How Would an Appreciation of the RMB Affect China's Trade Balance?
Senior Fellow, RIETI
China's global current account surplus in 2006 appears likely to approach 8% of Chinese GDP. The Chinese government, in its 2006-2010 five-year plan, has recognized the need to rebalance its economy. Many have argued that an appreciation of the renminbi would help to achieve this goal. How would an appreciation of the RMB affect Chinese exports and imports?
As the IMF (2005) discusses, very few studies report the responsiveness of China's exports and imports to exchange rate changes. This column reviews some work that looks into this question and then considers policy implications.
China's Bilateral Trade Surplus with the U.S.
China's bilateral surplus with the U.S. is more politically charged than China's global trade surplus. The U.S. Congress has proposed retaliatory action against China if it does not allow the RMB to appreciate against the dollar.
Thorbecke (2006) has investigated how an appreciation of the RMB against the dollar would affect the China/U.S. trade balance. Using data on bilateral exports and imports between China and the U.S., he finds that there are stable long run (cointegrating) relationships between China's exports and imports with the U.S., the real exchange rate, and real income. He controls for competition between China and ASEAN in U.S. markets by including a real exchange rate index for trade between ASEAN countries and the U.S.
The long run RMB exchange rate coefficients for both exports and imports are approximately equal to one. These coefficient estimates imply that if the RMB had been 10% stronger in 2005, the gap between nominal exports and nominal imports would have fallen from 11% to 10% of Chinese GDP.
Before concluding that the impact of an RMB appreciation would be trivial it is important to note that, because of the lack of bilateral trade prices, exports and imports in Thorbecke's paper were deflated by the U.S. consumer price index (CPI). As he discusses, this implies that the true price elasticities of demand are larger than the estimated exchange rate coefficients. Thus his results indicate that an appreciation of the renminbi would help to rebalance trade between China and the U.S.
China's Global Trade Surplus
While politicians focus on bilateral exchange rates and bilateral trade balances, economists are more interested in global trade balances and multilateral exchange rates. Marquez and Schindler (2006) have examined the effects of changes in the multilateral real RMB exchange rate on China's total exports and imports. Using time series methods, they find that a 10% real appreciation of the RMB lowers the share of Chinese exports in world trade by one percentage point and the share of Chinese imports in world trade by two-tenths of a percentage point.
Their paper has many strong points. They use Chinese trade as a share of world trade, thus avoiding the use of proxies such as the CPI for trade prices. They control for seasonality and for the effect of the Chinese New Year. They are careful to focus on econometric specifications exhibiting parameter constancy, white noise residuals, and the smallest standard error of the regression (SER).
Their results indicate that an increase in the real effective RMB exchange rate would help to reduce China's trade surplus.
Exchange Rates and Triangular Trading Patterns
The effect of a Chinese appreciation on China's trade balance would be even larger, however, if it led to a generalized appreciation in Asia. This is because China plays a unique role within global trading networks. It imports large quantities of intermediate goods from the rest of East Asia and exports large quantities of final products throughout the world. Table 1 sheds light on China's role in this triangular trading structure.
The data are taken from China's Customs Statistics, which distinguish between imports and exports linked to processing trade and ordinary imports and exports. Imports for processing are goods that are brought into China for processing and subsequent re-export. Processed exports, as classified by Chinese customs authorities, are goods that are produced in this way. Imports for processing are primarily intermediate goods but also include some primary goods and some final goods. They are imported duty free and neither these imports nor the finished goods produced using these imports normally enter China's domestic market. By contrast, ordinary imports are goods that are intended for the domestic market and ordinary exports are goods that are produced using local inputs.
Table 1 shows that in 2005 42% of China's imports were for processing. Of this 42%, seven-tenths came from other East Asian countries. By contrast, less than one-twentieth each came from the U.S. and from the EU. This indicates that the U.S. and the EU do not produce many intermediate goods demanded by China for processing.
The Table also shows that in 2005 55% of China's exports were processed exports. Of this 55% one-quarter went to the U.S., another one-quarter went to East Asia (excluding Hong Kong), one-fifth went to Hong Kong (largely as entrepot trade), and one-fifth went to Europe.
Because of these trading networks, Chinese value-added in processed exports is about 20%-30%, with the remainder coming from intermediate goods imported from the rest of Asia. Thus a unilateral appreciation of the RMB would not affect the costs of processed final products measured in the importing country's currency and hence China's trade surplus as much as a joint appreciation throughout Asia.
In recent work, Rahman and Thorbecke (2006) find that a joint appreciation in Asia would have a much larger effect on China's exports than a unilateral appreciation of the RMB. Thus, if China and other East Asian countries are concerned about rebalancing their economies, a joint appreciation would be more effective.
Achieving a Joint Appreciation in East Asia
To achieve a joint appreciation China and other countries in East Asia with less flexible exchange rates should adopt more flexible regimes. These regimes could be characterized by two elements: 1) a multiple currency basket-based reference rate instead of a dollar-based central rate, and 2) a wider band around the reference rate.
These two elements would provide policy-makers with greater flexibility in managing the speed and magnitude of any necessary appreciation while still taking into account their own individual economic conditions.
A free float would cause exchange rates to more accurately reflect market fundamentals. However, given the shallow and narrow domestic capital markets in some East Asian economies, a free float for some countries would generate excessively volatile exchange rates and harm economies in the region that are highly exposed to fluctuations in international trade.
Thus, greater exchange rate flexibility in the context of a multiple currency basket-based reference rate with a band rather than a free floating regime would be appropriate for China and other economies in emerging Asia. This would allow the regional trade surpluses arising from processing trade to produce appreciations throughout the region, contributing to an orderly rebalancing in the global economy. This in turn would help China to achieve its goal of promoting production for domestic markets, allowing Chinese consumers to enjoy the fruits of their own labor.
IMF, 2005, Asia-Pacific Economic Outlook (International Monetary Fund, Washington, DC)
Marquez, J., and Schindler, J., 2006, "Exchange Rate Effects on China's Trade: An Interim Report," Federal Reserve International Finance Discussion Paper No. 861 (Federal Reserve Board, Washington)
Rahman, M., and Thorbecke, W., 2006, "Estimating the Effects of Unilateral and Joint Appreciations on China's Exports," unpublished working paper, (RIETI, Tokyo).
Thorbecke, W., 2006, "How Would an Appreciation of the Renminbi Affect the U.S. Trade Deficit with China?," The B.E. Journal in Macroeconomics: 6, 2006: No. 3, Article 3.
January 12, 2007
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