China Economic Review 23 (2012) 763–775
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China Economic Review
Vertical trade and China's export dynamics ☆ Wei LIAO a, Kang SHI b,⁎, Zhiwei ZHANG c a b c
Hong Kong Institute for Monetary Research, Hong Kong, China Department of Economics, Chinese University of Hong Kong, Hong Kong, China China International Capital Corporation, China
a r t i c l e
i n f o
Article history: Received 27 March 2010 Received in revised form 14 October 2011 Accepted 26 March 2012 Available online 10 April 2012 JEL classification: F3 F4 Keywords: Vertical trade Exchange rates Export dynamics Currency invoicing
a b s t r a c t This paper examines how China's exports are affected by exchange rate shocks from countries that supply intermediate inputs to China. We build a simple small open economy model with intermediate goods trade to show that due to the intra-regional trade in intermediate goods, a devaluation of other Asian currencies does not necessarily hurt China's exports, as imported intermediate goods could become cheaper. The effect of intermediate goods costs depends critically on the share of intermediate goods used in China's export goods production and the degree of exchange rate pass-through in imported intermediate goods prices. If prices for intermediate goods are not very sticky, the effect through this channel could be large, and China's exports could even benefit. We find that these findings do not depend on China's choice of currency invoicing between the RMB and the US dollar or the choice between fixed and flexible exchange rate regimes. © 2012 Elsevier Inc. All rights reserved.
1. Introduction While the RMB/US exchange rate experienced limited volatilities in recent years, the volatilities between RMB and other Asian currencies have been very high. The Korean Won, for instance, depreciated against RMB by 40% from August 2008 to February 2009 before reversing the trend afterwards. A similar episode was observed during the Asian Financial Crisis in 1997–1998. How would the large movements of emerging Asia's currencies against the RMB affect China's exports? This paper attempts to address the question from a theoretical perspective. The conventional trade models are not capable of answering the question. This is because the trade in East Asia is to a large extent vertically integrated: China's exports contain a substantial amount of inputs imported mostly from other East Asian economies. This East Asian supply chain is particularly dominant in electronic products, as illustrated by Koopman, Wang, and Wei (2008). Conventional trade models do not consider vertically integrated trade. In such models, a devaluation of other countries' currencies would lead to a loss of competitiveness in China's exports as Korean and Chinese export goods compete in the world market — a direct channel which is the conventional wisdom. However, if China's exports use Korean inputs, a depreciation of the Korean Won could lower production costs for China's exports. If China's exports contain many imported inputs, this indirect channel could be large and might (partly) offset the direct channel. In other words, a depreciation of the Korean Won could even lead to higher competitiveness for Chinese exports. Such a channel seems straightforward, and it has been discussed informally in the academia and among policy makers, but there is no theoretical study on this issue.
☆ The views expressed in this paper are those of the author, and they do not necessarily reflect those of the Hong Kong Monetary Authority and China International Capital Corporation. ⁎ Corresponding author. E-mail addresses:
[email protected] (W. Liao),
[email protected] (K. Shi),
[email protected] (Z. Zhang). 1043-951X/$ – see front matter © 2012 Elsevier Inc. All rights reserved. doi:10.1016/j.chieco.2012.03.011
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Following Shi and Xu (2010), this paper sets up a dynamic general equilibrium model with vertical trade structure and studies how exchange rate shocks from other Asian economies affect China's exports. The main finding is that the effect depends critically on the share of intermediate goods in China's exports and the degree of exchange rate pass-through in intermediate goods prices. Intuitively, consider a company in China that uses imported LCD monitors from Korea to assemble computers and exports the computers to the US. Suppose the Korean Won depreciates against the RMB and the US dollar by 10%, and the RMB/US exchange rate remains unchanged. If the price for monitors in RMB terms declines substantially due to the depreciation of the Korean Won, (i.e., the degree of exchange rate pass-through is high), the production cost for the computers will decline, making China's computer exports more competitive. On the other hand, if the price for monitors barely changes in RMB terms, the depreciation of the Korean Won will have no effect on the competitiveness of Chinese computers. We also find that this conclusion holds even if the RMB/US exchange rate is flexible and China's exports become invoiced in RMB rather than in the US dollar. As long as China's import prices in RMB terms do not change much in response to the changes in the RMB exchange rates, such exchange rate shocks will not affect the competitiveness of Chinese exports through the costcutting channel. These findings are important for the discussion on global imbalance. The appreciation of RMB has been advocated by many as a solution to the global imbalance, but how much appreciation is needed to stabilize the trade balance in China? As the imported contents in China's exports are high, even a large appreciation of RMB will not affect exports by much. However, will a collective appreciation of the RMB and other Asian currencies be more effective in restoring global imbalance? The findings in this paper show that the answer depends on to what extent prices for intermediate inputs of China imports are flexible. If these prices are flexible, China's exports will indeed become less competitive if other Asian currencies appreciate against RMB. Note that price flexibility is not the same as currency invoicing. Even if all intermediate goods are priced in the US dollar, their values could still change quickly as the exchange rate moves. How much do we know about the degree of exchange rate pass-through for intermediate goods prices? There is limited research on this issue, but anecdotal evidence suggests that prices could be quite flexible for intermediate goods in Asia. Prices for many computer parts are available on a daily basis in major technology parks in China, 1 but it is not clear how much they change when exchange rate shocks take place. Empirical research on this issue warrants more attention. This paper is related to the literature on the exchange rate and Chinese economy. However, most literature focuses on empirical investigation. For example, Baak (2008) studies how the bilateral real exchange rates between China and the US affect bilateral trade. According to the estimation of cointegration vectors, 1% depreciation of the RMB raises Chinese exports to the US by 1.7%, whereas 1% depreciation of the US dollar raises the US exports to China by around 0.4%. Xing (2006) investigates the role of China's exchange rate policy in its foreign direct investment boom and finds that the devaluation of the RMB substantially enhances the inflows of direct investment from Japan. Hua (2007) finds that there exists statistically significant negative effect of the real appreciation of the RMB on manufacturing employment using panel data of 29 Chinese provinces for the period 1993–2002. Recently, Ahmed (2009) studies the effect of East Asian currency exchange rates on China's exports and found some mixed evidence for linkage between the two. Our paper differs from their studies in that ours is a theoretical work, which emphasizes the importance of intra-regional trade in explaining export dynamics. 2 Our paper is also closely related to some works on intermediate goods trade and monetary policy (Devereux & Engel, 2005; Huang & Liu, 2006; Shi & Xu, 2007). These papers, however, focus on the effect of intermediate goods trade on monetary policy, whereas our paper concentrates on the effects of intermediate goods trade on export dynamics. This paper is organized as follows. Section 2 presents some stylized facts about vertically integrated trade in East Asia. Section 3 lays out the model. Section 4 discusses the export dynamics in response to an exchange rate shock. Section 5 concludes. 2. Vertically integrated trade in East Asia A large portion of trade in East Asia is vertically integrated, as China imports intermediate inputs from other economies in the region, assembles them into final goods, and exports them to overseas markets. 3 One way to quantify the importance of the vertical trade is to look at the share of processing exports in China's total exports. 4 In 2008, 47% of China's exports are classified as processing exports, i.e., they use imported intermediate inputs (Fig. 1). The share was above 50% in previous years. How much imported inputs are embedded in the processing exports? The answer is about 56% in 2008. The imported contents in processing have been declining in recent years as more parts and components are made in China. Nonetheless, vertical trade is still an important part of China's exports, as imported intermediate goods account for 26% of China's exports (Fig. 2). Imported intermediate inputs for processing trade are mostly from East Asia. The Chinese authorities do not report how much imports from each country are used as inputs for processing trade. To find out the sources of processing imports, we rely on a firm-level database that covers all import and export transactions for every firm that operates in China from 2003 to 2005. The 1
Some prices are available at www.zol.com.cn. In terms of regional trade, Cook and Devereux (2006) argues that the practice of setting export goods prices in dollars led to a powerful internal propagation effect of the Asian crisis within the region, contributing greatly to the decline in regional trade flows. However, their model does not capture the vertical trade structure in East Asia, which is the focus of our paper. 3 Gaulier et al. (2007) argue that the emergence of China has intensified the international segmentation of production processes within Asia, but it has not created an autonomous engine for the region's trade, as Asia still depends on outside markets for its final goods exports. 4 Processing exports are defined as exports that use imported intermediate inputs. The Customs in China classify each import and export transaction into processing and non-processing categories. Imported intermediate inputs for processing trade purpose are eligible for import tax rebates. 2
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USD bn 1600 1400 Non-processing Exports
1200 Processing Exports
1000
753.9 600.7
800
458.8
600
345.6 265.4
400 200 0
145.7
196.6
180.0
241.8
328.3
2002
2003
2004
416.7
510.6
2005
2006
617.5
675.3
2007
2008
Source: CEIC. Fig. 1. Processing and non-processing exports from China.
0.70 0.68 0.66 0.64 0.62 0.60 0.58 0.56 0.54 0.52 0.50 2002
2003
2004
2005
2006
2007
2008
Source: CEIC. Fig. 2. Imported contents in processing exports.
details of the database are discussed in Manova and Zhang (2008). Fig. 3 illustrates the breakdown by source countries for imported inputs in 2005. Japan, Korea, Taiwan, Hong Kong, and ASEAN economies provided 67% of imported inputs, whereas the US and Euro area only accounted for 11%. 5 The imported inputs for processing trade are concentrated in the sectors of electronics and machinery, which account for 57% of the total (Fig. 4). This finding is consistent with anecdotal evidence that the East Asian supply chain in the electronics business is highly fragmented across countries. It is also consistent with Koopman et al. (2008), who find that the domestic value added in China's exports of electronic products is low. According to their estimates, only 8.2% of China's exports of electronic computers are actually made in China. There is a clear production network in East Asia with China as the assembly point, and with inputs coming mostly from other economies in the region. Intuitively, this type of trade structure indicates that exchange rate shocks that occur in other East Asian economies may have implications for the costs of China's exports. The next section employs a theoretical model to study this issue.
3. Basic model To investigate quantitatively the effect of other countries' currency fluctuation on China's export dynamics when vertical trade presents, we build a small open economy model following Shi and Xu (2010). There are three economies: the domestic country (A or China) which is of our interest, other Asia economy (B or Korea), and the world market (C or the US). For simplicity, we model
5 Two issues about Fig. 3 warrant some explanation. First, 13% of imported inputs are from China itself. This is (at least partly) because some firms sell their intermediate products to Hong Kong, and these products were imported into China as inputs for processing trade. Second, the inputs from the US and Euro area could be underestimated. For instance, computer CPUs from the US are exported to Taiwan and assembled into a motherboard, which could be exported to China and assembled into a computer. In our database, the CPUs would be counted as imports from Taiwan instead of the US. However, the size of this estimation bias should not be large.
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US 5%
Others 9%
Euro Area 6%
ASEAN 13% Japan 18%
Hong Kong 3%
Taiwan 18%
China 13% Korea 15%
Source: Authors’ estimates. Fig. 3. Sources for imported inputs in China's processing trade, 2005.
Others 21%
Chemicals 3% Textiles 5%
Electronics and Machinery 57%
Metals 7% Plastics/Rubber 7%
Source: Authors’ estimates Fig. 4. Imported inputs by products, 2005.
country B as the intermediate goods supplier to country A's traded-goods sector, 6 and country C is the destination of country A's exports. Domestic agents consume the home-produced non-traded goods and the imported foreign goods from country C. There are three types of agents in the domestic economy: consumers, firms, and a monetary authority. Domestic households determined their consumption, labor supply, and how much to borrow or lend from domestic and international financial markets. The monetary authority sets a domestic interest rate targeting rule, which can be used to represent the exchange rate regime. There are two sectors in this small open economy: the non-traded goods sector and the traded goods sector. Firms in these two sectors produce differentiated goods and therefore can set prices. Moreover, all firms face costs of price adjustments. Nontraded firms produce output using only labor, whereas export goods are produced by combining labor and import intermediates, which are imported from country B. Our model departs from that of Shi and Xu (2010) in two aspects. 7 First, they assume that the traded sector is competitive and takes the world price of traded goods as given, whereas we assume that the traded goods
6 As China has become an export platform for the rest of Asia, the increase in China's export to the US (at least in some industries) may imply less export to the US from other Asian countries. Such interaction between China and other Asian countries may affect the big picture of global imbalance. In this paper, we do not explicitly model the rest of Asia and its interaction with China, because our main focus is to study how the fluctuation of other currencies affects China's export dynamics when the vertical linkage is present, instead of its implication for global imbalances. As long as country B sets the intermediate goods prices and competes with China on the US market, our model can evaluate the effects of these two channels. 7 Shi and Xu (2010) study the implication of exchange rate pass-through to intermediate goods price for business cycle dynamics in a small open economy model characterized by vertical trade.
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producers in country A are also monopolistically competitive. This gives export firms monopoly power to set the prices so that we can investigate if the currency of export pricing matters in export dynamics. Second, the demand for country A's export goods is affected by the fluctuation of country B's currency, which captures the competition effect on the world market. Our model also has an important feature, i.e., export goods are priced in foreign currency (the US dollar), which is consistent with the observation in China. We assume that the Chinese exchange rate is S A, which is the RMB price of the US dollar; the Korean exchange rate is S B, which is the Korean Won price of the US dollar. Therefore, we have S A = S ABS B, where S AB is the RMB price of the Korean Won. In the model, we consider S B as an external exchange rate shock. The detailed structure of the economy is described below. Where appropriate, foreign currency C (dollar) prices are indicated with an asterisk. 3.1. Households The representative household has the following utility function: " # 1−ρ 1þψ ∞ X Ls s−t C s EU ¼ Et −η β 1−ρ 1þψ s¼t
ð3:1Þ
where Ct is the aggregate consumption; Lt is the labor supply; β is the discount factor; ρ is the inverse of the elasticity of intertemporal substitution; and η is a scale parameter for the disutility of the labor supply; and ψ is the elasticity of labor supply. The consumption index, C, is defined as C t ¼
1 α α ð1−α Þ1−α
α C 1−α Nt C Ft , where CN is the aggregate non-traded goods, CF is the
consumption of foreign goods, 8 and α is the share of imported foreign goods in the total consumption expenditure of domestic 1−α α households. Given the consumption index, the consumer price index for domestic households can be derived as Pt = PNt PFt, where PN and PF are the prices of domestic non-traded goods and imported foreign goods, respectively. The households' budget constraints for households are ϕ 2 þ 1 þ i S D þ ð1 þ i ÞB ¼ W L þ Π þ S D þ B : ð3:2Þ P t C t þ P t D Dtþ1 −D t t t t t t t t t tþ1 tþ1 2 The households' revenue flow in any period comes from the wage income, WtLt, profits from both the non-traded sector and the traded sector, Πt, and the new loan from the domestic market and international capital market. The expenditure includes consumption, debt repayments from the last period, (1 + it*)StDt + (1 + it)Bt, and portfolio adjustment costs. We assume that trade in international bonds is subject to portfolio adjustment costs. If the household borrows an amount, Dt + 1, then the adjustment 2 , where D is an exogenous steady–state level of net foreign debt. cost will be ϕ2D Dtþ1 −D The household optimal conditions can be characterized by the following conditions: " # 1 ϕD P t C ρt P t Stþ1 ¼ βE 1− D − D ð3:3Þ tþ1 t 1 þ itþ1 St C ρtþ1 P tþ1 St 1 CρP ¼ βEt ρ t t 1 þ itþ1 C tþ1 P tþ1 ψ
ρ
W t ¼ ηLt P t C t :
! ð3:4Þ ð3:5Þ
Eqs. (3.3) and (3.4) represent the Euler equations for the foreign and domestic bond holdings, respectively. Eq. (3.5) is the labor supply equation. Combining Eqs. (3.3) and (3.4) gives the interest rate parity condition for this economy. 3.2. Firms 3.2.1. The non-traded goods sector The non-traded sector is monopolistically competitive, and it contains a unit interval [0,1] of firms indexed by j. Each firm j produces a differentiated non-traded goods, which is an imperfect substitute for each other in the production of composite goods, YN, produced by a representative competitive firm. Aggregate non-traded output is defined using the Dixit and Stiglitz function λ λ−1 λ−1 , where λ is the elasticity of substitution between differentiated non-traded goods. Therefore, the demand Y Nt ¼ ∫10 Y Nt ðjÞ λ dj −λ Y Nt , where the price index for composite non-traded for each individual non-traded goods, j, can be derived as Y Nt ðjÞ ¼ PPNtNtðjÞ 1 1−λ : goods, PNt, is given by P Nt ¼ ∫10 P Nt ðjÞ1−λ
8 In reality, China also imports a substantial amount of manufactured goods from other Asian countries. The depreciation of the Asian currency may potentially increase China's import from those countries, which may have a substitution effect on China's demand for US goods or domestically produced non-traded goods. Nevertheless, in this paper we focus on the export dynamics, which depends critically on factors affecting the activities of the export sector, such as the competition effect and the cost-cutting effect. In other words, it is determined by the production side of the Chinese economy. Hence, how the consumption basket is modeled in the paper will not affect the export dynamics. For simplicity, we assume that all foreign consumption goods are imported from the US only.
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Each monopolistically competitive firm has a linear production technology: Y Nt ðjÞ ¼ LNt ðjÞ:
ð3:6Þ
We follow Rotemberg (1982) in assuming that each firm bears a small direct cost of price adjustments. As a result, firms will only adjust prices gradually in response to changes in demand or marginal cost. Non-traded firms are owned by domestic households. Thus, a firm maximizes its expected profit stream, using the household's marginal utility as the discount factor. We can define the objective function of the non-traded firm, j, as follows: Et
∞ X l¼0
ϕP ðjÞ−P Ntþl−1 ðjÞ 2 P l β Γ tþl P Ntþl ðjÞY Ntþl ðjÞ−MC Ntþl Y Ntþl ðjÞ− N P tþl Ntþl ; 2 P Ntþl−1 ðjÞ
ð3:7Þ
where Γ tþl ¼ P 1C σ is the marginal utility of wealth for the representative household, MCNt = Wt represents the marginal cost for tþl tþl non-traded firm j, and the third term inside the parentheses describes the cost of price adjustment incurred by firm j. As all non-traded goods firms are alike, after imposing symmetry, we can write the optimal price setting equation as follows9: ϕP N P t P Nt λ P Nt MC Nt − P Nt ¼ −1 λ−1 λ−1 Y Nt P Nt−1 P Nt−1 ð3:8Þ ϕP N Γ tþ1 P tþ1 P Ntþ1 P Ntþ1 Et β þ −1 : λ−1 Γ t Y Nt P Nt P Nt When ϕPN = 0, firms simply set prices as a markup over the marginal cost. In general, however, the non-traded goods price follows a dynamic adjustment process. 3.2.2. The traded goods sector It is assumed that there is a unit interval [0,1] of firms indexed by i in the traded goods sector as well. Each firm, i, in this sector λ λ−1 λ−1 sells differentiated export goods, and the aggregate traded goods is given by Y Tt ¼ ∫10 Y Tt ðiÞ λ di : 10 However, export firms face the world market and use different production technologies. Each monopolistically competitive firm i imports intermediate goods from country B to produce differentiated goods, and it re-exports its output to the US market. The production function of the export firm, i, is given as follows Y Tt ðiÞ ¼
LTt ðiÞ αT IMt ðiÞ 1−αT αT 1−α T
ð3:9Þ
where αT is the share of labor in the traded goods production. Then, the marginal cost, MCTt, is given by MCTt = (Wt) αT(Pm) 1 − αT, where Pm is the domestic price of intermediate goods. It is set by intermediate goods firms from country B. Each traded firm, i, sets prices in a way similar to the non-traded goods firms, but the export prices are set in terms of the US dollar. Thus, the firm's profit maximization problem is given by: " !2 # ∞ X ϕP P ðiÞ−P TFtþl−1 ðiÞ l Et β Γ tþl St P TFtþl ðiÞY TFtþl ðiÞ−MC Ttþl Y TFtþl ðiÞ− T P tþl TFtþl ; ð3:10Þ P TFtþl−1 ðiÞ 2 l¼0 subject to Y TFt ðiÞ ¼
P TFt ðiÞ −λ Y Tt , P Tt
* where PTFt + l(i) and YTFt + l(i) represent the dollar prices and the output of traded goods firm, i,
which sets its price in dollar. YTt represents the aggregate output of domestically produced traded goods, which is given by11 Y Tt ¼
P Tt P asiat
−1
Xt :
ð3:11Þ
For simplicity, we assume Pasiat = (Sbt) − ω, where ω b 1 measures the sensitivity of aggregate Asia export to the change in currency B. Finally, Xt is the demand from the US market. * is given as follows: The optimal price setting equation for PTFt ϕPT 1 P t P TFt λ MC Tt P TFt − −1 P TFt ¼ λ−1 St λ−1 St Y TFt P TFt−1 P TFt−1 " # ð3:12Þ ϕP T 1 C ρt P t P tþ1 P TFtþ1 P TFtþ1 Et β þ −1 : ρ St C tþ1 P tþ1 Y TFt P TFt λ−1 P TFt where YTFt = YTt in a symmetrical equilibrium. 9 When the pricing equation is linearized, the Rotemberg-type pricing is equivalent to the standard Calvo-type pricing. This finding implies that, we can choose the value of ϕPN to match the dynamics of price under Calvo pricing. 10 The empirical finding in Kang (2008) shows that China's export structure has been rapidly shaped into differentiated products. 11 This implies that the elasticity of substitution between domestic goods and foreign goods is unitary, which is the standard assumption in the international macroeconomic literature. For example, see Devereux and Engel (2003).
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3.3. Prices of imported consumption goods and intermediate goods To determine the domestic prices of imported consumption and intermediate goods, we will allow for the possibility that there is some delay between movements in the exchange rate and the adjustment of imported consumption and intermediate goods prices. Without loss of generality, we assume that the domestic prices are adjusted in the same manner as prices in the non-traded goods sector. That is, in the face of exchange rate changes, foreign export firms, which adjust the local currency (RMB) price of their goods, are subject to a price adjustment cost. Therefore, these price adjustment costs will determine the degree of exchange rate pass-through to imported consumption prices and intermediate input prices. Finally, it is assumed that the intermediate goods are also differentiated with elasticity of substitution, λ, across varieties. Thus, the problem of a foreign (Korean) intermediate goods firm that sets intermediate goods prices can be described as follows:
∞ X ϕP P ðiÞ−P Mt−1 ðiÞ 2 P Mt ðiÞ t E0 β −W t IMt ðiÞ− M Mt ; AB P Mt−1 ðiÞ 2 St t¼0 −λ I Mt is the demand where Wt* can be considered the marginal cost of imported inputs in terms of foreign currency, I Mt ðiÞ ¼ PPMtMtðiÞ for import intermediate goods, i, and IMt is the total demand for import intermediates of the domestic country. For simplicity, we assume λ that the foreign currency price of inputs is P Mt ¼ λ−1 W t . Thus, the imported input price faced by domestic traded firms is given by ϕP M 1 P Mt P Mt −1 P Mt ¼ SAB t P Mt − λ−1 IMt P Mt−1 P Mt−1 ð3:13Þ ϕP 1 P Mtþ1 P Mtþ1 −1 : þ M Et β IMt P Mt λ−1 P Mt The interpretation of Eq. (3.13) is that the foreign firm would like to charge the same price in the Chinese market as its home market. However, it incurs quadratic price adjustment costs, and unless ϕPM = 0, it will move its price only gradually towards the desired price. The higher these adjustment costs are, the lower the degree of exchange rate pass-through into the domestic imported intermediate goods prices. Given the assumption that the imported consumption goods are also differentiated with elasticity of substitution, λ, across varieties, we can derive the domestic price of imported consumption goods similarly: 1 P Ft P Ft −1 λ−1 T Mt P Ft−1 P Ft−1 ϕP F 1 P Ftþ1 P Ftþ1 Et β þ −1 ; T Mt P Ft λ−1 P Ft
P Ft ¼ SP Ft −
ϕP F
ð3:14Þ
* is the dollar price of consumption goods in the US market, and T where PFt Mt is the demand for the foreign consumption goods. Similarly, the parameter ϕPF determines the degree of exchange rate pass-through to imported consumption goods prices. * and P * are constant over time and are normalized as unity. In our model, for simplicity, we assume that PMt Ft
3.4. Monetary policy rules The monetary authority uses a short-term domestic interest rate as its monetary instrument. 12 The general form of the interest rate rule can be written as 1 þ itþ1 ¼
μ μ πnt πn St S ð1 þ ı Þ: π n S
ð3:15Þ
The parameter μπn allows the monetary authority to control the inflation rate in the non-traded goods sector around a target rate of π n . μS controls the degree to which the monetary authority attempts to control variations in the exchange rate, around a The general form of the interest rule (3.15) allows for two types of monetary policy stances. The first rule is one in target level of S. which the monetary authority targets the inflation rate of non-traded goods (NTP rule), thus, μπN → ∞. This rule is analogous to a domestic inflation targeting rule. The exchange rate is flexible under such rule, thus, this rule implies a flexible exchange rate 12 In fact, China uses multiple monetary policy instruments, including benchmark lending rates and deposit rate, along with the conventional instruments, such as required reserve ratio, interest rate for excess reserve, and open market operations. As Goodfriend and Prasad (2007) points out, there is no simple formula for China's monetary policy rules. Nevertheless, one important feature of China's monetary policy regime is the quasi-fixed exchange rate prior to 2005 and the increasing exchange rate flexibility of RMB against the US dollar since July 2005. Thus, we should take that into consideration when we model the monetary policy in China. Although using a single monetary rule to represent China's monetary policy is difficult, the Taylor-type interest rate rule specified in our model has the merit of being general enough to include both the flexible exchange rate and the fixed exchange rate regime, which seems to be the appropriate way to model monetary policy regime in China. Moreover, because of continuous reform in the financial sector, the interest rate has been playing a more and more important role in the monetary policy conduct in China. Finally, it is standard in the literature to use the interest rate targeting rule to model the exchange rate regime in a small open economy.
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regime. The second rule is a simple fixed exchange rate rule (FER rule) by setting μs → ∞, in which the monetary authority adjusts interest rates to keep the nominal exchange rate fixed at the target level of S. 3.5. External exchange rate shocks In the model, the only uncertainty the small open economy faces is the exchange rate changes of currency B, which follows ð3:16Þ log Sbtþ1 ¼ ρs logðSbt Þ þ t : where 0 b ρs b 1 and t is an i.i.d. shock. 3.6. Equilibrium In equilibrium, aside from the optimal conditions for firms and households, we have the following labor market, goods market, and bonds market clearing conditions: LNt þ LTt ¼ Lt ; ð3:17Þ −1 Wt Y Tt . The market clearing conditions for non-traded goods, imported consumption goods, export goods, and where LTt ¼ α T MC Tt intermediate goods are given by Y Nt ¼ ð1−α Þ
ð3:18Þ
Pt Zt ; P Ft
ð3:19Þ
P asia X; P Tt t
ð3:20Þ
TMt ¼ α Y Tt ¼
Pt Zt ; P Nt
P M −θ IM t ¼ ð1−α T Þ Y Tt ; MC Tt
ð3:21Þ
where Zt is the aggregate expenditure, which includes consumption, international bond adjustment cost, and price adjustment cost for traded and non-traded firms. 2 2 1 P Nt 1 P 1 2 Z t ¼ C t þ ϕpN −1 þ ϕpT TFt −1 þ ϕD Dtþ1 −D ð3:22Þ 2 2 2 P Nt−1 P TFt−1 In equilibrium, the representative household's domestic bond holding is Bt = 0. Therefore, using Eq. (3.22), we can rewrite the household's budget constraint as St P Tt Y T t −αP t Z t −P m IMt þ St Dtþ1 − 1 þ it St Dt ¼ 0:
ð3:23Þ
This is a balance of payment condition, where trade surplus will be affected by imports for both consumption goods, αPtZt, and intermediate inputs, StPmIMt. 4. Export dynamics 4.1. Calibration The parameters that need to be calibrated in our model are listed in Table 1. The coefficient of risk aversion, ρ, is set to 2, as is commonly assumed in the literature. The discount factor, β, is calibrated at 0.99, so that the steady-state annual real interest rate is 4%. The elasticity of labor supply, ψ1 , is set to unitary. The elasticity of substitution across individual export goods λ is chosen to be 11, which implies a steady-state markup of 10%. ω is set to 0.08, which approximately equals the market share of country B (Korea) in the total Asian market. We set αT = 0.3, making the share of labor in the production of trade goods close to the estimation in previous studies. 13 However, we will vary the value of αT in the experiment. α is set to 0.22 so that the import share (including goods consumption and intermediates) of GDP is about 0.3, which is consistent with China's import data. 13 Our model currently does not include domestically produced non-labor inputs and the intermediate goods inputs imported from countries whose currencies do not experience devaluation, both of which may lead to an over-estimation of the cost effect when the model is applied in empirical studies. However, our focus here is to provide a theoretical framework to help understand what may be important for the China's export dynamics. It is easy to extend the model to incorporate these features. For example, the “labor” in our model can be interpreted as all domestic inputs other than imported inputs. In the simulation exercise, we will conduct an experiment with different shares of imported intermediate goods in China's exports to see how it affects the results.
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Table 1 Calibration parameters.
Household
Firm
Shock
Parameter
Target
β = 0.99 ρ=2 α = 0.22 ψ=1 ϕD = 0.0007 αT = 0.3 λ = 11 ϕP N = ϕP T = 4 ω = 0.08 ρs = 0.5, σ = 0.1
Quarterly data, annual interest rate 0.04 Elasticity of intertemporal substitution (0.5) China's import share of GDP (0.3) Elasticity of labor supply (1) Curtis and Mark's (2011) calibration for China Share of intermediate goods in production 10% markup, standard in literature Price adjustment probability (0.75) Export share of Korea in Asian economies Authors' estimation
To determine the degree of nominal rigidity in the model, we set the parameters governing the cost of price adjustment in the non-traded goods sector and the traded goods sector as ϕPN = 4 and ϕPT = 4, respectively, giving us an implied Calvo price adjustment probability of approximately 0.75. This probability is consistent with the standard estimates used in the literature that prices usually adjust on average after four quarters. Similarly, we also set ϕPF = 4 and ϕPM = 4 in our benchmark model, but we will vary their values in the experiment. Regarding the parameter governing the bond adjustment cost, we set ϕD = 0.0007, following the calibration of Curtis and Mark (2011) for the Chinese business cycle. For the stochastic process of external exchange rate, we assume ρs =0.5 and σ =0.1, which imply that the shock is 10 percentage change and lasts for about 1 year. In our numerical exercise, we set μπN =900 and μs =900 for the NTP rule and the FER rule, respectively. 4.2. Dynamics
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In this subsection, we analyze the responses of the economy to a foreign exchange rate shock Sbt under both fixed exchange rates and flexible exchange rates. The impulse responses of the variables in Figs. 5–8 are reported in terms of percentage change from their steady-state values under a 10% shock to Sbt.
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The effect of the depreciation of the Korean Won on China is different, depending on the degree of vertical trade integration between China and Korea. The more imported contents are in China's exports, the more the exporters benefit from the depreciation of the Korean Won, if prices for intermediate goods are flexible. To illustrate this point, we report the impulse response of various economic variables to an exchange rate shock under three scenarios. Under all three scenarios, we assume that the Korean Won depreciates against the US dollar by 10%, and that the RMB/US exchange rate remains constant. We also assume that the prices for intermediate goods are not very sticky, indicating that the exchange rate pass-through from an exchange rate shock to intermediate goods prices is large. In the first scenario, we assume that imported intermediate goods account for 20% of China's exports. In the second scenario, the ratio rises to 70%. In the third scenario, the ratio rises further to 100%. The results are shown in Figs. 5. The impulse response functions show that the share of intermediate goods in the export goods production is crucial in determining how the final goods exports respond to an external exchange rate shock. When imported intermediate goods account for 20% of exports, China's exports drop slightly following the exchange rate shock. As the share of imported intermediate goods in China's exports rises, the effect of the exchange rate shock on China's exports changes direction. In the extreme case that αT = 0, thus the intermediate goods share is 100%, China's exports can climb up to nearly 6% initially when the other currency depreciates by 10%. The above findings hold when the home country is under the flexible exchange regime, although the effect of the exchange rate shock on China's exports becomes smaller. We estimate the three scenarios again with a flexible exchange rate regime in China. The results are shown in Fig. 6. Take the extreme case (the intermediate goods share in the final goods production is 100%) as an example. When China follows a fixed exchange rate regime, China's exports rise by 6% following the Korean Won depreciation (Fig. 5). When China follows a flexible exchange rate regime, China's exports rise by 5% (Fig. 6). The reason behind the difference is intuitive. As the RMB exchange rate becomes flexible, RMB appreciates about 2.2% against the US dollar, which partly offsets the gains from the depreciation of the Korean Won. So far, the findings depend on a critical assumption: prices for intermediate goods are not very sticky so that exchange rate pass-through is large. What happens if the prices for intermediate goods are sticky? We also report the impulse response functions for the extreme case scenario (the intermediate goods share in the final goods production is 100%) and introduce price stickiness to intermediate goods. The value of parameter ϕPM shows how fast the intermediate goods price is adjusted to the exchange rate shock. Higher value of ϕPM implies slower price adjustment. We set ϕPM = 160 instead of 4 in this case. The results
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W. Liao et al. / China Economic Review 23 (2012) 763–775
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Fig. 7. Impulse response to exchange rate shock under fixed exchange rates( αT = 0, ϕPm = 160).
are shown in Fig. 7. Comparing Figs. 5 and 7, the only difference in the assumptions is intermediate goods flexibility, and the responses of exports to the Korean Won depreciation are quite different. When prices are stickier, China's exports drop initially after the exchange rate shock. The impulse responses in Fig. 7 are similar to those in Fig. 5 when trade is not vertically integrated. This finding is intuitive as price stickiness essentially shuts down the price transmission channel through intermediate goods. Therefore, China's exports cannot benefit from a depreciation of the Korean Won. The above analysis shows that due to the vertical trade, China's export may benefit from the devaluation of other Asian foreign currencies. This argument also seems to be consistent with the observation during the 1997 Asian Financial Crisis. During the crisis period, most Asian countries experienced large nominal depreciation against the US dollar, whereas the Dollar/RMB exchange rate remained relatively stable. According to our estimation in the Technical Appendix, the Asian currencies experienced a negative shock with a magnitude of around 20% against the US dollar in the fourth quarter of 1997. If we detrend the quarterly data of China's export to the US market from 1994Q1 to 2000Q4, we can find that, on average, China's export was 1.4% above its trend in the first year after 1997Q4 when the crisis began. This finding implies a steady increase in China's exports to the US market, instead of a decline as predicted by the conventional trade theory. To see if the export response of China implied by the model is consistent with the data, we calibrate the shock to the currency devaluation during the Asian Financial Crisis. To conduct such experiment, we set αT =0.3. This is because the imported content in China's processing trade is close to 70% before 2002. Meanwhile, we set ω=0.3, which is higher than our previous calibration value. This revision is performed as now country B in fact represents a group of Asian countries. Our numerical results show that, on average, China's export would increase by 1.87% in the first year. Noted that in the data, only half of China's export is classified as processing trade, but for simplicity, we only consider the processing trade in our model. This implies that, roughly, the total export would increase by 0.93%. That is, the vertical trade channel in our model can account for about 60% of the increase in China's export during the Asian Financial Crisis. 4.3. Effects of RMB internationalization The Chinese authorities have been actively promoting RMB internationalization and RMB trade invoicing. What happens if China's trade is priced in RMB instead of the US dollar? We find that our findings in the previous section do not change when exports are
W. Liao et al. / China Economic Review 23 (2012) 763–775
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Fig. 8. Impulse response to exchange rate shock under flexible exchange rates and RMB pricing.
priced in RMB and China follows a fixed exchange rate regime. To illustrate this point, we estimate the impulse responses under the extreme scenario in the previous section and change the currency invoicing of China's exports from the US dollar to RMB. Under fixed exchange rate regime, the currency invoicing does not matter in our exercise. This is not surprising because effective RMB pricing and US dollar pricing will be equivalent in terms of transmission of shocks in this model if the two are pegged. Does the exchange rate regime make a difference in our exercise? In Fig. 8, we find that the difference is marginal. Under the extreme case scenario, where China relies fully on imported intermediate goods to produce the final goods, if the RMB/US exchange rate is flexible, the depreciation of the Korean Won will cause China's export to increase by 6% when all the goods are priced in RMB, which is slightly higher than the 5% increment when the goods are priced in US dollar, as shown in Fig. 6.
4.4. Discussion The focus of this paper is to look into the dynamics of export in the face of foreign currency shock. For simplicity, we do not model country B explicitly. However, the devaluation of a third country's currency should have more than the direct competition effect and indirect cost-cutting effect on the export. For instance, the depreciation of the Korea Won can also reduce Korea's demand for Chinese goods. As the size of the Korea economy is relatively small, this channel may not be very important in the story. However, if we consider all the other Asian countries as a whole, the effect may be sizable. Furthermore, if the rest of Asia and its interaction with China were modeled explicitly, there would be other factors which have similar effects on China's export as the devaluation of foreign currency. For example, a positive productivity shock in Korean intermediate goods sector not only reduces the prices of Korean goods exported to the US market but also makes the intermediate goods exported to China cheaper, benefiting China.14 In our model, the domestic households own all the firms and enjoy the profit, which is a standard assumption in a representative agent general equilibrium model. However, in China, as Gaulier, Lemoine, and Unal-Kesenci (2007) point out, the 14 Our conclusion that devaluation of Asian currency may benefit China applies to real exchange rate shocks in a flexible price model as well. In our model, whether a devaluation of foreign currency benefits China depends on the degree of exchange rate pass-through into intermediate good prices. However, in a flexible price model, a real exchange rate shock or a productivity shock in foreign country will affect China's export prices immediately.
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foreign firm affiliates accounted for over 50% of China's total trade and 80% of processing trade in 2002. Obviously, the ownership structure between domestic residents and foreign investors can affect the profit distribution and then the household's welfare through the income effect. Thus, the consumption and leisure choices of domestic households may be affected if we take the ownership structure into consideration. However, the effect of ownership structure on export dynamics may be small, as these dynamics depends mainly on the export sector or the production side. In our model, export firms have monopolistic power. They will set the price simply based on their own marginal cost and the market demand, which are both affected by the change in foreign currency. Thus, even if we consider the ownership structure, our qualitative results still hold. In reality, imports of intermediate goods sometimes involve trade between a parent and its subsidiaries in the same multinational corporation. The parent–subsidiary relationship may affect the intermediate goods pricing behavior to some extent. However, this kind of relationship usually exists in the intermediate goods trade between China and developed countries such as, the US. In this paper, we mainly investigate the vertical trade between China and other Asian economies. Thus, the decision on intermediate goods price setting should be similar to what we have modeled in the paper, in which prices are set by monopolistic competitive firms. Therefore, our model's setting is fine in this sense. Furthermore, the main implication of parent–subsidiary relationship is still on profit distribution. As discussed above, the profit distribution may have welfare effect, but it should not have a large effect on export dynamics of China. In our model, as long as the changes in foreign currency can pass-through into the intermediate goods prices, the cost-cutting channel should be still at work. We also note that some of China's export competitors may have outsourced some production stages to China. In our model, the competition effect lowers China's export to the US market when RMB appreciates or when the currencies of the Asian competitors depreciate. Thus, the presence of outsourcing behavior could potentially dampen the competition effect. Nevertheless, the outsourcing behavior of China's competitors also implies that the vertical trade linkage discussed in the paper will be stronger. Although this behavior dampens the competition channel, it may strengthen the intermediate goods cost-cutting channel. Moreover, although the competition effect will be mitigated through the endogenous production location choices of the export competitors of China, such mitigation may be applied mainly to the competition among homogenous goods, whereas in our model we mainly emphasize the competition among differentiated goods. In summary, the issues of ownership, intermediate goods pricing, and the outsourcing are very important, but they should be investigated in a model with more micro-foundation, which is an interesting extension for future research. 5. Conclusion This paper studies how China's exports respond to exchange rate shocks from the currencies of intermediate goods suppliers' currencies. We find that a depreciation of suppliers' currencies could improve competitiveness in China's exports by reducing input costs when prices for intermediate goods are flexible. The more the imported contents are in China's total exports, the stronger this channel becomes. The choices of exchange rate regimes and currency invoicing do not change this finding. The findings in this paper indicate that future research on how flexible intermediate goods prices are would be promising. Without understanding this issue, we cannot make conclusive statements on how exchange rates affect trade in East Asia and on how the global imbalance can be resolved by exchange rate adjustments. However, the channel discussed in our paper should not be overemphasized. This is because the importance of processing trade in total trade has started to decline in recent years. This also implies that changes in trade pattern should be taken into consideration when we evaluate exchange rate policy. References Ahmed, Shaghil (2009). Are Chinese exports sensitive to changes in the exchange rate? Board of Governor of Federal Reserve Bank, Working Paper. Baak, SaangJoon (2008). The bilateral real exchange rates and trade between China and the U.S.. China Economic Review, 19(2), 117–127. 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