China is in the news; or more accurately, the Chinese currency, is. From Reuters:
A sharp rise in China’s yuan currency might cut the U.S. trade deficit by as much as one third and create enough American jobs to put at least a modest dent in the unemployment rate.
Then again, it may also lead to a destabilizing spike in Chinese unemployment and spark a trade war that drags the global economy back into a deep recession.
I don’t know how the politics surrounding the House bill will unfold. I will also defer on the issue of whether the threat of tariffs would induce Chinese acquiescence or spur retaliation (see Kash Mansouri for discussion of these issues.) I’ll focus on the economic (specifically trade flow) effects of a yuan appreciation. To begin with, it’s useful to think about where we’ve been, and where we’re going.
Figure 1: Log real value of CNY (blue. left axis), 2005=0; up is appreciation of the Chinese currency, and monthly trade balance, in bn USD (red, right axis), and trailing 12 month moving average Chinese trade balance (purple). Note: Real exchange rate uses weighte daverage of swap and official exchange rates for pre-1994. Source: St. Louis Fed FREDII, IMF IFS, ADB ARIC, Fernald, Edison and Loungani (JIMF, 1999), and author’s calculations.
Since over the recent period the real value of the CNY and the trade balance have covaried positively, some might think that real exchange rates don’t matter. However, we know that other variables are relevant, so it is useful to pursue this matter a little more deeply.
It might be true that the a 20% revaluation of the yuan would induce the US-China trade balance effects Bergsten mentions.* In my view, what is important is the impact on the Chinese overall trade balance; in macroeconomics, we typically care about overall trade balances, rather than bilateral (I know politics is different). One way to illustrate this is that given a Chinese revaluation, the US trade deficit might be re-apportioned to other countries. From the article:
“An appreciation of the yuan against the dollar would indeed reduce the U.S. trade deficit with China, but it is unlikely to have a major effect on U.S. job creation,” said Eswar Prasad,** a former International Monetary Fund official who now teaches international trade policy at Cornell University in New York.
The fact that yuan revaluation would not necessarily have a large impact on job creation (for that we need vigorous and immediate expansionary monetary and fiscal policy) does not mean that it wouldn’t be a (very) good thing, however. I think Eswar as well believes that accelerated yuan appreciation would be a good thing, in that it would facilitate global adjustment of current account balances, as well as the transition to a new development model for China. Paul Krugman has forcefully argued that accelerated yuan appreciation would help US employment, based on work by Autor, Dorn and Hanson (2011) (discussed in this post), and I’m willing to be convinced.
Returning to (an utterly conventional) partial equilibrium elasticities approach, what would be the impact on the Chinese trade balance of a yuan appreciation? Many of the studies that have been cited have been hampered by the lack of precise estimates of the relevant trade elasticities. In previous posts [1] [2] [3], I have discussed some of these estimates; the import elasticities have been particularly problematic. (On this general topic, see also [4]) Specifically, in a standard specification, the real exchange rate has the wrong sign.
In a recent paper, Yin-Wong Cheung HK City U., UCSC), Xing Wang (Kevin) Qian (SUNY Buffalo State) and I estimate export and import elasticities using dynamic OLS over a more recent sample spanning the Great Recession. We disaggregate the data, allow for supply effects, account for processing trade, as Yin-Wong Cheung, Eiji Fujii and I did in our 2010 paper. From “Are Chinese Trade Flows Different?”
we have found that for exports, while there is some diversity of responses to income and exchange rate variables, it appears to be the case that Chinese trade flows to accord with priors. Higher rest of world income results in higher Chinese exports, while a stronger yuan results in lower exports. However, the income elasticity is imprecisely estimated, varying widely depending upon the inclusion or exclusion of a linear time trend. In addition, the price elasticity varies widely between goods exported from [state owned enterprises] SOEs, foreign invested firms, and private firms. The latter appear to behave in a more price-sensitive fashion than the other types. As their share of exports continues to rise, one should expect the overall price elasticity to increase, holding all else constant.
We have replicated some of the puzzling results that other researchers have found relating to Chinese import behavior – namely an apparently negative income elasticity. We are tempted to ascribe this result to import substitution taking place as the Chinese economy’s structure alters drastically. However, that remains purely a conjecture.
On the other hand, the fact that disaggregation and the use of proxies for sectoral demands leads to positive coefficients on the activity variables is consistent with the view that rapid structural change has resulted in what appears to be unstable and perverse income and price elasticities at the aggregate level.
Disaggregation, however, only improves the results. We are unable obtain a specification without a large negative price coefficient for manufactured imports, which still constitute about 70% of Chinese imports, except when relative productivity is included. Indeed, inclusion of relative productivity makes the estimates much more plausible, and results in a correctly-signed exchange rate coefficient. To the extent that relative productivity is correlated with supply, this outcome is not entirely surprising.
In the end, Chinese trade flows do seem to respond to economic activity and price variables in the expected manner, at least when the data are sufficiently disaggregated or supply factors incorporated. This means that policymakers in principle had the means by which they could have affected the trade balance in the run-up to the crisis, had they wished.
Our estimated elasticities are obtained using dynamic OLS, which provides long run elasticities. In my next post, I’ll discuss the relationship of these estimates, along with those obtained using an error correction specification, to assessing the exchange rate impact on the Chinese trade balance (as opposed to Chinese exports).
*Disclosure 1: I serve on the academic advisory council of the Peterson Institute for International Economics.
** Disclosure 2: Eswar Prasad is a former coauthor.
I expect you to know more about this than I do (and honestly, I still get it mixed up), but I think there are a couple uses of the word Yuan in this post where the word Renminbi is more appropriate. But maybe I’m wrong. Or maybe, in the context of appreciation/depreciation, one could use either the name of the currency, or the unit of the currency.
I still haven’t seen any solid analysis on what tools China can use to counter a US tariff. Examples might be subsidies for Chinese exporters, targeting substitutable US imports, etc. What are the effects on US?
The other thing that’s not clear is whether USD would appreciate or depreciate vs CNY if US passes tough tariffs. Seems to me market would interpret that as bad news and escape to safety would push USD higher.
I wonder about the usefulness of “Returning to (an utterly conventional) partial equilibrium elasticities approach” …
I presume renminbi appreciation would come from reductions in official intervention in exchange markets. I have long argued that the amount of intervention is the appropriate target for anti-currency manipulation actions. If China’s capital controls are effective, then the reduction in such intervention will translate rather directly into a change into a like change in China’s trade balance. If one uses a partial equilibrium exchange rate approach, what (implicit) assumptions are being made about saving in China? The cessation of official intervention would bring a substantial change in this variable.
Let us assume that the current China/US import:export ratio is optimal for the exchange rate of the CNY:$. If that is the case now assume that the CNY appreciates against the $. What is a bad assumption is that the total level of trade will remain the same.
I think we can all agree that US imports from China would decline and perhaps US exports to China would increase but what would be the net?
If the CNY appreciates relative to the $ it will reduct exports but that will reduce the $ flowing into China so China’s imports of US goods would also decline. It is not a good assumption that China would convert CNY to $ to maintain their imports of US goods because the Chinese domestic consumption would decline.
An appreciation of the CNY against the $ will reduce the total trade between the two countries even though the net US exports might increase relative to imports.
Any currency manipulation that alters the ratio between the two currencies will decrease total trade because the traders who import and export adjust their trade to the exchange rate so that their imports and exports are optimal for both contries. Any alteration of that relationship forces the importers and exporters to determine a new equilibrium. For this reason the optimal exchange rates for total trade between countries is the existing exchange rate. Any manipulation, whether the $ against the CNY or the CNY against the $ and whether the manipulation is up or down, reduces total world trade.
Those who claim an advantage of trade by currency manipulation make the mistake of looking at only look at one side of the equation. It would be good for them to learn Henry Hazlitt’s “Economics in One Lesson” and look at both sides of the transaction.
So the Chinese imports get replaced by Korean and Japanese ones at the high end, Vietnamese, Filipino or Thai at the low end. It will help the US-China trade balance, yes, but it won’t bring back jobs, it will just shift them elsewhere. And that assumes that the increased cost of non-substitutable Chinese products doesn’t actually make up for the loss in substitutables.
Looks like a very long bet, big on risk and low on upside.
Nylund: Well, I think technically, you might be correct, as RMB is the currency, and the yuan is the unit. But I just use the ISO code for both as a shorthand.
LC: I think China could raise tariffs on US goods, or impose other sanctions, if the US actions are not WTO-consistent. They could also dump dollar denominated assets in a way that would raise US borrowing costs in a disruptive way (at a cost to themselves, admittedly).
don: I think of the partial equilibrium route as the first cut approach. Obviously, then one wants to imbed into a broader model; what do you want to use? I would use a Mundell-Fleming model, but you might choose something else.
Ricardo: I agree that looking at only one equation is problematic. But I’m not sure your multiequation system works. Why necessarily should Chinese consumption drop in response to an appreciation? Net exports decline, but in some models, consumption increases as the terms of trade adjusted GDP rises. And in a monetary approach to the balance of payments (much like the Hume price-specie-flow model), revaluation that pushes prices toward the right levels can reduce hoarding/dishoarding.
endorendil: If the Chinese revaluation allows the dollar to depreciate (against China, against rest of East Asia), then most econometric studies indicate a reduction of the current account deficit relative to baseline. Your assumption that East Asian exchange rates stay fixed even as the CNY moves is counterfactual; see this post.
Menzie, I think the post you link is interesting. It shows that the currencies of low-tech east Asian economies move relatively in synch with the Yuan (high-tech ones like Taiwan are clearly different). My conclusion is that – because these countries aren’t accused of currency manipulation – that the Chinese Yuan exchange rate isn’t really manipulated all that much. Or is Thailand hoarding dollars even more than China?
Of course, just because other countries’ exchange rate moved in tandem with China before does not mean it will forever. More importantly (for the actual debate going on in the US – which doesn’t control the Yuan exchange rate), if China is singled out by means of tariffs or other punitive measures, clearly the other east Asian manufacturers can step up exports – if only by re-exporting Chinese imports. There is absolutely no guarantee that a single low-paying or high-tech job will move back as long as American consumers are unable to afford American-made products, and the American education system does not produce enough engineers and scientists so the US doesn’t have to import them. There are fundamental reasons why both low-end and high-end jobs leave the US. The exchange rate has little to do with them.
The Yuan appreciated some 30% against US$ since 2005. Have any of your expectations of the effects of Yuan appreciation been proven correct?