Data and Methodology

2.1 China's Imports for Processing and Processed Exports

East Asia is characterized by intricate production and distribution relationships, constituting part of a global triangular trading network. Japan, the Republic of Korea (hereafter Korea), Taipei,China and multinational companies located in ASEAN countries produce sophisticated technology-intensive intermediate goods and ship them to the PRC and ASEAN countries for assembly by lower-skilled workers. The finished products are then exported throughout the world.

Foreign direct investment (FDI) flows and multinational companies (MNC) play an important role in these triangular trading patterns. As Gaulier, Lemoine, and Unal-Kesenci (2005) discuss, FDI flows and MNC activities reduce costs in host countries, transfer technological and managerial know how, increase local procurement, multiply trade in intermediate goods, and strengthen distribution networks. In the case of the PRC, the importance of FDI is seen by the fact that 84% of the PRC's processed exports in 2006 were produced by foreign-invested enterprises (Feenstra and Wei 2009).

Figures 1 and 2 show China's role in the triangular trading structure. The data are taken from the PRC's Customs Statistics, which distinguishes between imports and exports linked to processing trade and ordinary imports and exports.² Imports for processing are goods that are brought into the PRC for processing and subsequent reexport. Processed exports, as classified by PRC customs authorities, are goods that are produced in this way. Imports for processing are imported duty-free and neither these imported inputs nor the finished goods produced using these imports enter the PRC's domestic market. By contrast, ordinary imports are goods that are intended for the domestic market and ordinary exports are goods that are produced primarily using local inputs.

Figure 1 [ PDF 19.2KB | 1 page ] shows that the lion's share of imports for processing come from other East Asian countries. By contrast, only one-twentieth of each came from the United States (US) and from the European Union (EU).

Figure 2 [ PDF 30KB | 1 page ] shows that processed exports flow primarily to the US; Europe; Japan; and Hong Kong, China. Many of the exports to Hong Kong, China actually represent entrepôt trade. As Kwan (2006) notes, when PRC firms transship goods through Hong Kong, China the PRC government often does not know the final destination of the goods. They thus record these goods as being exported to Hong Kong, China. On the other hand, when the goods arrive at their ultimate destination the importing country records the goods as coming from the PRC. Kwan thus advocates using import data from both trading partners to calculate bilateral trade balances.³ Using this approach, Thorbecke and Smith (2010) found that the PRC's exports to Europe increased 12% and the PRC's exports to the US increased 50%. Thus exports to Hong Kong, China are largely bound for the US and Europe, and the PRC's processed exports flow primarily to high income countries.

2.2 The Imperfect Substitutes Framework

The imperfect substitutes model of Goldstein and Khan (1985) implies that the quantity of exports demanded by other countries depends on income in the other countries and the price of exports relative to the price of domestically produced goods in those countries. The quantity of exports supplied depends on the export price relative to the domestic price level in the exporting country. By equating demand and supply one can derive an export function:

where ex_t represents the log of real exports,rer_t represents the log of the real exchange rate, and rgdp represents the log of foreign real income.

Researchers often take the real exchange rate and real income as given when estimating trade equations (see, for example, Rose and Yellen 1989). However, this approach may be subject to simultaneous-equation and omitted-variable bias. If the elasticity of supply is infinite, however, it is possible to identify the parameters in equation (1).

In the case of the PRC's processed exports there are reasons to believe that the perfect supply elasticity assumption is reasonable. First, the PRC has hundreds of millions of redundant laborers. This large pool of workers seeking employment in the export sector holds wages down and may enable PRC exporters to increase supply at constant prices. Second, as the IMF (2005) argued, the supply of imports for processing will vary one for one with the demand for processed exports. Thus both labor and sophisticated intermediate goods tend to flow elastically into the PRC's export industries to accommodate increases in demand in the rest of the world.

2.3 Calculating an Integrated Exchange Rate for the PRC's Processed Exports

Most of the value-added for PRC processed exports comes from other East Asian countries. Therefore a unilateral appreciation of the CNY would not affect the costs of PRC processed exports measured in the importing country's currency as much as a generalized appreciation throughout East Asia. A generalized appreciation in Asia would change the relative foreign currency cost not just of the PRC's value-added but of the PRC's entire output of processed exports (Yoshitomi 2007).

Following Tong and Zheng (2008), the PRC’s value-added in processing trade can be measured as the difference between the value of the PRC’s processed exports (VPEt) and the value of imports for processing from all supply chain countries (Σ_iVIP_i,t):

where VA_Chin,t,equals the PRC’s value-added in processing trade. Each year data on the total value of processed exports and the total value of imports for processing are used to calculate the PRC’s value-added. These data are obtained from China Customs Statistics,

In calculating the share of total costs for other supply chain countries the focus is on ASEAN, Japan, Korea, and Taipei,China. As Figure 1 indicates, the lion's share of imports for processing come from these countries. The two other leading supply chain countries are Germany and the US.⁴. The nine major suppliers are thus Germany, Japan, Korea, Malaysia, the Philippines, Singapore, Taipei,China, Thailand, and the US. For these suppliers weights () are calculated by dividing their contribution to the PRC's imports for processing by the amount of imports for processing coming from the nine major suppliers together. These weights are then used together with the data on the PRC's value-added to calculate an integrated exchange rate index (irer_t) for the entire value (both domestically produced and imported) of the PRC's processed exports by using the following formula:

where chinare_t is the PRC’s real effective exchange rate at time t and reer_i,t, is the real effective exchange rate for supply chain country i at time t. An increase chinareer_t, reer_i,t, and irer_t represent real exchange rate appreciations. irer_t is set equal to 100 in 1992q4.

Data on the real effective exchange rate were taken from the IMF's International Financial Statistics except for Korea and Taipei,China. In these two cases the data were obtained from the Bank for International Settlements.⁵

Data on imports for processing and processed exports disaggregated by country were used to calculate the PRC’s value-added (VA_Chin,t) and the weights on supply chain countries(w_i,t). These data were obtained from the China Customs Statistics on an annual basis. As Figure 1 shows, these data series are relatively smooth. Linear interpolation was used to obtain quarterly data for the PRC’s value-added and the weights on supply chain countries.

2.4 Other Variables

Data on the PRC's aggregate processed exports were obtained from the China Customs Statistics via the CEIC database. These data are available monthly in US dollars and were summed to obtain quarterly values.

Price indices for the PRC's exports are not available over the sample period. Exports were deflated in three ways. First, following Cheung, Chinn, and Fujii (2010), the US producer price index was used. Second, following Thorbecke and Smith (2010), the Hong Kong, China export price deflator was used. Since many of Hong Kong, China's exports are re-exports from the PRC, this measure may be a useful proxy for PRC export prices. Third, following Eichengreen, Rhee, and Tong (2004), the US consumer price index was used to deflate the PRC's exports. This measure would be appropriate if the PRC's processed exports correspond to the bundle of goods purchased by US consumers. The results reported below are similar regardless of which deflator was employed.

Since the lion's share of processed exports go to higher income countries, quarterly data on income in Europe, North America, Japan, Korea, and Australia were used to represent real income in the importing countries.⁶ These data are measured in real US dollars and are seasonally adjusted. They were obtained from the Organisation for Economic Cooperation and Development (OECD).⁷

The other independent variables are the stock of FDI, the PRC capital stock in manufacturing, and a WTO dummy variable that takes on a value of one after the PRC joined the World Trade Organization (WTO). As discussed above, 84% of processed exports are produced by foreign-invested enterprises. It is thus important to control for the stock of FDI. In addition, Cheung, Chinn, and Fujii (2010) found that the PRC capital stock helped to explain the PRC's exports. Finally, Garcia-Herrero and Koivu (2007) and others argued that the PRC's WTO accession had a positive effect on the PRC's trade.

Data on the stock of FDI were obtained from the United Nations Conference on Trade and Development (UNCTAD) website.⁸ Data on the PRC capital stock have been constructed by Bai, Hsieh, and Qian (2006).⁹ The FDI and capital stock data were converted to quarterly frequencies using linear interpolation methods.

The WTO dummy variable was set equal to one starting in 2000, since Garcia-Herrero and Koivu (2007) posited that the PRC's WTO accession began affecting the PRC's trade after it became certain that the PRC would join the WTO in the beginning of 2000.

Imports for processing are not included in the specification because, following the IMF (2005), these are assumed to respond passively to demand for processed exports in the rest of the world. Since the goal is to estimate demand elasticities, including imports for processing might lead to overfitting.

2.5 Econometric Methodology

The model was estimated using DOLS, which involves regressing the left-hand-side variable on a constant, the right hand side variables, and lags and leads of the right hand side variables. The equation has the form:

Here x_t represents the PRC’s real processed exports to the world, irer_t represents the integrated real exchange rate index, rgdp_t equals real income in the rest of the world, FDI_t represents the stock of foreign direct investment,K_t denotes the PRC capital stock in manufacturing, WTO is the WTO dummy variable, and Time is a time trend. Seasonal dummy variables are also included. x_t, irer_t, rgdp_t, FDI_t, and K_t are measured in natural logs.

Data on processed exports are available from the CEIC database beginning in 1993Q1 and data on the stock of FDI are available until 2008Q4. Equation (4) is estimated using a DOLS(2,2) model. Since this involves using two leads and lags of the first differences of the right hand side variables, the actual sample period for the estimation is 1993Q4–2008Q1.

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