Domestic demand pressure and export dynamics – An empirical threshold model analysis for six euro area countries

Traditional specifications of export equations incorporate foreign demand as a demand pull factor and the real exchange rate as a relative price variable. However, such standard export equations have failed to explain the export performance of euro area countries during the crisis period. In particular, the significant gains in export market shares in a number of vulnerable euro area crisis countries did not coincide with an appropriate improvement in price competitiveness. This paper argues that, under certain conditions, firms consider export activity as a substitute of serving domestic demand. The strength of the link between domestic demand and exports is dependent on capacity constraints. Our econometric model for six euro area countries suggests domestic demand pressure and capacity constraint restrictions as additional variables of a properly specified export equation. As an innovation to the literature, we assess the empirical significance through the logistic and the exponential variant of the nonlinear smooth transition regression model. In the first case, we differentiate between positive and negative changes in capacity utilization and in the second case between small and large changes of the same transition variable. We find that domestic demand developments are relevant for the short-run dynamics of exports when capacity utilization is low. For some countries, we also find evidence that the substitution effect of domestic demand on exports turns out to be stronger the larger is the deviation of capacity utilization from its average value over the cycle.