China's Exports in a Protectionist World

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

Protectionism is exploding. The U.S. raised tariffs on Chinese products and at one point labeled China a currency manipulator. Other countries are also pursuing beggar-thy-neighbor policies. How do tariffs, exchange rates, and other factors affect China's exports?

In theory, tariffs and exchange rates exert identical effects on export volumes. Fontagné, Martin, and Orefice (2018) demonstrated this equivalence in a model with constant elasticity of substitution (CES) preferences. Krugman (1979) and Eaton and Kortum (2002) also showed this correspondence employing standard models.

In reality, tariffs deter trade more than exchange rate appreciations. Benassy-Queré et al. (2018) investigated bilateral trade flows between 110 countries at the Harmonized System (HS) six-digit level. They reported that a 10 percent tariff reduces exports by 14 percent and that a 10 percent exchange rate appreciation reduces exports by 5 percent. Fontagné, Martin, and Orefice (2018), Fitzgerald and Haller (2014), Ruhl (2008), and others have also reported this effect. It is called the international elasticity puzzle. It could arise because tariffs, as policy instruments, are more persistent than exchange rate changes and thus affect exporters' pricing decisions more than exchange rate fluctuations do. It implies that the response of exports to exchange rates provides a lower bound for the impact of tariffs on exports.

This paper estimates exchange rate elasticities across a wide cross section of Chinese exports. These findings shed light on how factors such as exchange rates and tariffs that influence tradable prices affect exports.

Table 1 presents trade elasticities for China's exports disaggregated by industry. Column (2) of the table indicates that 30.9 percent of China's exports in 2017 were in the electronics sector. Column (4) indicates that the exchange rate elasticity in this sector equals -1.56, implying that electronics exports are very sensitive to exchange rates. Column (2) shows that China's second largest export sector is textiles. This includes wearing apparel and knitted fabrics. Column (3) shows that China has a large share of the world's exports in this category and the exchange rate elasticity equals -0.76, which is much lower than for the other categories.

Column (4) of Table 1 indicates that exchange rate elasticities for the other sectors all exceed unity. They are largest for vehicles. Column (3) of Table 1 shows that China exported only 4.9% of the world's vehicles in 2017. China thus faces a lot of competition from other exporting countries in this category. In addition, purchasing vehicles is a major expenditure for consumers. This implies that these purchases will be more price elastic.

The important implication of these results is that China's exports are very sensitive to exchange rates. This is especially true for flagship industries such as electronics and machinery.

These large price elasticities indicate that tariffs threaten China's exports. The disruption to trade caused by tariffs is multiplied by the uncertainty that accompanies trade wars and protectionism. Bloom (2009) reported that uncertainty hinders investment. Investing in physical capital and in research and development is crucial for the electronics industry, given its short product cycles and volatile consumer demand. By reducing investment, uncertainty jeopardizes the ability of Chinese firms to remain competitive in the electronics industry and in other key sectors.

China could offset these uncertainties by signing free trade agreements (FTAs) with countries other than the U.S. These could strengthen economic cooperation and deepen integration. It could also rechannel China's exports to countries other than the U.S. This could reduce protectionist pressure with the U.S., especially in light of Thorbecke's (2015) finding that China's exports to the U.S. are disproportionate.

While China has concluded bilateral agreements with Chile, Georgia, New Zealand, Pakistan, Peru, Singapore, Switzerland and others countries, it has also been negotiating the Regional Comprehensive Economic Partnership (RCEP) with multiple Asian partners. These partners include the ten Association of Southeast Asian Nations (ASEAN), China, Japan, South Korea, Australia, and New Zealand. RCEP is important because it is the largest Asian trade deal under consideration and because many of these countries are linked through regional value chains. While the negotiations focus on establishing a region-wide free trade zone, the discussions also address investment, trade in services, technological cooperation and intellectual property (IP) rights.

Ratifying RCEP could be a boon for China. It would grant Chinese firms access to large markets in the region. It would also reduce prices on imports of food, footwear, medicine, and other goods.

In addition to RCEP, the Comprehensive and Progressive TPP (CPTPP) could benefit Chinese companies. The CPTPP sets high standards for labor and environmental rules, competition policy, state-owned enterprise behavior, and IP protection. China would need to do extensive preparatory work before it could join the CPTPP. However, as Chinese firms continue to upgrade technologically, high quality agreements with strong IP protection would be in their interest.

Trading blocs and trade wars foment uncertainty, misallocate resources, and break up value chains. China and the U.S. should assiduously pursue breakthrough agreements for their mutual benefit and as an example to other countries in the 21st century. China should also hedge against the risk of a failure in these negotiations by signing free trade agreements, improving connectivity with other trading partners.