Impact of Chinese Exchange Rate Policy and its Trade Balance with the United States


Master's Thesis, 2011
56 Pages, Grade: B

Excerpt

Table of Contents

Abstract

Chapter One
1. Introduction to the study
1.0 Introduction
1.1 Background Study
1.2 Statement of the Problem
1.3 Project Aims
1.3.1 Specific Objectives
1.3.2 Research Questions
1.4 Significance of the Study

Chapter Two
2. Literature review
2.0.1 Introduction
2.1 Theoretical Review
2.1.1 Elasticity Model of Trade Balance
2.2 The china-us bilateral trade deficit
2.2.1 US trade deficits with china
2.2.2 Exchange Rate on Employment
2.2.3 Summary

Chapter Three
3. Research Methodology
3.0 Introduction
3.1 Collection of primary data
3.2 Secondary data collection
3.3 Data analysis
3.4 Secondary data analysis
3.4.1 FAS conversion into FOB and conversion of CIF to FOB
3.4.2 Transit Trade of Hong Kong Value Adjustment and Transit Trade Transit Added
Value
3.4.3 Service trade adjusted statistics
3.5 Primary data analysis

Chapter Four
4. Results and Discussion
4.0 Primary data Results
4.1 Secondary data results
4.1.1 FAS conversion into FOB and conversion of CIF to FOB
4.1.2 Transit Trade of Hong Kong Value Adjustment and Transit Trade Transit Added
Value
4.1.3 Service trade adjusted statistics

Chapter Five
5. Discussion

Conclusion

References

Appendix 1: US Total Trade in Goods

Chapter One

1. Introduction to the study

1.0 Introduction

This chapter provides background information on the study, the statement of the research problem and the general aim of the study. It further details the research questions, research objectives and justification and significance of the study.

1.1 Background Study

The imbalances in the current account have remained substantially high across the world and there are fears that the world is currently faced with the risks of financial vulnerabilities and protectionism unless the capital flows behind these imbalances are halted (BIS, 2011, cited in Kharroubi, 2011, 1). The debate has been rife on how to correct these imbalances and put the global economy on the right path of balanced economic growth. In other words, the debate has been on how to reduce the large trade deficits of big economies as well the large trade surpluses witnessed in emerging economies. However, economists argue that rebalancing the global economy is not only a difficult task but is a slow process. For instance, it would be extremely difficult to reduce deficit countries reliance on consumption-led growth, and shift from export-led growth and boost domestic demand in surplus countries (Kharroubi, 2011, 1). In addition, it would be equally difficult to successfully coordinate such a shift without causing sudden fluctuations in the global aggregate demand. Thus, exchange rate has emerged as a significant issue in the current policy debates as the only means of achieving global rebalancing. At the centre of this debate is China and the US especially how the latter’s trade balance with the former is affected by China’s exchange rate policy.

The impact of China’s exchange rate policy on the US trade balances has been a longstanding problem between the two countries – and in deed to the global economy. The United States and other countries have been complaining that China has been deliberately controlling the value of renminbi in order to boost its trade surpluses and exports at the expense of its trading partners. The US government has repeatedly argued that China’s exchange rate policy of keeping the value of its currency artificially low has been impacting negatively on its trade balances as well as that of the world. It is argued that China needs to not only allow its currency to gain value at a faster rate but also to let the renminbi operate under the forces of the market (Scott, 2011, 1). International financial bodies such as the World Bank, the International Monetary Fund and many economists have been drawn to the debate about China’s exchange rate policy and how it affects the US and the global economy. They argue that China needs to adopt a more flexible exchange rate policy and to allow for faster appreciation of its currency to help solve the global trade imbalances (Bersgsten, 2010, 1). According to Kroeber (2011, 1), China has let its currency appreciate by about 25 percent against the dollar since 2005, not because of the sustained pressure on it to do so but due to its own domestic consideration. However, the pace of this appreciation is still very slow for the United States whose export industry continues to face stiff competition from Chinese low-priced commodities (Scott, 2011, 1).

Chou and Shih (1998, 168) state that when the dollar value declines or the RMB value appreciates, the trade deficit also appreciates. Consequently, researchers have pointed out that china needs to amend its policy on exchange rate in order to help in the reduction of the growing United States trade deficit. In addition, if the exchange rate of RMB/dollar decreases by 1%, the deficit also reduces by between 1.5% and 3.3% (Chou and Shih, 1998, 170). Consequently, there is need for the Chinese government to revalue the currency but this may change to some extent the United States trade deficit with the people’s republic of China. But whether China will cave to the mounting pressure is still unclear. However, experts have argued that by keeping a tight and consistent control of its exchange rates, China would not only cause a further decline in the US trade deficit with China but would also be hurting its own economy. For instance, through its consistent intervention which has consistently kept the country’s exchange rate substantially below the market level, China’s exchange rate policy would likely cause price distortion that would curtail normal functioning of the international markets. In addition, China would also be affected by such a price distortion, in that export manufacturing would attract large-scale investment at the expense of the domestic consumer market (Wolf, 2009, 1). Therefore, adopting a flexible exchange rate policy may seem beneficial to both China and the US economies, but Chinese policy makers have been reluctant to change their exchange rate policy. According to Scott (2007, 1) China sees controlled exchange rate as broadly advantageous to its economic development.

Exchange rate and in deed prices and other market mechanisms are seen by Chinese policy makers as instrumental in the wider development sense. Preeg (2003, 274) argues that the primary objective of China’s development strategy is to make the country a wealthy and powerful modern economy and therefore has little to do with creating a market economy as expected by the United States and other countries. Wolf (2009, 1) adds that China’s development strategy is premised on the understanding that all nations that became rich and powerful in the industrial era relied on export-led growth. Therefore, as China manages the exchange rate to promote exports, it is also managing prices and other markets in its domestic market so as to achieve its development goals. Because the country perceive and consider an export-led growth or strategy as the only way of attaining a rich and powerful-country status, China has been greatly suspicion of the assertions that abandoning export-led growth and accelerating the value of currency is in its best interest (Preeg, 2003, 270). Whether or not China’s exchange rate policy affects US trade balance with China (and to what extent) is the focus of this study. However, whether China – an independent geopolitical power, would see the need to review its exchange rate policy in order to help rebalance it trade with the US remains to be seen.

1.2 Statement of the Problem

There is a common agreement among economic scholars and experts that the exchange rate of a country is not just a concern for that particular country alone but it is a concern for its trading partners as well. This statement perhaps, applies more to big economies like China and US than small and developing economies. It is against this backdrop that the heavily managed Chinese exchange rate regime is considered a threat to one of its major trading partners – the US (see Appendix 1). For instance, the recent huge global trade imbalances between China and the US have particularly worked against the US efforts to achieve sustainable economic recovery and reduce its unemployment rates. China is currently the largest exporter in the world while its currency (renminbi) has remained substantially undervalued over the years thanks to Chinese government’s increased intervention in the foreign exchange market (Worf, 2009, 1). This has particular led to the considerable growth of its trade surplus. For instance, Bergsten (2010, 1) states that since the adoption of a “new policy” back in 2010, the country’s currency rise in value has never been more than 1 percent. It is this exchange rate policy adopted by the Chinese government that is believed to be causing the rise of the US trade deficit with China, which continues to grow every year (see figure 1).

US-China Trade Balance: 2000-2008

illustration not visible in this excerpt

Figure 1: US-China Trade Balance (Source: USITC Dataweb, cited in Morrison, 2011, 6).

Author’s Note: Data for 2008 are projections, based on actual data for January-July 2008.

1.3 Project Aims

The primary objective of this study was to investigate whether China’s exchange rate policy affects the United States trade balance with China.

1.3.1 Specific Objectives

- To establish the trade deficits between China and US
- To establish how China’s exchange rate policy affects the US trade deficit with China
- To explain the causes of US trade deficits with China
- To investigate options available for China with regards to its exchange rate policy

1.3.2 Research Questions

The study sought to answer the following questions:

- Is there increase in trade deficits between China and US?
- Does exchange rate policy in China increase United States trade deficit with China?
- What are the causes of United States trade deficit with China?
- Should China review its exchange rate policy?

1.4 Significance of the Study

By conducting this study, the researcher hoped to improve knowledge base on the issue of a country’s exchange rate policy and its effect on other trading partners as well as on the global economy. Specifically, this study will contribute to the current policy debate on whether China should review its exchange rate policy by revaluating its currency or allowing it to appreciate in order to encourage rebalancing in global trade – that is, by focusing less on export activities so as to enable deficit countries such as the US to increase their export.

Conclusion

This section has provided background to the study including the research questions to be answered in the study. In addition, the main purpose of conducting this study as well as the research objectives has also been outlined. Consequently, chapter one was important to enable the research to be objective and focused before the next section that includes literature review.

Chapter Two

2. Literature review

2.0.1 Introduction

This chapter provides a literature review of the theoretical framework and previous studies that are relevant and consistent with the aims and objectives of this study. In the chapter, theoretical underpinnings of exchange rate and trade balance of a country is discussed, and relevant literature pertaining to the US trade deficit with the China will also be analysed. It is divided into three parts – theoretical review, the US-China bilateral trade deficits and summary.

2.1 Theoretical Review

2.1.1 Elasticity Model of Trade Balance

The relationship between exchange rate devaluation and international trade has been a subject of many studies in international economics for too long. However, these studies have been centred on the conventional elasticity model that was first developed by three individuals – Bickerrdike, Robinson and Metzler, otherwise referred to as BRM in relation to their works conducted in 1920, 1947, and 1948 respectively. The model was later discussed and improved by Marshall and Lerner and became the Marshall-Lerner Condition – MLC (Marshall and Lerner, 1923, 1944). According to the MLC model, there must be a difference between the demand elasticity of imports and exports in order to effect improvements on the trade balances from devaluation. In other words, currency supply would be considered excess when a country’s exchange rate surpasses the level of equilibrium but an excess demand would result when it falls below the level of equilibrium. It would be only under this condition that the real exchange rate would be affected by the nominal devaluation to promote competitiveness and consequently improve trade balances.

Despite the fact that Marshall-Lerner Condition is generally assumed to underlie currency devaluation policy, economic scholars endeavoured to test the theoretical underpinnings of the MLC models through various empirical studies. A review of these studies will provide a preview of the relationship between China’s exchange rate and the US trade deficit with China. With the exception of Krugman and Balwin (1987, 5) who conducted a number of studies in the 1980s to test the relationship between US exchange rate and trade balance, other studies have dismissed MLC model’s use of direct estimations of the elasticities as untenable. For instance, Bahmani-Oskooee (1994), Rose (1991), and Rose and Yellen (1989) employed the cointegration technique in their studies testing the exchange rate coefficient. They found no significant relationship between trades balances and changes in exchange rate except in a few countries and thus rejected the MLC model. In his study of the bilateral trade between the US and Japan, Rahman et al. (1997, 662) reported that no evidence existed for positive correlation between balance of trade and changes in exchange rate. More evidence that there is no stable positive relation between exchange rate and trade balance was presented by Wilson (2001, 390) who applied the multivariate Johanson-Juselius cointegration method to study the bilateral trade of Japan and the US with three Asian countries- Korea, Singapore and Malaysia.

However, other studies have established that long run relationship exist and therefore have proved the positive relation between trade balance and changes in exchange rate (Bahmani-Oskooee, 1998, 90; Arize, 1994, 4). Applying the reduce form equations, Baharumshah (2001, 294) provided more supporting evidence in his study of Thailand and Malaysia and their bilateral trade with Japan and the US. Using the reduce form but with a more dissimilar structural cointegrating vector autoregressive distributed lag (VARDL) model, Boyd et al. (2001, 193) studied eight OECD economies and presented evidence supporting the positive relationship between trade balance and exchange rate. However, a survey conducted by Bahmani-Oskooee and Ratha (2004, 1378) on the empirical studies on the relationship between exchange rate and balance of trade showed that economists are yet to reach a consensus on this topic. An overview of different methodologies that have been employed in the literature to study emerging and developing economies has also presented different results (Stucka, 2004, 56). Identical economies have also presented different results when different methodologies are used and in different time periods.

As it appears in the literature, economists are yet to agree on how changes in exchange rate impact on balance of trade in a country and its trading partners. However, Rose and Yellen (1989, 55) argued that there is particularly no theoretical explanation that makes it presumptive that trade balance’s long run response to the real exchange rate has to be positive; but this only happens if the situation meets the BRM condition. In other words, it can be said that the positive relation between exchange rate and balance of trade has no comprehensive model with predictive result but is simply an empirical issue. According to Stucka (2004, 56), economists and countries that support the elasticity approach to the relationship between trade balance and exchange rate and support the adjustment of exchange rate as effective in achieving the desirable balance of trade, intrinsically considered the BRM not as a condition but as a law. Perhaps, it is this variation in literature and in opinion among economists that has made it difficult for China to see the impact of its real depreciation on the US trade deficit with China. In other words, China and the US have polar opposite views on the issue of China’s exchange rate policy and the US trade deficit with China.

Nevertheless, going by the evidence provided by various studies and for the objective of this study, it will be taken that there exist a relationship between balance of trade and exchange rate as shown by the elasticity model of trade balances (Krugler and Baldwin, 1987, 4). Generally, it is assumed that the real exchange rate is dependent on the nominal appreciation or depreciation of the exchange rate (see Bahmani-Oskooee, 2001, 108; Himarios, 1989, 145). As established by Marshall-Lerner Condition, Bahmani-Oskooee (2001, 107) argued that a country may be forced to devalue its currency or allow it to depreciate in order to gain competitiveness in the international market and also to help boost its trade balance. In other words, by devaluing its currency, a country would encourage exports by making it relatively cheaper to export, and reduce imports by making it relatively more expensive to import from other countries thus improving its balance of trade.

With this view, one would easily understand the reasons why China is under pressure to adopt more flexible exchange rate policy in order to help the United States improve its trade balance with China. However, because China is a geopolitical power pursuing its own development goals and objectives, it is not surprising that it has not made an effort to review its exchange rate policy. There is no doubt that China wants to remain as competitive as possible in the international trade and to improve its trade balances with other trading partners and this informs the Chinese exchange rate policy which has kept the value of renminbi artificially low. However, this comes at an expense of its trading partners, notably the US which must content with increased imports from China and relatively low export to China and thus the increase in trade deficit of the United States with China.

2.2 The china-us bilateral trade deficit

2.2.1 US trade deficits with china

The US trade deficit with China in the first three months of 2012 is $67,000 (see figure 2). In 2011, the US had a $295 billion in trade deficit with China, a significant rise from $273 billion in the previous year (see figure 3 for a detailed tabulation of the US trade deficit with China in the last ten years). The US trade deficit with China in the last two years has been the highest compared to the earlier years. Although the US exported the highest number of goods in 2011 more than any other year, the country still posted a large trade deficit with China. As shown in figure 3, $103.9 worth of goods was exported by the US to China in 2011, the highest in history. However, China’s imports in 2011 were equally high and stood at a record of $399.3 billion compared to the 2010 imports which were worth $364.9 billion (U.S. Census Bureau, 2012b, 1).

Note: The numbers in figure 2 and 3 below may not add up to the total because they have been rounded off. The figures are given in million US dollars.

Figure 2: US Trade in Goods with China (the first three months of 2012)

illustration not visible in this excerpt

Source: U.S. Census Bureau, 2012a

Figure 3: US Trade In Goods with China (in the last 10 years)

illustration not visible in this excerpt

Source: US Census Bureau, 2012a

How these huge differences in exports and imports between China and the US come about is the objective of this paper. Generally, most economists have argued that two factors contribute to the increase in Chinese goods in the US. – a relatively lower living standard that enables Chinese firms to pay workers lower wages; and an exchange rate policy that pegs the renminbi too low against the dollar. The latter has particular attracted debate and remains the objective of this study. According to Kroeber (2008, 1) China uses a fixed exchange rate to peg the value of its currency against the US dollar so that when the dollar depreciates, it would purchase more dollar through the US Treasuries to keep it strong. The value of renminbi is therefore maintained within the target range hence the imbalances in trade. Because the value of the dollar is always higher than the renminbi, goods from China are always cheaper than those made in the US. While some studies have contested the relationship between China’s exchange rate policy and the US trade deficit with China, others have contested the figures release by both countries on the US trade deficit with China.

For instance, Feenstra et al (1998, 1) reported that the actual trade deficit of the US bilateral trade with China is not actually known. They argued that in 1995, the US put its trade deficit with China at $34 billion while the Chinese government put the figure at $9 billion. Feenstra et al. (1998, 28) argue that the discrepancy between these figures arises because the two countries overlooks the role played by Hong Kong in the bilateral trade between the US and China. In their study to correct such discrepancies in the US-China bilateral trade balance, Feenstra et al. (1998) found “that proper adjustment for value added in Hong Kong on China’s exports going to the US reduced (on average) 91 percent of the discrepancy between the official US and official China estimates” (28) of the trade balance between China and the US. Thus, they concluded that the revised estimates of the US figures indicate a reduction of the official US estimates of its trade deficit with China by an average of one third. The findings of this study were consistent with other studies that have attempted to estimate the magnitude of the re-export mark-ups of the Hong Kong in the US-China bilateral trade balance (West, 1995, 10; Fung and Lau, 1996, 23; Sung, 1991, 34; Fung, 1996, 55; Lardy, 1994, 78).

Away from the role of Hong Kong on the bilateral trade balances between the US and China, other studies have focused on structural conditions and macroeconomic policies to explain the rise in the US trade deficit with China. For instance, Feenstra et al. (1998, 23) argue that the structural conditions and macroeconomic policies primarily determines the overall trade balance and that they operate in a saving and investment manner. They use the following decomposition to explain the determinants of the overall trade deficit:

CA = (S - I)private + (S - I)SOE + (S - I)govt

Whereby, for any given fixed value of the currency, the overall current account (CA) would be increased directly by the contractionary fiscal policy through the rise in (S-I)govt, while the CA would be increased by contractionary monetary policy through a reduction in the investment spending of the state-owned enterprises (SOEs) and the private sector. In addition, any structural condition that raises Sprivate and does not raise Iprivate would correspondingly lead to an increase in CA. these explains the situation that followed the initiation of open door policy and economic reforms in China in 1978. This explanation is consistent with Liu and Woo’s analysis of trade deficit using a life-cycle model. Liu and Woo (1994, 12) presented an empirical evidence indicating that a highly sophisticated financial market leads to a lower saving rate in the private sector.

2.2.2 Exchange Rate on Employment

One of the negative impacts of Chinese exchange rate policy has been that it has been indirectly contributing to increase in unemployment rate in the US by encouraging imports while reducing US exports to China. The relationship between exchange rate and employment in the manufacturing sector has been a subject of many studies in recent years; however, little has been done to investigate the impact of one country’s exchange rate policy on the unemployment rate in its trading partners. For instance, in his study that investigated the employment in selected Chinese province from 1978 to 2003, Hua (2007, 335) only focused on the how China’s real exchange rate affected employment in the manufacturing sector. In the study, he reported that a negative relationship between employment in manufacturing sector and real exchange rate. Hua explains that during the 1993-2002 periods, China posted an average rate of 4.1 percent per annum in currency appreciation, but recorded an average rate of -2.3 percent in job creation, leading to further increase in unemployment rate in the country.

This phenomenon is said to have coincided with the reduction of exports posted during the period of 1981 to 1993. Hua (2007, 349) reported that there was an increase in employment in the provinces of Zhejiang, Fujian and Guangdong by an annual average rate of 1 percent, 2.9 percent, and 1.4 percent respectively, against the background of an annual average real appreciation of renminbi of 4.4 percent, 4, percent and 3.2 percent respectively. The findings of this study demonstrate that job losses and job creation are affected by exchange rate. There is likelihood that people would switch jobs as manufacturing sector is affected by currency fluctuation – an observation supported by Ngandu (2008, 206) and Campa and Goldberg (2001, 478).

[...]

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Details

Title
Impact of Chinese Exchange Rate Policy and its Trade Balance with the United States
College
Oxford University
Grade
B
Author
Year
2011
Pages
56
Catalog Number
V211553
ISBN (eBook)
9783656395683
ISBN (Book)
9783656395911
File size
1033 KB
Language
English
Tags
impact, chinese, exchange, rate, policy, trade, balance, united, states
Quote paper
Joseph Katie (Author), 2011, Impact of Chinese Exchange Rate Policy and its Trade Balance with the United States, Munich, GRIN Verlag, https://www.grin.com/document/211553

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