Asian Development Bank Institute. ADBI Working Paper Series

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1 ADBI Working Paer Series How Would an Areciaion of he Yuan Affec he Peole s R eublic of China s S urlus in Processing Trade? Willem No. 219 June 2010 Asian Develomen Bank Insiue

2 Willem is a senior research fellow a ADBI. He hanks Ginalyn Komoo for excellen research assisance. The views exressed in his aer are he views of he auhors and do no necessarily reflec he views or olicies of ADBI, he Asian Develomen Bank (ADB), is Board of Direcors, or he governmens hey reresen. ADBI does no guaranee he accuracy of he daa included in his aer and acces no resonsibiliy for any consequences of heir use. Terminology used may no necessarily be consisen wih ADB official erms. The Working Paer series is a coninuaion of he formerly named Discussion Paer series; he numbering of he aers coninued wihou inerruion or change. ADBI s working aers reflec iniial ideas on a oic and are osed online for discussion. ADBI encourages readers o os heir commens on he main age for each working aer (given in he ciaion below). Some working aers may develo ino oher forms of ublicaion. Suggesed ciaion:, W How Would an Areciaion of he Yuan Affec he Peole s Reublic of China s Surlus in Processing Trade? ADBI Working Paer 219. Tokyo: Asian Develomen Bank Insiue. Available: h:// Asian Develomen Bank Insiue Kasumigaseki Building 8F Kasumigaseki, Chiyoda-ku Tokyo , Jaan Tel: Fax: URL: info@adbi.org 2009 Asian Develomen Bank Insiue

3 Absrac Enormous rade surluses are roblemaic for he Peole s Reublic of China (PRC) and he res of he world. They rimarily sem from rocessing rade. This aer invesigaes how exchange rae changes would affec he PRC s imors for rocessing and rocessed exors. The resuls indicae ha an areciaion hroughou Eas Asian suly chain counries would reduce he PRC s surlus in rocessing rade, while an areciaion of he yuan alone migh no. Even for an areciaion hroughou Eas Asia, however, he sum of he exchange rae elasiciies is no large. Thus, o rebalance he PRC s rade, exchange rae areciaions mus be accomanied by oher changes such as facor marke liberalizaion and greaer enforcemen of environmenal regulaions. JEL Classificaion: F32, F41 1

4 Conens 1. Inroducion PRC s Processing Trade Daa and Mehodology Secifying Exor and Imor Funcions Consrucing an Inegraed Exchange Rae The Economeric Model Resuls Discussion Conclusion References Aendix: Daa... 18

5 1. INTRODUCTION The Peole s Reublic of China (PRC) has mainained a egged exchange rae regime argeed a he Unied Saes (US) dollar. In he rocess i has accumulaed more han 2.4 rillion dollars in foreign currency reserves. The Peole s Bank of China has serilized hese inervenions and revened inflaion from acceleraing. However, serilizaion oeraions have forced commercial banks o hold more and more cenral bank bills, inerfering wih he allocaion of credi. They have also roduced an increasingly inefficien allocaion of resources since rivae and social raes of reurn are higher for invesmens in he domesic economy han for invesmens in US Treasury securiies. Many have hus advocaed a more flexible exchange rae regime for he PRC. How would he resuling exchange rae flucuaions affec he PRC s surlus wih he res of he world? The Marshall-Lerner condiion imlies ha, if rade is iniially balanced, an areciaion will reduce he rade balance if he sum of (he absolue values of) he demand elasiciies for exors and imors exceeds one. In he case of he PRC, he effec of exchange rae changes on he rade balance is more comlicaed because he PRC s rade surlus since 2008 has been almos enirely concenraed in rocessing rade. Processed exors are final goods ha are roduced using ars and comonens imored from he res of he world. Since much of he value-added of rocessed goods comes from oher counries, he effec of changes in he yuan on he volume of rocessing rade may be aenuaed. Yoshiomi (2007) documened ha ars and comonens for he PRC s rocessed exors came rimarily from oher Eas Asian counries. He hus noed ha an areciaion of he yuan would only affec he foreign currency coss of he PRC s value-added in rocessing rade, while a oin areciaion in Asia would affec he foreign currency cos of he PRC s enire ouu of rocessed goods. 1 A generalized areciaion should hus have a much larger effec on he PRC s rocessed exors. and Smih (2010) consruced a single inegraed exchange rae variable o measure changes in he relaive foreign currency coss no us of he PRC s value-added bu of he PRC s enire ouu of rocessed exors. Using dynamic ordinary leas squares esimaion and an annual anel daa se over he eriod, hey reored ha a 10% areciaion hroughou he region would reduce rocessed exors by 10%. Ahmed (2009) emloyed an auoregressive disribued lag model and quarerly daa over he 1996Q1 2009Q2 eriod and disaggregaed CNY exchange rae changes ino hose relaive o Eas Asian counries and hose relaive o oher counries. He reored ha a 10% areciaion of he yuan relaive o non-eas Asian counries would reduce PRC s rocessed exors by 17% and ha a 10% areciaion in oher Eas Asian counries would reduce PRC s rocessed exors by 15%. 2 This aer exends he revious work in a coule of ways. Firs, i invesigaes he facors influencing imors for rocessing as well as rocessed exors. This makes i ossible o consider how exchange rae changes affec no only he PRC s rocessed exors bu also he PRC s surlus of almos US$300 billion in rocessing rade. Second, i exands and Smih s daa se o include observaions from This eriod is imoran because boh he yuan and he PRC s rocessing rade exhibied maor flucuaions during hese years. 1 This is no enirely rue since no all of he imored inus used o roduce rocessed exors come from Eas Asia. 2 Marquez and Schindler (2007) and Cheung, Chinn, and Fuii (2010), and Garcia-Herrero and Koivu (2007) also resened valuable esimaes of rade elasiciies for he PRC. 1

6 The resuls indicae ha an areciaion hroughou Eas Asian suly chain counries would reduce he PRC s rocessing surlus. The evidence is less clear concerning wheher an areciaion of he yuan no accomanied by an areciaion in he res of Asia would have his effec. The nex secion resens a descriive analysis of he PRC s rocessing rade. Secion 3 resens he daa and mehodology. Secion 4 conains he resuls and Secion 5 discusses he imlicaions of hese resuls. Secion 6 concludes. 2. PRC S PROCESSING TRADE The PRC s Cusoms Saisics (CCS) disinguishes beween imors and exors linked o rocessing rade and ordinary imors and exors. 3 Imors for rocessing are goods ha are brough ino he PRC for rocessing and subsequen re-exor. Processed exors, as classified by he Chinese cusoms auhoriies, are goods ha are roduced in his way. Imors for rocessing are imored duy free and neiher hese imored inus nor he finished goods roduced using hese imors ener PRC s domesic marke. By conras, ordinary imors are goods ha are no imored duy free and ordinary exors are goods ha are roduced rimarily using local inus. Feensra and Wei (2009) reored ha 84% of he PRC s rocessed exors were roduced by foreign-invesed enerrises. Figure 1 shows ha mos of he PRC s rade surlus unil 2008 and all of he PRC s rade surlus afer 2008 was due o rocessing rade. CCS divides rocessing rade ino wo caegories, rocessing and assembly rade and rocessing wih imored maerials rade. As Gaulier, Lemoine, and Unal-Kesenci (2005) discussed, he firs caegory refers o foreign suliers imoring inermediae goods ha belong o hem and using hese inus o roduce goods for re-exor. The second caegory refers o foreign suliers imoring inus from oher firms and using hese o roduce goods for re-exor. The surlus in he firs caegory averaged US$20 billion beween 2007 and 2009 and he surlus in he second caegory averaged US$250 billion. This imlies ha, while he degree of inra-firm imors by foreign-invesed enerrises (FIEs) has remained sable, arms lengh ransacions by FIEs in he PRC are increasingly aking lace wih oher firms locaed in he PRC. 3 The websie for he PRC s Cusoms Saisics is 2

7 Fig. 1. PRC s Trade Balance by Cusoms Regime (Billions of US Dollars). Billions of U.S. Dollars Source: PRC Cusoms Office Ordinary Processing Ohers Toal Figure 2 disaggregaes rocessing rade using Harmonized Sysem (HS) classificaions. I shows ha machinery and elecrical roducs (HS 84 85) have become increasingly imoran on boh he imor and exor side while exiles (HS 41 43, 50 63) have become rogressively less imoran. Thus rocessing rade largely involves imoring sohisicaed ars and comonens and using hem o roduce comuers, elecommunicaions equimen, and oher high-ech goods. Fig. 2a: Imors for Processing by Indusry (% of Toal Value) Percen Animals, Food Minerals, Wood Chemicals, Plasics Texiles Foowear, Headgear Meals, Aricles Machinery, Elecrical Transor Misc. Manufac Source: Feensra and Wei (2009). 3

8 Fig. 2b: Processed Exors By Indusry (% of Toal Value) Percen Animals, Food Minerals, Wood Chemicals, Plasics Texiles Foowear, Headgear Meals, Aricles Machinery, Elecrical Transor Misc. Manufac Source: Feensra and Wei (2009). Table 1 shows he PRC s rocessing rade disaggregaed by counry beween 2006 and Two-hirds of he PRC s imors for rocessing came from Jaan, members of he Associaion of Souheas Asian Naions (ASEAN), and he newly indusrialized economies (NIEs), while only abou 5% each came from he US and Euroe. On he oher hand, Eas Asia, he US, Euroe, and Hong Kong, China each received abou 20% of rocessed exors. 4 As a resul, he PRC ran deficis of abou US$100 billion wih Eas Asia in rocessing rade and surluses of US$100 billion wih Euroe and US$130 billion he US and Hong Kong, China. 4 Processed exors o Hong Kong, China largely reresened enreô rade. 4

9 Table 1: PRC s Processing Trade, Imors for Processing (%) World Korea Taiei,China Jaan ASEAN Hong Kong, China Unied Saes Euroe Res of World Processed Exors (%) World Korea Taiei,China Jaan ASEAN Hong Kong, China Unied Saes Euroe Res of World Balance in Processing Trade (Billions of US dollars) World Korea Taiei,China Jaan ASEAN Hong Kong, China Unied Saes Euroe Res of World (28.29) (50.01) 1.76 (10.74) (18.12) (31.57) (57.18) (1.63) (10.46) (4.65) (27.07) (55.71) 0.99 (6.53) Noes: ASEAN includes Indonesia, Malaysia, Philiines, Singaore, and Thailand and Euroe includes Ausria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Luxembourg, Neherlands, Ialy, Porugal, Sain, Sweden and Unied Kingdom. Source: PRC Cusoms Saisics. 5

10 3. DATA AND METHODOLOGY 3.1 Secifying Exor and Imor Funcions According o he imerfec subsiues model of Goldsein and Khan (1985), exor and imor funcions can be reresened as: ex = α 10 + α 11 rer + α 12 y * + ε 1 (1) im = α 20 + α 21 rer + α 22 y + ε 2 (2) where ex reresens real exors, rer reresens he real exchange rae, y* reresens foreign real income, im reresens real imors, y reresens domesic real income, and all variables are measured in naural logs. In he case of he PRC s rocessing rade, i is necessary o modify hese equaions. Below I consider some of he oher facors ha should affec imors for rocessing and rocessed exors. For imors for rocessing, he Inernaional Moneary Fund (IMF) (2005) noed ha he rice elasiciy should be small because he inermediae goods are no roduced domesically, resuling in lile oenial for imor subsiuion. However, he huge surluses in rocessing rade ha have emerged since 2005 sugges ha firms have been able o source more inermediae goods from wihin he PRC. Thus he demand for imors for rocessing may have become more rice elasic in recen years. The IMF (2005) also argued ha imors for rocessing should vary one-for-one wih rocessed exors. Imors for rocessing should hus flow elasically ino he PRC in resonse o an increase in he demand for rocessed exors in he res of he world. Processed exors are herefore included as a righ hand side variable o exlain imors for rocessing. Since imors for rocessing are no inended for he domesic marke bu only for he assembly of rocessed exors, he referred secificaion below includes rocessed exors bu no PRC income. Foreign direc invesmen (FDI) flows and mulinaional cororaions (MNCs) also lay imoran roles in rocessing rade (see Gaulier, Lemoine, and Unal-Kesenci 2005). As discussed above, 84% of he PRC s rocessed exors in 2006 were roduced by foreigninvesed enerrises (Feensra and Wei 2009). FDI is hus included as a righ hand side variable. As Marquez and Schindler (2007) noed, he effec of FDI on imors could be osiive or negaive deending on wheher he invesmen generaes subsiuion effecs or comlemenary effecs. Following revious auhors (e.g., Garcia-Herrero and Koivu 2007), a World Trade Organizaion (WTO) dummy variable is included as a righ hand side variable. The PRC s WTO accession may have given foreign firms more confidence o ener ino longer-erm relaionshis wih PRC firms. Garcia-Herrero and Koivu (2007) osied ha he PRC s WTO accession began affecing he PRC s rade afer i became cerain ha he PRC would oin he WTO in he beginning of The WTO dummy variable is hus se equal o one beginning in For rocessed exors much of he value-added comes from imored inus, esecially inus roduced in oher Eas Asian counries. A generalized areciaion in Eas Asia would hus have a larger effec on he coss of he PRC s rocessed exors measured in he imoring counry s currency han a unilaeral areciaion of he CNY. A unilaeral areciaion would only change he relaive foreign currency cos of he PRC s value-added 6

11 in rocessed exors.5 An inegraed exchange rae is hus included ha weighs exchange rae changes in suly chain counries by he counries value-added in rocessing rade. 3.2 Consrucing an Inegraed Exchange Rae Following Tong and Zheng (2008), he PRC s value-added in rocessing rade can be measured as he difference beween he value of he PRC s rocessed exors (VPE ) and he value of imors for rocessing from all suly chain counries ( i VIP i, ): VA = ( VPE VIPi, ) / VPE = 1 VIPi, / VPE, Chin, i i (3) where VA Chin, equals he PRC s value-added in rocessing rade. Annual daa on he oal value of rocessed exors and he oal value of imors for rocessing is used o calculae he PRC s value-added. To calculae he value-added in suly chain counries his aer focuses on he nine leading roviders of imors for rocessing o he PRC. These are Germany, Jaan, he Reublic of Korea (hereafer Korea), Malaysia, he Philiines, Singaore, Taiei,China, Thailand, and he US. For hese suliers weighs ( w i, ) are calculaed by dividing heir conribuion o PRC imors for rocessing by he amoun of imors for rocessing coming from he nine maor suliers ogeher. These weighs are used o calculae a weighed exchange rae ( wrer, ) beween he PRC and each counry ha urchases rocessed exors from he PRC by calculaing he inner roduc of he weighs and he bilaeral real exchange raes beween he counries sulying imors for rocessing and counry : wrer w, = i, i rer i,,, (4) rer i where,, is he bilaeral real exchange rae beween suly chain counry i and counry urchasing he final rocessed exors. wrer The weighed exchange rae, is hen combined wih he bilaeral exchange rae rer Chin,, beween he PRC and counry ( ) o calculae a single inegraed exchange rae irer (, ) measuring how exchange rae changes affec he enire cos of he PRC s exors of rocessed goods o counry : irer = VA rer + 1 VA ) wrer. (5), Chin, Chin,, ( Chin,, To calculae irer in his way i is necessary o measure exchange raes using a common numeraire. This can be done by emloying he real exchange rae variables consruced by he Cenre D Eudes Prosecives e D Informaion Inernaionales (CEPII). The CEPII real exchange rae beween counries i and is calculaed by firs dividing gross domesic roduc (GDP) in US dollars for counry i by GDP in urchasing ower ariy (PPP) for counry i and doing he same for counry. The resuling raio for counry i is hen divided by he raio for counry. This variable measures he unis of consumer goods in counry i needed o buy a uni of consumer goods in counry. I can be comared across counries as well as across ime. Because i is comarable across counries, i can be used in equaion (2) o 5 This is rue assuming ha all of he PRC s imors for rocessing come from Asia. 7

12 calculae irer. Higher values of wrer and irer reresen sronger exchange raes in he PRC and in sulier counries. The oher indeenden variables are he PRC s caial sock in manufacuring, he sock of FDI, and a WTO dummy variable. Cheung, Chinn, and Fuii (2010) have found ha he PRC caial sock hels o exlain PRC exors. As discussed above, he FDI sock and he PRC s WTO accession may hel o exlain he increase in rocessing rade. The deenden variables are PRC imors for rocessing and PRC rocessed exors. These are obained from he PRC s Cusoms Saisics. Following Cheung, Chinn, and Fuii (2010), he Hong Kong, China o PRC re-exor uni value index is used o deflae he PRC s imors and he Hong Kong, China o US re-exor uni value index is used o deflae he PRC s exors. The daa are discussed in more deail in he Daa Aendix. 3.3 The Economeric Model Panel A of Table 2 reors he resuls from a baery of anel uni roo ess. 6 Column (1) resens he Im, Peseran, and Shin W-saisic, column (2) he asymoically disribuion free (ADF) Fisher Chi-square saisic, column (3) he Phillis-Perron Fisher Chi-square saisic, column (4) he Levin, Lin, and Chu -saisic, and column (5) he Hadiri heeroscedasic consisen Z-saisic. For he firs four ess, he null hyohesis is ha he variable has a uni roo while for he fifh es he mainained hyohesis is ha he variable is saionariy. In mos cases he resuls indicae ha he series have uni roos. Panel uni roo ess are no conduced for he series wih no cross-secional variaion (i.e., he PRC caial sock, PRC inward FDI, and PRC income). Panel B of Table 2 reors he resuls of he Kao residual coinegraion es. For boh he exor and he imor equaion he resuls indicae ha he null hyohesis of no coinegraion can be reeced. Panel dynamic ordinary leas squares (DOLS) esimaion, a echnique for esimaing coinegraing relaions, is hus emloyed. Table 2: Uni Roo and Coinegraion Tess Panel A. Uni Roo Tess Variable (1) (2) (3) (4) (5) Processed Exors ** 13.24** Imors for Processing ** 13.22** Inegraed Exchange Rae ** Res of World Income ** 12.45** (1) PP es Fisher Chi-square saisic (null hyohesis: uni roo) (2) Im, Pesaran, and Shin W-saisic (null hyohesis: uni roo) (3) ADF Fisher Chi-square saisic (null hyohesis: uni roo) (4) Levin, Lin, and Chu -saisic (null hyohesis: uni roo) (5) Hadiri Heeroscedasic Consisen Z-saisic (null hyohesis: saionariy) Noe: Lag selecion is based on he Schwarz Informaion Crierion. **denoes significance a he 5% level. 7 6 These ess are discussed in Breiung (2000), Choi (2001), Hadiri (2000), Im, Peseran, and Shin (2003), Levin, Lin, and Chu (2002), and Maddala and Wu (1999). 7 This es is discussed in Kao (1999). 8

13 Panel B. Kao Residual Coinegraion Tes Exor Equaion 7.17** Imor Equaion -3.18** (1) -saisic from Kao Residual Coinegraion es of he null hyohesis of no coinegraion.. Noe: Lag selecion is based on he Schwarz Informaion Crierion. **denoes significance a he 5% level. Source: Esimaion by he auhor. DOLS involves regressing he lef hand side variable on a consan, he righ hand side variables, and lags and leads of he righ hand side variables. The individual imor equaions have he form: im i, = β + β irer 10 α 11 1, rgd, = i, + β rgd 12 rgd C, + C, + β ex + β FDI + β WTO + α 13 1, ex, = ex 1, i, = 1,, T; i = 1,, N. Here im i, reresens real imors for rocessing from counry i o he PRC, irer i, reresens he inegraed real exchange rae, rgd C, equals real income in he PRC, ex reresens he PRC s oal real rocessed exors o he world, FDI denoes he sock of foreign direc invesmen, WTO is he WTO dummy variable, µ i is a counry i fixed effec, and reresens he number of leads and lags. im i,, irer i,, rgd C,, ex and FDI are measured in naural logs. im i, and irer i,, vary boh over ime and across counries and rgd C,, ex and FDI only vary over ime. The individual exor equaions have he form: 14 + α 15 1, FDI, = FDI α 1, irer, = irer + µ + u i i, + (6) ex i, = β 20 + β irer = α 21 2, rgd, i, + β rgd 22 rgd i, + i, 23 2, ex, K = 1,, T; i = 1,, N. + β K + β FDI + β WTO + = α 24 + = α 25 2, FDI, = FDI α 2, irer, irer + µ + u i i i,, + (7) Here ex i, reresens real rocessed exors from he PRC o counry i, irer i, reresens he inegraed real exchange rae, rgd i, equals real income in he imoring counry, K reresens he Chinese caial sock in manufacuring, FDI denoes he sock of foreign direc invesmen, WTO is he WTO dummy variable, µ i is a counry i fixed effec, and reresens he number of leads and lags. ex i,, irer i,, rgd i,, K and FDI are measured in naural logs. ex i,, irer i,, and rgd i, vary boh over ime and across counries and K and FDI only vary over ime. 9

14 Annual daa over he 1992 o 2008 eriod are used. One lead and lag is emloyed in he DOLS esimaion. 4. RESULTS Table 3 resens he resuls for imors for rocessing. The coefficiens on he exchange rae are osiive and saisically significan in every secificaion, indicaing ha an areciaion of he inegraed exchange rae will increase imors for rocessing. The coefficiens indicae ha a 10% areciaion of irer will increase imors for rocessing by beween 3.9% and 4.1%. Alhough no reored in Table 3, hese coefficiens remain virually unchanged if a rend erm is included Table 3: Panel DOLS Esimaes of he PRC s Imors for Processing From 25 Counries over he Period. Indeenden variables (1) (2) (3) (4) (5) CNY Exchange rae 0.41** 0.41*** 0.39** 0.40*** 0.42*** (0.16) (0.16) (0.16) (0.16) (0.16) PRC s Income -9.70*** (2.22) (2.01) (1.21) Processed exors *** 1.84*** 1.02*** (3.02) (0.07) (0.62) (0.08) FDI sock 21.27*** (4.86) (0.25) (2.06) (0.26) WTO dummy * *** (0.15) (0.09) (0.14) (0.08) Adused R-squared No. of observaions Noes: DOLS(1,1) esimaes. Heeroskedasiciy-consisen sandard errors are in arenheses. Imors are deflaed using he Hong Kong, China o PRC. re-exor uni value index. The daa exend from 1992 o Since he DOLS esimaion uses one lead and lag of he firs difference of he righ-hand side variables he acual samle eriod is from Counry fixed effecs are also included. *** (**) denoes significance a he 1% (5%) level. Source: Esimaion by he auhor. In he referred secificaions in columns (2) and (5) ha include rocessed exors bu no he PRC s income, he coefficiens on rocessed exors are close o uniy. These resuls suor he hyohesis of he IMF (2005) ha here is aroximaely a one-for-one relaionshi beween rocessed exors and imors for rocessing. The IMF (2005) also osied ha he exchange rae elasiciy for imors for rocessing should be small because here are few domesic subsiues. However, he evidence discussed in Secion 2, ha inerfirm ransacions by FIEs in he PRC are increasingly aking lace wih oher firms locaed in he PRC, suggess ha he exchange rae elasiciy may have increased in recen years. The exchange rae elasiciies reored in Table 3 are only significan when daa from are included. Fuure work should invesigae wheher imors for rocessing have become more sensiive o exchange rae changes over he las few years as he PRC has develoed more domesic subsiues o imored ars and comonens. Table 4 resens he resuls for rocessed exors. The coefficiens on he inegraed exchange rae are negaive and saisically significan in every secificaion, indicaing ha an areciaion in he PRC and oher suly chain counries will reduce rocessed exors. The coefficiens indicae ha a 10% areciaion across Eas Asia will reduce rocessed exors by beween 7.8 and 18.7%. Alhough no reored in Table 4, hese coefficiens remain highly significan when a rend erm is included. 10

15 Table 4: Panel DOLS Esimaes of he PRC s Processed Exors o 25 Counries over he Period Indeenden variables (1) (2) (3) (4) Inegraed exchange rae -0.79*** -1.20*** -0.78*** -1.87*** (0.16) (0.21) (0.16) (0.36) ROW Income 0.42** 1.64*** 0.44*** 3.08*** (0.18) (0.22) (0.15) (0.42) Caial sock 2.39*** 1.62*** (0.39) (0.11) FDI sock -1.01** 1.56*** (0.51) (0.28) WTO dummy *** *** (0.14) (0.17) (0.07) (0.12) Adused R-squared No. of observaions Noes: DOLS(1,1) esimaes. Heeroskedasiciy-consisen sandard errors are in arenheses. Exors are deflaed using he Hong Kong, China o US re-exor uni value index. The daa exend from 1992 o Since he DOLS esimaion uses one lead and lag of he firs difference of he righ-hand side variables he acual samle eriod is from Counry fixed effecs are also included. *** (**) denoes significance a he 1% (5%) level. Source: Esimaion by he auhor. The coefficiens on res of he world income are osiive and saisically significan in every secificaion, indicaing ha an increase in income in he res of he world will increase rocessed exors. The coefficien values equal abou 0.4 when he caial sock is excluded, and vary beween 1.64 and 3.08 when he caial sock is included. The coefficiens on he caial sock are also osiive and saisically significan in every secificaion. The coefficien values vary beween 1.62 and These values indicae ha a 10% increase in he Chinese caial sock would increase rocessed exors by beween 16 and 24%. These values are close o hose reored by Cheung, Chinn, and Fuii (2010). Table 5 resens he resuls for imors for rocessing using he yuan exchange rae as an indeenden variable insead of he inegraed exchange rae. The coefficiens on he exchange rae are osiive and saisically significan in every secificaion, indicaing ha an areciaion of he yuan will increase imors for rocessing. The coefficiens indicae ha a 10% areciaion of he yuan will increase imors for rocessing by beween 3.6 and 3.9%. 11

16 Table 5: Panel DOLS Esimaes of he PRC s Processed Imors From 25 Counries over he Period Indeenden variables (1) (2) (3) (4) (5) CNY Exchange rae 0.37** 0.36** 0.36** 0.37** 0.39*** (0.16) (0.16) (0.16) (0.16) (0.15) PRC s Income *** (2.12) (1.52) (1.79) Processed exors -3.92*** 0.91*** 2.01** 0.97*** (1.01) (0.03) (0.83) (0.06) FDI sock 22.95*** * (3.64) (0.10) (1.60) (0.16) WTO dummy 0.26** 0.19*** 0.21*** 0.25** (0.12) (0.05) (0.06) (0.12) Adused R-squared No. of observaions Noes: DOLS(1,1) esimaes. Heeroskedasiciy-consisen sandard errors are in arenheses. Imors are deflaed using he Hong Kong, China o PRC. re-exor uni value index. The daa exend from 1992 o Since he DOLS esimaion uses one lead and lag of he firs difference of he righ-hand side variables he acual samle eriod is from Counry fixed effecs are also included. *** (**) [*] denoes significance a he 1% (5%) [10%] level. Source: Esimaion by he auhor. Table 6 resens he resuls for rocessed exors using he yuan exchange rae insead of he inegraed exchange rae. The resuls indicae ha an areciaion of he CNY would reduce rocessed exors. The coefficiens on he yuan exchange rae are smaller ha he coefficens on he inegraed exchange rae. They average -0.77, comared wih an average of for he coefficiens on he inegraed exchange rae in Table 3. These resuls indicae ha an areciaion hroughou Asia would have a larger effec on rocessed exors han an areciaion of he yuan alone. Table 6: Panel DOLS Esimaes of he PRC s Processed Exors To 25 Counries over he Period Indeenden variables (1) (2) (3) (4) CNY Exchange Rae -0.68*** -0.95*** -0.71*** -0.74*** (0.14) (0.16) (0.13) (0.16) ROW Income 0.38** 1.62*** 0.38** 5.03*** (0.19) (0.26) (0.18) (0.39) Caial sock 2.51*** 1.94*** (0.33) (0.07) FDI sock -0.80* 2.16*** (0.42) (0.28) WTO dummy *** *** (0.10) (0.16) (0.05) (0.17) Adused R-squared No. of observaions Noes: DOLS(1,1) esimaes. Heeroskedasiciy-consisen sandard errors are in arenheses. Exors are deflaed using he Hong Kong, China o US re-exor uni value index. The daa exend from 1992 o Since he DOLS esimaion uses one lead and lag of he firs difference of he righ-hand side variables he acual samle eriod is from Counry fixed effecs are also included. *** (**) [*] denoes significance a he 1% (5%) [10%] level. Source: Esimaion by he auhor. 12

17 5. DISCUSSION PRC olicymakers have noed ha he PRC s rade surlus is oo large and needs o be rebalanced. The PRC s surlus in recen years has been concenraed in rocessing rade. How would an areciaion of Asian currencies or of he yuan alone affec he PRC s rocessing rade balance? The Marshall-Lerner condiion imlies ha if exors iniially equal imors an areciaion will reduce he rade balance if he sum of (he absolue values of) he demand elasiciies for exors and imors exceeds one. If he curren accoun is no iniially balanced i is necessary o emloy a general version of he Marshall-Lerner condiion (see Aleyard and Field 2001). This condiion saes ha an areciaion will reduce he rade surlus if: Z < α 21 + Z α 11 (8) where Z is he raio of exors o imors, α 21 is he rice elasiciy of imors, and α 11 is he rice elasiciy of exors. According o he PRC Cusoms Saisics, rocessed exors exceeded imors for rocessing over he las five years by a raio of 1.73 o 1. Z hus equals The coefficien α 21 in Table 3 averages Thus, inequaliy (8) imlies ha an areciaion of he inegraed exchange rae would reduce he rade surlus if he absolue value of he exor elasiciy is greaer han I is greaer han his in all four cases in Table 4 and averages This evidence indicaes ha a generalized areciaion in Asian suly chain counries would reduce he surlus in rocessing rade. In he case of a CNY areciaion alone, he coefficien α 21 in Table 5 averages Thus, according o (8), an areciaion of he yuan would reduce he rade surlus if he absolue value of he exor elasiciy is greaer han I is greaer han his in only one of he four cases in Table 4. Thus i is no clear han an areciaion of he yuan unaccomanied by areciaions in suly chain counries would reduce he surlus in rocessing rade. How could a oin areciaion hroughou Eas Asia be achieved? One way would be for he PRC o ado an exchange rae regime characerized by a mulile-currency, baske-based reference rae wih a reasonably wide band. In his case, he huge surluses generaed wihin Eas Asian roducion neworks would cause currencies in he region o areciae ogeher. Marke forces could hen allocae hese areciaions across suly chain counries based on heir value-added in rocessing rade. Even in he case of an exchange rae areciaion hroughou Asia, however, he exchange rae elasiciies in Tables 3 and 4 are no large. Thus he resuls in his aer imly ha exchange rae changes alone may no subsanially reduce he rocessing balance. To consider oher ways o reduce he surlus, i is helful o look a naional saving and invesmen in he PRC. These are loed in Figure 3. The figure shows ha saving and invesmen began diverging afer As he Asian Develomen Bank (ADB) (2009) reored, he shorfall of invesmen relaive o saving was driven by an increase in cororae saving in he PRC. I rose from 17% of naional disosable income in 2002 o 23% in

18 Figure 3: PRC's Saving and Invesmen as a % of GDP ( ) Percen of GDP Saving as ercen of GDP Invesmen as ercen of GDP Source: Inernaional Moneary Fund via CEIC daabase (h:// accessed Aril 16, Wha caused cororae saving o rise so raidly? The Asian Develomen Bank (2009) reored ha afer-ax cororae rofis rose by 6% of GDP beween 2003 and Par of his increase was due o raid economic growh and rising ouu rices ha increased he rofiabiliy of sae-owned enerrises (SOEs) and rivae firms. Since SOEs yically do no ay dividends, higher rofis direcly increase he firms gross saving. Several oher facors also conribued o high and rising saving raes among SOEs. Many have monoolies in various secors, such as China Mobile in elecommunicaions and China Naional Peroleum Cororaion in oil. As Xing (2009) discussed, he resuling monooly rofis conribues o high cororae savings, exraordinarily high comensaion among execuives a SOEs, and a skewed income disribuion. In addiion, as Huang (2009) documened, facor marke disorions rovided a subsidy o roducers of almos 2 rillion yuan (7% of GDP) in These subsidies include a yuan ha is undervalued, arificially low land rices and real ineres raes, adminisered rices for fuel and elecriciy, and environmenal laws ha are no rigorously enforced. These subsidies ransferred resources o he cororae secor and increased heir rofiabiliy. If hese subsidies were removed and PRC enerrises faced higher rices for resources, land, elecriciy, and oher iems, hen heir global comeiiveness would decline and his would reduce he roducion of radables in he PRC. Thus if olicymakers in he PRC wan o rebalance growh, exchange rae areciaions in Asia would robably have o be accomanied by oher changes. These include deregulaion, liberalizaion of facor markes, and he removal of olicy disorions ha favor he radables secor over he non-radables secor. 14

19 6. CONCLUSION PRC s egged exchange rae has caused roblems in he PRC and he res of he world. In he PRC i has inerfered wih he allocaion of credi by forcing commercial banks o hold increasingly large quaniies of cenral bank bills. In oher Asian counries he PRC s eg has caused cenral banks o inervene in currency markes and accumulae reserves in order o mainain comeiiveness agains he PRC. Many have hus argued ha he PRC should move o a more flexible exchange rae regime. This aer has invesigaed how he resuling exchange rae changes would affec he PRC s rade surlus. Since 2008 his surlus has been concenraed in rocessing rade. Processed exors are final goods roduced using ars and comonens coming rimarily from oher Asian counries. The resuls indicae ha an areciaion hroughou Asia would reduce he PRC s surlus in rocessing rade. An areciaion of he yuan alone may no reduce he surlus. One way for suly chain counries o have heir currencies areciae ogeher would be for he PRC o ado an exchange rae regime characerized by a mulile-currency, baskebased reference rae wih a reasonably wide band. In his case, he huge surluses generaed wihin Eas Asian roducion neworks would cause currencies in he region o areciae ogeher. Marke forces could hen allocae hese areciaions across suly chain counries based on heir value-added in rocessing rade. However, he fac ha he exchange rae elasiciies reored in his aer are no large suggess ha greaer exchange rae flexibiliy needs o be accomanied by oher olicies in order o rebalance growh. These include enforcing environmenal regulaions and liberalizing he markes for land, labor, fuel, and caial. Afer he PRC began liberalizing is roduc markes in he lae 1970s, growh exloded in a quaniaive sense. Liberalizing facor markes and fighing environmenal degradaion could similarly sark an exlosion of growh in a qualiaive sense. 15

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