A Markov Regime-Switching Model on Foreign Trade: The Case of China

Dongmei Li
School of Mathematical Science Shanxi University Taiyuan, Shanxi, P.R.China lidm@sxu.edu.cn

Zhihong Song
School of Management Shanxi University Taiyuan, Shanxi, P.R.China songzhihong@sxu.edu.cn

Libo Fan School of Business University of International Business and Economics Beijing, P.R.China lbfan@263.net

AbstractBased on Hamilton Markov regime-switching model applied to postwar U.S. business cycle (1989,1994), the paper uses Chinese import and export data from January 1999 to November 2010 to describe and investigate the dynamic growth path of Chinas foreign trade. The empirical results suggest that the growth path of Chinas foreign trade can be classified as longterm expansion regime1999.01~2008.08 and 2008.12~2010.11 and short-term recession regime (2008.09~2008.11), which means the growth path of Chinas foreign trade may experience a shift of regime. The global economic situation and Chinese economic policy during these periods may explain the move of regime. Chinese economy needs to shift from export-oriented economic growth to more reliance on indigenous innovation of firms and domestic demand-pulled growth, which maybe not only the results of the 2008 global financial crisis, but also reflects the need for continual growth of Chinese economy in the future. Keywords- Foreign trade; Markov regime-switching model; smoothing probabilities

in Chinas national economy. Empirical evidence suggests that import may improve Chinas total factor productivity by technology spillovers (Coe & Helpman, 1995; Coe, Helpman & Hoffmaister 1997). Hence, how to predict precisely the huge fluctuations of foreign trade is becoming a critical matter for Chinas short-term and long-term trade policy. This paper tries to employ a nonlinear Markov regime-switching model to predict the turning points of the foreign trade cycles. The paper is organized as follows: Section 2 depicts the data source and characteristics of foreign trade in China. Section 3 sets up a Markov switching model on foreign trade and estimates coefficients in the model with Gauss 7.0. Section 4 conducts a specification test to check the appropriateness of Markov regime-switching model. Section4 concludes the paper with policy implications. II. DATA

I.

INTRODUCTION

Chinas foreign trade barriers have been lowered since its entry into the WTO in 2001, which results in a substantial growth of foreign trade in China. According to WTO, the share of China in world merchandise trade raised from 8.9% in 2008 to 9.6% in 2009, surpassing Germany as the biggest exporter in the world; meanwhile, Chinas strong economic growth has created considerable market opportunities for other countries. In 2009, the percentage of China in world merchandise imports increased from 6.9% in last year to 7.9%, becoming the second largest importer in the world. In 2008, the subprime mortgage crisis originated in the U.S. eventually evolved into global crisis, causing low economic growth and sluggish market demand. The trade level in European Union fell about 16% in the fourth quarter of 2008 compared to the same period in 2007, North America and Asia fell about 7% and 5% respectively. In the process of global economic recovery, the controversy on free trade between developed and developing countries became more intense. The essence of the debate is on the relationship between international trade and economic growth (Grossman & Helpman, 1991; Young, 1991). Chinas economic growth has been led by an exportoriented policy. As one of three pillars for short- term economic growth, merchandise exports play an important role

We use monthly data of merchandise imports and exports from January 1999 to November 2010 as an indicator of foreign trade. All data are from Chinese Macroeconomic Database. The time series of imports and exports (MX) display obvious seasonal characteristics (See Fig. 1). The growth rate of MX series adjusted with X12 method demonstrates with no obvious seasonal characteristics (See Fig. 2). Fig. 2 depicts that foreign trade increased substantially in 2001, 2004, and 2009, decreasing rapidly in 2008, while remaining relatively stable in other time period.

This research is supported by Ministry of Education (06JJD79004)

978-1-4244-6581-1/11/$26.00 2011 IEEE

then st is a 32-state Markov process. The transition probability matrix, denoted by P, can be obtained from (2). * Therefore, when st = 1 , the conditional probability density function of yt is written as follows:

where, III. EMPIRICAL MODEL AND RESULTS Similarly, we can obtain the conditional probability density * function of yt when st = 2,3, ,32 . Let

A. Model setup We follow Hamilton's (1989) switching model, allowing that the mean of growth rate in Chinas foreign trade to be evolving according to a two-state Markov regime-switching process. We set up Hamilton's (1989) Model with AR(4) process as follows:

yt represents the growth rate of foreign trade in month t, st = 0 + 1 st denotes the conditional mean of yt
Where in state

and vector

st . st denotes the unobserved state variable, st =1 stands for expansions of the foreign trade and st =0 stands for

( t|t ) 321 gives the inference of st* based on

innovation in time t and population parameters, with

Pr( st* = j | Yt , ) as the jth element. The optimal inferences

and forecasts in time t can be obtained by the following two iterate equations (See Hamilton(1994: 690-695) for Derivation of the two iterate equations):

contractions of foreign trade.

is a white-noise shock, with

2 .

normal distribution and variance of The transition between states is governed by a first-order Markov process, which means the value of st is only related with st 1 . The transition probabilities are as follows:

In order to write the likelihood function of new regime variable st so that:

*

yt , we define a

The log-likelihood function for population written as:

YT can be

B.

Estimation results Maximum likelihood method was used for estimation. The Maximum likelihood (ML) estimation of our model is developed from the ExpectationMaximization (EM) algorithm discussed in Hamilton (1990). The estimations of p, q, 0, 1, 1 , 2, 3, 4 and 2 in the AR(4) process are reported in Tab. 1. The results are given by Gauss7.0 procedure.
TABLE 1 MAXIMUM LIKELIHOOD ESTIMATES OF FOREIGN TRADE MODEL Variable Coefficients Coefficients 0 -9.5658 -0.0033 1 11.1799 18.713 1 -0.7669 0.9921 2 -0.309 0.6239 3 -0.0784 4 -0.0033 18.713 2 p 0.9921 q 0.6239 Log-likelihood value: -281.55

Fig. 3 and Fig. 4 also suggest that Chinas foreign trade have been relatively stable in the state of expansion since 1999, which means the foreign trade grows steadily during this period until August 2008, followed by a short contraction period before returning to expansion. The transition between the two states reflects the background of global economy and domestic policy in China. C. Testing the Markov regime-switching model In Markov regime-switching model, the transition probabilities of p and q are not identified. Hence, we have to test whether the model is properly specified. According to Hansen (1992), the LR statistics can be used to test the nonlinear specification. The specific hypotheses to be tested are: H0: 1 = 0 versus H1: 1 0 The LR statistics is LR = Lm(qm)-L0(q0)~2( k) where k denotes difference between the number of parameters in two models. Given an estimate of qm and q0, we have Lm(qm) and L0 (q0) as the LR values for Markov regimeswitching model and AR model respectively. LR has the asymptotic Chi-square distribution with degree of k. Tab. 2 displays the estimation results for AR(4) process. We have LR = Lm(qm)-L0(q0)=-401.78, which obviously is not Chi-square distribution. Therefore, we reject H0.
TABLE 2 ESTIMATION RESULTS FOR AR(4)

Fig. 3 and Fig. 4 depict the smooth probability of an expansion of foreign trade being in expansion and contraction. The mean duration of foreign trade being in expansion (St=1) is far longer than the state being in contraction (St=0). The estimates of p and q in Tab. 1 represent the transition probability from expansion to expansion and the transition probability from contraction to contraction, respectively. We may calculate the expected durations of expansion and contraction as follows: Expected duration of expansion = 1/(1-0.9921) =126.5823(months) Expected duration of contraction=1/(1-0.6239) = 2.6589(months) (4) (3)

Variable C VMX(-1) VMX(-2) VMX(-3) VMX(-4) R squared Adjusted R2 S.E.of regression Sum squared Resid Log likelihood Durbin-Watson stat

Coefficient 0.036887 -0.313048 -0.468927 -0.003519 0.015480 0.256637 0.234280 0.103132 1.414605 120.2343 1.985649

S. E. t-statistics 0.010233 3.604742 0.085831 -3.647261 0.089956 -5.212826 0.085041 -0.041380 0.081480 0.189988 Mean dependent var S.D. dependent var A.I.C. Schwarz criterion F-statistic Prob(F-statistic)

Probability 0.0004 0.0004 0.0000 0.9671 0.8496 0.021137 0.117857 -1.67006 -1.56400 11.4791 0.000000

IV.

POLICY IMPLICATIONS

REFERENCES
[1] [2] G. M. Grossman and E. Helpman. Innovation and Growth in the Global Economy. Cambridge: MA, MIT Press, 1991. A.Young, Learning by Doing and the Dynamic Effects of International Trade, Quarterly Journal of Economics, vol 106, pp.369-406, 1991. Coe, D. and E. Helpman, International R&D Spillovers, European Economic Review, vol 39, pp. 859-887, 1995. D.Coe, E. Helpman and A. Hoffmaister, North-South Spillovers, Economic Journal, vol 107, pp.134-149,1997. J. D.Hamilton, A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle, Econometrica , vol 57, pp. 357-384,1989. J.D.Hamilton, Time Series Analysis. Princeton, NJ: Princeton University Press, 1994. B.E.Hansen, The Likelihood Ratio Test Under Nonstandard Conditions: Testing the Markov Switching Model of GNP, Journal of Applied Econometrics, pp.S61-S82,1992.

The expansion and contraction of foreign trade in China are greatly influenced by the global economy. Global output decelerated sharply in 1998 as imports of Japan and East Asia fell for the first time since 1974 (first oil crisis). A strengthening of world economic output in 1999 reversed the slowdown of world trade in the first half of 1999 and led to a dynamic expansion of trade in the second half. Chinas foreign benefited from the global economy expansion, especially after Chinas entry into the WTO in 2001. The subprime mortgage crisis in the U.S. started to show its effects in the middle of 2007 and into 2008. The sharp declines of trade in the United States (13.9%), European Union (27) (14.8%) and Japan (24.9%) greatly reduced import demand for products from other countries, especially from China whose export share to these three trade partners constitutes nearly 50% of its total exports in 2009. As global demand deteriorated amid the deepening recession, Chinese government adopted active fiscal policy and stable monetary policy to alleviate the impact of foreign trade on Chinese economy. Since July 30th 2008, Chinese Ministry of Finance and State Administration of Taxation have raised the tax rebates for exports several times in an attempt to tackle slumping exports amid the global financial crisis. For policy makers, the economic growth in China should be transformed from export-oriented pattern to domestic demand-pulled pattern. which is not only the lesson learned by China during the 2008 global economic crisis, but also the need for stable economic growth in the future. V. CONCLUSIONS

[3] [4] [5]

[6] [7]

Foreign trade plays an important role in the growth of Chinese economy. How to predict precisely the huge fluctuations of foreign trade is becoming a critical matter for Chinese foreign trade policy. This paper tries to employ a nonlinear Markov regime-switching model to predict the turning points of the foreign trade cycles. Based on Hamilton Markov regime-switching model applied to postwar U.S. business cycle (1989,1994), the paper uses Chinese import and export data from January 1999 to November 2010 to describe and investigate the dynamic growth path of Chinas foreign trade. The empirical results suggest that the growth path of Chinas foreign trade can be classified as long-term expansion regime (1999.01~2008.08 and 2008.12~2010.11) and short-term recession regime (2008.09~2008.11), which means the growth path of Chinas foreign trade may experience a shift of regime. The global economic situation and Chinese economic policy during these periods may explain the move of regime. Chinese economy needs to shift from export-oriented economic growth to more reliance on indigenous innovation of firms and domestic demand-pulled growth, which maybe not only the results of the 2008 global financial crisis, but also reflects the need for continual growth of Chinese economy in the future.