Estimating the exchange rate pass through effect on prices at the micro level

This analytical note investigates the exchange rate pass-through mechanism at the micro level, i.e. at the level of individual enterprises. Theoretical models of the optimal behavior of companies and analysis of their actual activities demonstrate that when the national currency weakens (or strengthens), large companies with a relatively low proportion of import costs can raise (cut) prices more intensively than that proportion dictates. This variation is achieved through active margin management, i.e. increasing or decreasing of the margin in response to anticipated pricing activity of competitors. The pass-through effect, therefore, is not determined solely by the amount companies spend on imported materials and components or by the market share of importers. In order to estimate the intensity of the effect it is also important to know the number of companies in the market, as well as its structure, and, accordingly, the extent to which companies take into account their competitors actions. Using Russian data we have compared the estimates of the pass-through effect calculated on the basis of expenses with the estimates that take into account the ability of a company to manage their margin and the extent to which they consider competitors actions. The study shows that, first, the estimated pass-through effect calculated on the basis of expenses at the micro level was 0.18, which lies within the range of published macroeconomic estimates. Surveys indicate that the pass-through effect is asymmetrical: when the ruble weakens, the effect is twice as strong as when the ruble strengthens. Secondly, the pass-through effect estimates change only slightly when companies motivation to manage their margin actively is taken into account. In part, this reflects the insignificant intra-industry variation of the proportion of imports in costs, which reduces a companys motivation to correct the pass-through effect; moreover, to a certain degree, it reflects the different directions of pass-through effects at the industry level, which offset each other in the total price index. Our estimates show that in agriculture and food production the pass-through effect is strongly affected by companies behaviour: they closely track the pricing policy of their competitors. These industries are generally represented by several very large enterprises, which have a relatively high proportion of imports in costs, and a large number of small companies with smaller import ratios (regional producers). When the exchange rate is weakening, major market players have to decrease their margin in order to maintain their market share, whereas small companies can aggressively raise prices to improve their financial standing (at the cost of their larger competitors). Our estimates demonstrate that, as far as food production is concerned, the total market influence of small producers is prominent enough for the pass-through effect to be greater than the effect of transfer based on costs. As a result, prices turn out to be more volatile within given ruble exchange rate range (growing more intensively when the ruble weakens and falling when it strengthens) than they would be in a more homogeneous industry. Therefore, the strengthening of the ruble in 2016-2017 had an additional minor disinflationary effect in agriculture and food production due to the competition structure in these industries. This can help explain variation in the dynamics of food and core inflation in 2017 as well as the contribution of the pass-through effect to the food and core inflation in September, estimated at the macro level. Exchange rate shifts not only create price effects in the above industries, but also lead to the redistribution of profits between producers. When the ruble is falling (such as in 2014-2015), this redistribution negatively impacts the financial standing of larger borrowers (who usually have a large proportion of imports in costs) in the short term. This can lead to increased risks for financial stability. At the same time, small companies obtain additional resources for development and investments. As a result, in the midterm, the financial stability of these industries improves.