Research Digest

# Recent Findings on China's Exports Taking Account of Exchange Rates throughout the Supply Chain

Interviewee THORBECKE, Willem (Senior Fellow, RIETI) Research Digest No.09

Export-led growth was one of the great successes in economic history. Japan adopted this strategy in the 1950s, South Korea and Taiwan in the 1960s, the Association of Southeast Asian Nations (ASEAN) in the 1970s, and China in the 1990s. An export-oriented approach combined with high public and private saving rates, high rates of investment in physical and human capital, flexible labor markets, and pragmatic policies raised living standards at rates that are unparalleled in economic history.

Chinese economists, however, have enumerated problems with China's pursuit of export-led growth. Distortions such as inadequate enforcement of environmental laws have imposed costs on Chinese citizens. For instance, air pollution reduces people's life expectancy by many years, and polluting industries have contaminated the land and caused cancer. In addition, to maintain competitive exchange rates, China has accumulated trillions of dollars worth of U.S. Treasury bonds and other foreign exchange reserves. Returns from investing in U.S. Treasuries are far lower than the returns from investing in rural education and in remedying economic deficiencies in ways that would benefit the non-tradable sector. In addition, to sterilize the base money increases, the People's Bank of China has had to force banks to purchase central bank bills and to hold excess reserves. This erodes bank profitability and hinders small and medium-sized enterprises from obtaining loans. China's artificially weak currency has also transferred resources from Chinese consumers to producers, preventing Chinese workers from enjoying the fruits of their labors. For these reasons, it is interesting to study the determinants of China's exports and how China's trade can be rebalanced.

Evidence indicates that China's labor-intensive exports are sensitive to the renminbi (RMB) exchange rate. Profit margins for these goods are thin, and an RMB appreciation would cause labor-intensive exports to plummet.

For China's sophisticated exports such as tablet computers and smart phones, much of the value-added comes from parts and components produced in South Korea, Taiwan, Japan, and ASEAN. Exchange rates throughout the region should affect their price competitiveness. Recent results indicate that exchange rates throughout East Asia affect high end exports.

## What are you finding out about China's trade with the United States?

THORBECKE: China has consistently run deficits with East Asian supply chain countries and surpluses with the United States. Figure 2 shows China's exports to the United States and U.S. exports to China. The figure shows that China's exports of all goods to the United States have soared and far outstripped U.S. exports to China. As a result, the U.S. trade deficit with China has grown, and in 2013 was almost equal to the U.S. trade deficit with all other countries combined. Since the Global Financial Crisis, there has been a major rebalancing of U.S. trade with all other countries but growing imbalances with China. U.S. exports to China equaled $120 billion in 2013 while that to the rest of the world equaled$1.5 trillion. Thus, U.S. trade with China generated the same-sized deficit as U.S. trade with all other countries, even though the value of U.S. exports to China was only 1/12th of the value of U.S. exports to the rest of the world.

In a forthcoming DP, I investigate how the RMB-U.S. dollar exchange rate and exchange rates in supply chain countries influenced China's exports to the United States. The results indicate that the RMB exchange rate matters significantly for China's exports to the United States. Thus, the more than $500 billion in foreign exchange reserves that China accumulated in 2013 to keep the RMB from appreciating against the dollar helped maintain the large imbalances that are evident in Figure 2. Figure 2 suggests that there is something unusual about China's exports to the United States. In the forthcoming DP, I investigate whether they are an outlier. Economists use gravity models as a workhorse for explaining bilateral trade flows. Traditional gravity models posit that bilateral trade between two countries is directly proportional to GDP in the two countries and inversely proportional to the distance between them. In addition to GDP and distance, these models typically include other factors affecting bilateral trade costs such as whether trading partners share a common language. Figure 3 plots China's predicted and actual exports in 2012. In the figure, values above the diagonal line indicate that exports are more than predicted, and values below the line indicate that exports are less than predicted. The vertical distance between the observation and the diagonal line measures the degree of over- or under- prediction. The figure indicates that China's predicted exports to the United States in 2012 were$209 billion while China's actual exports were $395 billion. Thus, China's exports to the United States were almost twice as large as predicted, with the difference between the actual and predicted values equaling$186 billion. Figure 3 also indicates that China's exports to South Korea, Taiwan, Japan, and Singapore in 2012 were much less than predicted. For South Korea, the shortfall was $107 billion; for Taiwan,$83 billion; for Japan, $81 billion, and for Singapore,$22 billion. In percentage terms of the predicted value, South Korea's exports were 42%; Taiwan's were 32%; Japan's were 69%; and Singapore's were 52%. The results in the paper indicate that there is especially robust evidence that China's exports to South Korea and Taiwan in 2012 were large negative outliers. For every year after 2007, China's exports to the United States have been between $140 billion and$190 billion more than predicted, and for China's exports to South Korea, Taiwan, and Japan, they were more than \$50 billion less than predicted.

## What are the policy implications of your work?

THORBECKE: I agree with the Chinese economists who argue that reserve accumulation to maintain a competitive exchange rate is an inferior investment and that the associated sterilization policies to mop up liquidity misallocate resources. I think that Asia should move away from the export-led growth strategy that worked so well in the past.

The problem is that Asian countries devise their exchange rate strategies domestically while so much of their exports are produced within cross border production networks. The two largest suppliers of parts and components to China in 2013 were Taiwan and South Korea. Their global current account surpluses between 2005 and 2013 averaged almost 9% and almost 3% of GDP, respectively. However, Taiwan's REER depreciated over this period and Korea's REER appreciated by less than 5%. Taiwan and Korea both used foreign exchange reserve accumulation to slow the rate of appreciation. Then in 2014, as the Korean won appreciated, the RMB depreciated. So the price competitiveness of East Asia's exports is hardly affected and large surpluses with the West persist.

If central banks in China and other surplus countries together reduced their rates of reserve accumulation and gave greater play to market forces, the surpluses that they run in processing trade and in their overall current account balances would generate a concerted appreciation of East Asian currencies against importers' currencies and help to rebalance processing trade. Such an appreciation would have an attenuated effect on the export competition between East Asian economies in third countries because their currencies would be appreciating together. A joint appreciation would maintain intra-regional exchange rate stability and thus facilitate the flow of parts and components within production networks. It would also reduce the misallocation of resources that occurs when central banks sterilize the impact of reserve accumulation on domestic liquidity. Finally, it would increase citizens' purchasing power and redirect final goods to Asia. This would be helpful since less than 10% of China's, South Korea's, and Taiwan's imports in 2012 were consumption goods as compared to 20% for the Eurozone and 22% for the United States.