154) Are Chinese Exports Sensitive to Changes in the Exchange Rate?

Are Chinese Exports Sensitive to Changes in the Exchange Rate?
Shaghil Ahmed1
Board of Governors of the Federal Reserve System
International Finance Discussion Papers
Number 987, December 2009 --- Screen Reader Version*

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Abstract:

This paper builds a model of two types of Chinese exports, those processed and assembled laregely from imported inputs ("processed" exports) and "non-processed" exports. Based on this model, the sensitivity of Chinese exports to exchange rate changes is empirically examined. Unlike previous work, the estimation period includes the net real appreciation of the renminbi that has occurred over the past three years. The results show that greater exchange rate appreciation dampens export growth, both for non-processed and processed exports, with the estimated cumulative price elasticity being substantially greater than unity. When the source of the increase in the Chinese real exchange rate is appreciations against the currencies of other emerging Asian trading partners, the effect on processing exports is positive but insignficant, while the effect on non-processing exports is significantly negative. By contrast, when the source of the increase in the Chinese real exchange rate is appreciation against China's advanced-economy trading partners, the effects on both types of exports are negative. These results are consistent with the predictions of the theoretical model. Counterfactual simulations based on the estimated model strongly suggest that if the trade-weighted real renminbi had appreciated at an annual rate of 10 percent per quarter since mid-2005, Chinese real exports would have been roughly 30 percent lower today. Thus greater exchange rate flexibility could contribute to lowering China's huge trade surplus through restraining growth of exports.

Keywords: China, exchange rate, exports
JEL classification: F31, F32, F41

1 Introduction

China's ballooning current account surplus in recent years (reaching about 10 percent of GDP in 2008) and rapid accumulation of international reserves (to about $2.2 trillion) has raised concerns that Chinese authorities are heavily managing their currency and contributing to global imbalances. At the same time, many also question whether faster currency appreciation would reduce China's trade surplus significantly-one argument being that, given the high import content of Chinese exports, appreciation of the currency need not make Chinese exports more expensive to the rest of the world since the effective cost of the imported inputs would also fall. Despite this tension there is relatively little empirical evidence on how responsive Chinese exports have, in fact, been to currency movements that cover the period since the middle of 2005 when China revalued the renminbi (RMB) and started allowing a moderate appreciation trend, at least until the middle of last year.

This paper provides empirical estimates of the sensitivity of Chinese exports to exchange rate changes. It distinguishes between the effects on "processed" exports (produced using parts and components imported from abroad) and "non-processed" exports (largely sourced from domestic inputs). It also attempts to distinguish between unilateral changes in the Chinese exchange rate and those that are highly correlated with exchange rate changes of other economies in the region from which China imports parts and components, since this distinction is potentially very important when both processed and non-processed exports are being produced.

There are some existing empirical studies that also distinguish between processed and non-processed Chinese exports-Aziz and Li (2007), Cheung, Chinn and Fujii (2008), Garcia-Herero and Koivu (2009), Marquez and Schindler (2007), and Thorbecke and Smith (2008)-and Thorbecke and Smith also consider unilateral versus multilateral (across Asia) real effective exchange rate changes. However, only two of these studies incorporate any part of the period since mid-2005 in their sample period, and none of them consider the period from 2007 to mid-2008, when the pace of appreciation of the RMB apparently was accelerated. All told, the trade-weighted Chinese real exchange rate has appreciated about 13 percent, on net, since the end of 2006. Taking account of the greater recent variability of the exchange rate, this study provides up-to-date estimates and compares these to earlier estimates. Given concerns about possible currency undervaluation it also uses simulations from the empirical model to examine what the behavior of Chinese exports might have been if the RMB had appreciated more in recent years.

Another key distinguishing characteristic of this paper is that it develops a theoretical model of Chinese exports that explicitly incorporates the import of inputs for the production of some types of exports goods. This means that the estimated equations for exports are well-grounded in economic theory, including predictions about the different effects of RMB appreciation when its source is movements against the currencies of other emerging Asian economies and when its source is movements against the currencies of China's other trading partners. The explicit derivation of reduced-form export equations from theory also makes it clear that the estimated relative price elasticity should not be viewed, as it often is, as the slope of the demand curve, and the income elasticity should not be viewed as representing how much the demand curve shifts in response to a change in income, as the equilibrium quantities will incorporate supply-side parameters as well.

The main results of the paper can be summarized as follows: First, including the latest period of greater real exchange rate variability reinforces the conclusions of some earlier studies, such as Marquez and Schindler (2007), which found that Chinese exports respond quite strongly to movements in the real exchange rate, and go against studies which find little effect of exchange rate changes or effects that go in the opposite direction to conventional wisdom. Second, considering the components of the real exchange rate, consistent with the theoretical model, when the source of Chinese real exchange rate appreciation is movements of the RMB against other emerging Asian countries, this does not have a significant effect on Chinese processing exports, but it does have a significant negative effect on Chinese non-processing exports. On the other hand, when the source of the renminbi appreciation is movements against the currencies of non-emerging Asian Chinese trading partners, generally both types of exports go down. Moreover, even though processed exports remain very important for China, increases in non-processed exports have recently accounted for more of the overall increase in exports. Finally, model simulations indicate that the path of total Chinese real exports would have been quite a bit lower if the renminbi had appreciated more in recent years.

Overall, the results suggest that greater exchange rate flexibility could have significant impact on China's trade balance by restraining growth of exports, particularly non-processed exports.

The remainder of the paper is organized as follows. Section 2 sets the scene by discussing key developments in the Chinese external sector in recent years and Section 3 provides a selective review of the existing empirical work in this area. Section 4 presents a simple theoretical model of the behavior of Chinese exports that forms the basis of the empirical specification used. The empirical results on the exchange rate sensitivity of Chinese exports are presented and discussed in Section 5. Section 6 concludes.

Full paper here.