Exchange Rates and the Working Capital Channel of Trade Fluctuations

Global value chains (GVCs) figure prominently in global trade and lie at the intersection of two important themes. The first is the financing requirement for working capital. The second is the prevalence of dollar invoicing in global trade. The upshot of the interaction of these two themes is that the dollar exchange rate emerges as a determinant of GVC activity. Specifically, a stronger dollar is associated with tighter credit conditions and subdued GVC activity. As a result, exports from an emerging economy may fall when its currency depreciates against the dollar. Our paper highlights this financial channel of the dollar on global trade. In Thomas Friedman’s book The World is Flat, a logistics executive is quoted as saying “[w]hen our grandfathers owned shops, inventory was what was in the back room. Now it is a box two hours away on a package car, or it might be hundreds more crossing the country by rail or jet, and you have thousands more crossing the ocean.” [Friedman (2005, p.174)] The picture of boxes whizzing around the world is a marvel not only of modern communications but also of finance, as those boxes are inventories of the firm. On the balance sheet, they enter as assets and must be financed somehow. Long supply chains entail substantial financing needs, which increases in a non-linear way with the length of the supply chain. To see this, consider an auto manufacturer with plants in Japan, Canada and Mexico. The firm makes engines in Japan and ships it to its plant in Canada, where it undergoes further assembly. The semi-finished car then goes to Mex-