The Effect of the Exchange Rate on Chinas Bilateral Trade

Junior Independent Work

Advisor: Prof. Kenen Maggie Xiaolei Mou 12 2010-12-15 I pledge my honor that this paper represents my own work in accordance with University regulations.

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1. Introduction Starting from an almost completely closed economy in 1978, with trade representing just less than 1 percent of global trade, China has achieved remarkable growth as a significant force in international trade. Chinas share of world exports rose from only 1.8 percent in 1990 to almost 10 percent in 2009, overtaking Germany as the worlds largest exporter (WTO, 2009). According to an article from the Economist on January 7th 2010, Chinas exports grew by an annual average of 23 percent in dollar terms, more than twice as fast as world trade over the recent decade. Coupled with its remarkable economic growth, accumulating trade and current account surplus is Chinas de-facto fixed exchange rate of the Chinese yuan against the U.S. dollar since 1994. Firmly believing that the yuan was substantially undervalued, the United States and other trading partners of China urged the Chinese government repeatedly to revalue the yuan or to shift to a more flexible exchange rate regime. On July 21st, 2005, the Chinese government finally announced that it would appreciate the value of the yuan by 2.1 percent and it would move to a managed float of the yuan relative to a basket of currencies (the New York Times, 2005 July 22nd; the Economist, 2005 July 28th). Though this appreciation was welcomed by Western officials, the tension surrounding the value of the Chinese currency was far from resolved. Most recently, speaking at the European Central Banking Conference in Germany, Mr. Ben Bernanke, the U.S. Federal Reserve Chairman, said that Chinas decision to undervalue the yuan has slowed down the global economic recovery in the wake of the global financial
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crisis (MarketWatch, Nov 18th, 2010). The U.S. government under the Obama administration is likely to apply new pressure to the Chinese government to further appreciate its currency and shift towards a more flexible exchange rate regime. While the controversy surrounding Chinese currency appreciation has been most prominently debated in the political sphere, the core argument remains an economic issue. In fact, a vast literature, both theoretical and empirical, has focused on this subject in the last two decades. One group of economists is interested in knowing the optimal exchange rate of the Chinese currency and examines whether the yuan is undervalued and if so, by how much (Chang and Shao, 2004; Funke and Rahn, 2005). Another group of economists focuses on the responsiveness of Chinese trade to movements in the exchange rate, drawing the implications of a real yuan appreciation for Chinas trade balance and the effectiveness of exchange rate policy in reducing Chinas trade surplus (Garcia-Herrero and Koivu, 2007; Marquez and Schindler, 2006). Yet, a consensus has not been reached regarding the impact of a real yuan appreciation on Chinas trade balance, with one camp finding the exchange rate statistically insignificant in reducing Chinas trade surplus while the other arguing the opposite. It should be noted that the above mentioned literature mainly focuses on the total trade balance of China. This focus on the aggregate trade balance fails to account for the fact that, while China is running huge trade surpluses with developed countries like the United States, the European Union and Japan, its trade deficits with a number of Asian trade partners partially offset its trade surpluses. Breaking Chinas overall trade balance into its country-by-country components offers new perspective on the
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impact of the value of the Chinese currency for Chinas bilateral trade with its trading partners. Motivated by a lack of works that study the impact of the value of the yuan on Chinas bilateral trade with its trading partners, Baak (2008) conducted one of the few empirical analyses on this topic. His study focuses on China and the United States, the most important pair of bilateral trading partners and investigates the extent to which the bilateral real exchange rate between the Chinese yuan and the U.S. dollar affects the bilateral trade between the two countries from 1994 to mid-2006. In fact, since the recent global financial crisis, China is taking an even greater share of the U.S. market. The Economist reported on January 7th 2010 that, in the first ten months of 2009, the United States imported 15% less from China than in the same period of 2008, but its imports from the rest of the world fell by 33%, lifting Chinas market share to a record 19%. As a result, although the U.S. trade deficit with China narrowed, China now accounts for almost half of the U.S. total deficit, up from less than one-third in 2008. Given Chinas growing contribution to the U.S. trade deficit, it is more critical and relevant to analyze the impact of a real yuan appreciation against the U.S. dollar on the bilateral trade balance rather than the aggregate trade balance of China. Therefore, my paper would focus on the bilateral trade between China and the United States, its most important trading partner and empirically analyze the potential impact of a real yuan appreciation against the U.S. dollar on the bilateral trade balance.

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2. Literature Review Cerra and Dayal-Gulati (1999) were among the first economists to model Chinas export and import equations and estimate the price elasticity of Chinas exports and imports for the period 1983-1997. Their study finds export price elasticity to be negative and statistically significant and import price elasticity to be positive and statistically significant. A main drawback is the relative short range of their datasets. In fact, they failed to identify 1994 as a structural break point in Chinas export and import statistics mainly because of the small number of data points available after 1994. Dees (2001) improves the model for the export equation by disaggregating Chinas exports into two categories, those of products produced using domestic inputs (ordinary exports) and those of products assembled using imported inputs for re-exporting (processed exports). The disaggregation yields different results for the two categories of exports with ordinary exports more price sensitive to movements in exchange rate than processed exports. Yet, in the short run, both ordinary and processed exports are not responsive to changes in the exchange rate, and world demand for exports exerts much greater influence. Following Dees disaggregation model for Chinas exports, Marquez and Schindler (2006) further disaggregate Chinas imports into two categories, those of imported components for assembly and those of finished goods for domestic consumption. Another novel approach they take is that, instead of focusing on import and export volume, they estimate the impact of real exchange rate movements on
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Chinas share of total world trade so as to avoid employing proxies for Chinas export and import unit value indices. Their results report that a ten percent real appreciation of the yuan lowers Chinas export share of world trade by about one-half of a percentage point in the long run. Yet, one drawback they identify is that their results fit a multilateral trade model better than a bilateral trade model and ignore the potential differences in the exchange-rate sensitivity of Chinas trade across trading partners. Lau, Mo and Li (2004) estimate export and import trade elasticities for China with G3 (Japan, E.U. and the United States) using quarterly data from 1995 to 2003. Their choice of data avoids 1994 as the structural break point in Chinas export and import data, and they also include a VAT dummy variable to account for the increase in value-added tax rebates for exports in 1999. In fact, the VAT variable yields statistically significant result, confirming a structural beak in Chinas export data from 1999 onwards. They also conduct Augmented Dickey-Fuller (ADF) to test for the stationarity of the data series. After confirming the existence of a unit root for export and import data, they estimated a set of dynamic equations by regressing the first difference of the dependent variable on the first differences of explanatory variables plus the lags of the dependent and explanatory variables. Their results show that G3 demand has a positive and statistically significant coefficient in the long run while the effective exchange rate of the yuan plays a lesser role in determining Chinas exports and imports. Garcia-Herrero and Koivu (2007) conduct one of the few empirical analyses
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of both Chinas aggregate trade balance and its bilateral trade balance with its ten most important trade partners for exports and imports. They takes a similar approach to Lau, Mo and Li (2004), using AGF test to determine the existence of a unit root and detrending the stochastic trend the export and import data follow by taking first differences of the dependent and explanatory variables. Instead of using quarterly data, they use monthly deseasonalized data for the period 1994-2003. Yet, since most data for China are not available on a monthly basis other than trade data, the authors use a lot of proxies for economic indicators, which might be hard to justify. Their results show that Chinas trade balance is sensitive to fluctuations in the real effective exchange rate of the yuan, although the size of the trade surplus is such that exchange rate policy alone will be unable to address the imbalance. Baak (2008) focuses on the bilateral trade between China and the United States, since the author views the trade deficit with the United States as the most pressing issue that puts appreciation pressure on the Chinese government. His approach is unique in the sense that he is only interested in the impact of the real exchange rate between the yuan and the U.S. dollar on the trade between these two countries. He also employs a more recent dataset, from 1995Q1 to 2006Q2, to avoid the structural break in 1994. However, he is unable to verify whether 2005 is another structural break point, as the Chinese government announced that it would move to a managed float of the yuan relative to a basket of currencies; that is because only 4 quarters of data were available after the regime shift. Therefore, I hope to extend his empirical analysis by including more recent data, introducing new explanatory
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variables to his export and import equations, and potentially testing for a structural break in 2005.

3. Data The dataset used in this paper comes mostly from the International Financial Statistics (IFS) of the International Monetary Fund (IMF). Since this paper primarily focuses on the bilateral trade between China and the United States and uses the bilateral trade between China and ASEAN to provide the basis for comparison of Chinas regional trade patterns, the data are limited to China, the United States and ASEAN. If time permits, a similar analysis will be extended to more trading partners of China to offer a more complete picture. Data are also limited to the period from 1995Q1 to 2010Q3 to avoid year 1994, which has been empirically verified as the structural break in Chinas export and import statistics by Baak et al. (2008). Baaks regression employs data only up to 2006Q2. Though he admits that a better estimation will be possible if the 2005 regime shift is considered, he finds it econometrically intractable since the data set contains only 4 quarters after the shift. Hence, with 16 more quarters of macroeconomic data available, I hope to conduct a more robust empirical analysis, testing whether 2005 is a plausible structural break point for Chinas export and import. Quarterly nominal exports and imports of a country to and from its bilateral trading partners can be obtained from the Direction of Trade Statistics (DOTS) of the IMF. For countries other than China, the quarterly real export volume can be
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calculated by deflating the nominal export by the export unit value index of the country at interest, which is available from IFS. Yet, the case for China is complicated since neither export nor import price indices exist. Garcia-Herrero and Koivu (2007) suggest the use of Chinas consumer price index (CPI) as a proxy for an export price index. Baak et al. (2008) takes a different approach by replacing the real export volume of China to the United States with the U.S. import volume from China. This approach simplifies matters since the import unit value index of the United States is readily available from IFS. These two approaches are both plausible. Yet, if there is a huge discrepancy between the nominal exports of China to the United States and the nominal imports of the United States from China, the first proxy method would be preferable. The real GDP of the importing country is commonly used as a proxy for economic activity in the importing country. Again, the lack of quarterly data for Chinas real GDP poses a difficulty for data collection. Only quarterly nominal GDP data from 1999 onwards are available from IFS. Yet, it should be noted that annual real GDP data are available for 1978-present at 1978 prices from the Datastream, and quarterly real GDP growth rate data are available for 1992Q1-present from the Datastream. Using the method suggested by Baak et al. (2008), we will make some well-grounded estimation for quarterly real GDP of China from 1994Q1 to 2010Q3 as required. As for the real bilateral exchange rate, it is calculated from the nominal quarterly exchange rate of the exporting countrys currency against the importing
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countrys currency multiplied by the ratio between the quarterly consumer price index of the exporting country and that of the importing country. The consumer price index (CPI) can be collected from IFS and Datastream. Foreign direct investment (FDI) data on a quarterly basis could be collected from CEIC China Premium Database. Yet, FDI data is available only from 1997 onwards, hence two regressions might be calculated, one with FDI as an explanatory variable but for a shorter and recent period (1997Q1 to 2010Q3) and the other without the FDI variable and for a longer period and bigger dataset (1995Q1 to 2010Q3).

4. Methodology The first step in my research will be an attempt to construct the export function of China to its bilateral trade partners and the export function of the bilateral trade partners to China adapted from the model specified by Baak et al. (2008). The export function constructs a long-run equilibrium relationship between the export volume and other explanatory economic variables and has the following specification:
ln (Yijt) = 0 + 1ln ( gjt ) + 2ln ( pijt ) + 3ln ( ijt ) + 4ln ( fdiit ) + 5 ( policyit ) + ijt

where subscript t indexes time from 1995Q1 to 2010Q3. Here, Yijt denotes the real export volume from country i to country j at time t, i being the exporting country and j the importing country; gjt is the economic activity of the importing country j at time t and real GDP is used here as a proxy for economic activity since it is more readily available; pijt denotes the real bilateral exchange rate of the exporting country is
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currency against the importing country js currency at time t; ijt is the volatility of the real bilateral exchange rate between country i and country j at time t (calculated by taking the standard deviation of monthly exchange rates of the current and the one lagged quarter); ijt is the error term which will capture the effects of the variables that are omitted from the above model. Two additional explanatory variables are introduced to Baaks export equation: fdiit is the exporting country is stock of foreign direct investment (FDI) at time t. This will be a plausible factor influencing country is export if most FDI is geared towards export industry and a rise in FDI is likely to increase exports. A positive correlation between FDI and exports will be particularly relevant for a developing country like China. policyit is a dummy variable that takes on the value of 1 if a policy change has been implemented in country i at time t and 0 otherwise. Lau, Mo and Li (2004) express concerns over the possible structural breaks in Chinas export and import statistics, the most notable being the increase in value-added tax (VAT) rebates for exports in 1999, intended to maintain Chinas competitiveness following the depreciation of Asian currencies in 1997-98. For my regression, I think it is important to consider 2005 as a potential structural break point in Chinas export equation as the Chinese government announced its decision to move to a managed float of the yuan (the New York Times, 2005 July 22nd), in addition to the VAT rebates. Thus the coefficient 5 will measure the change in the real export from country i to country j after a significant policy change took place in the exporting country, holding other variables fixed.
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It is highly plausible that the change in the bilateral exchange rate will not have an immediate impact on a countrys exports. As a result, the regressors would need to be lagged. The export equation with lagged variables is specified:
ln (Yijt) = 0 + 1ln ( gjt-h ) + 2ln ( pijt-h ) + 3ln ( ijt-h ) + 4ln ( fdiit-h ) + 5 ( policyit-h ) + ijt

where h is the number of periods that the time t needs to be lagged, and h might vary depending on the economic conditions of the exporting country i. It is best to determine the number of lags h by testing for the existence of a cointegration vector using the Johansen procedure suggested by Garcia-Herrero and Koivu (2007). In the same paper, Garcia-Herrero and Koivu (2007) reported the non-stationary characteristics of exports, which means that probabilistic distribution of Yijt changes over time t. The above time series regression will be invalid if the current quarters real export volume has a different probabilistic distribution than any of the previous observations. Since the exact trend that Yijt follows is unclear, I would suggest two hypotheses and test for the validity of each at a later stage. If Yijt is simply a function of a deterministic trend, then it is a trend-stationary process and can be corrected by adding a trend variable T:
ln (Yijt) = 0 + 1ln ( gjt-h ) + 2ln ( pijt-h ) + 3ln ( ijt-h ) + 4ln ( fdiit-h ) + 5 ( policyit-h ) + 6T + ijt

If the trend varies over time, Yijt has a random walk trend. To test for the existence of a unit root that indicates such a random trend, I would perform the
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Augmented Dickey-Fuller (ADF) test. If the ADF test fails to reject the null hypothesis that the dependent variable has a unit root, then this stochastic trend could be detrended by taking the taking the first difference of Yijt with the following specification:
ln (Yijt) = 0 + 1ln (gjt-h ) + 2ln (pijt-h ) + 3ln (ijt-h ) + 4ln (fdiit-h ) + 5 ( policyit-h ) + ijt

whereYijt = YijtYijt-1, gjt-h = gjt-hgjt-h-1, and so on.

5. Anticipated Results and Conclusion Based on the trade data, I expect the coefficient for economic activity to be positive and statistically significant. The coefficient for economic activity could be interpreted as a rising demand in the importing country (the United States) by 1 percent that would raise the real bilateral export volume from China by 1 percent. In fact, Eckaus (2004) concludes that the effect of overall U.S. economic growth in attracting imports from China is statistically more significant than that of yuan appreciation. The coefficient 2 for the bilateral exchange rate is less predictable since previous research has produced the two opposite results stated above in the literature review. Theoretically, an appreciation of the exporting countrys currency against the importing countrys currency would weaken the formers exports, since price becomes less competitive to other exporting competitors. Yet, J-curve effects imply that a countrys trade deficit would temporarily worsen following the depreciation of
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its currency because higher prices on foreign imports will be greater than the reduced volume of imports. Hence, it is important to distinguish between the short-term and long-term effects of the exchange rate on the trade balance. I also predict the coefficient for foreign direct investment to be positive and statistically significant since most of the FDI inflow to China is geared towards the export industries and a higher level of FDI ought to imply a rising export level. Yet, whether the coefficient for this variable is statistically significant compared to those of other explanatory variables remains unpredictable. The coefficient of policy change tends to be positive, yet whether it will be statistically significant remains unclear. For China, one of the most prominent policy changes would be the increased value-added tax rebates in 1999. Its intended effects were to improve the export competitiveness of China following the weakening of other Asian currencies after the 1997 Asian Financial Crisis. As a result, the coefficient 5 can be interpreted as once the policy is implemented, after a certain number of years, it will have the effect of raising Chinas exports by 5 percent. That explains why the explanatory variable needs to be lagged since policies do not have immediate impact on their targets. Other possible policy changes could include accession to the WTO in 1999 and a regime shift in 2005. In conclusion, the main purpose of the paper is to construct a plausible model for the bilateral export and import equations for China and its bilateral trading partners, the most significant of which being the United States. I wish to extend the empirical analysis of Baak to include more recent data and to test for other possible
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structural break points in Chinas trade data that would facilitate future research. Regardless of the results of the studies, I hope to give a more comprehensive view of Chinas bilateral trade and the various explanatory variables that would potentially contribute to the remarkable growth of Chinas exports. The responsiveness of Chinese exports to movements in its exchange rate might give the U.S. policy makers a better reason to argue for yuan appreciation and give the Chinese government a better idea as to how to mitigate the appreciation pressure.

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References [1] Baak, SaangJoon, 2008. The bilateral real exchange rates and trade between China and the U.S. China Economic Review, 19, 117-227. [2] Cerra, V. & A. Dayal-Gulati, 1999. Chinas Trade Flows: Changing Price Sensitivities and the Reform Process, mimeo International Monetary Fund, Washington DC. [3] Chang, G.H. & Shao, Q., 2004. How much is the Chinese currency undervalued? A quantitative estimation. China Economic Review, 15, 323-324. [4] Dees, Stephane, 2001. The Real Exchange Rate and Types of Trade: Heterogeneity of Trade Behaviors in China. Paper presented at the workshop on Chinas Economy, organized by the CEPII (Centre dEtudes Prospectives et dInformations Internationales, Paris) in Paris on December 12, 2001. [5] Eckaus, R., 2004, Should China Appreciate the Yuan? MIT Working Paper 04-16. Cambridge: MA. [6] Funke, M. and Rahn, J., 2004. Just How Undervalued is the Chinese Renminbi? Hamburg University paper, Blackwell Publishing, 465-489. [7] Garcia-Herrero, Alicia and Koivu, Tuuli, 2007. Can the Chinese trade surplus be reduced through exchange rate policy? Bank of Finland Discussion Papers. [8] Lau F., Y.Mo, and K. Li, 2004, The Impact of a Renminbi Appreciation on Global Imbalances and Intra-Regional Trade. Hong Kong Monetary Authority Quarterly Bulletin, March, 16-26. [9] Marquez, Jaime and Schindler, John W., 2006. Exchange-rate Effects on Chinas
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Trade: An Interim Report. Board of Governors of the Federal Reserve System. International Finance Discussion Papers. Number 861.

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