Manufacturing industry firms that sell goods in domestic and international markets are subject to both domestic and external demand shocks. The continuity of their operations depends largely on how flexible these firms are in switching between domestic and international markets in response to these shocks. For example, a firm facing a negative domestic demand shock can minimize its losses by channeling as many sales as possible into exports, and, in some cases, make even more sales. The opposite can be observed when there is a negative external demand shock. At the micro level, these shocks affect a firm’s sales, but at the macro level, they affect economic activity. The size of these effects is often determined by the relationship between a firm’s domestic sales and exports. In this blog post, we will examine the relationship between domestic sales and exports of manufacturing firms and how much this relationship is affected by domestic demand conditions.
There are three main approaches to explain the relationship between domestic sales and exports at the firm level. The first of these approaches is capacity constraints, which suggests that an increase (decrease) in domestic demand leads to a decrease (increase) in exports due to short-term production constraints (Belke et al., 2015). In the absence of capacity constraints, the firm can adjust its sales in both markets independently from each other. The second approach takes domestically operating multinational corporations and foreign direct investments (FDI) into account (Wang et al., 2014). Accordingly, multinational corporations or FDI inflows help boost productivity and sales across local firms. However, the increased competition caused by the entry of multinational corporations has a negative impact on the sales of local firms. The third approach focuses on differential behaviors across exporters in international markets (McQuoid & Rubini, 2014). Accordingly, export-oriented firms are often referred to as permanent exporters. Firms that export to international markets only at certain times are referred to as temporary exporters.
For an empirical estimation of the relationship between exports and domestic sales, we use a panel data model. Taking firms’ real exports as the dependent variable, and lagged real exports, real domestic sales and various firm characteristics as explanatory variables, we estimate this model for the 2004-2015 period using the CBRT’s yearly sectoral balance sheets dataset.[1]
The results showed a pattern of substitution between domestic sales and exports of manufacturing firms. Put differently, firms tend to increase (reduce) exports in response to a fall (increase) in domestic sales. Quantitatively, a 10% decline in a firm’s domestic sales brings its exports up by 2.6% on average, holding all other variables constant. This is consistent with the findings of the studies conducted for European countries.
The second key outcome is that substitution patterns between domestic sales and exports vary depending on firm characteristics. The elasticity of substitution is estimated to be higher in export-oriented, low-indebted and younger firms than in domestic market-oriented, high-indebted and older firms. The sunk costs required to access export markets are expected to be higher for domestic market-oriented firms. Moreover, a part of these costs will likely require foreign currency financing. This explains why the elasticity is higher for export-oriented firms and low-indebted firms. The higher elasticity that younger firms have in allocating their sales between markets can be driven by factors such as the loyalty between sellers and buyers and the business choices they make. Accordingly, old firms become a part of certain supply chains through their relatively longer presence in the market and build a frequent buyer base, which may result in less heterogeneity in their exports against variations in domestic demand. Other possible reasons behind firm-level heterogeneity may include production technology (labor or capital intensive), export destinations, the degree of competition for products, the dependence on imported input, and price developments.
The third outcome shows that the pattern of substitution between domestic sales and exports is much stronger after periods of weaker-than-average domestic demand. Thus, firms seem to be flexible enough in switching from the domestic market to exports (or allocating their sales between markets) in times of weak domestic demand. As the mechanism is countercyclical, it can spur the economy through exports when economic activity is weakened by domestic demand, which indicates that reduced domestic demand might be one of the drivers of the recent export upturn.
In conclusion, our study shows that there is a pattern of substitution between domestic sales and exports of manufacturing firms. In other words, firms are flexible in moving to external markets when domestic sales are low. This elasticity of substitution stimulates the economy through external demand when economic activity weakens. In fact, despite the recent slowdown in domestic demand, firms have somewhat mitigated the downside risks to economic activity by switching to exports. Given the positive external demand outlook, we expect that net exports will continue to contribute to growth in 2019.
[1] For technical details, see: CBRT Inflation Report, Issue 2018-IV, Box 4.3.
References
Belke, A., Oeking, A., & Setzer, R., 2015. Domestic Demand, Capacity Constraints and Exporting Dynamics: Empirical Evidence for Vulnerable Euro Area Countries. Economic Modelling, 48, 315-325.
McQuoid, A., & Rubini, L., 2014. The Opportunity Cost of Exporting. Society for Economic Dynamics, 2014 Meeting Papers, 412.
CBRT Inflation Report, Issue 2018-IV, Box 4.3.
Wang, J., Wei, Y., Liu, X., Wang, C., & Lin, H., 2014. Simultaneous Impact of the Presence of Foreign MNEs on Indigenous Firms' Exports and Domestic Sales. Management International Review, 54 (2), 195-223.