Introduction

The People's Republic of China's (PRC) global current account surplus averaged US$400 billion in 2007 and 2008 and is forecasted to equal US$370 billion in 2009. Relative to gross domestic product (GDP), the PRC's current account surplus equaled 11% in 2007, 10% in 2008, and 9% in 2009. Economists and policymakers both inside and outside of PRC have argued that the PRC economy needs to be rebalanced and to rely less on exports. Many claim that an appreciation of the yuan would help to achieve these goals. Empirical evidence on the effect of a yuan (CNY) appreciation on the PRC's exports, however, has been mixed.

These mixed results are more apparent for processed exports than for ordinary exports. Processed exports, as defined by the China Customs Agency, are final goods that are produced using parts and components imported from the rest of the world. Ordinary exports, by contrast, are produced primarily using local PRC inputs. Marquez and Schindler (2007), employing an autoregressive distributed lag model and monthly data over the January 1997–July 2006 period, found that a 10% appreciation of the CNY would reduce China's processed exports relative to total world exports by 24 to 32 basis points. Thorbecke and Smith (2010), using a panel data set including annual exports to 33 countries over the 1994–2005 period, reported that a 10% appreciation of the CNY and other East Asian currencies would reduce processed exports by 10%. On the other hand Cheung, Chinn, and Fujii (2010), using dynamic ordinary least squares (DOLS) techniques and quarterly data over the 1993Q3 – 2006Q2 period, found that an appreciation of the CNY is associated with an increase in the PRC's processed exports (i.e., the coefficient has the wrong sign). While the results for processed exports were mixed, all of these authors reported that a CNY appreciation would lower ordinary exports.

One reason for these conflicting results is that, while the yuan exchange rate is the correct variable to use in explaining China's ordinary exports, it is not the correct variable to use in explaining processed exports. For ordinary exports, most of the value-added is produced domestically (see Gaulier, Lemoine, and Unal-Kesenci 2005). An appreciation of the CNY against the importing country would thus have a large effect on the foreign currency cost of China's ordinary exports. For processed exports, on the other hand, the majority of the value-added comes from imported parts and components rather than from production activities within China. An appreciation of the CNY against the importing country would thus have a smaller effect on the foreign currency cost of China's processed exports.

For example, the largest category of processed exports is computers and office equipment.¹ Koopman, Wang, and Wei (2008) found that China's value-added in the computer industry is small. Using mathematical programming techniques and detailed data from trade statistics and input-output tables they reported that Chinese value-added in electronic computers is less than 5%. Koopman, Wang, and Wei (2008) noted that in cases where the share of domestic content in exports is small, the effect of exchange rate changes in assembly countries on trade volumes will also be small.

Yoshitomi (2007) and the International Monetary Fund (IMF) (2007) similarly argued that a unilateral appreciation of the yuan would not affect processed exports much, since the majority of the value-added came from parts and components produced in other countries. A generalized appreciation in Asia, on the other hand, would essentially change the relative foreign currency cost of the PRC's entire output of processed exports. This should have a much larger effect on the PRC's processed exports.

This paper investigates how exchange rate changes throughout the supply chain would affect the PRC's processed exports. To do this it employs a DOLS model and quarterly data on the PRC's processed exports, as Cheung, Chinn, and Fujii (2010) did, but supplements the specification with exchange rates changes in supply chain countries. The results indicate that a joint appreciation of the yuan and of the currencies of the other (primarily East Asia) supply chain countries would produce a large drop in processed exports. An appreciation of either the yuan or the currencies of other supply chain countries individually, however, would produce smaller drops in processed exports. This finding perhaps reflects the fact that multinational corporations can shift production between the PRC and other supply chain countries in response to changes in relative exchange rates in Asia.

One way for Asian countries involved in processing trade to appreciate together would be for the PRC to adopt a regime characterized by a multiple-currency, basket-based reference rate with a reasonably wide band. In this case, the huge surpluses generated within East Asian production networks would cause currencies in the region to appreciate together. Market forces could then allocate these appreciations across supply chain countries as a function of the size of their surpluses in processing trade.

The next section presents the data and methodology. Section 3 contains the results. Section 4 concludes.

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