RMB Exchange Rate Appreciation And Trade Balance Adjustment

On July 21rd 2005, Chinese government lauched the exchange rate regime reform, which leads the RMB exchange rate to more manageble and flexible regime adjusted by the basket currency instead of the US dollar. This indicates RMB exchange rate begins to be priced independently and appreciate to the equilibrium level. Up to December 2011, RMB/USD had appreciated by 30.8 percent.The real effective exchange rate had appreciated by 28.1 percent and the nominal one had appreciated by 19.0 percent. Meanwhile in the new millennium the significant feature of the trade balance is that large and persistant trade surplus definited by the IMF has lasted for ten years. The CAB/GDP surged since 2002 and the yearly mean from 2005 to 2011 reached 6.70 percent while the maximum number is 10.13 percent in 2007. Throughout the Great Recession the trade suplus temporarily reversed, however the absolute level is still high. The topic of the paper is the adjustment dellema of the RMB exchange rate appreciation. This study empirically evaluates the influence of RMB exchange rate appreciation on the trade balance since the reform in 2005. Furthermore, we compare the international experience especially Japan and induce the common and special feature of China.Finally we illuminate the policy implications. This study helps understand the adjustment efficacy of the exchange rate and the origin and structure of Chinese trade suplus, which will advise the further policy on exchange rate of the central bank.From the theoretical perspective, the topic is devided into two aspects linked logically i.e. the first is how the exchange rate affects the relative price and the second is how the relative price affects the trade volume (Dornbusch,1996). The general form of Marshall Lerner Condition organically connects the two aspects and provides the theoretical and empirical framework. Accordingly, we decompose the topic into three questions i.e. the first is exchange rate pass through, the second is trade elasticity and the third is general effect based on the above two results. Here is how the paper is orginzed.Chapter 1 puts forward the topic and Chapter 2 overviews the related theory and literature. Chapter 3 studies exchange rate pass through of the import price from the general and industrial perspective. We employ a Distributed Lag Model and estimate the long-term coefficient of ERPT. Moreover, we analyze the relative factors in the deternmination of import price. The result is the ERPT is close to complete pass through in the long term while lag effect exists and industrial factor plays a role. Majority invoiced in USD and weak import substitutions are the main reason of the high ERPT. The production cost inflation trigged by the surge of resource materials impulsed the increase of import price while the nominal exchange rate is relatively minor.Chapter 4 studies exchange rate pass through of the export price from the general, time and industrial perspective. From the general perspective, we employ a Distributed Lag Model illustrated in two forms i.e. Benchmark Model and Alternative Model and estimate the long-term coefficient of ERPT. From the industrial perspective, we employ a panel data model in the long-term and short-term form and estimate the long-term coefficient of PTM. The result is the ERPT is close to zero pass through in the long term while lag effect exists. Chinese exporters have demonstrated the capability of pricing to market and it differs a lot in different industries. Economies of scale, the low-priced exchange rate and wage and the processing trade together from the supply side cause the low ERPT of export price. Similar to the import price, the production cost inflation pushed by the domestic nontraded sector plays a role in the determination of export price while the nominal exchange rate is relatively minor.Chapter 5 studies on the second aspect i.e. the trade elasticity from the general, time and industrial perspective. We employ the standard trade model and estimate the income elasticity and price elasticity using OLS method. The result is both the elasticities fit the interval of the advanced economies, however, the price elasticity of import is not stable and even positive using different time period. The trade balance is adjusted by the relative income while aggregation bias exists which refers to the average income elasticities of import of all industries is higher than the general while price elasticities of export of all industries is higher than the general. The real effective exchange rate appreciation hasn’t change the terms of trade.Furthermore we extend the standard Marshall Lerner Condition to the general form by deleting the assumptions sequentially and calculate the influence of exchange rate appreciation on the trade balance based on the empirical results of the above chapters i.e. the ERPT and PTM coefficients and price elasticities. The result is reflected in four aspects. First is the efficacy of exchange rate. RMB exchange rate appreciation adjusted the general and industries in the opposite direction. Second is the elasticity of exchange rate. When the RMB nominal effective exchange rate appreciates by 1 percent, the trade balance denominated in USD will decreased by 0.13 percent. This proves the elasticity pessimmism exsisting globally. The aggregation bias exists as well i.e. the individual elasticity optimism and the aggregate elasticity pessimmism. Third is the degree of difficulty of exchange rate adjustment among industries. When the intial trade balance is surplus, the capability of RMB exchange rate decrease from Machine and Equipment, Raw Material and Miscellaneous Products successively. Fouth is RMB exchange rate isn’t the main channel that adjusts the trade balance. The adjustment direction of exchange rate is opposite from the real adjustment and the absolute margin is relatively small. Actually income and currency anti-substitution offset the exchange rate effect and dominate the the accumulation of trade surplus since 2005. Overall, the price elasticity, the intial trade balance and exchange rate pass through determinate the efficacy of exchange rate successively in importance. Furthermore, we sketch the adjustment mechanism of how RMB exchange rate appreciation affects the trade balance.Chapter 6 we illustrate the international experience on the adjustment of trade balace. One part is the large and persistent trade imbalance and reversals while the other is Japanese Yen appreciation and trade balance. We focus on the similarity and difference between China and Japan. Finanlly in Chapter 7 we conclude and illuminate policy implications. First is to find the keypoint of exchange rate policy and improve the formation machnism of RMB exchange rate. Second is to lauch the surveillance on the price compositon of the trade sector and track exchange rate adjustment. Third is to reexamine the export-oriented policy and increase the price elasticity of the traded commodities. Fouth is to build the constraint mechanism the exchange rate and pursue structural reform.