Expected Exchange Rate Movement and Forward-Looking Importers

Abstract

This paper presents theory and empirical evidence on that a forward-looking potential importer facing sunk costs will respond to expectation of future exchange rate fluctuations. This finding indicates the importance of sunk costs in firms' decisions to import goods. Building upon a heterogeneous-firm framework, the model makes a variety of predictions about the effect of anticipated fluctuations in the domestic currency exchange rate. First, changes in the expectation of future exchange rates lead to the entry/exit of marginally productive firms, reshaping the extensive margin of imports, and inducing significant changes in aggregate import values. Second, the firm level marginal benefit/loss of importing diminishes as expected appreciation/depreciation persists, due to the impact of continued entry/exit on markups. This changing marginal benefit/loss consequently weakens the adjustment of the extensive margin in the long run. Third, firms present heterogeneous responses to forward exchange rate fluctuations in the presence of sunk costs; these responses are related to their access to credit and other firm-level characteristics. Using disaggregated transaction level data of Chinese imports from the United States combined with data on the US dollar-RMB future rates on the non-deliverable forward market, this paper confirms that the extensive margin of import significantly responds to forward exchange rate premiums. This paper also finds evidence on firms' heterogeneous responses to anticipated exchange rate changes that support the model predictions by merging import data with firm-level balance sheet data.