Currency Invoicing and Pass-through Effects

The empirical analysis shows that pass-through effects between Japan and the US differ significantly. In the long run, it is less than 50% for import prices of the US, but close to 100% for that of Japan. The difference could be intuitively explained by currency invoicing practices. In trade, exporters can set prices in their own currencies, referred as producer currency pricing (PCP) in the literature, in currencies of destination markets—local currency pricing (LCP), or in vehicle currencies. Currency invoicing choices affect the degree of pass-through effects (Goldberg and Tille [2004]). Theoretically speaking, if exporters choose PCP, then exchange rate variations will be fully transmitted into import prices. On the other hand, with LCP, import prices will be independent of exchange rate movement at least in the short run (Engle [2006]).

The PRC yuan is not convertible and the use of the yuan as an invoicing currency to settle the PRC's trade is very limited. PRC's exports to the US are mainly priced in dollars, the local currency of the US importers. Therefore, LCP practice limited the ability of PRC exporter to pass the yuan's appreciations into import prices of the US. When exporting to Japan, PRC exporters also use the dollar rather than the yen as a major invoicing currency to settle the transactions, despite of the fact that the yen is a fully convertible international currency. For instance, in 2009 more than 78% of PRC's exports to Japan were invoiced in US dollars, while only 18% were settled in yen and 3.5% in other currencies including the Euro, Swiss franc, Canadian dollar, and the yuan, etc. (Figure 3 [ PDF 24.1KB | 1 page ]).

Apparently, the dollar functions as a vehicle currency in the bilateral trade between the PRC and Japan. After a few devaluations, the PBC pegged the yuan to the dollar from 1995 until July 2005. When the yuan was pegged to the dollar, using the dollar as an invoicing currency was equivalent to using the yuan. The vehicle currency pricing in PRC's exports to Japan is actually equivalent to PCP. The high pass-through effects, 55% in the short run and 100%, a complete pass-through in the long run, are consistent with a theoretical argument based on PCP assumptions.

On the other hand, from July 2005 to July 2008, the PRC deviated from the rigid peg to the dollar policy by allowing the yuan to appreciate by about 21% against the dollar cumulatively. During this period, using the dollar as a vehicle currency would not be equivalent to using the yuan. Following the yuan's appreciation, if PRC exporters did not adjust their prices dollars when selling to Japanese importers, the estimated pass-through effect would be solely attributed to variations of nominal exchange rates between the yen and the dollar; if they raised their prices invoiced in dollars, part of the estimated pass-through effect should be attributed to the yuan's appreciation. An important question is to what extent the yuan's appreciation since July 2005 was passed on to prices of Japanese imports.

To evaluate the pass-through effects solely attributed to the yuan's appreciation since July 2005, I decomposed yen/yuan nominal exchange rates into two parts:

Where e_t^Yen/Yuan denotes nominal exchange rates between the yen and the yuan, e_t^Yen/$ nominal exchange rates between the yen and the dollar, and e_t^$/Yuan nominal exchange rates between the dollar and the yuan. All three terms are in the logarithm of the corresponding variables. Substituting equation (6) into the regression equation (5) yields

In the regression equation (6), coefficient β_i measures pass-through effects due to variations of yen/dollar exchange rates and coefficient λ_i indicates pass-through effects imposed by the yuan's appreciation against the dollar. If λ_i positive and statistically significant, it means that there exists pass-through.

Using the sample of 2005 to 2008, I estimated regression equations (6) for all Japanese imports from PRC as well as imports in food, apparel, raw materials, manufacturing, and machinery. The number of lagged independent variables was selected following previous estimations. Table 3 [ PDF 25.6KB | 1 page ] reports the estimated results. For all imports, the estimated coefficients of Δe_t^$/Yuan is 0.75, but this is insignificant, suggesting that the yuan's appreciation was not passed on to the import price. On the other hand, the estimated coefficient of Δe_t^Yen/$ is 0.49 and significant at 1% and that of Δe_t-1^Yen/$ is 0.47 and significant at 1%, indicating that 49% of yen/dollar exchange rate variations were passed into the import price in the short run and 96% in the long run, close to a complete pass-through. The empirical results imply that the yuan's appreciation against the dollar from July 2005 to 2008 did not affect the general prices of Japanese imports from the PRC. The estimated pass-through effect during this period was solely due to the fluctuation of yen/dollar exchange rates. Using the dollar as an invoicing currency gives rise to the complete pass-through.

Comparing the coefficients of Δe_t^Yen/$ and Δe_t-1^Yen/$ with that of Δe_t and Δe_t-1 reported in Table 2, which were estimated with yen/yuan exchange rates from 1998 to 2008, I found that they are very close, further suggesting that currency invoicing is the reason leading to 100% pass-through effects on prices of Japanese imports from the PRC. The estimates on the five commodity groups also show that the yuan's appreciation contributed little to changes of Japanese import prices. The estimated coefficients of Δe_t^$/Yuan are -0.217 in the food sector, 5.326 in raw materials, 1.825 in apparel, 0.671 in manufacturing, and -0.187 in machinery. All of them are statistically insignificant.

On the other hand, the estimated coefficients of Δe_t^Yen/$ are 0.474 in manufacturing and 0.519 in machinery, both are statistically significant at 1%; the estimated coefficients of Δe_t-1^Yen/$ are 0.474 in manufacturing and 0.441 in machinery and are statistically significant at 1%. These sectoral estimates show that, with the decomposition, pass-through effects of the yen/dollar exchange rates remained very high, close to 50% in the short run and 100% in the long run, very similar to the estimates when only yen/yuan exchange rates were included. In the food sector, the pass-through effect of yen/dollar into prices of Japanese imports was relatively weaker than before, about 27% in the short run, but still reached 70% in the long run.

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