East Asian Value Chains, Exchange Rates, and Regional Exchange Rate Arrangements

Macroeconomy and Low Birthrate/Aging Population (FY2016-FY2019)
East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances

China's trade surpluses with the U.S. are pronounced. They have led to tariffs and a trade war that is harming Northeast Asian economies. Adjustments through exchange rates may be preferable to adjustments through managed trade. However, China's exports contain value-added from upstream Asian countries. Thus, exchange rates in upstream Asian countries may matter along with the renminbi for China's exports.

This paper investigates how the renminbi and exchange rates in the leading suppliers of parts and components (p&c) to China affect China's exports. The major suppliers of p&c include South Korea, Taiwan, and Japan. The results indicate that a 1 percent appreciation of the renminbi would reduce China's exports by 1.3 percent and a 1 percent appreciation in upstream supply chain economies would reduce China's exports by 2.7 percent.

How have the renminbi and exchange rates in supply chain countries evolved? Figure 1 shows that the renminbi has appreciated 10 percent between the first quarter of 2012 and the last quarter of 2018. It also shows that that exchange rates in upstream supply chain countries (ssrer) have the same value at the end of 2018 as it did in the first quarter of 2012. Over this period 55 percent of ssrer's value has been driven by Taiwanese and Korean exchange rates and 80 percent by Taiwanese, Korean, Japanese and Singaporean exchange rates. Taiwan's current account surplus from 2010 to 2018 averaged 12 percent of GDP; Korea's averaged 5.7 percent; Japan's averaged 2.5 percent; and Singapore's averaged 17 percent. In spite of these enormous surpluses, their currencies have barely appreciated.

China's surplus in electronics goods has averaged $330 billion per year since 2011. This equals more than half of China's overall surplus. The paper also investigates how exchange rates in China and upstream Asian countries affect the price competitiveness of China's electronics exports. The results indicate that a 1 percent appreciation of the renminbi would reduce China's electronics exports by 1.2 percent and a 1 percent appreciation in countries providing electronic p&c to China would reduce China's electronics exports by 1.4 percent. These results corroborate the results discussed above indicating that appreciations in supply chain countries cause larger decreases in China's exports than appreciations of the renminbi.

It would be difficult for Korea, Taiwan, Japan, and other Asian economies if their currencies appreciated. However, appreciations would disrupt trade much less than equivalent tariffs. Benassy-Queré, Bussière, and Wibaux (2018) investigated bilateral trade flows between 110 countries at the Harmonized System (HS) six-digit level. They found that a 10 percent tariff reduces exports by 1.3 percent and that a 10 percent exchange rate appreciation reduces exports by 0.5 percent. Tariffs thus reduce exports three times more than appreciations do. This effect is called the international elasticity puzzle, and has also been reported by Fontagné, Martin, and Orefice (2018), Fitzgerald and Haller (2014), and Ruhl (2008).

The disruption caused by tariffs is multiplied by the uncertainty that accompanies trade wars and protectionism. Bloom (2009) showed that heightened uncertainty deters investment. Capital formation is crucial for East Asia's flagship industry, electronics, and for many other industries. By reducing investment, uncertainty jeopardizes the ability of Asian firms to stay close to the technological frontier.

Appreciations would not only be less disruptive than tariffs and trade wars. The paper also finds that appreciations would benefit Northeast Asian economies by increasing the purchasing power of consumers and allowing them to import more. These results imply that stronger exchange rates may allow Asian consumers to supplant American consumers as a source of demand for the region's exports.

To strengthen the potential for East Asia to be an engine of growth, economies in the region should establish ironclad free trade agreements among themselves. When South Korea deployed the US-built Thaad missile shield, Beijing banned Chinese tour groups from visiting South Korea. When South Korea and Japan faced off over wartime labor, the Japanese Finance Minister threatened tariffs on Korean products. Asian countries should eschew protectionism and employ other policy instruments to address difficult issues.

To appreciate together Asian countries need to decrease the weight of the U.S. dollar in their implicit currency baskets. The paper finds that the U.S. dollar still has a large weight in these baskets.

Ogawa and Ito (2002) noted that if an important trading partner of Asian country A puts heavy weight on the U.S. dollar, it may cause country A to do so also. This can produce a Nash equilibrium. On the other hand, if A's trading partner put more weight on regional currencies, then it may be optimal for A to put more weight on regional currencies. This would also be a Nash equilibrium. Putting more weight on regional currencies however would facilitate a concerted appreciation against the dollar.

No Asian country wants to let its exchange rate appreciate against the U.S. dollar for fear of losing price competitiveness relative to its Asian neighbors. However, perennial surpluses put pressure on their currencies to appreciate. Policymakers should consider acceding to these market forces and allowing their currencies to appreciate together. In addition, if Japan put less emphasis on its 2 percent inflation target the yen could appreciate. If South Korea and Taiwan reduced outflows from insurance companies and government pension funds, the won and New Taiwan dollar could appreciate. If China extended fewer high interest rate loans to poorer countries, the renminbi could appreciate. None of these countries should act unilaterally though. Rather, given the intricate value chains linking Japan, Korea, Taiwan, China, and ASEAN, policymakers should view exchange rates as a regional issue and confer deeply about exchange rate policy. They could propose a deal with the U.S. resembling the Plaza Accord whereby their currencies appreciate against the dollar in response to assurances of free trade and reductions in U.S. budget deficits.

East Asia's miraculous growth occurred as Asian countries succeeded at exporting in industries such as electronics with tight profit margins. Investments in human and physical capital and the discipline of competing in world markets contributed to learning by doing and productivity growth. Exchange rate appreciations could act as a stick and open markets abroad as a carrot to goad Asian firms to continue mastering new technologies and innovating.

Note: The Weighted Exchange Rate is the geometrically weighted average of real effective exchange rates in the nine leading suppliers of imports for processing to China.
Source: CEIC Database and calculations by the author.