Exchange rate volatility, UK imports and the recent financial crisis: evidence from symmetric ARDL and asymmetric ARDL methods

Abstract

Uncertainty in the amount and direction of changes in exchange rates is described as the exchange rate volatility. This research examines the role of exchange rate volatility in determining the UK’s real imports in a broader perspective by including: i) the third country exchange rate volatility; and ii) the impact of the current financial crisis on the relationship between exchange rate volatility and UK imports. In the context of international trade, exchange rates are often more important than the prices of the traded goods and services because the prices are observed to be more stable and predictable in comparison to the exchange rate movements. Thus, a rise in exchange rate volatility causes an increase in the degree of risk aversion of the traders, which results in the reduction of trade volume. This research contributes to the empirical literature on the subject by offering evidence based on the Symmetric ARDL bounds testing approach (Pesaran, Shin and Smith, 2001) and the Asymmetric ARDL method (Shin et al., 2013). These models are capable of addressing important issues related to the non-stationary and nonlinear characteristics of the underlying macroeconomic data. The analysis sample includes the UK’s major trading partners, i.e. the US, Germany and Japan representing the developed countries and Brazil, China and South Africa representing the developing economies. Results suggest that exchange rate volatility plays an important role, and also reveal that there is a significant effect from the recent financial crisis on UK imports. This finding is consistent when we test for the third country volatility effect. We also find that there is a significant causal relationship between exchange rate volatility and UK imports, both in bilateral tests and in tests that account for the third country exchange rate volatility. Comparative analysis of developed and developing countries shows that the third country effect is significant for all the countries. The UK imports’ demand elasticity to different determinant variables, including exchange rate volatility, changes significantly after the inclusion of the financial crisis. These changes are more pronounced under the Asymmetric ARDL method, where positive and negative changes in determinant variables, especially exchange rate volatilities, affect UK imports differently before and after inclusion of the financial crisis. These findings contribute to the existing literature as no evidence of the third country effect and asymmetric behavior of exchange rate volatility on UK trade flows currently exists in the literature. This has significant implications for trade policy and international trade to minimise the underlying risk factors and ensure stable trade flows in different economic scenarios.

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ORCID for Taufiq Choudhry: orcid.org/0000-0002-0463-0662

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