Download Exchange Rate and International Outsourcing: Would Chinese

Exchange Rate and International
Outsourcing: Would Chinese Yuan
Appreciate Against U.S. Dollar?
Chu Ping Lo
K.C. Fung
Chelsea C. Lin
Shih-Hsun Hsu
1. Introduction
• We live in a world of both specialization and globalization.
• Encouraged by innovation in computer, communication and
transportation technology, firms tend to specialize in particular
stages or components of production, exporting them to other
countries for further processing or input.
• Grossman and Helpman (2005) noted:
Firms seem to be subcontracting an ever expanding set of
activities, ranging from product design to assembly, from
research and development to marketing, distribution, and
after-sale services. Some firms have gone so far as to become
“virtual” manufacturers, owning designs for many products
but making almost nothing themselves.
China: Factory of the World
China’s yuan should appreciate?
• China has the fastest economic growth in the world (e.g., three times larger
than U.S.).
• It is widely expected that China will continue this high economic growth
rate for the next two decades or so.
• Steady trade surplus
• Enormous flooding inflow of FDI
• Successfully controlled inflation in the 2000’s.
Instead:
• China has repeatedly devalued its currency as a means of promoting trade
and FDI (foreign direct investment) in the 1980s and early 1990s.
• Zhang (1996) argues that a key reason for China’s continuous currency
devaluation is to reduce the price distortion and promote exports.
• Wang (1993) has found that there is a positive relationship between the
currency of China and its exports.
• Brada et al. (1993) also found that devaluation of the yuan serves to
improve its balance of trade.
Figure 1. Nominal & Real Exchange Rate of the RMB
1979~1996
Yuan per U.S. Dollar
10
8
6
8
4
6
2
4
0
2
REAL
NOMINAL
0
80
82
84
86
88
90
92
94
96
Year
Source: International Financial Statistics, various Issues (Zhang, 1996)
Figure 2. Trade performances in China
$100 Million
10000
8000
T otal Trade
6000
4000
Exports
2000
Imports
0
90
92
94
96
98
00
02
Year
Why China needs to keep a low-cost
environment?
• Naughton (1996) and Fung (1998) show that China’s trade is
heavily dependent on enterprises from other economies and a
substantial amount of China’s trade is conducted by foreigninvented enterprises.
• A high degree of trade related to foreign investment:
foreign firms conducted 56.2 percent of China’s imports and
54.8 percent of exports in 2003.
• A high incidence of re-exports through Hong Kong: an
average of 53 percent of Chinese exports was re-exported
through Hong Kong over the period 1988-1998 (Feenstra et al.,
2002).
More critical reason for currency
undervaluation?
• In 2004, China had about three hundred millions of laborers in
the agriculture, and at least more than two hundred million
agricultural workers are “redundant” in the long run (v.s. U.S.).
• In 2004, there is about 66M worker in state-owned-business.
• Therefore, China has incentives, and is under great pressure, to
devalue its currency in order to encourage international
outsourcing activities for accommodating these redundant
laborers.
2. The Model
• Labor is a unique production factor in a world of North-South.
• The labor in the North is skilled, while the labor in the South is
relative unskilled.
• Consumers are assumed to have homogeneous preferences on
all differentiated goods.
• The demand function for a representative final-good is given
by
(1)
y j   pj 1/(1 ) ,
0  1
, where p j is price of the final good j and  is a given parameter.
Incomplete contract
• Firms in the North generate the high-tech inputs but outsource
the low-tech inputs domestically or abroad. If the specialized
low-tech inputs are bad quality, the output of the final-goods
will be zero. Otherwise, the output is given by
(2)
y  xh
1 z
x Iz ,
0  z 1
, where   z  z (1  z) z 1 .
• Assume that the wage rate in the North is w N , and the wage
rate in the South is wS in term of the currency of the North.
• Let’s assume that the exchange rate  is exogenously
determined by the government of the South, which usually
pegs its currency against the North’s currency.
Profit Maximization :
When low-tech input is produced in the North
• If the low-tech inputs are produced in the North, the profit of the final-good
producer is given by
(3)
 N    1 xh (1 z ) xI z  wN xh  wN xI
• With respect to each output, the first order conditions show that the optimal
price for the final-good producer is given by
w
p N ( z)  N
(4)

• Substituting (4) into (3), we get the profits of the final-good producer as
(5)
 N ( z )  (1   ) (
wN

)  (1 )
Profit Maximization :
When low-tech input is outsourced to the South
• The North and the South bargain over the surplus from the relationship after
that the South can provide good quality low-tech inputs.
• With this ex-post Nash bargaining, supposed that  py is attributed to the South,
and the remaining surplus, (1   ) py is attributed to the the North,
where 1    0 .
• The firm in the North is to maximize (1   ) py  wN xh .
• The low-tech producer in the South is to maximize py  wS xI .
• The F.O.Cs of the joint profits yield an equilibrium as
(1  z )(1   ) wN xh

(6)
z
wS x I
• Combining the F.O.C. and (6), we obtain the optimal price of the final good as
(7)
pS ( z )  (
wS z
wN
) (
)1 z

 (1   )
Profit of the Northern firm after Outsourcing
• Combining (6), and (7), we obtain the profit of the Northern firm as
1   [ z  (1  z )(1   )]
(8)
w
1 w
[ ( S ) z ( N )1 z ] (1 )
 
1 
• For a profit-maximization firm in the North, the strategy of international
outsourcing is preferred if  N ( z )   S ( z ).
• Comparing (5) to (8), we find that international outsourcing is carried out if
 S ( z)  
1
1
A
(

,
z
)

(
) z [(   z (1   ) z 1 ] z   
(9)
1   [ z  (1  z )(1   )]
wN
, where  
.
wS
A( ,0)   .
• We have lim
z 0
• A( , z ) is nonincreasing in z for z  [0,1] . (Antra`s, 2004).
1
1


• We also have lim A( ,1)   1 (
)  .
z 1
1  
1
Figure 2. Equilibrium in the Choice of Location
1
1    zf ( z )dz  Yg L ( z )
S
z

1
LN
 zf ( z )dz  Y

g
z
 ( z  0) 
1    Yg LS (0)
;
  Yg
LN
lim A( ,0)  
z 0
 ( z  1) 
1  Yg LS (1)
  ,
Yg
LN
1   1
A(1)   (
) 
1  
1
*The low-tech input is produced in the South if z  z  A1 ( )
, otherwise in the North.
3. Redundant Labor and Currency Manipulation
• Full employment in the North.
• Assume there are substantial amount of redundant laborers in the South
reside in agriculture sector or in state-owned business.
• International outsourcing activities (i.e., offshore production) from the
North to the South provide jobs for the South’s redundant laborers.
• Therefore, we argue that the South might tend to encourage international
outsourcing activities to both accommodate these redundant laborers and to
become more industrialized.
Table 1. Labor Supply in China
Source: National Bureau of Statistics of China.
(In Million)
Total labor Supply
Labor Supply in State-owned
Enterprise
Labor Supply in Agricultural &
Fishery
2000
2001
2002
2003
2004
720.85
730.25
737.4
744.32
75200
78.78
74.09
69.24
66.21
64.38
327.97
324.51
319.90
312.60
305.96
Relative share in world value-Added
• World income equals world output on all goods, so that E  wN LN  wS LS
• Assume the labor demand in the South LS (z ) increases with a lower
outsourcing threshold, that is, L'S ( z )  0 .
• Let F (z ) be the fraction of industries with z  z and f (z ) be the corresponding
probability density function.
• The relative share of world income can be expressed as:
1
(10)
1    zf ( z )dz  Yg
LN
wN LN
z


1
LS ( z ) wS LS ( z )
 zf ( z )dz  Y

z
g
• Here we denote Yg as the output of the South’s homogeneous sector (say
agricultural sector) in world income E.
• Rewrite (10) as to express the relative wage rate of the North to the South as:
1
(11)
1    zf ( z )dz  Yg L ( z )
S
z

1
LN
 zf ( z )dz  Y

z
g
Elasticity of labor demand
• Obstfeld and Rogoff (2004) find that a decrease in the trade deficit to GDP
of 1% requires a decrease in the exchange rate somewhere between 7% and
10% in the U.S.
• Olivier, et al. (2005) estimate, supposed that the U.S. export to GDP is
about 10%, that a reduction of the ratio of the trade deficit to GDP of 1%
requires a depreciation of 15%.
• It is feasible to argue that the change in the ration of trade deficit to GDP is
equivalent to the change in employment.
el 
 dLS L S
d  as the elasticity of labor demand with respect to
• Denote
exchange rate in the South.
• The estimate of U.S. elasticity of labor demand with exchange rate ranges
from 0.07 (implied from Olivier, et al., 2005) to 0.14 (implied by Obstfeld
and Rogoff, 2004).
• Assume 0 e l  1 .
Figure 3. The South manipulatively undervalues its currency
1
1    zf ( z )dz L ( z )
S
z

1
LN
 zf ( z )dz

z
*When the South devalues its currency (i.e., a smaller  ), the A( , z )
curve shifts downward to the new equilibrium with a lower threshold ~
z ,
, where ~
z  z.
Hypothesis
• A smaller  (i.e., depreciation) leads to a lower outsourcing
threshold (i.e., a smaller z ).
• It turns out the South acquires a larger share of world
1
1


income as in equation (10).  LN
z zf ( z)dz  Yg
 LS ( z )

1
  zf ( z )dz  Yg
z
• Meanwhile, the total employment in the South increases
with a lower outsourcing threshold (i.e., LS (~z )  L( z ) ).
• The South could turn its redundant labor into productive by
undervalued currency, but maybe at the sacrifice of its real
income.
4. Conclusions
• A South that has large amount redundant labor tends
to undervalue its currency to attract more
international outsourcing activities from the North to
accommodate its redundant laborers.
• The South as a whole benefits from the international
outsourcing activities because it binds itself tighter
into the global value-chain. This is the reason why
usually the South resists currency appreciation even
though its currency is expected to appreciate.