CHINA S EXCHANGE RATE MOVEMENTS AND CORPORATE CURRENCY INVOICING STRATEGIES

Transcription

1 Discussion Paper 31 CHINA S EXCHANGE RATE MOVEMENTS AND CORPORATE CURRENCY INVOICING STRATEGIES Jingtao Yi Copyright China Policy Institute & Centre for Global Finance June 2008 China House University of Nottingham University Park Nottingham NG7 2RD United Kingdom Tel: +44 (0) Fax: +44 (0) CPI@nottingham.ac.uk Website: The China Policy Institute, part of the School of Contemporary Chinese Studies at The University of Nottingham, was set up to analyse critical policy challenges faced by China in its rapid development. Its goals are to help expand the knowledge and understanding of contemporary China in Britain, Europe and worldwide, to help build a more informed dialogue between China and the UK and Europe, and to contribute to government and business strategies. 1

2 China s Exchange Rate Movements and Corporate Currency Invoicing Strategies Jingtao Yi * Abstract After China introduced a new managed floating exchange rate regime in 2005, the persistent appreciation of the renminbi against the U.S. dollar led Chinese firms to reassess their choice of an invoice currency among the dollar and other international alternatives in which to price their exports. This paper performs a systematic invoice currency analysis through surveying literature, summarizing criteria for decision making, and evaluating the choices available to Chinese exporters who seek to maximize expected profits. This study finds that the euro may play an increasing role as the invoice currency at Chinese firms, though the U.S. dollar will still play a dominant role. Chinese exporters may shift gradually from the dollar to the euro in the face of the falling dollar, balancing between the two by necessity. KEY WORDS: renminbi exchange rate, invoice currency, consumer currency pricing, producer currency pricing, vehicle currency JEL Classification: F31, F41, L11 * Dr. Jingtao Yi is Associate Post Doctoral Research Fellow at the China Policy Institute, School of Contemporary Chinese Studies, the University of Nottingham, UK. He is also Senior Research Fellow at the Centre for Global Finance at the University of Nottingham Ningbo, China. 2

3 China s Exchange Rate Movements and Corporate Currency Invoicing Strategies Jingtao Yi 1. Introduction Prior to July 2005, China maintained a de facto peg to the U.S. dollar and the movement of the Chinese renminbi exchange rate against the dollar was stable. Combined with the fact that the U.S. dollar is the world s vehicle currency for most international transactions, the majority of China s exports are denominated in the dollar. However, after China introduced a new managed floating exchange rate regime with reference to a currency basket in July 2005, the renminbi experienced a persistent appreciation against the dollar with increasing fluctuations. This in turn augments currency risks and raises costs of production for Chinese exporters in terms of their U.S. dollar denominated exports. Rising numbers of exporters were shunning the U.S. dollar or devising ways to offset the impact of the falling dollar as they confronted the rising costs of labour and raw materials at home (Kwong, 2008). This raises a new point of interest among academics regarding a firm s choice of invoice currency in pricing its exports. Their topic of investigation is whether an exporter should choose producer currency pricing (PCP), consumer currency pricing (CCP), or vehicle currency pricing (VCP). 1 Early research on firms choice of invoice currency concentrated on the explanation that the U.S. dollar is the world s vehicle currency for international transactions. Research on vehicle currency can be divided into two main categories in accordance with the function of money (Oi, Otani and Shirota, 2003). The first is 1 This describes a firm s currency invoicing behaviour regarding its export price setting. A firm quotes the price of its exports in producer currency (PCP), consumer currency (CCP), or vehicle currency (VCP). The vehicle currency could be the third country s currency. See Krugman (1980) for details of the vehicle currency.

4 based on money as a medium of exchange. Swoboda (1968) argued that the currency of a country was chosen as the vehicle currency due to low transaction costs and a large volume of transaction in the foreign exchange market denominated in this currency. Krugman (1980) found that the currency with the lowest transaction costs associated with the largest transaction volume would become the vehicle currency and argued that inertia could also play a role in determining the choice of vehicle currency. Rey (2001) studied the choice of vehicle currency based on the strength of trade ties and the size of transaction costs and found that the currency of the country that maintains the greatest degree of openness associated with the lowest transaction costs of currency exchange would become the vehicle currency. The second is founded on money as a unit of account. McKinnon (1979) argued that a single vehicle currency would be used for trading of homogenous primary goods because of increasing transaction efficiencies in their specialized exchange markets by expressing their prices in the same currency, whereas the producer currency was chosen for trading highly heterogeneous goods. In addition, Grassman (1973) focused on the invoice currency in the trade of Sweden and Denmark in terms of heterogeneous goods and found that both countries tended to use the producer s currency as the invoice currency. The research on vehicle currency does not examine firms actual invoice decision making process and ignores the possibility of a non vehicle currency being the invoice currency, especially for countries bilateral trade. Giovannini (1988) studied the choice of invoice currency from the perspective of maximizing expected profits under uncertainties of exchange rate movements. This led to substantial research on the partial equilibrium approach to the choice of invoice currency for firms, founded on their expected profits maximization. The partial equilibrium theory predicts that the currency that will maximize a firm s expected profits could be chosen among alternatives as the invoice currency, given the uncertain exchange rate fluctuations confronted by a firm. 4

5 Obstfeld and Rogoff s (1995) pioneering work on new open economy macroeconomics introduced micro mechanisms to the dynamic general equilibrium open economy model. This line of research incorporated the firm s invoicing decision to allow for its role in the transmission of monetary policy and the optimal exchange rate regime. Lane (2001) surveyed theoretical literature relating a firm s price setting behaviour to new open economy macroeconomics. These developments in international macroeconomic theory have shed new light on research on the theory of currency invoicing of firms based on the general equilibrium approach. The currency that will maximize a firm s expected profits could be chosen to be the invoice currency, given exchange rate uncertainties and fluctuations of other macroeconomic factors, i.e. shocks in money supply and production. The depreciation of the U.S. dollar is diminishing its role in Chinese firms export pricing behaviour. The dollar as a reliable vehicle currency for their invoice currency is likely to be replaced by other international alternatives over time. Chinese exporters intend to observe changes in the status of international currencies and then make a decision on which currency is appropriate as the invoice currency, allowing them to maximize profits or minimize potential risks. The theoretical research described above provides an extremely useful guideline for assessing the choice of an invoice currency among alternatives, given the fact that the U.S. dollar is no longer the only choice. This study aims to do a systematic analysis of invoice currencies to help evaluate the choice of Chinese exporters following the norm of maximizing expected profits. The remainder of the paper is organized as follows. Section 2 reviews the theory of currency invoice determination of a firm. Section 3 examines renminbi exchange rate movements since July Section 4 discusses Chinese exporters currency invoicing strategies, founded on the theory of currency invoicing. Section 5 summarizes the main findings of the study and concludes the paper. 5

6 2. Theory In the literature, the choice of invoice currency by a firm is founded on how a currency is chosen in order to maximize expected profits in the presence of uncertainty. Regarding the specification of uncertainty, the research can in principle be divided into two main types. The first type is based on the partial equilibrium approach that assumes exchange rate fluctuations as a source of uncertainty for a firm. The second type uses the general equilibrium approach that takes into account feedbacks from shocks in money supply and production to changes in the exchange rate and other macroeconomic factors, and treats macroeconomic shocks and their interaction with exchange rate fluctuations as a source of uncertainty. The general equilibrium approach centres its attention on developments in new open economy macroeconomics that regard all feedbacks from external shocks to other macroeconomic variables including the exchange rate in the study of economic theory and policy. By surveying this literature, we intend to clarify both the criteria adopted and the decision made regarding the choice of invoice currency. 2.1 Partial equilibrium approach The partial equilibrium approach studies the choice of the invoice currency for firms facing a downward sloping demand curve in the presence of uncertainty of exchange rate fluctuations. Based on this approach, models of invoice currency choice include the simple one firm model, where only one domestic firm exports to a foreign market dominated by foreign firms that set the price in their own currency, and the multiple firm model, where multiple domestic firms compete in the export market and have to take the invoicing choice of other firms into account (Oi, Otani and Shirota, 2003). The multiple firm model allows the exporting country to have a large market share in the foreign market. It assumes that foreign firms set prices in their own currency since the focus of analysis is on the invoicing decision of exporters. 6

7 The one firm model examines the choice of a firm facing uncertainties in exchange rate movements among the PCP, CCP and VCP cases to maximize its expected profits. Regarding the choice of the invoice currency between the PCP and CCP cases, a risk averse firm will choose the CCP to stabilize the consumer currency price of its exports against exchange rate fluctuations, whereas a risk seeking firm will choose the PCP to tolerate changes in the consumer currency price in response to exchange rate fluctuations (Bacchetta and Wincoop, 2005). 2 In the case of CCP, a firm s expected profit is the same as the profit with the actual exchange rate being equal to its expected level since the profit function is linear with respect to the exchange rate. In the case of PCP, its expected profit is lower than the profit with the expected exchange rate if it is risk averse (the profit function is concave) while this is higher if it is risk seeking (the profit function is convex). Here, risk attitudes of a firm play a significant role in determining the choice between the two cases based on the norm of maximizing expected profits. When the property of the product that a firm exports is examined, the low price elasticity of demand for this product will prefer the PCP case while the high price elasticity of demand will favour the CCP case. The lower the price elasticity of demand for a product, the less sensitive the response of consumers to price fluctuations. A firm is more likely to choose the PCP for its exports when price elasticities of demand for them are lower, while choosing the CCP when they are higher. Since the product of lower price elasticity of demand is more differentiated, the firm will go for the PCP when the degree of product differentiation is high whilst choosing CCP when it is low (Bacchetta and Wincoop, 2005). Here, product differentiation also plays a significant part in determining the choice of invoice currency between the two cases. 2 Bacchetta and Wincoop (2005) found that the choice of invoice currency between the PCP and CCP cases depends on the shape of the profit function. When the function is concave, the CCP will be selected; when it is convex, the PCP will be selected. 7

8 Regarding the choice of invoice currency among the PCP, CCP and VCP cases by introducing the third country s vehicle currency, a risk averse firm will go for the CCP to stabilize the consumer currency price against exchange rate fluctuations (Friberg, 1996 and 1998). In this context, the CCP case offers the highest expected profits while the VCP provides the second highest expected profits if the fluctuation in the exchange rate between the vehicle currency and the consumer currency is smaller than that in the exchange rate between the producer currency and the consumer currency. For a risk seeking firm, the PCP will be selected if the fluctuation in the exchange rate between the producer currency and the consumer currency is larger than that in the exchange rate between the vehicle currency and the consumer currency. Otherwise, the VCP will be selected. In this context, the CCP offers the lowest expected profits. The choice of the invoice currency among the PCP, CCP and VCP cases therefore depends not only on risk attitudes, but also upon the degree of uncertainty in currency movements among the three cases. The multiple firm model investigates the choice of multiple firms facing uncertainties in exchange rate movements between the PCP and CCP cases to maximize its expected profits (Bacchetta and Wincoop, 2005). A firm that is risk seeking will go for the PCP associated with maximized expected profits while a risk averse firm will behave in a different way and not necessarily choose the CCP in this new context. When the exporting country has a small share of the foreign country market, exporting firms will have to face large risks in that foreign demand for its product varies with exchange rate fluctuations. They therefore go for the CCP in order to avoid these risks. When the exporting country has a large share of the foreign market, Bacchetta and Wincoop (2005) found that there are three possible equilibria, but if they coordinate, they all prefer the PCP if either the market share or the rate of risk aversion is large enough. In the first case, all exporting firms could choose the PCP in order to avoid risks arising from exchange rate fluctuations, given the choice of PCP made by other exporting firms. Foreign demand for their products 8

9 is based not only on one firm s invoicing decision but also on other firms invoicing decisions and all firms compete in the same foreign market. The demand for one firm s product in the market is negatively linked to its price and positively linked to the price of others. The same invoicing strategy will help insulate them from exchange rate fluctuations, given their risk averse attitudes. In the second case, all exporting firms could choose the CCP to avoid exchange rate risks. In the third case, a fraction of firms choose the PCP while the rest choose the CCP. Given the choice of the CCP for some firms, the rest could choose the PCP to avoid their risks and maximize their expected profits. This is because exchange rate fluctuations could neither influence foreign demand for products of firms using the PCP nor significantly affect that of firms using the CCP. However, if they coordinate their invoicing strategies, they will all go for the PCP because nominal receipts in the home currency from their exports will vary with exchange rate fluctuations in the CCP case. The model indicates that risk attitudes and market share are crucial to firms invoicing choice. They are more likely to choose the PCP if their country s market share is large. 2.2 General equilibrium approach The partial equilibrium approach assumes that the exchange rate is exogenous and the only source of uncertainty. From the partial to the general equilibrium approach, the exchange rate is no longer exogenous but endogenous, and the source of uncertainty shifts from external shocks to macroeconomic fundamentals (Bacchetta and Wincoop, 2005). The shocks are likely to influence the exchange rate and other macroeconomic variables simultaneously. The choice of invoice currency is made by taking all these feedbacks into account. Bacchetta and Wincoop (2005) considered shocks to money supplies in the home and foreign countries as the source of uncertainty by assuming that the variances of money supplies in both countries are identical. They studied the choice 9

10 between the PCP and CCP cases by comparing their expected profits under both nominal and real wage rigidities. In the first case of rigid nominal wages, the demand risk associated with the PCP case is reduced because an appreciation of domestic currency reduces foreign demand for domestic firms products, which is induced by an increase in foreign money supply that tends to raise the demand. An exporting firm that is risk seeking will choose the PCP in spite of a reduction in the demand risk. A firm that is risk averse will choose the CCP if the exporting country has a small share of the foreign market. But if it has a large market share, all exporting firms will choose either the PCP or the CCP in equilibrium. However, if they coordinate on the invoicing choice, they prefer the PCP when they are risk averse. In this situation, market share is still crucial in determining the invoicing choice and the reduction in the demand risk makes the PCP more attractive. Regardless of firms risk attitudes, the larger the exporting country s market share, the more likely that the PCP will be chosen. In the second case of rigid real wages, nominal wages move in proportion to the consumer price index and this in general relies on exchange rate fluctuations in the smaller country but not in the larger country. By introducing an asymmetry between the large and the small country, Bacchetta and Wincoop (2005) found that it is more likely that exporting firms in a small country will choose the CCP whereas those in a large country will choose the PCP. This is because firms in the small country are influenced by exchange rate fluctuations far more than those in the large country. Exchange rate fluctuations raise expected costs of firms in the small country and lower their expected profits when choosing the PCP. This makes the CCP more attractive to them. In this case, market size plays a critical role in determining invoicing choice and firms from small countries are more likely to choose the CCP. In contrast with Bacchetta and Wincoop (2005), Devereux and Engel (2001) built a dynamic general equilibrium model to study invoicing choice between the PCP and CCP cases by allowing for the role of varied variances of money supplies in the 10

11 home and foreign countries of this choice. They found that both domestic and foreign firms would choose the currency of the country with the smallest variance in the money supply. When the variance of money supply in the home country is smaller, firms from the home country choose the PCP and those from the foreign country choose the CCP. In this case, money supply volatility becomes a key factor in determining invoicing choice. 2.3 Criteria for the invoicing decision In light of the literature survey above, we can summarize the basic criteria for considering an invoicing decision made by exporting firms, founded on both partial equilibrium and general equilibrium (Oi, Otani and Shirota, 2003). (1) When firms are risk averse, exchange rate volatility makes the CCP the most attractive choice. The currency that has the smaller exchange rate variance with the trading partner s currency will also be chosen as the invoice currency. (2) The greater the degree of product differentiation, the more likely it is that the PCP will be chosen. (3) The higher the home country s share in the foreign country market, the more likely it is that the PCP will be chosen. (4) The larger the size of the economy, the more likely it is that the PCP will be chosen. (5) The smaller the variance of money supply in the home country compared to the foreign country, the more likely it is that the PCP will be chosen by firms in the home country. The literature shows that exchange rate volatility, product differentiation, market share, size of the economy, and money supply volatility are major factors in determining the invoicing choice amongst the PCP, CCP, and VCP cases. These are 11

12 used in our study to evaluate the invoicing choice for Chinese exporters in the presence of the renminbi s continuous appreciation against the U.S. dollar. 3. Renminbi Exchange Rate Movements Prior to July 2005, the Chinese renminbi was de facto pegged to the U.S. dollar and the renminbi exchange rate fluctuations mainly depended on movements of the dollar exchange rate against other trading currencies. The dollar peg regime will favour the choice of the dollar made by Chinese exporters as the invoice currency in which to price their exporting products from the perspectives of both the traditional vehicle currency theory and exchange rate volatility. However, the renminbi started to appreciate against the dollar with increasing fluctuations after July 2005 in the Chinese foreign exchange market. This could challenge the choice of the dollar as the invoice currency for Chinese exporters because of unfavourable movements of the renminbi dollar exchange rate. With a focus on movements of the renminbi exchange rate during the period after July 2005, we intend to examine features of the renminbi exchange rate against China s major trading partners currencies in order to shed light on the study of the invoicing choice of Chinese exporters. The renminbi appreciated against the U.S. dollar from 8.28 yuan per dollar in July 2005 to 7.01 yuan per dollar in March 2008, amounting to an appreciation of percent (see figure 1). The renminbi dollar exchange rate moved rather smoothly in a gradually downward adjusted direction, with a standard deviation of 3.59 (see table 1). The renminbi started to appreciate against the euro until the end of 2005 and then depreciated afterwards with an upward trend (see figure 2). From July 2005 to March 2008, the renminbi depreciated against the euro by percent. The movements in the renminbi euro exchange rate were quite volatile, with a standard deviation of 5.44 (see table 1). The renminbi yen exchange rate moved in a downward trend before July 2007 and shifted in an upward trend 12

13 afterwards (see figure 3). From July 2005 to March 2008, the renminbi appreciated against the yen by 6.44 percent. The movements in the renminbi yen exchange rate were volatile as well, with a standard deviation of 5.29 (see table 1). The renminbisterling exchange rate moved very steadily before the end of 2007 and then shifted downward sharply until the end of the period (see figure 4). From August 2006 to March 2008, the renminbi appreciated against the sterling by 5.79 percent. The movements in the renminbi sterling exchange rate were extraordinarily smooth, with a standard deviation of 2.70 (see table 1). Figure 1 The Chinese Renminbi U.S. Dollar Exchange Rate July 2005 March 2008 Source: The State Administration of Foreign Exchange, Figure 2 The Chinese Renminbi Euro Exchange Rate July 2005 March

14 Source: The State Administration of Foreign Exchange, Figure 3 The Chinese Renminbi Yen Exchange Rate July 2005 March 2008 Source: The State Administration of Foreign Exchange,

15 Figure 4 The Chinese Renminbi Sterling Pound Exchange Rate August 2006 March 2008 Source: The State Administration of Foreign Exchange, Table 1 The Chinese Renminbi Exchange Rate Volatility Renminbi US Dollar Renminbi Euro Renminbi Japanese Yen Renminbi Sterling Pound Standard Deviation Source: Author s calculation (based on exchange rate index with the base of 100), In general, the renminbi appreciated against almost all major trading currencies in the period, with only the exception of the euro. Its appreciation against the dollar was the highest amongst major currencies. Although the renminbi started to appreciate against the dollar in July 2005, fluctuating increasingly in the foreign exchange market, the renminbi dollar exchange rate was still less volatile compared 15

16 to other major currencies (e.g. the euro and the yen). However, the renminbi sterling exchange rate was the least volatile. 4. Chinese Exporters Currency Invoicing Strategies The renminbi s continuous appreciation against the U.S. dollar makes the existing choice of the dollar as the invoice currency less attractive to Chinese exporting firms because of demand reduction induced by the appreciation. These firms have to make a decision on the invoicing currency among alternatives to maximize profits. In order to address this issue, we intend to use the criteria for an invoicing decision to evaluate the invoicing choice among major trading currencies for these exporting firms based on the norm of maximized expected profits. 4.1 Exchange Rate Volatility Exchange rate volatility plays a crucial role in determining the invoicing choice. For risk averse firms, it makes the CCP the most attractive to them. They can choose the consumer currency as the invoice currency in which to price their exports in order to remove the demand risk induced by unfavourable exchange rate movements. However, this is inconsistent with the fact that most exporters in the Chinese trade sector choose the vehicle currency of the U.S. dollar as their invoicing currency, rather than select each of the trading partners currencies separately as the invoicing currency for their corresponding exports. If the CCP is not favoured, the third country s currency that has the smallest exchange rate variance with the home country s currency against the trading partners currencies will be chosen as the invoice currency for firms that are riskaverse. Table 2 shows renminbi exchange rate volatilities relative to China s major trading currencies. For the United States, one of China s major trade partners, the renminbi U.S. dollar exchange rate provides a smaller variance than other renminbi exchange rates with the exception of the sterling. It is the same case for the EU and 16

17 Japan. From the perspective of exchange rate volatility and taking other factors as given, the U.S. dollar still appears to be a better choice as the invoice currency for Chinese exporters. In addition, it is interesting to note that the renminbi sterling exchange has the smallest variance among others, which provides some scope for the role of the sterling in the Chinese choice of invoicing currency. However, China started to publish the renminbi exchange rate against the sterling in August Therefore, this argument could be constrained in this case where data for the exchange rate are only available for the short term. Table 2 The Renminbi Exchange Rate Volatility Relative to China s Trade Partners China's Trade Partner Renminbi US Dollar Renminbi Euro Renminbi Japanese Yen U.S EU Japan UK Source: Author s calculation (based on table 1), Renminbi Sterling Pound 4.2 Differentiation of the Exported Product The greater the degree of product differentiation, the more likely it is that the home country currency is chosen for the invoice currency. In order to study the invoicing choice, we may first investigate the relationship between the invoicing decision made by firms in Chinese industries and the price elasticity of demand for their exports. This is because the greater the degree of product differentiation, the lower the price elasticity of demand to exchange rate changes. This implies a negative relationship between the degree of price elasticity of demand for exports and the possibility of choosing the home country currency for the invoice currency. 17

18 Table 3 Price Elasticity of Industrial Exports to the Renminbi Exchange Rate Rate Industries Renminbi Exchange U.S. Dollar Germa n Mark French Franc Italian Lira Japanese Yen Medicinal Products Textile Yarn and Thread Woven Textile Non cotton Textile Products Footwear Watches and Clocks Sound Recorders Jewellery Source: Voon, Li and Ran (2006). Table 3 shows price elasticities of demand for exports in several Chinese industries relative to the renminbi exchange rate against major trading currencies. For medicinal products, currencies in the EU have a higher price elasticity of demand than others. Since a higher elasticity of demand implies more scope for the role of consumer currency in the invoicing choice, the euro may well become a better choice of invoice currency for Chinese exporters in this industry. A lower elasticity of demand implies more scope for the role of producer currency, which undermines the role of the yen as an invoice choice for Chinese firms which export to Japan in this industry. For textile yarn and thread, a low price elasticity of demand for their exports allows for the role of producer currency in their invoicing choice. In other words, they can choose the renminbi as the invoice currency to price their exports to the U.S., the EU, and Japan within these industries with the objective of maximizing their expected profits. For industries of woven textile non cotton, textile products, and footwear, a high price elasticity of demand for their exports to the U.S. implies that the U.S. dollar is a suitable choice as the invoice currency for firms in this industry. In contrast, a low price elasticity of demand for their exports to the EU and 18

19 Japan undermines the role of the euro and the yen as the invoicing choice from this industry. For the watch, clock and sound recorder industries, firms could be better off pricing their exports in the U.S. dollar, the euro and the Japanese yen to the U.S., the EU, and Japan respectively. For jewellery, the euro may become a better invoicing currency choice for exporters to the EU in this industry. Table 4 Invoicing Choice for Chinese Industries Industries The U.S. The EU Japan U.S. Medicinal Products dollar Euro Renminbi Textile Yarn and Thread Renminbi Renminbi Renminbi Woven Textile Noncotton U.S. dollar Renminbi Renminbi Textile Products U.S. dollar Renminbi Renminbi Footwear U.S. dollar Renminbi Renminbi Watches and Clocks U.S. dollar Euro Yen Sound Recorders U.S. dollar Euro Yen Jewellery Renminbi Euro Renminbi Source: Author s evaluation, The results for the invoicing decision of our evaluation are shown in table 4. In general, China has a low price elasticity of demand for most of its exports, which implies more scope for the role of the renminbi in the invoicing choice. However, since the renminbi is not convertible, a vehicle currency like the U.S. dollar replaces it to play a major role. Interestingly, the results also indicate an increasing significance of the euro in the currency invoicing choice. For specific industries in China, such as medicinal products and jewellery, the euro is likely to play a part, which will diminish the role of the U.S. dollar in the invoicing decision made by Chinese exporters. 4.3 Market Share 19

20 The home country s share in the foreign market is positively related to the percentage of exports denominated in the home currency. The higher the home country s market share, the more likely it is the home currency will be chosen as the invoice currency. In other words, if China s share is higher, the renminbi is more likely to become an invoicing choice for Chinese exporters. Table 5 China s Share of the Importing Market of Major Partners Share of U.S. Imports Share of EU Imports Share of Japan Imports Share of UK Imports % Source: U.S. Census Bureau, 2008; Eurostat, 2008; Statistics Bureau of Japan, 2008; HM Revenue & Customs of UK, Table 5 shows China s share of the import markets of the U.S., the EU, Japan, and the UK in For the U.S. and the EU, China s share of their imports increased rapidly year on year, which could promote the role of the renminbi as an invoicing choice for its exporters. However, since the renminbi is not convertible, the U.S. dollar as a vehicle currency may still play a significant part. For Japan, China s market share of its imports was already high enough, which could undermine the role of the yen as the invoice currency for Chinese firms. For the UK, China s market share was very low, and this increases the possibility of the sterling becoming the invoice currency in which Chinese firms price their exports to the UK. 4.4 Size of the Economy The size of the economy of the exporting country is crucial to the choice of invoicing currency of its exporting firms. The greater the size of the economy, the more likely that the producer currency will be chosen as the invoice currency. In 20

21 particular, it is more likely that a firm in a small country will prefer the consumer currency as its invoicing currency when a firm in a large country chooses the producer currency. Table 6 Size of the Economy in China and Major Partners GDP(US$ Trillion, PPP) China U.S. EU Japa n UK Source: The World Bank, 2006; International Monetary Fund, Table 6 shows the size of the economy in China at purchasing power parity, compared to its major partners in China is smaller than the U.S. and the EU in terms of the size of its economy, but greater than Japan and the UK. Most exports out of the U.S., Germany, and France are priced in the home currency (Oi, Otani and Shirota, 2003); therefore it is better for China to choose the consumer currency as its invoicing currency for exports to these areas. This implies that the U.S. dollar will still play a major part while the euro is playing an increasing role in the invoicing choice of Chinese exporters. For Japan, a small percentage of its exports using the producer currency as the invoicing currency undermines the role of the yen in the invoicing choice of Chinese firms. For the UK, a relatively small economy could also undermine the role of the sterling in Chinese firms invoicing choice. 4.5 Money Supply Volatility The divergence in money supply variance between the home country and the foreign country is critical to home country firms invoicing strategies. The currency of the country with a smaller variance in money supply is likely to be chosen as the invoice currency. 21

22 Table 7 Money Supply Volatility in China and Major Partners China The U.S. The EU Japa n UK Standard Deviation Source: Author s calculation (based on money supply index with the base of 100), 2008; The People s Bank of China (M2), 2008; The Federal Reserve of the U.S. (M2), 2008; European Central Bank (M2), 2008; Bank of Japan (M2), 2008; Bank of England (M4), Table 7 shows money supply volatilities in China and its major partners over the period. For firms exporting to the U.S., a smaller variance of money supply in the U.S. than in China suggests that the U.S. dollar could be a better invoicing choice. For exporting to the EU and the UK, the euro and the sterling may play the part of the invoice currency. For Japan, since the percentage of Japanese exporting firms denominated in the yen is low and the yen is used as an invoice currency much less for imports than exports (Oi, Otani and Shirota, 2003), the lowest variance in its money supply is unlikely to promote the role of the yen in Chinese firms invoicing choice. In this case, vehicle currencies such as the U.S. dollar or the euro may play a part. 5. Conclusion The persistent appreciation of the renminbi against the U.S. dollar challenges the existing choice of the dollar as the invoicing currency for Chinese exporters. It augments currency risks and raises the costs of production. In response to unfavourable movements in the renminbi dollar exchange rate, these firms attempt to reconsider their invoicing choice in order to minimize costs or maximize profits. Our study finds that the euro is likely to play an increasing role in the invoicing choice of firms in China, although the U.S. dollar may still play a major part as the vehicle currency. We survey literature on currency invoicing choice and summarize criteria for the invoicing decision made by firms. The literature indicates that exchange rate 22

23 volatility, product differentiation, market share, size of the economy, and money supply volatility are significant factors in determining the invoicing choice. Exchange rate volatility and money supply volatility both suggest that the U.S. dollar could still be an appropriate choice of invoice currency for Chinese firms. Market share underlines the significant role of the U.S. dollar as the vehicle currency in their invoicing decision. The size of the economy favours the argument for the increasing role of the euro as the invoice currency. The differentiation of an exported product suggests varied invoicing strategies for Chinese firms in different industries. For exporting to the U.S. and Japan, the dollar may play a significant part as the vehicle currency in a variety of industries due to the renminbi s inconvertibility; for exporting to the EU, the role of the euro in Chinese firms invoicing choice is likely to increase over time, especially in the industries studied: medicinal products, watches and clocks, sound recorders, and jewellery. The relatively small trade volume between China and the United Kingdom limits the scope of the role of the sterling as the invoicing choice of Chinese firms. The euro may play an increasing role as the invoicing choice of Chinese firms, but the U.S. dollar will still dominate. It will take a long time for the euro to build its reputation as a vehicle currency before it can play a greater part in the invoicing choice. Chinese firms are likely to shift gradually from choosing the U.S. dollar to selecting the euro in which to price their exports but they have to achieve a sophisticated balance between the two. References Bacchetta, Philippe and Wincoop, Eric van (2005), A Theory of the Currency Denomination of International Trade, Journal of International Economics 67, pp Devereux, B., Michael, and Engel, Charles (2001), Endogenous Currency of Price Setting in a Dynamic Open Economy Model, NBER Working Paper No

24 Friberg, Richard (1996), On the Role of Pricing in a Third Currency, Working Paper No. 128, Stockholm School of Economics. Friberg, Richard (1998), In Which Currency Should Exporters Set Their Prices? Journal of International Economics 45, pp Giovannini, Alberto (1988), Exchange Rates and Traded Goods Prices, Journal of International Economics 24, pp Grassman, Sven (1973), A Fundamental Symmetry in International Payments Pattern, Journal of International Economics 3, pp Krugman, Paul (1980), Vehicle Currencies and the Structure of International Exchange, Journal of Money, Credit and Banking 12, pp Kwong, Robin (2008), Chinese Exporters Shun Flagging Dollar, Financial Times, March 27. Lane, R. Philip (2001), The New Open Economy Macroeconomics: A Survey, Journal of International Economics 54, pp McKinnon, Ronald (1979), Money in International Exchange: The Convertible Currency System, Oxford University Press. Obstfeld, Maurice and Rogoff, Kenneth (1995), Exchange Rate Dynamics Redux, Journal of Political Economy 103 (3), pp Oi, Hiroyuki, Otani, Akira, and Shirota, Toyoichirou (2003), The Choice of Invoice Currency in International Trade: Implications for the Internationalization of the Yen, Institute for Monetary and Economic Studies Discussion Paper No E 13, Bank of Japan. Rey, Helene (2001), International Trade and Currency Exchange, Review of Economic Studies 68, pp Swoboda, K. Alexander (1968), The Euro Dollar Market: An Interpretation, Essays in International Finance No. 64, Princeton University. 24

25 Van, Jan P., Guangzhong, Li, and Ran, Jimmy (2006), Does China Really Lose from RMB Revaluation? Evidence from Some Export Industries, Applied Economics 38, pp