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The Impact of Real Exchange Rate Movements on Service Sector Firms

The Impact of Real Exchange Rate Movements on Service Sector Firms. Jen Baggs School of Business, University of Victoria Eugene Beaulieu Department of Economics, University of Calgary Loretta Fung Department of Economics, University of Alberta. Motivation. Important Question:

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The Impact of Real Exchange Rate Movements on Service Sector Firms

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  1. The Impact of Real Exchange Rate Movements on Service Sector Firms Jen BaggsSchool of Business, University of VictoriaEugene BeaulieuDepartment of Economics, University of CalgaryLoretta FungDepartment of Economics, University of Alberta

  2. Motivation Important Question: How do large real exchange rate movements affect service sector firms? • Services are becoming increasingly tradable and exchange rate has been identified as a key factor that affects service trade (Deardorff et al, 2001). • For services that are exposed to trade, exchange rate movements can influence the degree of competition and firm behavior.

  3. Motivation (cont.) • This paper builds on two groups of literature: • Exchange rate effect on volume of service trade: Deardorff et al, 2001, Hung and Viana, 1995, and Freund and Weinhold, 2002 • Impact of international competition on Canadian manufacturing firms, particularly, the effect of trade liberalization and exchange rate movements Trefler (2004), Baldwin and Gu (2003, 2004), Baggs (2005), Baggs and Brander (2006), LaRochelle-Côté (2007), Baggs et al (2008).

  4. Motivation (cont.) Empirical Analysis: • Between 1986 and 1997, the Canadian economy experienced a large currency appreciation followed by a large depreciation. • Examine the exchange rate effects on firm profits, survival, sales and leverage using micro data.

  5. Hypotheses: Derived from a combination of Fung’s (2008) and Melitz and Ottaviano’s (forthcoming) model: • Appreciations of home currency reduce firm profit. • Appreciations of home currency reduce firm probability of survival and this effect is less pronounced for more productive firms. • When the exit rate is low, appreciations of home currency cause a reduction in total sales. • Appreciations lower profits and induce firms to allow debt and leverage to rise. Home currency depreciations have opposite effects.

  6. Exchange Rate Measure • Industry-specific trade-weighted real exchange rate: Weighted average of normalized real exchange rate of Canada’s top 10 trade partners.

  7. Longitudinal Micro-data: T2-LEAP • From “T2” tax forms, and the Longitudinal Employment Analysis Project (LEAP) • Every incorporated Canadian establishment that legally hires employees AND files a “T2” from 1984 to 1998 (we use 1986 to 1997). • Annual data on the firm’s employment level, profit, revenues, debt, equity, assets, location, and industry affiliation at the 3-digit SIC level.

  8. T2-LEAP (Cont.) • Focus on service industries that are exposed to international trade: • Construction • Communication • Finance and insurance • Business services • Other services (e.g. films and organized sports)

  9. T2-LEAP (Cont.) • This data set is ideal for identifying entry/exit because it consists of the universe of Canadian firms. Constructing panels of survivors and exiters: Baggs’ (2005) criteria: • Initial population of firms are those that existed in 1986. • Augmented each year by removing exiting firms and adding new firms. • A firm is removed from the sample in the year in which the firm files its last tax return or if it is the last year that the firm hires employees. • A firm enters our sample in the first year it both hires employees and files a tax return.

  10. Table 1 – Descriptive Statistics

  11. Empirical Evidence: Firm Profits • Firm Profits • f: firm; i: industry. • lnprofit is set to 0 when profit is negative or 0. • ERit: industry-specific trade-weighted real exchange rate. • xft-1: age, size category and labour productivity. • yit-1: industry concentration (CR4), industry sales growth, real interest rate and GDP growth rate. • Also include time trend (τt) and industry fixed effects (at the 2-digit SIC level). • Interaction: lnERit*lnproductivityft-1 • Model: OLS and Tobit. • Tobit: deal with data truncation.

  12. Empirical Evidence: Firm Survival • Firm’s probability of survival: • surviveft = 1 if firm f survived in year t; =0 otherwise. • Model: probit

  13. Empirical Evidence: Firm Sales • Firm Sales • Model: OLS.

  14. Empirical Evidence: Leverage • Firm Leverage Prediction: Appreciations lower profits and induce firms to allow debt and leverage to rise. • Models: OLS and 2SLS • OLS: reduced form. • 2SLS: • Profit is instrumented by exchange rate and industry sales growth. • Regress leverage on predicted profit and other independent variables.

  15. Conclusions • Significant exchange rate effects: • Real appreciations of home currency reduce firm probability of survival and this effect is less pronounced for more productive firms. • Real appreciations reduce firm profits, sales and leverage. • The leverage reduction induced by currency appreciation may result from reduced profit. • Overall, the direction of exchange rate effects are the same as the empirical findings for Canadian manufacturing firms.

  16. Conclusions (cont.) • To our knowledge, this is among the first empirical research on the exchange rate effects on service sector firms. Further investigation into their behavior is much needed.

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