we identify important heterogeneity in the sample, suggesting that it is the large majority of small firms that has benefitted the most, while large firms may have experienced some trade diversion.

Acknowledgments

We thank conference participants at ETSG in Birmingham, 2013, Lund Seminar Series in International Economics 2013, and SNEE in Mölle, 2014. In addition, we thank Hans Carlsson for his advice.

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

This work was supported by the Jan Wallander and Tom Hedelius Foundation [P2016-0114] and Torsten Söderberg’s Foundation [ET3/13].***

Notes

¹ For an overview of this literature, see the surveys by Baldwin (2006) and Flam (2009).

² At the time of the implementation of the euro, Sweden’s exports to and imports from the Eurozone accounted for 42% and 52%, respectively, of Sweden’s total exports and imports.

³ Notice that trade diversion in this context differs from the traditional trade-diversion effects in custom-union analysis since there will be no negative impact on within-union countries. The formation of a customs union eliminates tariffs between member countries and creates a tariff-revenue loss on imports for the government. A common currency, on the other hand, involves no such loss. The removal of currency-related trade costs will only lead to lower prices that benefit consumers of imported goods.

⁴ Although we have data for the period 1997–2011, we focus our analysis to the 1997–2003 period as the effect of the euro is expected to be more pronounced in the early years just after its implementation in 1999. This also allows us to ignore trade effects from the EU enlargement and the 2008 financial crisis. We do, however, estimate the effect for the whole period as a robustness check.

⁵ We divide our sample in small, medium and large firms defined by having 1–49, 50–249, and +250 employees, respectively. This gives us 9127, 2297, and 515, small, medium and large firms, respectively.

⁶ Estimating the effects for the period 1997–2011 provides very similar results for the extensive margin. For the intensive margin, the overall positive effect of the euro remains but with a lower magnitude (around 7%), while the heterogeneous effect disappears. These results are available upon request.