Trade and Financial Channel of the Exchange Rate With Dollar Dominance: Is Export Growth Elusive?

ABSTRACT This paper explores the trade and the financial channel of the exchange rate through the lens of the Dominant Currency Paradigm (DCP). On the trade front, the DCP posits that exchange rate depreciation has a limited effect on exports; however, whether exports can increase through the extensive margin has largely been unaddressed. On the finance front, as trade tends to be more reliant on external finance, the availability of credit matters for exporters. By examining the foreign currency exposure of banks, the paper explores whether exchange rate variations affect exports through this financial channel. Employing the PPML (Poisson pseudo‐maximum‐likelihood) estimator on export data for 157 economies from 1996 to 2019, the paper finds: (i) a positive relationship between exchange rate depreciation and exports only at the product‐extensive margin; (ii) when the net foreign asset exposure of banks is positive, an appreciation contracts exports, whereas a depreciation has an augmenting effect only for lower levels of foreign currency exposure; and (iii) this asymmetry can be attributed to the global financial cycle. The results underscore the diminishing relationship between exchange rate depreciation and exports and shed light on how these movements can affect banks' balance sheets, ultimately hindering exports.