Global value chains and the missing link between exchange rates and export diversification

Conceptually, the present paper links export diversification and the real exchange rate (RER) by investigating the direction of causation. On one hand, a stable and competitive exchange rate is a key instrument in promoting export diversification through the tradable sectors’ profitability. But on the other hand, export diversification can help to reduce macroeconomic volatility, which in turn helps to consolidate a stable and competitive exchange rate. We propose a Granger causality test using panel data of the relationship in the middle-income countries of Asia and Latin America over the period from 1995 to 2015. We augment our baseline specification by examining how FDI (a key vehicle of GVC participation) and financial crises (which expose GVCs to disruptions) affect the causal relationship. Intuitively, the benefits of participation in GVCs may differ across countries, depending on external factors that might influence economic outcomes. Looking at the whole sample, our study finds a unidirectional positive causality running from export diversification to RER changes when we consider financial crises. However, we observe no causality for the regional sub-samples, meaning that it is global interactions that are the issue here. To go further, we rule out small islands from the Granger causality test. Again, our empirical findings show that the financial crises affect the causation but in contrast to the previous result, we observe the same unidirectional positive causality in the Asian sub-set. Overall, there is clear evidence that during financial crises, export diversification helps to reduce RER fluctuations, corroborating recent development studies that make a case for diversification to build macro resilience.