- Rmb Exchange Rate And Trade Balance In China Economics Essay - Free Essays on Economics Rmb Exchange Rate And Trade Balance In China Economics Essay

Essay Writing Service

Rmb Exchange Rate And Trade Balance In China Economics Essay

In the last two decades, China has shown a spectacular growth in its share of world trade. Although China has already become third largest exporter in the world, a relatively balanced trade account remained in China until recent years. China’s trade surplus dramatically increased from approximately 32 billion US dollars, or 1.7% of China’s GDP in 2004, to nearly 180 billion US dollars, close to 7% of China’s GDP in 2006.

Get Help With Your Essay

If you need assistance with writing your essay, our professional essay writing service is here to help!

Find out more

In particular, among those trades between China and other countries around the world, the one between China and the US should be the most representative. From 1984 to 2002, there is 7.4 times rise in US total exports to China, from 3 billion US dollars to 22 billion US dollars. By comparison, the total imports of the US from China increased 40.8 times from 3.1 billion US dollars to 125.2 billion US dollars during this period.

Since the similar things as between China and the US happened between China and increasing countries, there came a heated debate on the large size of trade surplus in China, because the issue had directly or indirectly caused some troubles in many countries. For example, the employment in the US manufacturing industry had not declined so much ever until a very large bilateral trade deficit with China. Besides, Europe and Japan had been struggling with weak economic growth due to the challenge by a rising China.

In the debate, many scholars claim that there exists a link between the Chinese currency, namely, RMB and international trade in China, and some of them even believe that the recent trade surplus of China can be explained by an overly depreciated exchange rate of RMB. The reason is that China could capitalize from external demand and spur a higher economic growth by maintaining an undervaluation of RMB. However, there are doubts that the exchange rate can be an effective tool to generate the trade surplus.

Following the debate on the issue of large trade surplus in China, increasing appropriate statistics became available, encouraging research on how related are the exchange rate of RMB and foreign trade in China. Much of the research has concentrated on assessing the equilibrium exchange rate which is best for China’s trade, while much more of it has been contributed to if China should appreciate its currency – if there does exist a link between exchange rate and trade balance – to eliminate the enormous trade imbalance in the interest of economic growth of the whole world.

This paper, using cointegration analysis by Alicia and Tuuli (2007), empirically analyses how related are the exchange rate RMB and the trade balance in China. According to the results, China’s trade surplus would shrink following a real appreciation of RMB, but the reduction would be limited. The relatively small impact, the size of the imbalance, is mainly explained by the unique price elasticity we find for imports, namely, Chinese imports appear to fall following a real appreciation. By estimating bilateral import equations, it is found that imports from other Asian countries fall, while those of some industrial countries, Germany in particular, increase, which might be explained by the vertical integration of Southeast Asia and China’s key role in the regional production network.

The rest of the paper is arranged as follows. Part 2 covers literature review, where some analysis approaches from some scholars are presented, and hence some different conclusions are given. Part 3 describes the theoretical model and data used in the paper. Part 4 draws a conclusion on the theoretical model. Part 5 exhibits the appendix.

Chapter 2. Literature review

Many scholars did valuable research and gave instructive opinions on the relationship between exchange rate and the trade surplus in China. These opinions can be divided into two categories in terms of the influence exerted by exchange rate on China’s trade balance. The first one finds that a currency appreciation could discourage the trade balance by decreasing exports, increasing imports or both. The other one give evidence that exchange rate should have no significant impact on China’s trade account or even a positive one.

Zhang S G (2005) tested China’s FDI function, which is regarding import and export and the flexibility of exchange rate. The cost of exchange rate appreciation was also estimated in different level, mainly including the decrease of foreign capital, exports and the GDP, and following higher unemployment rate. Most importantly, the author found that an appreciation of exchange rate will bring a remarkable effect to the magnitude of import and export, but it will last less than two years, and afterwards, disappear.

Lu X Q and Dai G Q (2005) drew a conclusion that the fluctuations of weighted real exchange rate in China exerted a marked influence on the import and export trade when the M-L condition was met with the working “J curve” effect, after investigating the relationship between fluctuations of weighted real exchange rate of RMB to some main foreign currencies and the import and export in a long-term range, from 1994 to 2003, with the cointegration vector autoregression technique.

After analyzing the relationship of China-the US trade and exchange rate of RMB, Chou (2000) found that the fluctuation of real exchange rate of RMB to dollar will bring China’s export to the US a negative effect, that is, the export will decrease when there is a drastic fluctuation. Nevertheless, the paper discussed only the fluctuation of exchange rate, not the effect brought by the real exchange rate and nominal exchange rate to the trade between China and the US.

Cerra and Dayal-Gulati (1999), from a different angle, adopting an error correction model, estimated the price elasticities of exports and imports of China from 1983 to 1997 and found that there were a significantly negative one for exports and a significantly positive one for imports, and both increased with time.

Based on the previous analysis, Dees (2001) divided China’s exports and imports into two groups, the processed and the remainder. It was discovered that, an appreciation of exchange rate will decrease exports in the long run. It was also reported that ordinary exports are more price sensitive, compared with processed ones. By contrast, in the short term, nothing but the demand of the world will influence exports.

Bénassy-Quéré and Lahrèche-Révil (2003) simulated the impact of a 10% real depreciation of RMB and concluded a growth in China’s exports to OECD countries but a reduction in China’s imports from rising Asian countries.

Eckaus (2004), from aggregate annual data for the period 1985-2002, found that the appreciation of RMB decreased China’s exports to the US and the share of Chinese exports in total US imports.

Lau, Mo and Li (2004) assessed the exports and imports structure between China and the G3 and found that, in the long term, an appreciation of the real effective exchange rate would contribute to lower exports. By comparison, neither ordinary imports nor processed ones seem to be affected by the REER. In any event, the results are difficult to interpret since it is not clear how they discount exports and imports, and the number of observations is very low (quarterly data from 1995 until 2003).

Thorbecke (2006) used a gravity model to study the effect of exchange rate changes on triangular trading patterns in Asia and disaggregates exports into intermediate, capital and final goods. His results indicated that a 10% appreciation of RMB will reduce Chinese final exports by nearly 13%. However, the appreciation would not significantly affect Chinese imports from the US.

Voon, Guangzhong and Ran (2006), in turn, used sectoral data for the period 1978 to 1998 and incorporated the degree of overvaluation of RMB when estimating China’s export equations; they reported a fall in exports to the United States as a consequence of real exchange rate appreciation.

Shu and Yip (2006) estimate the impact of exchange rate movements on the Chinese economy as a whole and find that currency appreciation can reduce exports due to an expenditure-switching effect, resulting in a moderate contraction in aggregate demand.

Surprisingly, other papers offer a somewhat different view on how exchange rate policy may affect China’s trade surplus. In particular, Kamada and Takagawa (2005) use a simulation model to estimate the effects of China’s exchange rate reform and show that a 10% revaluation would boost Chinese imports slightly, while the impact on exports would be tiny. However, their OLS estimations on China’s import equation do not show the real exchange rate having a significant effect on the volume of imports. Unfortunately, they do not estimate China’s export equation. According to their results, exports boost imports, which may indicate that there could be an indirect impact from the exchange rate on imports via exports.

Jin (2003) estimated the relationship between real interest rates, real exchange rates and China’s balance of payments and concludes that a real appreciation tends to increase the balance of payments surplus.

Finally, Cerra and Saxena (2003) used sectoral data to study the behaviour of Chinese exporters and find that renminbi appreciation has actually boosted exports, particularly in recent years. In any event, their results – as any other with sectoral data – should be treated with care, since only about half of Chinese exports are covered in the sectoral data and no quality adjustment is reported for their unit price data.

Wang Z (2007) used cointegration vector autogression to show that there exists a long-standing and stable relationship between REER of RMB and trade balance; the fall of the real effective exchange rate of RMB is one of the reasons of the increasing trade surplus, however, the influences it brings are less than domestic GDP and trade partner’s GDP do. So, increasing the flexibility of the exchange rate of RMB, broadening the exchange rate’s float space between RMB and dollar are a necessary part of the package policies in solving the trade surplus.

Xu Z H investigates empirically the validity of the aforementioned claim. Specifically, I use annual and monthly data to test whether there are indeed statistically significant links between the RMB/dollar exchange rate and the rising US trade deficit in the short run and in the long run. Based on the empirical results of this study, there was no evidence for a short-run significant relationship between the RMB/dollar exchange rate and the US trade deficit. But there did exist a statistically significant long-run relationship between the RMB/dollar exchange rate and the rising US trade deficit.

Virginie Coudert tries to measure the size of a possible misalignment in the Chinese real exchange rate by two ways. On one hand, we address the issue of the “Balassa effect”, by which the real exchange rate of a catching-up country should appreciate. We compare China with other emerging countries, in order to assess the size of a “normal” “Balassa effect”. On the other hand, we follow the FEER (Fundamental Equilibrium Exchange Rate) approach. We use the NIGEM model for representing the foreign trade of China, the United States, the Euro area, South Korea and Japan. We calculate the real effective exchange rate that is consistent with sustainable current accounts. Both methods yield an undervaluation of the renminbi.

Xu Y F (2000) thinks that exchange rate stability can be a sensible policy for China at present, because the exchange rate is more useful as a nominal anchor than an expenditure-switching tool to influence the balance of payments. This property reflects a fundamental fact that the after two decades of economic reform, Chinese economy has already become sufficiently marketized and open to foreign trade and investment. In addition to the arguments presented above, two other relevant considerations have also been cited against a possible depreciation of the yuan. One is that a depreciation of the yuan may trigger further competitive devaluations in other East Asian economies, thus, aggravating the economic and financial crises there. The other is that a depreciation of the yuan may also enlarge China’s existing trade imbalances with her

major trading partners, especially the United States, thus, exacerbating trade tensions with

them. Though a case has been made in the present paper for China to pursue exchange stability at present, more exchange rate flexibility will be needed in the future, as China gradually liberalize capital controls and make the yuan convertible for the capital account as well. It is well known that under perfect capital movement, a fixed exchange rate is incompatible with an independent monetary policy that is mainly focused on domestic economic objectives, especially for large economies such as China. Nevertheless, in view of the shaky banks and immature financial markets now in China, capital account liberalization should not proceed hastily.

Find out how UKEssays.com can help you!

Our academic experts are ready and waiting to assist with any writing project you may have. From simple essay plans, through to full dissertations, you can guarantee we have a service perfectly matched to your needs.

View our services

China should not change its exchange rate policies simply because other countries are urging it to do so. But by the same token, the fact that many are recommending a revaluation of the RMB is not sufficient reason for rejecting that policy option if it is the best one available. The main reason for revaluing the RMB by an appropriate amount is that it increases the odds that China will be able to achieve the economic objectives it has long pursued, namely, domestic financial

reform, domestic macroeconomic stability, open market access for its exports, and a healthy, sustainable rate of economic growth. One cannot rule out the possibility that China will be able to rein-in excessive bank lending and rising inflationary pressures without exchange rate action-by implementing administrative controls and (if that fails) by increasing domestic interest rates. But the effectiveness of administrative controls over the medium term is uncertain, and higher domestic interest rates may suck in further capital inflows. If these measures do not do the job, imbalances will eventually grow in size, and there will be a need for more draconian policy adjustments thereafter. Exchange rate action differs from other policy measures in one crucial respect: it addresses simultaneously internal balance (overheating)

and external balance (the surplus in the balance of payments). The cost of a hard landing is too high to rely on half measures.

China’s decisions on its future currency regime should pay primary attention to China’s own

circumstances-not to one-size-fits-all prescriptions. Given the still fragile state of China’s banking system, the capital-account decision should be delinked from the currency regime decision. All things considered, two-stage currency reform is better than the alternatives because it reduces China’s current internal and external imbalances, it promotes the right sequencing of reforms within China, it contributes to the timely correction of payments imbalances abroad, and it moves monetary policy independence and capital-account liberalization in the desired direction in the long term.

Chapter 3.

To prove the relation between Chinese exports and imports and the exchange rate of RMB, the price elasticity of export and import should be estimated.

First of all, the real effective exchange rate (REER) needs to be defined. It is drawn from the IMF’s international financial data, as follows:


where N stands for the total number of currencies in the index, wi for the weight of the ith currency and reri,t for China’s bilateral real exchange rate against each of its trading partners.

Then, the general empirical framework for the analysis can be built up as the following two equations:

Xt =

Mt =

where Xt stands for the number of exports out from China, Mt for the number of imports into China. REER, as stated above, stands for the real effective exchange rate of RMB, Yt* for foreign demand for Chinese commodities and Yt for the domestic demand of China. Besides, a1 is the price elasticity of exports, a2 is the income elasticity of exports, b1 is the price elasticity of imports and b2 is the income elasticity of imports.

Considering the big weight of processing goods in China’s imports and exports, it is necessary to distinguish between goods to be processed to re-export and ordinary imports. Similarly, processed and ordinary exports are separated. To be specific, processing goods includes imports of materials processible to be exported, exports of processible materials from China and exports of goods imported materials process into. Ordinary goods, relatively, mean goods that can not be further processed and goods not assembled from imported materials.

It is a thorny problem in dealing with trade statistics of China that there are no single export price index and import price index, so the number and value of export and import cannot be separated. Thereby, proxies need to be introduced. The prices of imports can be substituted by the export prices of China’s top twenty-five trade partners, with which, then, the imports of China is deflated. As for export prices, China’s consumer price index (CPI) is adopted as a proxy. Why such a general price measure is taken is because there do not exist a producer price index and a wholesale price index.

As commodities of China compete with other countries in the global market, theoretically, the price elasticity of exports is supposed to be negative, while the price elasticity of imports is not so clear. Imports should be encouraged by a real appreciation, on the condition that the decreased domestic demand due to the associated reduction in exports is covered by the purchasing power gained. It is necessary to point out that which effect is stronger depends much on the structure of import. As a matter of fact, if the imports are ordinary goods which can directly substitute Chinese products, the price elasticity of imports is expected to be positive. To be simple, imports are spurred by an appreciation of RMB. However, if the imports are materials and parts to be processed domestically and then re-exported, the price elasticity of imports may become negative with an appreciation of RMB that reduces the volume of exports.

Foreign demand for Chinese goods is assessed by global imports and deflated by the global import price index. Industrial production, deflated by the CPI, is taken for domestic demand inside China. The reason why industrial production is adopted instead of GDP is that it is monthly available. The income elasticity is expected to be positive for both exports and imports.

A few additional controls should be introduced in the case of China. First, value-added tax rebates exporting companies can get are considered to encourage exports, so they are included in the equation for export. Import tariffs, in the same way, are an additional control in the equation of import, although they have declined swiftly because of China’s entry to WTO, leading to the surge in imports.

Second, as for supply, a third variable, called capacity utilization, is used in the export equation to help take into account supply constraints by which export growth could be impeded. The definition of capacity utilization is given by the difference between industrial production and its trend, which is calculated with a Hodrick-Prescott filter.

Third, the stock of foreign direct investment (FDI), deflated by the CPI, is added to both the equations of export and import. An increase in FDI, normally, should encourage exports of China as long as FDI is linked to the export industry. The influence on imports is also expected to be positive because imported materials and machines are more popular in production of foreign companies than companies in China.

Last but not least, it is needed to include a deterministic trend variable in the equations of export and import, provided that it is significant in statistics. The usage of the trend variable is to assist gain of productivity improvement and the on-going reforms in Chinese economy.

Monthly deseasonalized data from 2000 to 2009 is adopted. It should be noticed that the research does not last for a long period is because there was not many years since China entered a more market-oriented economy and it would make little sense to start the research when China was still in a period of planned economy.

Despite China’s entry to the WTO in December 2001, the long time of preparation for accession and transition made Chinese exports and imports influenced by WTO before that time. The sample used, hence, takes into account the reforms from the beginning of 2000.


Most Used Categories

EssayHub’s Community of Professional Tutors & Editors
Tutoring Service, EssayHub
Professional Essay Writers for Hire
Essay Writing Service, EssayPro
Professional Custom
Professional Custom Essay Writing Services
In need of qualified essay help online or professional assistance with your research paper?
Browsing the web for a reliable custom writing service to give you a hand with college assignment?
Out of time and require quick and moreover effective support with your term paper or dissertation?