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Arm's-Length Trade: A Source of Post-Crisis Trade Weakness

Core Content

This working paper by Csilla Lakatos and Franziska Ohnsorge explores the role of arm's-length trade in the post-crisis trade slowdown. It highlights how trade between unaffiliated firms has been disproportionately affected by the global financial crisis compared to intra-firm trade.

Main Viewpoints

• Trade Growth Slowdown: Global trade volume growth dropped significantly after the financial crisis, from 7.6% (2002-08) to 4.3% (2010-14). The U.S. trade data show that arm's-length trade, not intra-firm trade, accounts for most of this slowdown.
• Compositional Effects: Arm's-length trade is more reliant on emerging market and developing economies (EMDEs), which experienced sharp slowdowns in output growth post-crisis. It is also more sensitive to demand changes and real exchange rates.
• Income and Exchange Rate Elasticity: Arm's-length exports have a higher income elasticity (about one-fifth higher) and real exchange rate elasticity (one-tenth higher) than intra-firm exports. This makes arm's-length trade more vulnerable to global economic downturns.
• Firm-Level Constraints: Unaffiliated firms faced more challenges during the crisis, including constrained access to finance, heightened policy uncertainty, and lower productivity, which likely contributed to the trade slowdown.
• Role of Global Value Chains (GVCs): Intra-firm trade is more closely associated with GVCs, which may have made it more resilient to exchange rate fluctuations and demand shocks than arm's-length trade.

Key Information

Data and Methodology

• The study uses U.S. trade data from the U.S. Census Bureau, focusing on arm's-length and intra-firm trade.
• Intra-firm trade is defined as transactions between firms under common ownership or control, while arm's-length trade involves unrelated firms.
• The ownership threshold for related-party exports is set at 10%.
• The paper applies an econometric model to estimate the elasticity of U.S. exports to GDP growth and real exchange rate changes.

Sectoral and Regional Composition

• Arm's-Length Trade: Comprises about 57% of total U.S. trade, with a higher share in EMDEs (64%) than in advanced economies (51%).
• Intra-Firm Trade: Accounts for about one-third of global exports and is more concentrated in North America and in sectors like machinery, chemicals, and electronics.
• Regional Trade Partners: Canada and Mexico are major destinations for intra-firm trade, with over half of U.S. exports and imports to these countries being intra-firm. In contrast, exports to large European and Asian countries are predominantly arm's-length.

Post-Crisis Trends

• Intra-firm trade growth recovered closer to pre-crisis levels by 2014 (4.3% for exports and 5.0% for imports), while arm's-length trade growth remained significantly lower (4.7% for exports).
• The U.S. dollar appreciation post-crisis likely dampened arm's-length trade more than intra-firm trade, as the latter is more integrated into GVCs.

Factors Affecting Arm's-Length Trade

• Compositional Effects: Arm's-length trade is more exposed to EMDEs and sectors that experienced rapid growth pre-crisis but stagnated post-crisis, such as textiles and machinery.
• Access to Finance: Unaffiliated firms faced tighter credit conditions, which likely constrained their ability to engage in arm's-length trade.
• Size and Productivity: Larger and more productive firms, which are more likely to engage in intra-firm trade, were better able to adjust to demand shocks.
• Supply Chain Complexity: The "bullwhip effect" suggests that firms higher up in complex supply chains experienced greater demand volatility, which may have affected arm's-length trade more.
• Policy Uncertainty: Increased uncertainty during and after the crisis may have led to a preference for intra-firm transactions over arm's-length ones.

Conclusion

The paper concludes that the post-crisis trade slowdown was largely driven by the higher sensitivity of arm's-length trade to global demand and exchange rate changes, combined with its greater reliance on EMDEs and declining growth sectors. These factors, along with firm-level constraints, have contributed to the relative weakness of arm's-length trade compared to intra-firm trade.

Structure of the Paper

1. Introduction: Outlines the trade slowdown and the focus on arm's-length trade.
2. Characteristics of Arm's-Length and Intra-Firm Trade: Examines the data, definitions, and composition of U.S. trade.
3. Evolution of Trade Flows: Discusses how trade growth changed pre- and post-crisis.
4. Factors Contributing to the Slowdown: Identifies key economic and structural factors affecting arm's-length trade.
5. Empirical Estimation: Presents econometric results showing the differential elasticity of arm's-length and intra-firm trade.
6. Conclusion: Summarizes the findings and their implications for trade policy.