The impact of exchange rate fluctuations on international trade: a case study of Saudi Arabia

Abstract

This study investigates the impact of exchange rate fluctuations of the Saudi riyal vis-à-vis other currencies on the international trade flows of Saudi Arabia. It is argued that a country with a pegged exchange rate is affected by the exchange rate movements of major currencies as long as these currencies fluctuate against one another. Such movements can cause changes in a country's bilateral as well as its effective exchange rates, which in turn affect its trade flows from trading partners. Since the advent of the floating exchange rates in the early 1970s, Saudi Arabia chose to peg its currency to the U.S. dollar, then to the SDR, and later switched back to the dollar-peg. Consequently, Saudi Arabia could not avoid fluctuations in its exchange rate against the currencies of its major trading partners. This study empirically investigated the impact of exchange rate fluctuations on Saudi Arabia's trade flows. Both aggregate as well as disaggregate trade flows (i.e., both exports and import demand functions) were examined using annual time series data for the period 1973 through 1995. In assessing the impact of exchange rate variability on the trade flows of Saudi Arabia, a variety of exchange rate measures were used along with the other commonly used variables The study found that cross-exchange rate fluctuations had an adverse effect on Saudi Arabia's trade flows. Both aggregate as well as bilateral trade flows were negatively affected by the exchange rate variability. At the aggregate level, both aggregate exports and imports are shown to have been adversely affected by this variability. The results of our estimates of the disaggregate exports and imports also confirm our hypothesis that cross-exchange rate variability has adversely affected Saudi bilateral exports as well as imports. Other variables such as world income, relative prices, and domestic income were also found to have an effect on the Saudi trade flows, however, the effect is not uniform. The "oil gap" and other political factors have also played a significant impact on Saudi aggregate exports. The impact of the exchange rate policy switch to the dollar-peg is shown to be negative on both exports and imports, however the magnitude of the effect is greater in the case of aggregate exports than imports. The implication of these findings is that pegging the riyal to the US dollar may not be the optimal policy of promoting Saudi exports. A better choice of exchange rate regime would be a switch to a trade-weighted currency basket. This basket should truly reflect the trade patterns of Saudi foreign trade.