Domestic demand, capacity constraints and exporting dynamics: Empirical evidence for vulnerable euro area countries

•We argue that firms try to substitute low domestic demand by higher export sales.•We estimate export equations as non-linear smooth transition regression models.•Exports substitute for low domestic demand during business cycle extremes.•This relationship empirically holds for four out of five countries studied.

In this paper we consider five euro area countries with current account and especially trade deficits during the last years which have recently improved. We argue that one reason for the improvement could be firms trying to substitute for low domestic demand by shifting sales to the export market, particularly during economic recessions. Our econometric model therefore adds domestic demand as a further variable to smooth transition regression model that tries to capture business cycle effects by capacity constraints. In four out of our five countries, we find a substitutive relationship between domestic and foreign demand during more extreme stages of the business cycle. We conclude that for these countries, during business cycle troughs as currently found, domestic demand is indeed relevant for the short-run exporting dynamics.