RDP 9310: Explaining the Recent Performance of Australia's Manufactured Exports 1. Introduction

The process of international integration has been accompanied by important changes in Australia's balance of payments. One such change is the marked increase in the nation's export orientation, parallelling an increase in import penetration. Another is the diversification of the type of goods that are exported. Historically, Australia has exported mainly primary commodities. Although such commodities continue to account for the majority of Australia's merchandise exports, manufactured export volumes have grown strongly in recent years. In fact, since the mid-1980s, they have grown at twice the rate of traditional exports. How can the performance of manufactured exports be explained?

In popular discussion it has been argued that Australian exporters of manufactures have established so-called ‘beachheads’ in foreign markets.^[1] If so, it can be expected that sales to these markets will not be abandoned readily even when economic conditions faced by exporters change. Thus the pattern of export growth that has emerged since the mid-1980s may persist for some time, contributing to a structural change in the nation's merchandise trade.

There is a growing body of literature that seeks to explain structural changes in patterns of trade in the context of hysteresis.^[2] It is argued that, following a shock to an economic system, there is a change in the pattern of trade that fails to be reversed when the shock is reversed (Baldwin 1988; Baldwin and Krugman 1989). Failure to revert to the initial equilibrium arises because agents incur sunk costs when entering a market (Dixit 1989).

The existing literature arose to explain the apparently hysteretic effects of the prolonged swing in the value of the US dollar during the 1980s.^[3] It tends to focus on exchange rate movements as the potential source of a permanent change in trade volumes. However, it is plausible that other shocks may also be important. The decision of firms to export will be influenced by the profitability of selling output locally compared with selling to foreign markets. Therefore, changes in world and domestic demand could, in principle, be as important as changes in the exchange rate.

In this paper, a standard export model is altered by allowing for the existence of sunk costs. In the world of the sunk-cost model, agents do not necessarily respond in the standard way to economic forces. Sunk costs effectively create a hurdle that any would-be exporter must surmount. Exporters may not appear to respond to changed incentives (such as tariff reductions) until a threshold value is reached. Furthermore, even if the shock is reversed (as exchange rate and demand shocks can be) they may not abandon their markets, having paid their sunk costs.

The main theoretical result of the model is that both demand and exchange rate shocks to the economic system can generate hysteresis. Another result is that tariff reductions may appear to have no effect on exports until a threshold is reached. An attempt is made to relate this theoretical model to the actual performance of manufactured exports. Econometric and survey data support a structural break in the mid-1980s. A case for hysteresis is developed where the catalysts for change are the historic mid-1980s exchange rate depreciation, the most recent recession and the process of internationalisation begun in the early 1970s (embodied in tariff reductions). It is also suggested that the existence of positive externalities has enabled and will continue to enable new exporters to benefit from the presence of Australian firms already established in overseas markets.

The paper is organised as follows. In Section 2, stylised facts are presented. In Section 3, a sunk cost model is developed. In Section 4, some evidence of hysteresis in Australia's manufactured exports is considered, along with evidence relating to other explanations. Finally, implications and conclusions are drawn.

Footnotes

The landing of the Allies at Normandy in World War II established a ‘beachhead’. [1]

Hysteresis is the failure of a shocked variable to return to its original state when the cause of the shock is fully reversed. [2]

For example, Baldwin (1988) found evidence for an altered pass-through of import prices. [3]