Introduction

The exchange rate regime of the People's Republic of China (PRC) has been the focal point of the global community, either in the context of global imbalances, or the bilateral trade deficit between PRC and the United States (US). With a US$370 billion current account surplus, the PRC's de facto peg to the dollar policy has attracted widespread international criticism, which argues that the inflexible exchange rate regime artificially suppresses the value of the yuan and unfairly enhances the competitiveness of PRC exports. The “undervalued yuan” has been perceived as a major factor widening the US trade deficit with the PRC and driving global imbalances.

A substantial revaluation of the yuan has been called for in order to fix the PRC-US trade imbalance. Letting the yuan appreciate against the dollar has been prescribed as an effective solution (e.g, Lim, Spence, and Hausman [2006]; Goldstein [2007]; Obstfeld [2006]; Krugman [2010]). The logic of the argument is straightforward. The yuan's revaluation would raise prices of PRC exports and also lower import prices of foreign goods and services. Following the presumed price changes, demand for PRC exports would decrease, but PRC consumers' demand for imports would increase. As a consequence, the PRC's trade surplus would shrink while the deficit of its counterparts, for instance the US, would decrease. Numerous empirical studies (e.g., Thorbecke and Smith [2010]; Garcia-Herrero and Koivu [2007]) estimated the PRC's export elasticity to real exchange rates and concluded that the yuan's appreciation would give rise to a significant decrease in the PRC's exports, thus reducing the PRC's trade surplus substantially.

As a matter of fact, the effectiveness of the yuan's revaluation on the PRC's trade balance largely depends on the extent the appreciation could be passed on to the import prices of the PRC's trading partners. If the PRC producers are unable to pass rising costs induced by the yuan's appreciation to foreign importers because of market competition, but are instead compelled to absorb most of the rising cost with profit margin adjustments and efficiency improvements, then the prices of PRC exports may change very little. In other words, the transmission mechanism of the yuan's revaluation on the trade balance depends on exchange rate pass-through effects. Without passing on the appreciation to prices of exports, the expected changes on import demand and the bilateral trade balance would not materialize and the yuan's appreciation might have very limited impact on PRC-US trade deficits as well as the global imbalance.

In addition, real exchange rates are a combination of nominal exchange rates and relative prices. The estimated export elasticity in the empirical literature basically uncovered how responsive PRC's exports are to price changes rather than to nominal exchange rate changes, unless relative prices are assumed constant. All arguments for the yuan's appreciation primarily emphasize changes of nominal exchange rates of the yuan and their impact on exports and assume a complete pass-through, which is actually not true. Pass-through effects represent the first step in the process of chain reactions from nominal exchange rate adjustments to eventual changes in exports and trade balance.

In July 2005, the People's Bank of China (PBC) switched its policy from the peg to the dollar to a basket of major currencies. The regime change opened the gate to the yuan's nominal appreciation. Since then, nominal exchange rates of the yuan against the dollar gradually dropped to 6.8 yuan per US dollar from 8.3 yuan per US dollar, implying about 21% cumulative appreciation. The substantial appreciation provides opportunities to examine the relation between the yuan's nominal exchange rates and price adjustments of PRC exports. Empirical exercises on the relation are necessary and imperative for assessing the effectiveness of the yuan's appreciation on the PRC-US trade imbalance as well as the PRC's current account surplus. Given the cumulative appreciation of more than 20%, important empirical questions are whether prices of the PRC's exports have been raised correspondingly, and to what extent the appreciation has been passed on to prices of foreign imports.

There is a plethora of theoretical and empirical literature on exchange rate pass-through. Most of these studies focus on the experiences of industrialized countries such as the US, Japan, and Germany. Studies on the PRC, the second largest trading country, are scant. An exception is Jabara (2009), which estimated pass-through effects of the yuan's appreciation to import prices of the US from 2005 to 2008. This paper studied pass-through effects of the yuan's appreciation on import prices of the PRC's major trading partners the US and Japan. In the case of the US, pass-through effects were examined on general import prices of all commodities imported from PRC. In the case of Japan, not only was the pass-through on general import prices analyzed, but also the pass-through on prices of various commodity groups.

The peg to the dollar policy limits variations of the bilateral exchange rates between the dollar and the yuan. The relatively short period of the yuan's appreciation from July 2005 to July 2008 may not reveal full information on the pricing behaviors of PRC exporters coping with the yuan's appreciation. On the other hand, under the peg regime, the bilateral exchange rates between the Japanese yen and the yuan fluctuated in accord with exchange rate fluctuations between the yen and the dollar. Hence, in the case of Japan, we are able to study the issue over a relatively long time horizon, from 1998 to 2008. In addition, currency invoicing and market competitiveness affect degrees of pass-through (Gopinath, Itskhoki, and Rigobon [2009]; Golderg and Engel [2006]). By comparing pass-through effects between the US and Japan, one could understand to what extent pass-through effects of the yuan's appreciation was affected by currency invoicing and destination markets.

Based on the monthly data from 2004 to 2008, I found that in the short run, 23% of the yuan's appreciation against the dollar would be passed on to import prices of the US, compared with 47% in the long run. For the case of Japan, the empirical results suggest that, in the short run 55% of the yen/yuan exchange rate variations were passed on to Japanese import prices while close to 100%, a complete pass-through, occurred in the long run. The exceptionally high degrees of pass-through are also found in the disaggregated sectoral analysis. In food, raw materials, apparel, manufacturing, and machinery, a 1% nominal appreciation of the yuan to the yen led import prices in these categories to rise 0.38% to 0.62% in the short-run and an increase from 0.71% to 1.10% in the long run.

The high degree of pass-through into Japanese import prices, however, does not imply that PRC exporters have pricing power for their exports to Japan. Further analysis indicates that, the pass-through ability is basically ascribed to the PRC's peg to the dollar policy and the fact that the dollar is used as an invoicing currency for the PRC's exports to Japan. After controlling the currency invoicing factor, I found no significant evidence that the yuan's cumulative appreciation from July 2005 to July 2008 was passed on to Japanese import prices either in the short run or in the long run.

Download this Paper [ PDF 217.3KB| 18 pages ].

Comment(s)

There are [0] comment(s) for this entry. Post a comment.