Cheap Labor Meets Costly Capital: The Impact of Devaluations on Commodity Firms

Transcription

1 Cheap Labor Mees Cosly Capial: The Impac of Devaluaions on Commodiy Firms Krisin J. Forbes MIT-Sloan and NBER Augus 5, 200 Absrac: This paper examines how devaluaions affec he relaive cos of labor and capial and herefore influence producion levels, profiabiliy, invesmen decisions, and sock reurns for firms in he crisis counry as well as compeiors in he res of he world. The paper develops hese ideas in a small, open-economy model and hen performs a series of empirical ess using informaion for abou,00 firms in 0 commodiy indusries beween 996 and The empirical ess suppor he model s main predicions. ) Immediaely afer devaluaions, firms in he crisis counry have higher raes of oupu growh han compeiors in oher counries; 2) Immediaely afer devaluaions, firms in he crisis counry have higher raes of operaing-profi growh han compeiors in oher counries; 3) The effec of devaluaions on fixed capial invesmen and sock reurns (and herefore expeced long-erm oupu and profis) is deermined by capial/labor raios and changes in he cos of capial. For example, crisis-counry firms have higher raes of capial growh and beer sock performance afer devaluaions if hey had lower capial/labor raios and here was no subsanial increase in heir ineres raes. Even hough crisiscounry firms may benefi from cheaper labor immediaely afer devaluaions, compeiors in oher counries may benefi in he long run if firms in he devaluing counry used capial inensively and/or heir capial becomes more cosly. Auhor conac informaion: MIT-Sloan School Phone: (67) Room E Fax: (67) Memorial Drive kjforbes@mi.edu Cambridge, MA 0242 Web page: hp://web.mi.edu/kjforbes/www *Thanks o Sebasian Edwards and paricipans a he IASE meeings a he NBER 2000 Summer Insiue for helpful commens and suggesions.

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3 I. INTRODUCTION In 997 he rupiah was devalued and hen allowed o depreciae. In 998, Indonesia s economy conraced by abou 4 percen. Several companies and indusries, however, increased producion and profis improved subsanially. For example, in 998 he planaion secor (which includes coffee, cocoa, rubber, palm oil and ea) grew by 6.5 percen. One of he larges planaions in he counry repored ha profis increased by a muliple of four in he same year. Over he same period, however, numerous firms complained abou a credi crunch and heir inabiliy o obain financing o increase heir producive capaciy and ake advanage of lower dollar expor prices. Many firms even claimed ha hey were unable o obain enough working capial o purchase inpus necessary o coninue producion a pre-devaluaion levels. Financial crises no only affec firms in he devaluing counry, bu can also impac compeiors around he world. Afer Brazil devalued he real in January of 999, Argenine companies were forced o reduce heir expor prices for soya beans in order o compee wih cheaper Brazilian expors. 2 During he Asian and Russian crises, sock reurns for firms ha compeed wih devaluing-counry expors were significanly lower han for oher firms in he same counries. 3 This suggess ha he Asian and Russian devaluaions negaively impaced expeced earnings and profis for firms ha compeed wih expors from he crisis counries. This paper examines how devaluaions affec relaive coss, producion decisions and profiabiliy for firms wihin a crisis counry as well as compeiors in oher counries (where a crisis counry is defined loosely as a counry ha devalues is currency). More specifically, i analyzes how devaluaions influence firms oupu, profiabiliy, capial invesmen, and sock reurns, as well as indusry prices and quaniies, in he shor and long run. In he heoreical model, firms are assumed o use wo variable inpus (labor and maerials) and one fixed inpu (capial). Labor is priced in domesic currency. Maerials and capial are priced in dollars, and he price of capial also incorporaes domesic risk and any local developmens in capial markes. The immediae impac of devaluaions is o lower he relaive cos of labor in he crisis counry. Firms in he devaluing counry increase oupu and profis, while compeing firms decrease oupu and profis. In he longer erm, however, devaluaions raise he cos of capial for firms in he crisis counry (poenially by more han he relaive exchange-rae movemen.) If his increase in he cos of capial is large enough and he firm s capial/labor raio is high enough, more The previous saisics on Indonesia are from he Asian Wall Sree Journal (999). 2 Unied Naions Conference on Trade and Developmen (999). 3 Forbes (2000).

4 expensive capial could ouweigh he benefis of relaively cheaper labor. Therefore, in he long run, devaluaions could decrease oupu, profis, and capial invesmen for firms in he devaluing counry, and increase oupu, profis and capial invesmen for compeiors in oher counries. The empirical secion of he paper uses daa for over,00 firms in 0 commodiy indusries o es he model s main predicions during a series of devaluaions beween 997 and Resuls show ha immediaely afer devaluaions, firms in he crisis counry have higher raes of oupu growh and profi growh han compeiors in oher counries. These growh effecs are shor-lived and end o disappear wihin a year, alhough he levels of oupu and profis remain higher indefiniely. Moreover, invesmen growh raes and sock reurns (boh of which signal changes in expeced long-erm oupu and profiabiliy) are correlaed wih capial/labor raios and changes in he crisis-counry cos of capial. For example, crisis-counry firms have larger increases in capial invesmen and beer sock performance afer devaluaions if hey had lower capial/labor raios and heir ineres raes did no increase subsanially. Firms in non-crisis counries had worse sock performance afer devaluaions if hey compeed wih more laborinensive firms (and beer sock performance if hey compeed wih more capial-inensive firms). Therefore, alhough he empirical analysis is no a formal es of he heoreical model, he resuls agree wih he model s cenral predicions. Even hough crisis-counry firms may benefi from cheaper labor immediaely afer devaluaions, compeiors in oher counries may benefi in he longer-erm if firms in he devaluing counry used capial inensively and/or heir capial becomes more cosly. This paper focuses on firms ha produce commodiies (or any undiffereniaed produc) mainly for expor. Alhough i is possible o exend his framework o oher indusries, he paper mainains his narrow focus for hree reasons. Firs, commodiy expors are a large share of GDP in mos counries ha abruply devalue heir currency (including many counries ha had crises in he lae 990 s). Moreover, many of hese counries rely heavily on commodiy expors for ax revenues and foreign currency. Second, alhough here has been a subsanial amoun of research on he impac of currency movemens on differeniaed-goods firms (such as he pricing-omarke lieraure), here has been relaively lile analysis for homogenous-goods firms. Third and finally, he producion srucure for mos commodiies is exremely useful in isolaing some of he key effecs of devaluaions. For example, many commodiies require a large, fixed invesmen in capial (such as planing rees or drilling mines) ha mus be made several years before he resuling oupu is sold. This srucure helps differeniae beween he shor- and long-run impac of devaluaions. Also, he producion of mos commodiies requires impored inpus and capial, as well domesic labor, so ha i is possible o capure how devaluaions inerac wih relaive 2

5 inpu inensiies and relaive inpu coss o affec oupu, profis, and invesmen. These facors appear o have played an imporan role in he impac of recen devaluaions on firms around he world. The remainder of he paper is divided ino four secions. Secion II briefly reviews several branches of relaed lieraure. Secion III presens a heoreical model of how devaluaions affec firms in he crisis counry and res of he world in he shor and long erm. I esablishes several condiions under which devaluaions are more likely o increase firms oupu, profiabiliy, and invesmen levels. Secion IV uses firm-level daa for a series of devaluaions beween 997 and 2000 o es four cenral predicions of he model. Secion V concludes. II. LITERATURE REVIEW This paper is relaed o six diverse branches of lieraure: he impac of devaluaions on expors; he effec of financial crises on domesic producion; conagion and he inernaional ransmission of currency crises; he imporance of exchange-rae exposure o sock reurns; he exen of pass-hrough from currency movemens o goods prices; and he deerminans and effecs of flucuaions in commodiy prices. Each of hese branches of lieraure is so exensive ha his survey does no make any aemp o discuss all of he relevan papers. Insead, i simply highlighs he key quesions and approaches and refers o recen surveys and aricles ha are closely relaed o his paper. The firs branch of lieraure examines how devaluaions affec expor growh. A sandard argumen jusifying devaluaions is ha hey should reduce he relaive cos of expors on inernaional markes and herefore improve expor growh. There are, however, a number of reasons why devaluaions may no have his desired effec, such as if demand for expors is relaively inelasic or impored inpus are a large componen of producion. Ghei and Priche (999) provide a deailed summary of why devaluaions may or may no improve expor performance, as well as why i is difficul o measure hese effecs. Afer a review of he empirical work on his subjec, hey conclude ha expors ypically increase afer a devaluaion, and ha mos of his response occurs rapidly (in abou one or wo years). 4 A closely relaed branch of lieraure examines how devaluaions affec no only expor growh, bu also oher macroeconomic variables such as oupu, income levels, invesmen, and 4 Rose (99) uses more formal ime-series echniques and finds lile impac of exchange-rae movemens on rade balances. Several papers have also examined specific examples of how devaluaions affec expor growh. For example, Duagupa and Spilimbergo (2000), Higgins and Kligaard (2000), and Barh and Dinmore (999) examine he impac of he devaluaions on Asian expors. 3

6 inflaion. Agénor and Moniel (996) provide an excellen summary of his lieraure and develop a general-equilibrium model showing he various channels by which devaluaions can affec he macroeconomy. They also survey empirical work on his subjec and conclude ha he evidence on wheher devaluaions are conracionary is mixed. 5 More recenly, several papers exend his line of research o examine he impac of "crises" (which are generally defined o include movemens in ineres raes and/or foreign reserves, as well as exchange raes) on macroeconomic variables. Gupa, Mishra and Sahay (2000) is one of he mos recen papers on his subjec. Their resuls sugges ha abou 40 percen of he currency crises beween 970 and 990 have been expansionary. 6 While hese branches of lieraure focus on he domesic impac of devaluaions and crises, a more recen and rapidly growing body of work examines "conagion" and how crises affec oher counries. Many of hese papers focus on "real" linkages beween economies, such as rade compeiion or shifs in he demand for expors. Oher papers focus on financial linkages, such as bank lending or muual fund invesmen, or on changes in invesors beliefs and behavior. Claessens and Forbes (200) include recen surveys of his lieraure, as well as a number of case sudies and empirical ess of differen cross-counry linkages. 7 While almos all of he empirical work on his subjec uses macroeconomic daa, one excepion ha is closely relaed o his paper is Forbes (2000). She examines how he Asian and Russian crises affeced sock reurns for a sample of over 0,000 companies locaed around he world. Her resuls sugges ha rade linkages are imporan deerminans of how crises are ransmied inernaionally. A fourh relevan branch of lieraure also focuses on sock reurns and measures he exen of exchange-rae exposure for various ypes of companies. This lieraure argues ha exchange-rae movemens can affec sock reurns hrough a number of channels, such as impor prices, expor prices, and shifs in demand. Raher han esimae each of hese channels separaely, mos of hese papers esimae reduced-form, marke models of how exchange-rae movemens affec sock reurns. Dominguez and Tesar (200) is one of he mos recen and 5 Edwards (989) also provides an excellen survey of his lieraure and deailed evaluaion of he hisorical evidence on how devaluaions impac a variey of macroeconomic variables. Kamin (988) is anoher deailed sudy and shows ha he impac of devaluaions on macroeconomic variables flucuaes over ime. Calvo and Reinhar (2000) compare he impac of currency crises on macroeconomic variables for emerging markes versus developed counries. 6 Calvo and Reinhar (2000) compare he impac of currency crises on macroeconomic variables for emerging markes versus developed counries. 7 In paricular, Claessens, Dornbusch, and Park (200) is an excellen survey of his lieraure. Glick and Rose (999) and Forbes (200) provide evidence of he imporance of rade in ransmiing crises inernaionally. Van Rijckeghem and Weder (200) discuss he role of bank lending, and Kaminsky, Lyons and Schmukler (999) discuss he role of muual funds. 4

7 horough examples of his lieraure. 8 They perform an exensive series of ess o deermine he percenage of firms affeced by exchange-rae movemens, as well as he imporance of differen firm characerisics. They conclude ha abou 2-23 percen of firms are significanly exposed o exchange-rae movemens. Their esimaes of a fairly low level of exposure agree wih mos work on his subjec. A fifh lieraure closely relaed o his paper examines how exchange-rae movemens affec oupu prices. This lieraure includes he work on pricing-o-marke and pass-hrough and emphasizes he role of indusrial srucure and he form of compeiion. 9 In cerain siuaions, exchange-rae movemens may be wholly absorbed in a firm s price-cos margins and have no impac on produc prices. Dornbusch (987) develops hese ideas in several simple models, and numerous papers have found evidence of pricing-o-marke in specific indusries. Goldberg and Kneer (997) is an excellen survey of he empirical lieraure on his subjec. They conclude ha he impac of exchange-rae movemens on local currency prices of foreign producs varies widely by indusry, and ha for producs shipped o he U.S, he average price response is abou one-half he exchange-rae movemen. 0 A final branch of lieraure relaed o his paper is he exensive work on various issues relaed o commodiies. For over 50 years economiss have racked commodiy prices and aemped o explain heir deerminans as well as predic fuure prices. Cashin, McDermo, and Sco (999) is a recen paper ha surveys much of his work and analyses commodiy-price cycles. Oher papers have focused on he imporance of commodiies o various counries, and he impac of commodiy price movemens on a variey of macroeconomic saisics. For example, Edwards (986) examines how coffee expor prices affec Colombia s real exchange rae. Oher papers in he indusrial organizaion lieraure or agriculural economics lieraure have performed deailed analyses of numerous issues from carels o he adopion of new echnologies o he impac of El Nino--for specific commodiies, counries and/or evens. Despie he range of heoreical frameworks and empirical ess used in hese six branches of lieraure, none of hese papers has explicily addressed he key quesion explored in his paper: 8 Also see Bodnar and Wong (2000) for an overview of empirical issues in esimaing exchange-rae exposure. Jorion (990) is a classic example of his lieraure. 9 More recenly, several papers have exended his framework o examine how exchange-rae movemens affec micro-level variables oher han prices. For example, Campa and Goldberg (999) examine he impac of exchange-rae movemens on secoral invesmen. Klein, Schuh and Tries (2000) and Goldberg and Tracy (999) examine he impac on wages and employmen. 0 Kneer (993) and Marson (990) are wo examples of his lieraure. One noeworhy sudy ha combines his approach wih he work on exchange-rae exposure is Allayannis and Ihrig (2000). They examine how marke srucure, including expor and impor compeiiveness, affecs he exchange-rae exposure of a large sample of U.S. firms. 5

8 how do devaluaions affec oupu growh, profiabiliy and invesmen decisions of firms around he world? The majoriy of his lieraure focuses on macroeconomic relaionships and counrylevel evidence. The lieraure on exchange-rae exposure and pricing-o-marke uses firm-level models and daa, bu focuses on how exchange-rae movemens affec sock reurns or produc prices. Moreover, he pricing-o-marke lieraure focuses on differeniaed-goods indusries in developed counries, undoubedly due o daa limiaions for developing counries and is moivaion from yen-dollar exchange-rae movemens in he 980 s. Moreover, none of hese branches of lieraure has focused on he key radeoff analyzed in his paper: how devaluaions simulaneously give exporers a relaive cos advanage in erms of cheaper labor and a cos disadvanage in erms of more expensive capial. This radeoff generaes a number of ineresing predicions for firms in he devaluing counry as well as compeiors in he res of he world. III. THE THEORETICAL MODEL This secion develops a model o show how devaluaions affec firms oupu decisions, profis, and capial invesmen in he shor and long run. I describes firms ha produce commodiies for expor (or any undiffereniaed produc where he firm has no pricing power), and considers he impac of devaluaions on no only firms in he crisis counry, bu also compeing firms locaed in he res of he world. Par A of his secion models firms decisions in he shor run when heir level of capial invesmen is fixed. Par B models firms decisions in he long run when hey can adjus heir levels of capial invesmen. Par C examines he shor-run impac of devaluaions, and par D considers he long-run impac. This model and framework form he basis of he empirical ess in Secion IV. Before developing he model in deail, he nex few paragraphs briefly highligh is key componens and cenral predicions. Each firm uses hree inpus (labor, maerials, and capial) o produce he same commodiy. Firms are locaed in wo "counries," he crisis counry (ha devalues is currency) and he res of he world (hereafer refereed o as r.o.w.). Each firm produces a small share of global oupu and has no impac on global prices. There is no differeniaion beween any firms' oupu, nor any rade barriers or ransporaion coss. As a resul, he commodiy's price is deermined by global supply and demand and all firms expec he same oupu price. Firms make heir producion decisions in wo sages. In he shor-run, each firm's level of capial is fixed. This Duagupa and Spilimbergo (2000) provide empirical suppor for his assumpion during he Asian crisis. They find ha expor supply prices are insensiive o own quaniies bu very sensiive o nominal exchange-rae movemens. 6

9 fixed invesmen could include anyhing from planing rubber rees o exploring for naural resources and drilling mines. Given his fixed level of capial, each firm chooses is opimal level of labor and maerials o maximize shor-run profis. Labor is priced in domesic currency and can be inerpreed as any local componen of producion, while maerials are priced in r.o.w. currency and can be inerpreed as impored inpus. Firms have company-specific produciviy parameers, so ha firms in he same counry can have differen levels of oupu and profis. In he longer erm, each firm can also adjus is level of capial. Capial is priced in r.o.w. currency and includes a counry-specific componen (o capure differences in domesic risk and capial markes.) Each firm chooses is level of capial expecing relaive prices and exchange raes o remain consan (a leas unil he nex chance o inves). Then he crisis counry devalues is currency. In he shor-run, he devaluaion reduces he relaive cos of labor in he crisis counry. This causes crisis-counry firms o increase oupu, and he increase in oal producion lowers he global price of he commodiy. Firms in he r.o.w. respond by decreasing producion, alhough by less hen he aggregae increase by crisis-counry firms. Therefore, he aggregae shor-run impac of he devaluaion on he commodiy is o increase global producion and decrease he global price. The magniudes of hese effecs are deermined by he crisis counry s share of global producion and he share of labor in oupu. The devaluaion also decreases profis for firms in he r.o.w. and increases profis for firms in he crisis counry (as long as he price elasiciy of global demand is no oo small and/or he crisis counry s share of global producion is no oo large). Over longer periods, however, each of hese effecs of he devaluaion can be reversed. Firms can adjus heir levels of capial invesmen o compensae for he changes in oupu prices and relaive inpu prices. Since capial is priced in r.o.w. currency, he relaive cos of capial increases for firms in he crisis counry and can increase by even more han he exchange-rae movemen if here is a simulaneous increase in domesic risk or a conracion in lending. If his increase in he cos of capial for crisis-counry firms is large enough, i could ouweigh he benefis of relaively cheaper labor. More specifically, if he firm s capial/labor raio is large enough, or he increase in he cos of capial is large enough, he devaluaion could acually raise he oal cos of producion for crisis-counry firms so ha hey decrease oupu. This would raise he long-run price of he commodiy and cause r.o.w. firms o increase producion (alhough by less han he aggregae decrease by crisis-counry firms.) In he long run, he devaluaion could increase profis for r.o.w. firms and decrease profis for crisis-counry firms. On he oher hand, if he cos advanage for crisis-counry firms from relaively cheaper labor afer he devaluaion ouweighs he cos disadvanage from relaively more expensive 7

10 capial, hen he key predicions from he shor-run model will also apply in he long run. More specifically, if he firm s capial/labor raio is small enough or he increase in he cos of capial is fairly small, crisis-counry firms would increase oupu and r.o.w. firms would decrease oupu. The global commodiy price would fall. Profis would increase for firms in he crisis counry and decrease for firms in he r.o.w. Therefore, alhough he model s shor-run predicions of he impac of devaluaions on oupu and profis are fairly clear, he long-run predicions depend on capial/labor raios and he relaive changes in inpu coss. Before developing his model in deail, i is worh menioning wha he model does no consider. Firs, i does no allow for any sor of sraegic pricing behavior by firms. Firms are assumed o ake he global oupu price as given and are unable o affec his price by adjusing producion levels or forming carels. Similarly, maerial inpus are priced in r.o.w. currency and exchange-rae movemens are fully passed hrough ino he price of hese impored inpus. Second, alhough exogenous shocks can affec global demand for he commodiy in each period, he model does no incorporae any direc impac of he devaluaion on global demand. More specifically, i assumes ha firms expor mos of heir oupu, so ha any domesic conracion resuling from he devaluaion will no affec demand. Fourh and finally, all prices are in real erms and here is no allowance for inflaion differenials across counries. Therefore, he model assumes ha he real impac of he devaluaion on relaive prices is no eroded by changes in inflaion raes. III.A. The Shor-Run wih a Fixed Level of Capial 2 In order o produce mos commodiies, firms mus make a large, upfron invesmen in fixed capial. Afer making his iniial invesmen, here is ofen a subsanial ime lag before he firm can begin producion and he firs uni of oupu is sold. For example, here is abou a six-year lag afer coffee is iniially planed unil he beans can be harvesed and sold. To capure his aspec of commodiies, I model firms decisions in wo sages. In he shor-run, defined as he periods from T, a firm s level of capial is fixed. In he long run when >T (which is modeled in par B) a firm is able o choose is level of capial. 3 Beginning wih his shor-run scenario, each firm i has a fixed level of capial k i >0. A firm s oupu in each period is deermined by is choice of wo variable inpus: domesic labor 2 This shor-run version of he model is loosely based on Dornbusch (987). 3 Alhough he model does no explicily include enry and exi, firms can se oupu and capial invesmen o zero in he long run and herefore exi he indusry. Enry is capured by allowing firms o increase heir level of capial invesmen in he long run. 8

11 (l i, ) and impored maerials (m i, ). Oupu is given by a Cobb-Douglas producion funcion ha has decreasing reurns o scale 4 : () q i, Ai ki li, mi, wih <. A i is echnology parameer (which varies across firms). The cos of labor is w and he cos of maerials is s. The firm chooses a combinaion of he variable inpus o maximize shor-run profis ( π SR i, ) in each period: (2) Maxπ i, P qi, wli, smi, l,m SR where P is he sale price per uni of oupu. Each firm produces idenical goods and here is no differeniaion beween markes (such as barriers o rade or ransporaion coss). In oher words, here is one global marke for he good and he price is deermined by global supply and demand. Therefore, he global price of he good can be expressed as a funcion of oal global oupu (Q ), and o simplify he model soluion below, assume ha his global price is deermined by a consan-elasiciy demand funcion: (3) P ϕ ZQ where Z is any period-specific shock o global demand and /ϕ is he elasiciy of demand. The commodiy is a normal good, so ha ϕ>0. Moreover, assume ha each firm produces a relaively small fracion of global oupu and herefore akes inpu coss and he indusry price as given. In oher words, each firm assumes ha any changes in is own inpu demands or oupu quaniies will have no affec on inpu coss or he global oupu price. These assumpions are fairly accurae descripions of compeiion in mos commodiy indusries. Wihou loss of generaliy, assume ha firms are locaed in wo counries : he crisis counry (which will devalue is currency) and he res of he world (hereafer called r.o.w.). In he noaion ha follows, all variables for he crisis counry ha differ from he r.o.w. are wrien wih a, and firms in he crisis counry are indexed by j. Crisis-counry and r.o.w. firms face he same price of oupu (P) and cos of impored maerials (s), boh of which are expressed in he 4 Decreasing reurns o scale ensures ha he mos efficien firm does no produce all of global producion. 9

12 0 r.o.w. currency ha can be inerpreed as dollars. In he shor run, he only price ha differs beween he wo counries is he domesic wage. The exchange rae can be expressed as he relaive cos of labor in he wo counries: (4) w w e, so ha a devaluaion in he crisis counry is a decrease in e. Equaion (2) herefore refers o he profi funcion for firms in he r.o.w. If he r.o.w. wage is normalized o equal one, hen he producion funcion and profi-maximizaion equaion for firms in he crisis counry (corresponding o equaions and 2 for firms in he r.o.w) are: (5) j j j j j m l k A q,,, and (6) j j j SR j m s l e P q Max,m l,,,, π Combining equaions () hrough (6), i is sraighforward o solve each firm s shor-run profi-maximizaion problem. For a fixed level of invesmen and given oupu price, each firm chooses is opimal combinaion of he wo variable inpus and oupu quaniy in order o maximize profis in period. The opimal oupu levels for firms in he r.o.w. and crisis counry are: (7), i i SR i s w A k P q (8), j j SR j s e k A P q Nex, in order o obain he global oupu price and quaniy produced, assume ha here are n firms in he r.o.w, and ñ firms in he crisis counry. Toal global oupu can be expressed as: (9) n j j n i i q q Q,,

13 If q and q are he average quaniy produced by each firm in he r.o.w. and crisis counry, respecively, he oal quaniy produced and indusry price can be wrien as: (0) q n nq Q, so ha () ( ) ( ) ( ) ϕ ξ SR e s Ak n w s Ak n Q (2) ( ) ( ) ( ) ϕ ϕ ξ SR e s Ak n w s Ak n P where ( ) ( ) ϕ ξ Z and ( ) ( ) ϕ ϕ ξ Z and,, A, k A and k are he produciviy parameers and invesmen levels for he mean-quaniy producing firm in he r.o.w. and crisis counry, respecively. The equaion for SR Q yields he inuiive resul ha global oupu of he commodiy is greaer for: a lower cos of eiher variable inpu; a greaer number of firms in eiher counry; or a larger average oupu for firms in eiher counry (which is, in urn, deermined by average produciviy levels and he amoun of fixed capial invesmen.) The equaion for SR P shows ha he global price is greaer for a higher cos of eiher variable inpu or lower aggregae oupu from eiher counry. The formula also has he appealing resul ha in he shor-run, price is deermined by he variable cos of producion in each counry weighed by oal oupu in each counry. III.B. The Long-Run wih Variable Capial In periods longer han T, firms can adjus heir level of capial invesmen. The cos per uni of capial invesmen is r and r in he r.o.w. and crisis-counry, respecively, and is fixed a he sar of he period. Capial is priced in r.o.w. currency, bu can vary across counries due o facors

14 2 such as domesic risk, capial marke liquidiy, capial conrols, ec. Firms chose heir opimal level of capial ( i k 0 and j k 0) o maximize long-run profis ( LR T π ) unil he nex opporuniy o adjus heir capial levels. To simplify he algebra, assume ha here is no discouning and he profi-maximizaion equaions for firms in he wo counries are: (3) ( ) T i i i i LR T i rk m s w l P q E Max k,,,, π (4) ( ) T j j j j LR T j k r m s l e P q E Max k,,,, π Nex, assume ha companies expec inpu prices and demand shocks o be consan (so ha E[w ]w, E[e ]e, E[s ]s, and E[Z ]Z.) As a resul, prices from o T are expeced o be consan and E[P ]P. Subsiuing he shor-run soluions from equaions (7), (8), (), and (2) ino equaions (3) and (4), he opimal levels of capial invesmen for firms in he r.o.w. and crisis counry are: (5) ζ r s w A P k i i and (6) ζ r s e P A k j j wih ( ) ( ) ( ) ζ T As a resul, firms will chose a greaer level of capial invesmen if: hey are more producive; he expeced oupu price is higher; or any of he inpu prices are lower. Nex, using equaions (5) and (6) i is possible o solve for each firm s opimal longrun oupu level a each ime. As long as he realizaion of each inpu price and he global

15 3 demand shock are equal o heir expeced values, he soluions for firms in he r.o.w. and crisiscounry are: (7) Ψ r s w A P q i LR i (8) Ψ r s e P A q j LR j wih ( ) ζ Ψ. As a resul, firms will chose a higher oupu level if: hey are more producive; he oupu price is higher; or any inpu prices are lower. Finally, he global quaniy and price in he long run is: (9) ( ) ( ) ( ) ϕ Φ r s e A n r s w A n Q LR (20) ( ) ( ) ( ) ϕ ϕ Φ r s e A n r s w A n P LR where: ( ) ( ) ϕ ζ Φ Z and ( ) ( ) ϕ ϕ ζ Φ Z.

16 The equaion for Q LR yields he inuiive resul ha global oupu is greaer for: a lower cos of any of he hree inpus; a greaer number of firms in eiher counry; or a larger average oupu level in eiher counry (which is, in urn, deermined by average produciviy levels.) The equaion for P LR shows ha he global price is greaer for a higher cos of any inpu or a lower aggregae oupu level in eiher counry. The formula also has he appealing resul ha in he long run, he global price is deermined by he oal cos of producion in each counry weighed by oal oupu in each counry. III.C. The Shor-Run Impac of Devaluaions on Firms around he World The remainder of his secion uses he model developed above o predic he impac of devaluaions in he crisis counry on firms in he crisis counry and he r.o.w. This subsecion examines he shor-run impac of devaluaions (when capial is fixed) and he nex subsecion examines he long-run impac (when firms adjus heir level of capial.) In he shor-run, he main impac of devaluaions is o reduce he relaive cos of labor in he crisis counry. To simplify noaion and clarify inuiion, I use he abbreviaions: ˆ Row, SR Ak Q n, w s ˆ Crisis, SR Ak Q n e s, and World SR Row SR Crisis SR Qˆ,,, Qˆ Qˆ o represen funcions of he oal quaniy produced in he r.o.w., crisis counry, and enire world in he shor run. To begin, assume ha firms have already chosen heir level of invesmen (so 0<<T) and here is an unexpeced devaluaion in he crisis counry. Also assume ha here are no exogenous shocks o global demand for he commodiy (i.e. here is no impac of he devaluaion on Z in equaion (3).) 5 The immediae impac of he exchange-rae movemen on global oupu and prices is: (2) SR dq de Γ e ˆ Crisis, SR Q ϕ ( ) ( ˆ ) World, SR Q ϕ( ) < 0 5 This assumpion is realisic for commodiy firms in mos emerging markes since he majoriy of producion is expored o developed counries, and mos devaluaions have minimal impac on growh, incomes and/or demand in hese developed counries. In selec cases, such as he Russian devaluaion in Augus of 998, his assumpion is less realisic. For hese siuaions, i is sraighforward o exend he model and allow exchange-rae movemens o affec global demand. 4

17 (22) SR dp de Γ e ˆ Crisis, SR Q ϕ ( ˆWorld, SR Q ) ϕ( ) > 0 where ξ Γ - - ϕ ( ) and Γ Γϕ. In he shor run, devaluaions in he crisis counry (a decrease in e) cause global oupu of he commodiy o increase and he global price o fall. The impac of devaluaions on Q and P is proporional o he share of labor in producion and he share of global oupu produced by firms in he crisis-counry. Since he only impac of devaluaions on inpu prices in he shor-run is o reduce he relaive cos of labor in he crisis counry, i is inuiive ha he impac of devaluaions is proporional o he share of he relaively cheaper inpu in global producion. The effec of devaluaions on shor-run oupu quaniies for firms in he r.o.w. and crisis counry are: SR SR (23) dq i,, q i ( ) de SR P SR dp > 0 de SR SR (24) dq j, q j, ( ) de SR P SR dp < 0 de e Movemens in he exchange rae affec oupu quaniies for firms in he r.o.w only hrough movemens in he global commodiy price. Therefore, a devaluaion in he crisis counry causes firms in he r.o.w. o reduce oupu in he shor run. On he oher hand, movemens in he exchange rae affec firms in he crisis counry hrough wo channels in he shor run: changes in he global commodiy price and changes in he relaive cos of labor (capured in he las erm of equaion (24).) The firs effec is he same as for firms in he r.o.w. Couneracing his oupuprice effec, however, is an inpu-price effec. Devaluaions reduce he cos of labor in he crisis counry relaive o he cos of he oher inpus, as well as relaive o firms in he r.o.w., and causes crisis-counry firms o increase producion. Some algebraic manipulaion shows ha his second inpu-price effec always dominaes he firs oupu-price effec. In oher words, devaluaions unambiguously cause crisis-counry firms o increase oupu quaniies in he shor run. Finally, since global oupu increases and oupu by r.o.w. firms decrease, oupu by crisiscounry firms mus increase by even more han he increase in global producion. In oher words, 5

18 afer he devaluaion, firms in he crisis counry will sell o cusomers/markes ha were previously serviced by firms in he r.o.w. In order o more fully examine he impac of devaluaions on individual firms, i is also useful o consider he effec on shor-run profis. If shor-run profis are defined in equaions (2) and (6), which do no include he cos of capial invesmen, hen he shor-run impac of devaluaions on profis for firms in he r.o.w. and crisis counry are: SR SR dπ (25),, SR i π i dp > 0 de SR P de and d SR SR π SR Crisis,SR (26) j j, π, dp Qˆ < 0 if > and/or X de P de e World,SR Qˆ <, ϕ where ( ) ϕ X. ϕ Therefore, devaluaions unambiguously decrease shor-run profis for firms in he r.o.w. This is no surprising because devaluaions have no effec on r.o.w. inpu coss, while devaluaions will lower r.o.w oupu quaniies and he global price (as shown in equaions (23) and (22), respecively). On he oher hand, devaluaions increase shor-run profis for firms in he crisis counry if he global elasiciy of demand for he produc is greaer han one and/or if he crisis counry has a small enough share of global oupu. In oher words, if he price decline leads o a large enough increase in global demand, or if he impac of he devaluaion on global prices is fairly small (since he crisis counry only produces a small fracion of global oupu), hen devaluaions increase shor-run profis for firms in he crisis counry. There is a lenghy debae in he developmen lieraure on wheher he elasiciy condiion ( ϕ > ) in equaion (26) holds for mos commodiies. Esimaes of he price elasiciy of demand are highly dependen on characerisics of he individual commodiy, how narrowly i is defined, and he lengh of ime consiuing shor run. In mos cases, however, he oupu-share condiion Crisis,SR ( Q Qˆ World,SR X ) ˆ is saisfied because he producion of mos commodiies is < widely dispersed across counries. Even for commodiies wih exremely low price elasiciies of demand and exremely low oupu shares for labor and maerials, his condiion should be 6

19 saisfied. 6 Moreover, even when a counry is heavily specialized in a specific commodiy, i rarely has a dominan share of global producion. Agénor and Moniel (996) make his poin and documen ha only 6 developing counries have as much as 0 percen of he world marke for any commodiy (based on 3-digi SITC classificaions). Mos counries have lile conrol over he prices a which hey sell heir commodiy expors. Therefore, devaluaions are generally expeced o increase shor-run profis for firms in he crisis counry. Devaluaions unambiguously decrease shor-run profis for firms in he r.o.w. III.D. The Long-Run Impac of Devaluaions on Firms around he World Over he longer erm, however, he shor-run impac of devaluaions on oupu and profis can be reversed. Devaluaions also affec he relaive cos of capial in he crisis counry, and when T, firms can adjus heir capial invesmen accordingly. More specifically, assume ha: dr (27) 0 de dr and < 0 de. In oher words, devaluaions in he crisis-counry have no impac on he cos of capial for firms in he r.o.w., bu increase he cos of capial for firms in he crisis counry. The cos of capial could increase in he crisis counry for a number of reasons. For example, if capial invesmen is financed in r.o.w. currency and/or impored from abroad, hen he crisis-counry ineres rae would move in proporion o he devaluaion. If devaluaions also raise domesic ineres raes, such as by increasing he counry risk premium, conracing bank lending, and/or decreasing propery and collaeral values, hen ineres raes in he crisis counry could increase by significanly more han he iniial exchange-rae movemen. To simplify noaion and clarify inuiion in he remainder of his secion, I use he abbreviaions: ˆ Row, LR A Q n w s r, ˆ Crisis, LR A Q n, and World LR Row LR Crisis LR Qˆ, Qˆ,, Qˆ e s r. 6 For example, if ϕ5 so ha he price elasiciy of demand for he commodiy is 0.2 (which is unrealisically low), and 0.5 (which is also unrealisically low, especially for an emerging marke), hen X.60. In oher words, even using exreme parameer values which make i more difficul o saisfy his condiion, a counry would have o expor over 60 percen of he global share of a commodiy in order for ˆ Crisis,SR ˆ World,SR Q Q X. > 7

20 These are funcions of long-run oupu in he r.o.w., crisis counry and world, respecively, and correspond direcly o he shor-run abbreviaions in he las secion. The long-run impac of a one-ime exchange-rae movemen on global oupu and he commodiy price is: (28) dq LR Crisis LR dr Qˆ, dr de 0 if ( ) e r de < > ϕ e r de ϕ( ) World LR ( Qˆ, ) (29) LR dp de dr e r de ϕ World LR ( Qˆ, ) ϕ( ) Crisis LR Qˆ, > 0 if dr > e r de where Φ - - ϕ ( ) and ϕ. In oher words, devaluaions can eiher increase or decrease global oupu and prices in he long run based on he relaive shares of labor and capial in producion and he impac of he devaluaion on he crisis-counry s cos of capial. If labor is a more imporan componen of producion han capial and/or if he impac of he devaluaion on ineres raes is small, hen he devaluaion is more likely o increase global producion and decrease global prices. This resul direcly follows from he fac ha relaive prices remain consan in he r.o.w., while he relaive cos of labor decreases and he cos of capial increases in he crisis counry. If he cos advanage from cheaper labor ouweighs he cos disadvanage of more expensive capial, hen he oal cos of producion for crisis-counry firms will decrease and cause he global price o fall (and demand for he commodiy o increase.) Equaions (28) and (29) also show he inuiive resul ha he impac of devaluaions on global oupu and prices is greaer (in eiher direcion) when he crisis counry produces a larger share of global oupu. Nex, he long-run impac of devaluaions on oupu quaniies and capial invesmen for firms in he r.o.w. is: dq LR dp dr, > 0 if > de LR P de e r de LR LR (30) i q i, ( ) (3) LR LR dk LR i k i dp dr,, > 0 if > de LR P de e r de 8

21 In he long run, exchange-rae movemens coninue o affec oupu quaniies for r.o.w. firms, as well as invesmen levels, only hrough movemens in he global commodiy price. Therefore, a devaluaion in he crisis counry could cause r.o.w. firms o eiher increase or decrease heir oupu quaniies (and corresponding invesmen levels), based on wheher he devaluaion leads o a long-run increase or decrease in he global price as deermined by he crieria o he righ of equaion (29). If producion is relaively more capial inensive hen labor inensive, or if he devaluaion causes a large increase in he crisis counry s ineres raes, hen here is a greaer chance ha he global price increases and r.o.w. firms subsequenly increase oupu and capial invesmen. For firms in he crisis counry, he impac of he devaluaion on oupu quaniies and capial invesmen is: LR j dp dr dr, 0 if de LR P de e < > r de e r de LR LR dq q (32) j, ( ) (33) LR dk j, de LR k LR j dp ( ) dr, LR P de e < 0 r de C LR dr Qˆ, if > and and/or e > Θ r de W LR Qˆ, ϕ < Θ. where, Θ f (,,, ϕ, e, r, dr de) Θ. Therefore, he devaluaion affecs oupu quaniies and capial invesmen for crisiscounry firms hrough he same global price effec as shown for r.o.w. firms in equaions (30) and (3). The devaluaion also has wo addiional effecs on crisis-counry firms in he long run, however, hrough changes in he relaive coss of labor and capial. Algebraic manipulaion shows ha he crierion for d q j, de < 0 is he same as he crierion for LR dp de < 0. In oher words, a LR devaluaion only increases oupu for crisis-counry firms in he long run if: he share of labor in oupu is relaively larger han he share of capial and he increase in he cos of capial is no oo large. This is an inuiive resul. Devaluaions will only cause crisis-counry firms o increase oupu if he cos advanage ha hey gain from relaively cheaper labor is greaer han he cos disadvanage from relaively more expensive capial. 9

22 The crieria for he devaluaion o increase capial invesmen in crisis-counry firms are even more sringen. In his case, no only mus he condiion for a decline in he global price be saisfied, bu some combinaion of wo addiional condiions mus be me: he global price elasiciy of demand mus be sufficienly large and/or he share of global oupu produced by he crisis counry mus be sufficienly small. In oher words, if he devaluaion lowers he commodiy price, crisis-counry firms will only increase heir capial levels if he price decline leads o a large enough increase in global demand, or if he impac of he devaluaion on global prices is fairly small (since he crisis counry only produces a small fracion of global oupu). As discussed a he end of Secion III.C, he oupu-share condiion (ha Crisis,SR World,SR Qˆ Qˆ sufficienly small) is usually saisfied because he producion of mos commodiies is rarely concenraed in an individual counry. To complee his analysis of he long-run impac of devaluaions, equaions (34) and (35) repor he effecs on long-run profis for firms in he r.o.w. and crisis counry, respecively. Longrun profis are defined as shor-run profis plus he cos of capial. is (34) LR LR d π LR i i dp dr, π, > 0 if > de LR P de e r de (35) LR d π j, de LR π j, P LR dp dr < de e 0 r de dr > if and > Ω e r de ϕ and/or C LR Qˆ, W, LR Qˆ < Ω where and Ω f (,,, ϕ, e, r, dr de) Ω. The sign of dπ LR i, is he same as he sign of dp LR. Therefore, if he devaluaion de de reduces he global commodiy price, as specified in he condiion o he righ of equaion (34), hen profis decrease for r.o.w. firms in he long run. On he oher hand, he sign of d π LR j, is he de opposie of he sign of dp LR if he global elasiciy of demand for he commodiy is large de enough or he crisis counry s share of global oupu is small enough. As discussed above, he oupu-share condiion is saisfied for mos commodiies. Therefore, in mos cases, devaluaions will have he opposie impac on long-run profis for firms in he crisis counry versus firms in he r.o.w. For example, if capial is used more inensively in producion han labor and/or he 20

23 devaluaion subsanially raises ineres raes in he crisis-counry, hen he devaluaion will: increase he global oupu price; increase profis for firms in he r.o.w.; and decrease profis for firms in he crisis counry. To summarize, Secions III.C. and III.D. have used he model developed in Secions III.A. and III.B. o explore he impac of devaluaions on firms around he world. In he shor-run, when each firm s level of capial invesmen is fixed, he model s predicions are fairly sraighforward. The devaluaion reduces he relaive cos of labor in he crisis counry and firms in he crisis counry increase producion. Lower inpu coss reduce he global price of he commodiy, and his effec is proporional o he size of he crisis counry in global producion and he relaive share of labor in producion. Since he global oupu price falls and inpu prices for firms in he r.o.w. remain consan, firms in he r.o.w. reduce producion. The increase in oupu by crisis-counry firms is greaer han he decrease in oupu by r.o.w. firms, so ha global producion increases. Shor-run profis unambiguously decrease for firms in he r.o.w. Shor-run profis will generally increase for firms in he crisis counry (as long as he counry s share in global oupu is relaively small and/or he global elasiciy of demand is no oo small.) In he long run, however, firms are able o adjus heir levels of capial invesmen and he impac of devaluaions will depend on producion parameers and changes in relaive inpu coss. No only do devaluaions reduce he relaive cos of labor in he crisis counry, bu hey also increase he relaive cos of capial (possibly by more han he iniial exchange-rae movemen.) Therefore, he long-erm impac of devaluaions hinges on he relaive imporance of labor and capial in producion and he impac of devaluaions on crisis-counry ineres raes. If he cos advanage for crisis-counry firms from relaively cheaper labor ouweighs he cos disadvanage from relaively more expensive capial, hen he key predicions from he shor-run model also apply in he long run. Firms in he crisis counry increase oupu and invesmen and heir profis rise. Firms in he r.o.w. decrease oupu and invesmen and heir profis decrease. On he oher hand, if he cos disadvanage from relaively more expensive capial ouweighs he cos benefi from reduced wages in he crisis counry, hen each of hese predicions is reversed. Firms in he crisis counry decrease producion and invesmen, and heir profis fall. Firms in he r.o.w. increase oupu and invesmen, and heir profis rise. Therefore, he long-run impac of devaluaions hinges on he imporance of capial and labor in producion and he relaive changes in he coss of hese wo inpus. 2

24 IV. EMPIRICAL TESTS This secion ess four of he model s key predicions. Par A describes he daa se, devaluaion episodes, and commodiy groups used for he analysis. Par B examines how devaluaions affec oupu growh for firms in he crisis counry and r.o.w. Par C analyzes how devaluaions impac profi growh. Pars C and D assess he expeced long-run impac of devaluaions by examining changes in firms capial invesmen and sock reurns, respecively. These wo secions also consider how capial/labor raios and changes in he cos of capial deermine he impac of devaluaions on differen groups of firms. Alhough his empirical analysis is no a formal es of he full heoreical model, he resuls suppor he model s cenral predicions for how devaluaions will impac oupu quaniies, profiabiliy, and capial invesmen for firms around he world. IV.A. The Evens, Daa, and Commodiy Groups The empirical analysis focuses on major devaluaions in 8 counries beween January, 997 and December 3, Major devaluaions are defined as episodes where he local currency/u.s. dollar exchange rae increased by 5 percen or more wihin any 4-week period. 8 Table liss he counries wih major devaluaions in chronological order, as well as he monhs when he devaluaions occurred. 9 This lis of major devaluaion episodes includes he sandard evens during his period ha are ypically analyzed in he currency-crisis lieraure: several Asian counries in ; Souh Africa and Russia in 998; and Brazil in 999. The empirical ess focus on 0 commodiy groups: naural rubber and relaed fores producs; mining for silver and gold ores; naural gas and crude peroleum; preserved fruis and vegeables; edible oils and fas; cigarees; indusrial inorganic chemicals; plasics, maerials and synheics; indusrial organic chemicals; and ferilizers. 20 The firm-level informaion includes daa for over,00 firms and is from he Worldscope daabase on CD-ROM published by Primark (200). Table 2 shows he disribuion of firms (and average firm size) by counry and region. 7 This ime period was chosen o correspond wih he available firm-level daa. 8 The exchange-rae daa is from he Daasream daabase. 9 Afer a major devaluaion, he nex four weeks are excluded so ha here can be, a mos, one devaluaion even wihin any 4-week period. The only major devaluaion ha is no included in his analysis is Ecuador s crisis saring in January of 999. This even is excluded because here is no firm-level daa for Ecuador and Ecuador expors less han percen of oal global expors for each of he commodiy groups in he sample. 20 These commodiy groups were chosen based on hree crieria: () firm-level daa exised for a leas 20 companies in he 3-digi indusry; (2) a leas 5 percen of he firms in he indusry were locaed in devaluing counries; (3) he indusry roughly fis he characerisics of a commodiy as described in he heoreical model. Several of he resuling indusry groups are no ypical commodiies, bu as shown in he sensiiviy ess below, he resuls are robus across sricer and looser definiions of commodiies (excep ha naural gas and crude peroleum is occasionally an oulier). 22