Introduction

The People's Republic of China (PRC) has maintained a pegged exchange rate regime targeted at the United States (US) dollar. In the process it has accumulated more than 2.4 trillion dollars in foreign currency reserves. The People's Bank of China has sterilized these interventions and prevented inflation from accelerating. However, sterilization operations have forced commercial banks to hold more and more central bank bills, interfering with the allocation of credit. They have also produced an increasingly inefficient allocation of resources since private and social rates of return are higher for investments in the domestic economy than for investments in US Treasury securities. Many have thus advocated a more flexible exchange rate regime for the PRC.

How would the resulting exchange rate fluctuations affect the PRC's surplus with the rest of the world? The Marshall-Lerner condition implies that, if trade is initially balanced, an appreciation will reduce the trade balance if the sum of (the absolute values of) the demand elasticities for exports and imports exceeds one. In the case of the PRC, the effect of exchange rate changes on the trade balance is more complicated because the PRC's trade surplus since 2008 has been almost entirely concentrated in processing trade. Processed exports are final goods that are produced using parts and components imported from the rest of the world. Since much of the value-added of processed goods comes from other countries, the effect of changes in the yuan on the volume of processing trade may be attenuated.

Yoshitomi (2007) documented that parts and components for the PRC's processed exports came primarily from other East Asian countries. He thus noted that an appreciation of the yuan would only affect the foreign currency costs of the PRC's value-added in processing trade, while a joint appreciation in Asia would affect the foreign currency cost of the PRC's entire output of processed goods.¹ A generalized appreciation should thus have a much larger effect on the PRC's processed exports.

Thorbecke and Smith (2010) constructed a single integrated exchange rate variable to measure changes in the relative foreign currency costs not just of the PRC's value-added but of the PRC's entire output of processed exports. Using dynamic ordinary least squares estimation and an annual panel data set over the 1992–2005 period, they reported that a 10% appreciation throughout the region would reduce processed exports by 10%.

Ahmed (2009) employed an autoregressive distributed lag model and quarterly data over the 1996Q1–2009Q2 period and disaggregated CNY exchange rate changes into those relative to East Asian countries and those relative to other countries. He reported that a 10% appreciation of the yuan relative to non-East Asian countries would reduce PRC's processed exports by 17% and that a 10% appreciation in other East Asian countries would reduce PRC's processed exports by 15%.²

This paper extends the previous work in a couple of ways. First, it investigates the factors influencing imports for processing as well as processed exports. This makes it possible to consider how exchange rate changes affect not only the PRC's processed exports but also the PRC's surplus of almost US$300 billion in processing trade. Second, it expands Thorbecke and Smith's data set to include observations from 2006–2008. This period is important because both the yuan and the PRC's processing trade exhibited major fluctuations during these years.

The results indicate that an appreciation throughout East Asian supply chain countries would reduce the PRC's processing surplus. The evidence is less clear concerning whether an appreciation of the yuan not accompanied by an appreciation in the rest of Asia would have this effect.

The next section presents a descriptive analysis of the PRC's processing trade. Section 3 presents the data and methodology. Section 4 contains the results and Section 5 discusses the implications of these results. Section 6 concludes.

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