Firm size, exchange rate and exports performance: A firm level study of Pakistan's manufacturing sector

Abbas, Asad; Sheikh, Muhammad Ramzan; Abbasi, Muhammad Nauman Article Firm size, exchange rate and exports performance: A firm level study of Pakistan's manufacturing sector Pakistan Journal of Commerce and Social Sciences (PJCSS) Provided in Cooperation with: Johar Education Society, Pakistan (JESPK) Suggested Citation: Abbas, Asad; Sheikh, Muhammad Ramzan; Abbasi, Muhammad Nauman (2015) : Firm size, exchange rate and exports performance: A firm level study of Pakistan's manufacturing sector, Pakistan Journal of Commerce and Social Sciences (PJCSS), ISSN 2309-8619, Johar Education Society, Pakistan (JESPK), Lahore, Vol. 9, Iss. 3, pp. 818-836 This Version is available at: https://hdl.handle.net/10419/188224 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc/4.0/ Pak J Commer Soc Sci Pakistan Journal of Commerce and Social Sciences 2015, Vol. 9 (3), 818-836 Firm Size, Exchange Rate and Exports Performance: a Firm Level Study of Pakistan’s Manufacturing Sector Asad Abbas Government College Qadir Pur Rawan, Multan Email: [email protected] Muhammad Ramzan Sheikh Bahauddin Zakariya University Multan, Pakistan Email: ramzansheik[email protected].pk Muhammad Nauman Abbasi Bahauddin Zakariya University Multan, Pakistan Email: [email protected] Abstract Most of the countries are now focusing on changing its exports structure, concentration and direction. Among many other factors, firm-size and exchange rate are the vital factors that influence the export performance of a country. This study has attempted to investigate the effects of firm size and exchange rate on domestic and exports sales. The study has used panel data technique over 10 years data focusing 205 manufacturing firms representing fourteen different industrial sectors. Two models are specified to explore the impact of firm size and exchange rate. First model examines the effects on export sales while the second model explored the effects on domestic sales. The findings of the first model suggest positive link among firm size, exchange rate and export sales. The second model exposed positive effect of firm size on domestic sales ratio while real effective exchange rate and domestic sales ratio are found negative. Keywords: firm size, exchange rate, exports sales, domestic sales, manufacturing sector 1. Introduction In this age of globalization each country is striving hard to grasp the export-led phenomenal growth. Exports being an engine of economic growth accelerate the process of development. In the realm of exports, domestic firms can reap economies of scale and profitability by more internationalization and globalization. Escalation in exports produces more foreign exchange earnings and permits the country to import the necessary raw material and capital goods to achieve development needs. Export concentrated countries acquire more economic efficiency because of advanced technology, competition and learning by doing (Krugman, 1984). In fact, exports are the sources of many other positive externalities such as generating employment opportunities, improving production chains and creating innovation and competitiveness. Thus, exports enhance the economic efficiency and productivity gains Abbas et al. 819 of the countries by getting technological transfer and diffusion. Mostly East Asian countries have adopted the export-led growth strategy with more economic integration to achieve growth targets. This gives real insight to policy makers of the developing countries to give more attention to exports. The export performance of domestic firms is very critical especially for developing countries. Pakistan is focusing to expand its exports but fail to get a large share in the World market due to many reasons e.g. less diversification of exports, semi-manufactured goods, narrow export base, outdated technology and machinery, devaluation, increase in the sick indusial units, technical barriers, political instability etc. Unfortunately, due to aforesaid factors, Pakistan’s exports are undesirable. Despite of the bouncy efforts by government, exports to GDP ratio in Pakistan remained the same over the years and share in world exports is 0.13 percent (Din et al., 2009). Pakistan as a developing country is facing many economic challenges. An export led growth strategy can be a better choice to overcome the low economic growth. For this, exports performance must be expedite. Keeping in view of the above discussion, this study determine the relationship among firm size, exchange rate and export performance and to the best of our knowledge; it is the pioneer study on the connection between firm-size and export performance of manufacturing firms. An attempt has been made to evaluate the effects of exchange rate on the firms’ exports by constructing exchange rate indices for exports and imports which has not been formed earlier in Pakistan. Moreover, none of the previous studies has formulated exchange rate indices for Pakistan to examine the export performance. A concentration index has also been constructed and its impacts on export performance have been observed to explore whether the domestic monopoly can outperform the competitive firms in the international export market. Finally, many other important factors such as global economic conditions, domestic and foreign prices have been included in the estimation to encapsulate the effects of such factors at firms with diverse characteristics. 2. Review of Assorted Studies Export is considered an important ingredient of economic growth. Among many other factors, firm-size and exchange rate are the vital factors that can influence the export performance of a country. This section present review of various studies on firm-size, exchange rate and export performance. 2.1 Studies on Firm-size and Export Performance This section present snapshot of existing studies that have examined the relationship between firm-size and export performance (See Table 1). Surprisingly, all studies portrait positive link between firm size and export performance except Bonaccorsi (1992), Wolff and Pett (2000) and Gabbitas and Gretton (2003), wherein, mixed findings have been observed. Firm Size, Exchange Rate and Exports Performance 820 Table: 1 Selected Studies on Firm size and Export Performance Author(s) No of Firms Measurement Results Bonaccorsi (1992) 8810 No of Employees Total Assets Negative Positive Calof (1994) 14072 No of Employees Sale Positive Positive Archarungroj & Hoshino (1998) 500 Sale Positive Papadogonas et al. (1999) 1652 Sale No of Employees Positive Positive Moen (1999) ----- Sale No relationship Dean et al. (2000) ----- Sale No of Employees Positive Positive Wagner (2000) 348 Total asset Inversely U-shaped Wolff & Pett (2000) 157 Sale Sale Positive Negative Sterlacchini (2001) ----- Sale Inversely U-shaped Gabbitas and Gretton (2003) 350 Sale No of Employees Positive Negative Mittelstaedt &Ward (2003) 2777 Total asset Total asset Positive Positive Barua et al. (2010) 750 Total asset Positive Esteve et al. (2011) ------- Sales Negative Chandran & Rasiah (2013) 100 No of Employees Positive LiPuma,, Newbert, & Doh (2013) 10,000 No of Employees Positive but with institutional quality Rajah & Fathimath (2013) ------- No of Employees Positive Source: Authors’ Comparative Analysis of Various Studies. 2.2 Studies on Exchange rate and Export Performance This section reviews the studies that have explored the relationship between exchange rate and export performance. All the studies have inferred the inverse relationship between the two variables (See Table 2). Abbas et al. 821 Table: 2 Selected Studies on Exchange Rate and Export Performance Author(s) Objectives Results Mustafa and Nishat (2004) To investigate exchange rate volatility and exports growth between Pakistan and leading trade partners Negative Majeed and Ahmad (2006) Determinants of Exports in developing countries Negative Hsu (2007) Exchange rate changes and industry profitability and firms exports volume Effect of depreciation on exports of individual firm is not clear Robert Jeong and Ryoo (2007) Exchange Rates and firm level exports Negative Veeramani (2008) Exchange rate appreciation and Indians Exports Negative Cheung and Sengupta (2012) Exchange rate and Firms Exports Negative Shuangshuang (2012) Real effective exchange rate, inflation and export performance in Switzerland Negative Srinivasan and Kalaivani (2013) Exchange rate volatility and real exports in India Negative Source: Authors’ Comparative Analysis of Various Studies. It can be inferred from the aforementioned studies that firm-size and export performance indicate positive relationship, however, some studies have reported negative relationship. These studies have justified conflicting result with various logical reasons. Undoubtfully, there exists consensus among the economists that exchange rate appreciation negatively influences the exports of a country. The existing empirical studies have explored the determinants of exports at macro level but very rare attempts have been made to address the issue in context of Pakistan. It is therefore, using the firm-level data this study examined the export performance of the country. 3. Theoretical Underpinning 3.1 Firm Size and Export Performance The theoretical foundation of this study is derived from Barua et al. (2010). Following Barua et al. (2010), we consider a domestic firm that tries to maximize its own profit in the short run. Furthermore, we considered a small open economy so that the domestic firms behave like a perfect competitor in the international market. To derive the size and export performance relationship we proceed as follows: The domestic price is assumed to be an inverse function of domestic output and imports, that is )( MQfPd Firm Size, Exchange Rate and Exports Performance 822 Where d P is domestic price, Q is domestic industrial output produced for domestic market and Mis import. The individual firm profit function is specified as under: (1) This firm has two revenue sources, the proceeds from domestic sales d i dqP and foreign sales converted to domestic currency f i fqeP . Note that e is the exchange rate that is defined in terms of domestic currency per unit of foreign currency, f P is foreign price and the individual firm take it as given. d i q And f i qare the outputs supplied to the domestic and foreign markets respectively. While . The last term in equation (1) is the cost function which gives the minimum possible cost for the production of an optimal level of output. We have assumed a Cobb-Douglas type cost function with constant returns to scale. Further, the firm use both domestic and foreign factor of production with rewards, d W to the domestic factors and f W to foreign factors.  and )1(   are the shares of foreign and domestic factors in the production, respectively. While β in qβ represent shares of output in total cost which is less than one. The individual firm in model acts exactly like price discriminating monopolist, producing output with common costs but for two different markets. The firm maximizes its profit by setting the respective marginal revenues equal to common marginal cost. Thus profit maximizing gives the first order conditions (FOCs): (2) (3) These are the FOC of profit maximization. Here X and m X are industrial exports and imports of input into to the industry, respectively. The first concern of this study is to see the effect of firm size on its export performance. For this purpose we take benefit of the approach followed by Barua et al. (2010) with the FOC mentioned above. From the above two FOCs, we can derive the relations between the firm size and it exports to turn over ratio as follows: Firstly note that if the marginal costs of firms are indistinguishable, all firms would generate the identical output levels as implied by equation (2) and (3). This further means that export shares of all the firms will also be same, this can be seen as: Let define export share as for the ith firm. But if ji qq  then it implies that j f j i f i q q q q However, if the marginal cost of production is different, the more efficient firm would produce high volume of output, regardless the domestic sales of the firm would be the same i.e. independent of the cost conditions (Barua et al. 2010). This can be proved as follows: (1 ) ( ) ( ) d d f f f d i i i Max P q eP q A eW W q                 (1 ) (1 ) ( 1) 0 d d m d d f d f d i d d d m d i i i P Q e X P q A W W q q A eW W q Q q X q                                                        (1 ) (1 ) ( 1) 0 m f f f f d f d i f f m d i i i e X e X eP P q A W W q q A eW W q X q X q                                                Abbas et al. 823 We know that a firm that sales its product in more than one markets is in equilibrium when it equates the revenues realized from the sale of last unit in each market, that is: i f i d iMCMRMR  Or the firm is in equilibrium when the following conditions hold: (4) For ease of reference let MC is: The equation (4) implies that for two firms i and j to be in equilibrium, the following identity must hold irrespective of the cost conditions. (5) It means that at equilibrium, the marginal revenue for each exporter firm will be the same to the marginal cost of production. This identity further implies that the total supply to the domestic market will be the identical in the face of same cost conditions for two exporter firms. Another implication of the identity is that if marginal cost of production is different i.e. then the above identity would be maintain at different level of outputs. Then if it means that output of firm i will be greater than the output of firm j, i.e. and vice versa. However d j d iqq  irrespective of the cost condition as implied by equation (2) and (3). The above discussions lead us to the following important conclusion: The larger firm trades a smaller share of its output in the indigenous market and a smaller firm sells a loin’s share of its output in the native market. This can be seen as: If then i.e. the firm i (larger in size) than that of firm j but both the firms sell the same amount of output in the local market as implied by equation (2) and (3). It means that the larger firm sells lesser share of its output in the domestic market in comparison with the smaller firm. Accordingly, the larger firm sells a high volume of output in foreign market and the smaller firm trades a smaller level of output in foreign market. Thus, the firm size and export to sales ratio are positively related. This can be proved as follows: If and so that and and if And also given that         (1 ) (1 ) ( 1) d d m d d f f f f d f d i i d d f m d i i i P Q e X e X P q eP P q A W W q q A eW W Q q X q X q                                                                (1 ) (1 ) ( 1) mf d f d m d i e X A W W q q A eW W X q                                  d d d d d d f f d d i j d d f d d i i j P Q e X P Q P q eP P q P q Q q X q Q q                                          Firm Size, Exchange Rate and Exports Performance 824 Then the following relationship must hold: (6) The theoretical model concludes that the firms with higher marginal costs would have less export than those firms that have less marginal costs. 3.2 Exchange Rate, Export and Domestic Sales Performance To derive a theoretical model that captures the effects of changes in a country exchange rate and input prices on firm domestic and foreign supplies, we have modified the FOC by allowing the exports of the industry and imports of inputs to affect the corresponding exchange rates. These FOCs have been solved to get the firm supply functions to the domestic and foreign markets as follow: (7) (8) (9) (10) The expression in equation (9) explains the firm supply to the domestic market which is a function of domestic price, imported and domestic input prices, the rate of change in exchange rate, domestic price due to imports of inputs and domestic industrial output respectively. The changes in exchange rate affect the domestic supply through the channel of cost as the firm uses imported inputs in the production process. Equation (10) indicates that the supply to the foreign markets is a function of foreign prices, exchange rate, prices of both the domestic and foreign inputs and the rate of change in exchange rate due to import of inputs and industrial exports. To observe the effects of changes in exchange rate on the supply functions, we have differentiated both the functions with respect to the exchange rate respectively. d j d iqq           (1 ) (1 ) m d d d f d f d d i m d d d i i e X P Q P A eW W A W W q q X q Q q                                        (1 ) (1 ) m f f d f d f f i m d f i i e X e X eP A eW W A W W q P q X q X q                                        (1 ) (1 ) d f d d im d d f d m d d d i i P A eW W q e X P Q A W W X q Q q                                      (1 ) (1 ) f f d f im f d f m d f i i eP A eW W qe X e X A W W P X q X q                             Abbas et al. 825 (11) (12) As it is evident from equation (11), the exchange rate has negative relation with the domestic output supply. The only effect that exchange rate can bear on domestic supply is through the changing cost of imported inputs. So for as the foreign market is concerned, the total effects of changes in exchange rate on the supply to the international market is uncertain because exchange rate in this case influence both the revenue and costs structure of the firm. This can be observed from equation (12). The first term in the numerator has positive sign while the second has negative. Because these term has opposing effects on the supply, so nothing can be said a priori about the total effect of the changes in exchange rate on the foreign output supply. 4. Econometric Specification, Data and Description of Variables 4.1 Model Following the theoretical framework, we express exports-sales ratio as a function of firm size and exchange rate as: ESR = f (Firm size, Exchange Rate, Control variables) The econometric model can be written as: (13) 1234567 , , , , , , 0   Domestic sales model can be specified as: (14) 1 4 5 , , 0     , 2 3 , 0    4.2. Data and Description of Variables The study is based on the data of 205 firms representing fourteen different industries of Manufacturing Industry of Pakistan. Mostly, the data have been collected from ‘Balance Sheet Analysis of Joint Stock companies listed on Karachi Stock Exchange’, published by State Bank of Pakistan (SBP). Fourteen industries, which includes, Textile Spinning,                     2 (1 ) (1 ) (1 ) (1 ) ( 1) (1 ) m d d m f d f d f d d f d m d d d m d di i i i m d d f d m d d d i i e X P Q e X Ae W W A W W A W W P AeW W X q Q q eX q dqde e X P Q A W W X q Q q                                                                                                  2 0                           2 2 (1 ) (1 ) (1 ) ( 1) 2 (1 ) m f f d f d f f f d m f f fi i i mf d f m d f i i e X e X P Ae W W A W W P eP AeW W eX q eX q dq ee X e X A W W P X q X q                                                                                                0 1 2 3 4 5 6 7 _ it it t t jt it it t it ESR TA REERx REER VOL CON K GPR WGDP                   0 1 2 3 4 5 it it t t t it it DSR TA REERm INF PERC INVES               Firm Size, Exchange Rate and Exports Performance 832 The other firm-specific variable specified in the model is gross profit-sales ratio (GPR). The parameter is negative but statistically insignificant. The possible reason of negative relationship between the gross profit-sales ratio and exports sales ratio may be that an increase in profit-sales ratio (due to increase in price level) results in reduction in demand for exportable as these become expensive therefore export sales ratio decreases. To capture the monopoly in an industry, the degree of concentration is used. It is a matter of interest both for customers, sellers and regulatory authorities to have the information of market concentration. We have used the four-firm concentration ratio (CON) to encapsulate the potential for uncompetitive price fixing in the manufacturing sector firms. The relationship between concentration ratio and the export sales ratio is positive and highly statistically significant. The reason of positive relationship may be that as the concentration ratio increases, the share of the large firms increase. Very large suppliers are able to exert influence over market price. This is because they limit the availability of substitutes and therefore reduce the degree of price elasticity of demand. Faced with a relatively price inelastic demand curve, the firm can then raises the price to increase revenues. This in turn enhances the profitability and export sales of the firm. We have also introduced the concentration ratio in square and it suggests the positive bearing on exports sales ratio as well. Our results are in line with (Hsu and Tasai, 2008). We have also introduced the square of concentration ratio to analyze its intensity on export-sales ratio. It appears positive and statistically significant. To incorporate the impacts of economic conditions of Pakistan’s trading partners on export performance, the external sector variable World GDP (WGDP) has been used as a proxy variable. The relationship between WGDP and export sales ratio is positive and statistically significant. This positive relationship can be defensible because WGDP represents the income potential of the foreigners or trading partners of Pakistan. If the WGDP increases, they would have more resources on spend on Pakistani exports. There may be a case that the trading partners would spend on the other countries’ exports and but increase in Pakistani exports can also happen. This in fact depends on a lot factors besides the exports elasticity of demand. Therefore, the positive sign is correct and according to our expectations. Further, our results are compatible with (Zada et al., 2012). 6.2.2 Firm Size, Exchange Rate and Domestic Sales Now we examine the effects of firm size, exchange rate on domestic sales. The results of estimation are displayed in Table 9. It can be observed that the value of the parameter of total assets of the manufacturing firms (TA) is positive. If we compare the value of coefficient of total assets in both the equations i.e. export sales and domestic sales, we can infer that the magnitude of the value of total assets is more in export sales than that of domestic sales. This is in accordance with our theoretical model. The firm with more total assets can be classified as large firm. The relationship between total assets and domestic sales ratio is positive and statistically highly significant. It means that as the size of the firm increases, its productive capacity increases and it would be able to supply more in the local market. The large firm would have more cost advantage due to economies of scale and scope. So the large firms with low average cost provide more supply in the domestic markets in comparison with the small firms. Abbas et al. 833 Table: 9 Estimates of Firm size, Exchange Rate and Domestic Sales (Dependent Variable: Domestic Sales ratio) Regressors Coefficient Std. Error t - statistic Prob. Constant - 2577.287 472.7036 - 5.452227 0.0000 TA 110.9951 31.11420 3.567344 0.0004 REERm - 32.21793 8.143843 - 3.956109 0.0001 INF - 11.62856 3.860836 - 3.011928 0.0026 PERC 5.84E - 08 1.22E - 08 4.778615 0.0000 PERC^2 - 2.78E - 19 5.31E - 20 - 5.240260 0.0000 INVES 0.002530 0.001414 1.790153 0.0736 Source: Authors’ calculations Note: All the estimations are carried out by Eviews 7. The second variable specified in the equation is real effective exchange rate for imports (REERm). The parameter is highly significant and negative. This variable encompasses the impact of relative prices on domestic sales ratio. It shows the price competitiveness of imports and captures effects of valuation of currency. If the real effective exchange rate for imports depreciates, the cost of imported inputs accelerates therefore the firm would be unable to boost its sales locally. In fact, the firms that are using imported raw material, machinery etc more, their production cost is more associated with the real effective exchange rate for imports. The next variable that can influence the domestic sales ratio is investment (INVES). The parameter is positive and highly significant. It shows that when there is an increase in the investment expenditures, the domestic sales ratio increases because due to increase in investment, the productive capacity of the firms would increase and they can supply more in the domestic market. To capture the resource effect of the country on firms’ domestic sales, we have included the variable of per-capita income (PERC) in the specified equation. The coefficient of per-capita income shows that when the per-capita income of the country increases, people would have more resources to spend on firms’ offerings. The same we have observed in the parameter of per-capita income. Moreover, we have introduced the square of percapita income to encapsulate the long term effect of per-capita income on firm domestic sales ratio. This appears with opposite sign i.e. negative sign interestingly. The negative relationship between the square of per-capita income and local sales ratio may be justified with the reason that doubling the per-capita income would induce the consumers to tilt their expenditures towards the foreign goods rather than the indigenous products. In fact with the double of per-capita income, local products become inferior for the people and they tend to purchase the imported commodities due to demonstration effects. Finally, we have the variable of inflation rate (INF) in the equation. The parameter shows negative relationship with statistical significance. The possible reason of negative relation between the inflation rate and domestic sales ratio may be that CPI based inflation rate reduces the purchasing power of the local consumers. They demand less when the inflation rate increases because their real income falls and resultantly the sales of firms condense. Firm Size, Exchange Rate and Exports Performance 834 7. Conclusion and Policy Recommendations This study has been organized to analyze the impacts of firm size, exchange rate on the domestic and exports sales. For this we have specified two models: first shows the impacts of firm size and exchange rate on exports performance of the firms and other model explore the relationship among firm size, exchange rate and domestic sales of the firms. The study has focused only on the manufacturing sector. In order to show the firm size, we have used the variables of total assets in both the models. To observe the exchange rate effects on exports sales and domestic sales, exchange rate for exports and imports have been devised. Exchange rate for exports has been used in the exports sales model while the exchange rate for imports has been introduced in domestic sales model. The results of exports sales model suggest that larger firms have more exports sales than the smaller ones. The variable of total assets has found positive and significant in the exports sales model validating the economies of scale and learning effects. Exchange rate is other focused variable to capture price competitiveness of exports and valuation of currency. It is also found positive and highly significant in our model suggesting that exchange rate depreciation makes the exports cheaper in foreign market and resultantly exports-sales ratio escalates. In the same fashion, second model i.e. domestic sales model also shows that total assets of the firms are positively related with the domestic sales due to reasons mentioned in the exports sales model. Another concentrated variable exchange rate for imports has been found negative and highly significant due to the fact that exchange rate depreciation increases the cost of imported inputs therefore the firm would be unable to boost its sales locally. In brief, we can claim that larger firms have more potential of enhancing both levels of sales and real effective exchange rate for exports boosts the exports sales while real effective exchange rate for imports retards the domestic sales. This study has also spelled out two policy implications based upon its findings. i) The study shows the importance of scale in promoting the domestic and exports sales. The policy makers can focus on the scale of production to increase the productive efficiency for boosting the domestic and exports sales ratios. ii) From Pakistan’s economy perspective, our results indicate that exchange rate policy affects the domestic and exports sales. 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