China's Import–exchange Rate Linkage: Evidence from the China‐bound Exports of Japan and Korea

• Published date: 01 January 2014
• Author: Chan‐Guk Huh,Guangyao Zhu
• DOI: http://doi.org/10.1111/j.1749-124X.2014.12052.x
• Date: 01 January 2014

45

China & World Economy / 45–66, Vol. 22, No. 1, 2014

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China’s Import–exchange Rate Linkage: Evidence

from the China-bound Exports of Japan and Korea

Chan-Guk Huh, Guangyao Zhu*

Abstract

This paper examines how the China-bound exports of Japan and Korea are related to

exchange rates, motivated by the fact that processing trade makes up a large proportion of

China’s trade, and that Japan and Korea are the leading source countries for processing

imports. Because processing imports are inputs for exports, the link between such imports

and China’s exchange rates are ambiguous. We estimate export functions that include

China’s RMB real effective exchange rates (REER) along with bilateral real exchange rates

(BRER) using Johansen’s cointegration method and find that the RMB REER significantly

affects Japanese and Korean exports to China, even more so than BRER in most cases

examined. These two exchange rates appear in the export equations with opposite signs.

Subsequently, we use the estimated model to illustrate the importance of accounting for a

concurrent change in BRER when analyzing the effects of a hypothetical RMB revaluation on

China’s trade balances despite the apparently weak imports–BRER linkage.

Key words: exchange rate elasticity, Japan, Korea, real effective exchange rates, trade

JEL codes: F14, F31

I. Introduction

China has emerged as the leading trading country globally, and, therefore, interest in the

prominence of its processing trade, in which many imported goods are transformed into

finished products and exported, has risen rapidly in recent years.1 Korea and Japan, in that

*Chan-Guk Huh (corresponding author), Professor, Department of International Trade, College of

Economics and Management, Chungnam National University, Daejeon, Korea. Email: chanhuh@cnu.ac.

kr; Guangyao Zhu, Department of Audit, KPMG and KPMG Huazhen (Special General Partnership),

Shanghai, China. Email:zhuguangyao311@hotmail.com. The authors acknowledge the helpful comments

provided by participants of the Association of Korean Economic Studies session at the 2013 Economics

Joint Conference held in Seoul, Korea as well as by Dr. Koo Jahyoeng on an earlier draft of the paper. Any

remaining errors are our own. This study was financially supported by the research fund of Chungnam

National University.

1See Hummels et al. (2001) as well as the subsequent examinations by Koopman et al. (2008) and Dean

et al. (2011) for discussions on the basic concepts of related vertical intra-industry trade and its application

to China.

46 Chan-Guk Huh, Guangyao Zhu / 45–66, Vol. 22, No. 1, 2014

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

order, were the top two source countries for China’s processing imports in 2010 (Yu and

Tian, 2012). As processing imports are brought into China as inputs for exports, the link

between such imports and China’s exchange rate tends to be ambiguous. Ordinarily, imports

are substitutes for domestically-produced goods and an appreciating home country currency

makes imports less expensive, leading to a positive linkage between a currency’s exchange

value and imports. In processing trade, goods are imported to be processed and turned into

exports. An appreciation of the home currency in this context makes exports less competitive,

thus lowering (processing) imports. At the same time, however, a strengthening RMB

should positively affect China’s imports by lowering their costs. Such a mechanism makes

estimating the exchange rate elasticity of China’s imports with precision inherently uncertain.

Many authors have studied the implications of China’s trade structure for the link

between trade and exchange rates. Commensurate to the large magnitude of China’s overall

trade and bilateral trade imbalances with its largest trading partner (i.e. the USA), estimating

China’s exchange rate elasticities has also been a subject of keen interest to these researchers.

However, estimation results vary. A rather distinct pattern in the empirical literature on

China’s trade elasticities is the contrasting results for its import price elasticity: both positive

(Cerra and Dayal-Gulati, 1999; Dees, 2001) and negative (Lau et al., 2004; Garcia-Herrero

and Koivu, 2009; Thorbecke and Smith, 2012; Xing, 2012) signs have been reported

with varying degrees of precision (Marquez and Schindler, 2007; Aziz and Li, 2008;

Cheung et al., 2010).

Acknowledging this shortcoming, many studies since Dees (2001) have grouped

Chinese data into ordinary and processing trades (e.g. Aziz and Li, 2008; Ahmed, 2009).

Although the trade–exchange rate patterns found in these sub-groups conform to the

expectations derived from trade theories, the results also seem to be vulnerable to data

problems such as the potential over-reporting of processing imports.2 Even then, findings

on the import–exchange rate linkage are generally mixed. In addition, the paucity of key

prices and quantity data for earlier years in China presents a serious barrier to empirical

verification.

The present paper takes an alternative approach to verify the exchange rate–import

linkage empirically without grouping import data into different types. To overcome the

issue of the limited availability of Chinese data, we estimate a variant of the conventional

export equation that includes RMB real effective exchange rates (REER) along with the

2“However, some firms consider their imported intermediate inputs as ‘processing imports’ upon arrival

on the ports but sell their final value-added products in the domestic market. Such a behavior reinforces

the idea that the high share of processing exports is due to the addition of value involved in processing

trade” (Yu and Tian, 2012, p. 6). A similar point was made by Aziz and Li (2008).