Exchange rate adjustment mechanism in a globalized economy:
Evidence from the Czech Republic*
It is demonstrated on a panel of Czech exporting industrial branches that fluctuations of the
nominal exchange rate of the Czech Koruna are directly reflected in the operational
profitability of domestic private firms (local-currency-pricing strategy) whereas it seems that
firms under foreign control can limit exchange rate fluctuations through transfer pricing.
Transfer pricing is carried out by the multinational company-related trade by which profits are
shifted from high taxed countries to low taxed countries. As a result, the effectiveness of the
exchange rate adjustment mechanism is deteriorated by cross-border optimizing activities of
Keywords: Multinational company-related trade; Nominal exchange rate; Tax
optimization; Transfer pricing
JEL classification: F23; L11
The opinions in this article are of the author and are not necessarily endorsed by the Czech National Bank.
Czech National Bank, External Economic Relations Division, Na Příkopě 28, 115 03, Prague 1, Czech
Republic (e-mail: firstname.lastname@example.org).
Foreign direct investment (FDI) as a form of private capital investment started to penetrate the
world economy only in 1980’s. Although a vast number of FDI still proceeds mainly within
developed countries, for transition countries of Eastern Europe, FDI represents a symbol of
economic restructuring. The Czech Republic is often appraised as a successful country in FDI
attraction. Nevertheless, a high presence of FDI in the economy changes its prevailing
macroeconomic characteristics as well. Among others, mostly positive effects, FDI can
influence the effectiveness of the exchange rate adjustment mechanism. It is because
production of firms under foreign control is mainly export oriented and, at the same time, it is
significantly linked to a foreign mother company.
Benvignati (1990) remarks that an economy which is characterized by a high amount of FDI
requires more complex analysis of its foreign trade and additional explaining factors should
be implemented. A key factor is the multinational company-related trade or intrafirm trade.
Hipple (1990) gives four definitions of the multinational company-related trade. His
narrowest definition comprises transactions between a parent company and its affiliates only.
Nevertheless, it is very difficult to monitor the narrow intrafirm trade. Commonly, a broader
definition which includes all trade transactions where a parent firm or an affiliate participates
as a buyer and/or seller is used. The broader one is also the definition used by the U.S. Bureau
of Economic Analysis to calculate the level of merchandise trade associated with U.S.
As the number of multinational companies has increased, intrafirm trade started to play an
important role in the world economy. Clausing (2003) finds, by analyzing US international
trade prices, direct evidence indicating that intrafirm trade prices are likely influenced by the
tax-minimization strategies of multinational firms. Also in the case of the Irish economy,
Barry (2005) claims that multinational companies are engaged in profit shifting through the
manipulation of prices charged for the transfer of goods and services between a parent
company and its foreign affiliates. Neighbour (2002) confirms a high proportion of the
intrafirm trade on the total world trade. Due to growing importance of the intrafirm trade, the
OECD (2001) introduced guidelines which aim to regulate international transfers of goods
and services within a multinational company.
It is estimated in this paper that the share of the broader intrafirm trade on the total foreign
trade of the Czech Republic exceeds 50 percent. At the same time, the Czech currency
experienced several episodes of a rapid nominal exchange rate appreciation without
significant impacts on real exports. Knowing the owner structure of exporting firms in the
economy (domestic private firms and firms under foreign control), it seems relevant to
analyze potential effects of exchange rate fluctuations on micro-level to reveal potential
macroeconomic effects on the whole economy level.
By traditional macroeconomics, fundamental movements of a flexible exchange rate are
supposed to cause adequate changes in terms of trade and, depending upon corresponding
elasticities, the volume of exports and imports adjusts accordingly.1 Consequently, a trade
balance surplus is suppressed by currency appreciation and, to the contrary, a trade balance
deficit is smoothed away by currency depreciation. A neoclassical perfect competition
assumption is in the background of the exchange rate adjustment mechanism. However,
economists have been proposing new models of international trade since 1980’s that stress
imperfect competition and dynamic aspects. Even if these models have often proved difficult
to test, they help to better understand the economic reality.
Limited effectiveness of the exchange rate adjustment mechanism is commonly attributed to
the pricing-to-market (PTM) phenomenon (Krugman, 1986). PTM means that a monopolistic
Short-term price inelasticity of supply and demand curves in international trade causes the J-curve effect which
is the expression used to describe the initial deterioration and subsequent improvement of the trade balance
following a depreciation of the exchange rate.
competitive producer decides to sell his products for different prices on separate foreign
markets. Foreign prices of exports and imports are therefore constant irrespective of exchange
rate movements and the traditional “expenditure switching” role of the exchange rate is
reduced. Firms absorb exchange rate movements in their profit margins instead in order to
avoid the loss of foreign market shares.
PTM is, de facto, a combination of international market segmentation by imperfectly
competitive firms and local currency price-setting. In practice, especially in case of relatively
small economies, exports are invoiced in the foreign currency of a destination market (local-
currency-pricing). Local-currency-pricing as opposed to producer-currency-pricing thus
implies incomplete exchange-rate-pass-through (Corsetti and Pesenti, 2005). Betts and
Devereux (2000) argue that deviations of nominal exchange rates from purchasing power
parities are, aside from the existence of nontradables, caused by PTM.
In addition, the existence of multinational company-related trade plays an important role in
the exchange rate adjustment mechanism as well. The intrafirm trade which is associated with
transfer pricing is characteristic for countries where multinational companies are important,
i.e. countries with a high stock of FDI on their GDP. The Czech Republic is a typical
A theoretical background for the analysis provided in this paper draws mainly on Horst
(1971) who claims that the intrafirm transactions of multinational companies are not valued in
an open market but these firms choose, within certain limits, an optimal transfer price. The
important finding is that transactions between a parent and affiliate are not “arms-length”2 or
valued at market prices but represent the production and distribution operations of the
vertically integrated multinational company.
An arms-length transaction is a transaction between two related or affiliated parties that is conducted as if they
were unrelated, so that there is no question of a conflict of interest. Initially, Cook (1955) and Hirshleifer (1956)
dealt with the problem of pricing the goods and services that are exchanged between mutually related divisions
within a firm.
In this paper, different reactions to exchange rate fluctuations between domestic private firms
(controlled by residents) and firms under foreign control (affiliates of multinational
companies) will be analyzed. Possible differences will serve as an implicit evidence of
different price setting strategies between these two sectors with resulting macroeconomic
2. Tested hypothesis and data
From a methodological point of view, it is assumed that exporting firms in the Czech
Republic apply PTM strategy, i.e. nominal exchange rate fluctuations are not reflected in
foreign export prices but are absorbed in firms’ profit margins. In this way, firms stabilize
their real exports and foreign market shares regardless of nominal exchange rate fluctuations.
Dornbusch (1987) refers to the absence of a comprehensive matched data set of export,
import, and domestic prices. If we intend to identify price strategies of exporting firms, we
need to accept some simplifying assumptions. In this note, the indicator of the operational
profitability of sales is used to demonstrate immediate effects of exchange rate movements on
the profitability of exporting firms:3
π ti = (1)
where π ti is the operational profitability of an exporting industrial branch i in time t. Π it
stands for the operational profit and Sti for firms’ sales. Year-on-year changes of the
operational profitability of individual manufacturing branches are then calculated from
quarterly data. As significant results had not been found for the sector as a whole, the paper
focused on individual institutional sectors only, particularly on private domestic firms and
By using operational profitability, profits and losses from financial operations (hedging against the currency
risk) are subtracted.
firms under foreign control. The hypothesis is tested using a linear function. In formal we
∆π ti ,diff = α i + β∆zt + ε t (2)
where ∆π ti ,diff = ∆π ti ,d − ∆π ti , f denotes the difference of the yearly profitability change
between domestic private firms ∆π ti,d and firms under foreign control ∆π ti, f in industrial
branch i in time t. Parameter α i is the specific effect of the profitability in industrial branch i.
Variable ∆zt stands for a year-on-year change of the nominal effective exchange rate (NEER)
of the Czech currency and β is its corresponding parameter. The growth in NEER means
appreciation. The i.i.d. disturbance is denoted by ε t .
Based on the PTM hypothesis, it is assumed that the profitability will decrease if NEER
appreciates and it will increase if NEER depreciates. Of course, NEER changes may have a
diverse impact on different industrial branches.
Data from the database of economic results of non-financial firms with more than one
hundred employees compiled by the Czech Statistical Office (CSO) were analyzed. The CSO
publishes the aggregated data for each industrial branch with the sub-aggregation for
individual institutional sectors. Selected financial indicators were available according to
individual industrial branches (OKEC/CZ-NACE) and institutional sectors: firms under
foreign control, domestic private firms and public firms. Only the branches with more than 60
percent of direct exports on the total production were analyzed. The share of value added of
exporting industrial branches on total value added of the manufacturing industry was 55
percent in 2006.
The exporting branches included: manufacturing of textiles, textile products and clothing
industry (DB), manufacturing of leather and leather products (DC), manufacturing of wood
and wood products out of furniture (DD), manufacturing of chemicals, chemical products and
man-made fibers and pharmaceuticals (DG), manufacturing and repairs of machinery and
equipment (DK), manufacturing of electrical and optical appliances and equipment (DL),
manufacturing of transport vehicles and equipment (DM) and manufacturing of unclassified
products (DN). All indicators were in nominal values. The quarterly indicators from the first
quarter 1998 until the fourth quarter 2006 were available. At the same time, the Czech
Republic has been practising a flexible exchange rate regime of the Czech Koruna.
Knowing the additional data4, the export share of firms under foreign control is estimated to
about one-half of total exports of the Czech Republic while the share of sales from direct
exports of goods and services of firms under foreign control on total sales from direct exports
of industrial firms reaches more than 70 percent.
We have 32 observations of year-on-year changes in the operational profitability of the eight
exporting industrial branches. The average yearly change of the operational profitability of
domestic private firms ∆π ti ,d reaches 0.2 percentage points with the standard deviation of 3.9
percentage points while the average change of the operational profitability of firms under
control ∆π ti , f is -0.1 percentage points with the standard deviation of 6.0 percentage points.
The average nominal exchange rate appreciation during the period was 4.5 percent with the
same standard deviation. The data shows that despite a relatively stable average profitability
its fluctuations were quit high.
3. Estimation results
The estimation of diverse effects of exchange rate movements on the two selected institutional
sectors was carried out by estimating equation 2 using the fixed effects panel data estimator
The Czech National Bank publishes The Annual Report on Foreign Direct Investment which includes, among
others, selected indicators of firms under foreign control. The Czech Statistical Office publishes the statistics of
industry and construction.
on a sample of 256 observations. The results are shown in Table 1. Although the coefficient
of determination is low, both coefficients α i and β are statistically significant in the case (1)
Fixed effects estimation results
αi β R2 D.W.
(1) ∆π ti ,diff 2.03 (0.56)*** -0.38 (0.09)*** 0.08 1.77
(2) ∆π ti ,d 2.28 (0.3)*** -0.46 (0.05)*** 0.28 1.66
(3) ∆π ti , f 0.25 (0.54) -0.08 (0.09) 0.01 1.56
Periods included: 32; Cross-sections included: 8; Total panel (balanced) observations: 256
Standard errors are given in parentheses. Asterisks denote significance as follows: *** 1 %, ** 5 %, and * 10 %.
If we decompose the difference (1) into the effect of NEER changes on the profitability of
domestic private firms (2) and firms under foreign control (3), we find out that, intuitively, the
exchange rate appreciation implicates a decrease in the profitability of sales; negative sign of
the coefficient β . Nevertheless, NEER changes have a significant direct effect on domestic
private firms only. One percent appreciation implies a decrease in the operational profitability
of sales of about 0.46 percentage points. The effect on firms under foreign control is
It is evident that the operational profitability of firms under foreign control is more resistant
against NEER changes. This fact could be caused by transfer pricing. The effect of transfer
pricing is quantified to about 0.38 percentage points ( ∆π ti ,d - ∆π ti , f ). It is therefore assumed
that firms under foreign control are able to manipulate their intrafirm prices of
imports/production consumption and exports/sales in order to stabilize the operational
Both individuals and firms prefer stability of their income before its volatility.
Factors which may determine profit shifting of multinational firms comprise, among others,
income tax optimization. A possible channel through which a management of a multinational
company can affect financial results of a particular subsidiary firm (firm under foreign
control) is exactly the multinational company-related trade. From a simple regression (see
Figure 1), it is clear that multinational companies actually attain high profits in low taxed
countries at the expense of high taxed countries. The linear regression indicates a significant
relationship between the profitability of FDI (firms under foreign control) and the effective
taxation. Both estimated parameters in the equation are statistically significant.6
Linear relationship between firms’ taxation and the profitability of FDI
y = -0.6346x + 24.905
Profitability of FDI in 2004 - 2005 (%)
R = 0.7255
Lithuania Czech Republic
10 14 18 22 26 30 34 38
Firms' effective tax rates in 2005 (%)
Source: Eurostat and ZEW (2006); own calculations
Note: The profitability of FDI in individual countries is a ratio of the debit size of the FDI income balance in
time t on the stock of FDI in time t-1. The sample of countries comprises Austria, the Czech Republic, Denmark,
Estonia, Finland, France, Germany, Hungary, Ireland, Italy, Latvia, Lithuania, the Netherlands, Poland, Portugal,
Slovakia, Slovenia, Sweden and the United Kingdom.
If the effective taxation were zero, the annual profitability of foreign direct investment would reach nearly 25
Countries with a lower taxation are at the upper left corner of Figure 1. These countries are
characterized by a higher profitability of FDI and include Ireland, Slovakia and Latvia. On the
other hand, high taxed countries are at the bottom right corner of Figure 1. These countries are
characterized by a lower profitability of FDI. They comprise France, Italy and Germany.
Germany has the highest effective taxation (36 percent). In the Czech Republic, firms are
taxed by the effective tax rate of 22.9 percent and their average profitability reaches 12.8
Even if profits of a multinational company were taxed on the consolidated basis7 in the home
country of a foreign investor, there would be a possibility how to avoid higher taxes in a home
country. A multinational company can simply retain (reinvest) all profits in its subsidiaries.
That’s why foreign activities of multinationals are in a large extent financed by reinvested
profits. The policy of repatriated dividends taxation leads multinationals to prefer financing of
subsidiary firms by the equity capital before the debt capital and it discourages multinational
companies from the repatriation of foreign profits (Horst, 1977).8
Except low taxation, some countries apply the economic policy of investment incentives
including tax holydays for several years. Multinational companies have thus sufficient
motives to manipulate their profits through internal prices. Multinational companies
concentrate their production into countries which have the lowest production costs and final
products are then placed on foreign markets where the highest price is reached.
There are in general two alternative ways of multinational company taxation. The one is known as income
taxation on a consolidated basis and the other one is known as income taxation on a territory basis. The first
alternative is characterized by taxation of all profits of a multinational company irrelevant the country of their
origin and afterwards taxes which have been already paid abroad are deducted. The second alternative is to tax
profits which have been generated on the territory of a certain country.
Subsidiary firms which operate in high tax countries are financed by an intrafirm loan instead of an equity
The paper analyzed diverse impacts of nominal exchange rate fluctuations on the operational
profitability of exporting domestic private firms and firms under foreign control in case of the
Czech Republic. The analysis was motivated by significant presence of FDI in the Czech
economy which implies a high share of foreign trade transactions carried out within a
multinational company structure. Based of previous findings, intrafirm prices of a
multinational company may deviate from market prices with subsequent implications into the
exchange rate adjustment mechanism.
The main findings of this paper are the following, exchange rate fluctuations are directly
reflected in the operational profitability of domestic private firms (owned by residents)
whereas firms under foreign control (affiliates of multinational companies) are able to control
the impact of exchange rate fluctuations on the profitability. The difference between domestic
private firms and firms under foreign control is ascribed to transfer pricing which is carried
out by the intrafirm trade within a multinational company. It is proved on a sample of EU
countries that multinationals actually shift profits from high tax countries to low tax countries.
The effectiveness of the exchange rate adjustment mechanism is thus deteriorated by growing
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Clausing, K.A., 2003, Tax-motivated transfer pricing and US intrafirm trade prices. Journal
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Cook, P.W., 1955, Decentralization and the Transfer-Price Problem. Journal of Business 28,
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