Traditionally, exports behavior is modeled only as a function of the foreign demand and the real exchange rate. However, it is by now widely acknowledged that these variables are not able to fully explain exports developments. This paper suggests considering domestic demand pressure as an additional variable, revisiting its economic rationale and assessing its empirical importance. In particular, we consider the Portuguese case and find that domestic demand developments are relevant for the short-run dynamics of exports. Moreover, it is found that this relationship is asymmetric, being stronger and more significant when domestic demand is falling than when it is increasing.
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An earlier attempt to assess the role of domestic demand pressure on Portuguese exports behavior can be found in Cartaxo (1985).
In contrast, the “new trade theory” developed in the late 1970s and 1980s, based on product differentiation, increasing returns to scale and monopolistic competition, supports a positive relationship between the domestic market and exports (see Krugman 1979, 1980; Helpman 1981; Helpman and Krugman 1985; among others).
In practice, this argument can be potentially refuted since one can argue that this effect is already taken into account through the real exchange rate. However, one can also argue that prices are relatively rigid in the short run (especially downward) so that they do not reflect adequately changes in domestic demand pressure (as pointed out, for example, by Zilberfarb 1980).
Note that under the usual small open economy assumption, the foreign demand is perfectly elastic, and therefore, the effect is likely to be high.
One should note that in the Portuguese case, there seems to be scope for this relocation in terms of market destination. For instance, in the manufacturing sector, in 2010, only one-third of the firms were exporting, and for those firms, the export intensity, defined as the exports to sales ratio, was on average around \(30\) %.
Nevertheless, one should bear in mind that both at the theoretical and empirical levels, the relationship between exports and domestic sales is not clear cut. For instance, on the theoretical front, one may have a positive correlation between domestic sales and exports through overall efficiency improvements (as in the case of learning-by-doing or learning-by-exporting effects). Another reason that may induce such a positive link is related to liquidity constraints (see Berman et al. 2011). Concerning the empirical front, the results by Berman et al. (2011) suggest that exports and domestic sales are complementary for a panel of French firms.
In the same spirit, models have been developed whereby exports depend on a nonlinear function of the exchange rate (see, for example, Amable et al. 1994, 1995; Belke et al. 2013). The underlying idea is that because of sunk costs, a firm’s decision to enter or exit from a foreign market will not take place for the same value of the exchange rate, resulting in a hysteretic behavior.
For more details see, for example, Francois et al. (2007).
For example, Cabral and Esteves (2006) show that the significant Portuguese market share losses recorded in 2004 and 2005 occurred in sectors where it has been observed market share gains for some developing countries, namely China. One should note that the main conclusions drawn from the empirical results do not change when one controls for such a period.
Furthermore, the recent evolution of price competitiveness indicators could be biased given the public wages cuts. These cuts tend to favor the usual price competitiveness indicators that are computed for the overall economy. Hence, it would be better to account only for the private sector, which, however, is not done given the lack of timely, reliable and coherent information across countries.
Although we follow a macroeconometric approach, it would also be interesting to address this issue using Portuguese firm-level data (see Banco de Portugal 2013).
One should mention that the domestic demand variable did not prove to be significant in the long-run relationship in the ECM models. In fact, from a theoretical point of view, it is also not clear the way the effects of domestic demand pressure operate on the long-term export performance (see, for example, Renton and Duffy 1970). On the one hand, periods of high domestic demand pressure may stimulate investment allowing for a higher trend growth rate of exports. On the other hand, the absence of periods of very low pressure may lead to a general neglect of export opportunities.
We also conduct parameter stability tests, namely the ones proposed by Hansen (1992). Based on both individual and joint tests, we do not found evidence of parameter instability in any of the estimated models. To save space, the results are not presented but are available from the authors upon request.
One should mention that domestic demand change is negative in one-fourth of the total number of observations.
One should note that the imported content of domestic demand in the Portuguese case has not changed substantially over the last decades.
Frequently, the Industrial Production Price Index is pointed out as a potential alternative indicator because it also covers other production costs, and it is possible to be computed exclusively for the manufacturing sector. Unfortunately, this indicator is not available for several countries.
For instance, in the seminal paper of Engle and Granger (1987), it has been suggested that the evidence against cointegration may result from omitted variables. In particular, considering wages and prices in the USA, they argue that the lack of cointegration found between the two variables could be due to the omission of a third variable such as productivity. In addition, Granger and Lee (1991) argue that, in practice, one may expect to encounter structural shifts as the economy evolves over time, and therefore, the assumption of a stable long-run relationship among economic variables may not be valid.
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Esteves, P.S., Rua, A. Is there a role for domestic demand pressure on export performance?. Empir Econ 49, 1173–1189 (2015). https://doi.org/10.1007/s00181-014-0908-5
- Domestic demand pressure
- Error correction models