Can More Service Trade Openness Help Mitigating Real Exchange Rate Volatility?

Febrio Kacaribu, Syahda Sabrina, Teuku Muhammad Riefky Hasan

Several studies have found that a higher ratio of exports and imports to GDP tends to lower real effective exchange rate volatility (Hau, 2002; Bleaney, 2008; Calderón, 2018). While much literature has discussed the effect of trade openness on the volatility of the real effective exchange rate, there is no clear evidence of how the structure of trade contributes to RER volatility. First, we confirm that trade openness lowers the real
exchange rate fluctuations. Also, monetary shocks and inflation, unsurprisingly worsen the exchange rate volatility. Interestingly, both goods and services trade openness contribute to lowering the RER volatility. We further divide the service sector into manufacturing related vs. non-manufacturing related services and found that the nonmanufacturing related service trade has a slightly higher magnitude than the overall trade on service in moderating the shocks of the exchange rate. If an economy wants to improve its trade openness, while struggling with the more challenging global trade environment for goods, a focus on improving its non-manufacturing related-services could bring in a similar result in terms of lower RER volatility