Exchange Rates and Tariffs: Unravelling their impacts on China's ICT exports while accounting for product sophistication

President Trump imposed tariffs on imports from China that rose to 145% by April 9th. Then on April 11th he exempted imports of smartphones, computers, semiconductor devices, and other electronics imports from these tariffs. How do tariffs and exchange rates affect electronics exports and how did China become so successful at electronics manufacturing?

To examine how exchange rates and tariffs affect China’s electronics exports, we select 44 major Information and Communications Technology (ICT) Harmonized System 4-Digit categories. The ICT products are divided into 7 categories: computers, telecommunication equipment, semiconductors, semiconductor manufacturing and testing equipment, software, scientific instruments, and associated parts and accessories. Most of the ICT products are highly sophisticated. They are linked to influential, significant, and innovative industries such as artificial intelligence, 4G, 5G, internet banking, and modern manufacturing. ICT products also undergird services and digital trade. Thus, these products figure prominently in trade disputes.

We also investigate whether exchange rates and tariffs matter less for more sophisticated ICT products. Sophisticated goods that require relatively higher technological inputs are less ubiquitous than simple goods, implying that buyers may need more time to find substitutes (Hidalgo and Hausmann, 2009). For this reason, Abiad et al. (2018) noted that complex goods should have lower price elasticities of demand. Therefore, exchange rate may exert limited effects on export volumes for more sophisticated goods.

To measure product sophistication we use the method of Hidalgo and Hausmann (2009). They posited that a country that has a comparative advantage in more products has more capabilities. They also posited that products that fewer countries have a comparative advantage in are less ubiquitous. Figure 1 shows the intuition undergirding their framework.

In Figure 1, country C1 has all three capabilities a1, a2, and a3. It can thus produce all three products p1, p2, and p3. Country C2 has two capabilities a2 and a3. It can thus produce two products p2 and p3. Country C3 has only one capability a3. It can thus produce only one product p3. Since country C1 can produce all three products it is the most advanced and since country C3 can only produce one product it is the least advanced. Since only one country can produce product p1 it is the least ubiquitous and most complex and since all three countries can produce product p3 it is the most ubiquitous and least complex. Building on this intuition the Harvard Growth Lab has constructed measures of how advanced countries are and how complex products are.

We examine how exchange rates and tariffs impact China’s electronic exports and whether their impacts are smaller for more complex goods (with complexity measured using the Harvard Growth Lab measure). The results indicate that renminbi appreciations reduce ICT exports and that exchange rate elasticities are lower for more sophisticated products. Tariffs also reduce exports much more than appreciations do, especially for highly sophisticated ICT exports. High-end ICT products, such as advanced semiconductor chips or state-of-the-art communication equipment, require a complex supply chain involving components from several countries. A protectionist environment disrupts these supply chains by increasing the cost of imported inputs, causing multinationals to relocate production to countries whose finished products are not subject to tariffs, and multiplying uncertainty.

Finally, we consider how China, as a latecomer in telecommunications, was able to catch up and advance technologically. Catching up countries follow a process from imitation to innovation (Zhou, Lazonick and Sun, 2016). First, they acquire and learn the technology from advanced economies and from the spillover effects of foreign direct investment (FDI) technology. Then latecomers can accumulate domestic capabilities to innovate for higher-quality and lower-cost products.

China has succeeded by focusing on infrastructure building, technological development of innovative firms, liberalizing trade and FDI policies, and following ambitious technological upgrading strategies. China’s telecommunication infrastructure has markedly improved and cellular subscriptions have skyrocketed, strengthening the foundation for telecommunications development.

Huawei pursues maximum R&D efficiency (e.g., by hiring innovation pioneers rather than forming large teams). Employees at Huawei have cultivated a corporate culture that views pursuing innovation and efficiently solving problems for consumers as their own highest goals.

In 2018, Huawei submitted 5,405 intellectual property (IP) applications to the World Intellectual Property Organization (WIPO), which ranked first among global multinational corporations (MNCs).

China’s large domestic markets also drives innovation among domestic companies as they understand customers’ needs and problems with devices better than foreign MNCs.

These factors have accelerated the development of China’s telecommunications industry after China’s World Trade Organization accession in 2001.

The results in the paper indicate that tariffs are very disruptive for even highly sophisticated exports. Tariffs on intermediate goods upend global supply chains by raising input prices, leading to renegotiation of contracts or searches for new suppliers. One policy implication is that, even as President Trump launches a trade war, other countries in their trade with each other should eschew tariffs and other forms of protectionism as much as possible. As the British economist Joan Robinson observed, if your trading partner throws rocks into his harbor, that is no reason for you to throw rocks into your own. A second policy implication is that countries that want to advance technologically should not only liberalize trade but also focus on infrastructure building, technological development of innovative firms, and welcoming FDI. They should also encourage firms to use the domestic market as a training ground for competing in world markets.