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M & D FORUM Relationship of Sino-US Trade Balance and RMB Exchange Rate WANG Lin1, 2 1. School of Economics, Huazhong University of Science and Technology, P.R.China, 430070 2. School of Economics and Management, Huazhong University of Science and Technology Wuchang Branch, P.R.China, 430070 [email protected] Abstract: Based on annual data from 1994 to 2005, the paper showed that RMB exchange rate appreciation have influence on China-US trade balance in the long run to a certain extend but not the main reason for China-US trade imbalances through cointegration analysis and Granger causality test. Development of U.S. economy and domestic policy in U.S. can be said to the main reason for China-US trade surplus. In the current economic situation, China-US trade surplus is still one of the important engines of economic development. So U.S. economic downturn leading to the decline in our exports has to be guarded against. On the other hand, the opportunity of RMB exchange rate appreciation can be utilized to adjust our economic structure and accelerate the pace of industrial upgrading. Keywords: Sino-US trade balance, RMB real exchange rate, VAR model, Cointegration, Granger causality test 1 Introduction Since exchange rate reform in July 2005, the exchange rate of RMB against US dollar has taken on a trend of slow rise on the whole and presented sometimes the two-way fluctuating feature of “rising and falling”. Meanwhile, the twin surplus of China's international balance of payment, especially the influence of exchange rate on trade, has always been the hot topic for policymakers. From 2005 to the end of 2008, nominal exchange rate of RMB against US dollar appreciated 15.22% cumulatively. In recent years, the increase of US trade deficits scale has caused the United States to pay further attention to the issues of Sino-US trade. On the one hand, the United States imposes restrictions on the import volume of Chinese goods by various means of dumping investigation and technical trade barriers, resulting in the increasing trade conflicts between the two countries. On the other hand, the United States imposes pressure on the appreciation of RMB exchange rate on the ground of relieving US trade balance. The domestic studies on RMB exchange rate and trade balance relations mainly focus on the influences of adjustment of exchange rate values on trade balance. With data of 1978 to 2000, Xie Jianguo and Chen Ligao (2002) drew the conclusion that the depreciation of RMB exchange rate had no significant effects on the improvement of China’s trade balance by using the methods of cointegration analysis and variance decomposition. Through the analysis of the data of 1981 to 1995, Dai Xiangzu (1997) concluded that the sum of import and export elasticity of exchange rate was 1.3, meeting Marshall-Lerner Condition and that the depreciation of RMB would be helpful to improve trade balance. With the data of 1994 to 2003, Lu Xiangqian and Dai Guoqiang (2005) discovered that the effective exchange rate of RMB had a remarkable influence on import and export by using the imperfect substitution model. Sun XiaoChong and Song Fengming (2008) held that nationality model was more effective and that the establishment of real exchange rate index of RMB against other countries improved the former condition of roughly applying the exchange rate of RMB against US dollar to analyze China’s overall trade balance. Many other scholars have studied the relations between exchange rate fluctuation and trade balance. By using the cross-section data of China’s 22 major trade partner countries of the year 1991 and 1995, Chen Ping and Xiong Xin (2002) established trade gravitation model and held that the increase of exchange rate fluctuation would lead to the drastic decrease of exports. Pan Gongyu (2007) tested the influence of exchange rate fluctuation on the exports to China’s three major trade partners by taking the standard 360 M & D FORUM deviation of exchange rate yields as the proxy variable of exchange rate fluctuation. LI Zhibin (2009) analyzed the short and long term relationship between RMB exchange rate and Sino-America trade balance by employing GARCH model to estimate the conditional heteroskedasticity of RMB exchange rate and introducing the conditional heteroskedasticity into the trade balance equation as the proxy variable of RMB exchange rate fluctuation. Avoiding certain limits of the analyses of some scholars and absorbing some of the enlightened views, this paper presents the following characteristics. (1) Since trade balance and exchange rate are not in a simple two-spot relation, other factors may have a greater influence on trade balance than exchange rate. Therefore, VAR model is applied in this paper to comprehensively analyze the dynamic relations among trade balance, exchange rates, Sino-US GDP multivariable. (2) Considering the appreciation of nominal exchange rate of RMB against US dollar and the rises of inflation rates in both the United States and China, real exchange rate is adopted to establish model for empirical analysis. (3) This paper has a narrowed study scope. Since the general data we find are about RMB exchange rate against US dollar, this paper will focus on the issues of Sino-America trade balance. 2 Theoretical Analysis In the aspect of influence of exchange rate on trade, researches conducted by scholars both home and abroad generally concentrated on whether the ML condition is set up and the J-curve effect is in existence. flexibility under the circumstance of partial equilibrium is employed in ML condition. That is to say, assume other conditions remain unchanged, when sum of exchange rate flexibility of exports and that of imports is greater than 1, the rising exchange rate (Local currency devaluation) is conducive to improve international balance of payment of a country. However, generally speaking, it is difficult to satisfy all the assumed conditions of partial equilibrium analysis. In addition, It is necessary to judge in an object manner whether the unchanged factors assumed in partial equilibrium analysis just pose secondary impact that can be neglected on the analyzed conclusions. It is discovered when investigating influencing factor of international balance of payment that in addition to fluctuation in exchange rate, elements that directly influence international balance of payment also include national revenue, fluctuation of which produces impact through marginal propensity to import and money stock etc. Furthermore, the rising exchange rate (Local currency devaluation) will generate the influence of inflation on domestic price. Analysis of the paper is based on the dynamic integrated model presented by Lawson and Metzler, which assimilates the absorption analysis approach of regulating international balance of payment proposed by Alexander and identifies that the regulating function of exchange rate fluctuation on international balance of payment depends on the operation of economic system. Followings are the two equations for the fundamental model presented by Lawson and Metzler: Y=D(Y, r)+X(r) X(r) –r M(Y, r)=0 In the two equations, there are two unknown numbers (endogenous variable): Y, the national revenue and r, the exchange rate. YC and YA, national income of China and America respectively, namely, YC=D(YC, r)+X(YA, r) X(YA, r) –r M(YC, r)=B will be taken into consideration with the reason that the article is targeted at the relationship between Sino-US trade balance and exchange rate of RMB. Moreover, a number of theoretical and empirical studies both domestic and international demonstrate that it is the fluctuation of real exchange rate that indeed produces influence on the international competitiveness of productions and macroeconomic operation of a nation, and the reason why the currency devaluation policies can not prove effective in some developing countries in history primarily lies in that the inflation is not effectively inhibited, resulting in rather rising than depreciation of the real exchange rate. Therefore, the real exchange rate of RMB will be figured out with price index adjustment in the article. That is to say, the real exchange rate will be recorded as R=e*Pf/Pd, among which e represents nominal rate of RMB and Pf and Pd stand for foreign (Here refers to America) and Chinese consumer price index respectively. 361 M & D FORUM Combining the aforementioned equations, it can be indicated that there is a closer relationship between real exchange rate and trade balance. As a result, the Sino-US trade balance can be demonstrated as the function form of real exchange rate, national income of China and that of America: B=B(e*Pf/Pd, YC, YA). 3 Empirical Analysis 3.1 Data source and process Sample interval: annual data from 1994 to 2008. Sino-US trade balance (B) is calculated with the raw data of Sino-US bilateral trade published by the State Statistics Bureau (www.stats.gov.cn) of People’s Republic of China; American price index employs the consumer price index of International Financial Statistics on the official website of International Monetary Fund (www.imf.gov). Actual Sino-US trade balance can be drawn by dividing the two. Sample data of empirical analysis in the paper can be obtained through taking natural logarithm of these data. The real exchange rate (R) can be acquired from the above-mentioned formula, namely, R=e*Pf/Pd, nominal rate of direct quotation is obtained according to the annually average price of RMB exchange rate published by the State Statistics Bureau (www.stats.gov.cn) of People’s Republic of China; Sino-US price indexes adopt the consumer price indexes in International Financial Statistics on the official website of International Monetary Fund (www.imf.gov). Take the natural logarithm after figuring out values with the formula of R=e*Pf/Pd. GDP of China and America (YC, YA) are calculated from annually nominal GDP of the two nations released by the State Bureau of Statistics (www.stats.gov.cn ) of PRC; Sino-US price indexes adopt the consumer price indexes in International Financial Statistics on the official website of International Monetary Fund (www.imf.gov); Actual GDP can be obtained by dividing the nominal one with corresponding price index, and then sample data of the paper can be drawn from taking natural logarithm. Long-term equilibrium model of Sino-US trade balance can be established as followed in the relationship research of real exchange rate, national incomes of China and America as well as trade balance: LnB=C0+ C1LnR+C2LnYC+C3LnYA+ε 3.2 Variable unit root test The ADF method is put into application in the paper to test each variable unit root. Build models with both simultaneous intercept and trend term for data with a significant time trend; bound respectively or simultaneously the constant term and time trend as 0 for data with indistinctive time trend. Conduct ADF test by divisions. Select the greater lags according to the minimum AIC information criterion. Calculate corresponding AIC and then deduct P until the minimum AIC, based on the minimum AIC the final lags are determined. See Table 1 for the ADF testing results. LnB LnR Ln YC, Ln YA DLnB DLnR DLn YC, DLn YA Table 1 Variable unit root test Critical value ADF test value Type of test 5% 10% C,T,3 -3.3113 -3.9333 -3.4200 0,0,1 -0.2797 -1.9709 -1.6036 C,T,0 -1.0557 -3.7911 -3.3422 C,T,1 -2.3600 -3.8289 -3.3629 -3.1928 -3.1199 -2.7011 (C,0,0) 0,0,0 -3.8838 -1.9709 -1.6036 C,T,0 -3.3629 -3.8289 -3.3418 C,T,1 -3.4448 -3.8753 -3.3883 ( ) ( ) ( ) ( ) ( ) ( ) ( ) 362 Stationarity Instable Instable Instable Instable Stable Stable Stable Stable M & D FORUM According to test results, annual data for Sino-US trade balance, MRB exchange rate, GDP of China and America are all greater than the marginal value with the significance level of 10%, indicating the four instable sequences. However, all the first-order difference sequences of the four sets of data reject the null hypothesis under the significance level of 10%, namely, they are stable sequences. As a result, all the time sequences are single and entire in the first order, that is to say, they are I(1) sequences. 3.3 Co-integration Test Johansen Co-integration Test, which estimates the long-term relationship of all the variable on the foundation of VAR model, is adopted because the article test co-integration of multivector. The paper confirms VAR model as well as lags of co-integration model in accordance with unrestraint VAR model. Selection of VAR model lags follows the AIC and SC principles. Optimal regression order of VAR(P) can be figured out through testing different and corresponding values of them. According to the principle, the optimal regression order of the paper is 2. Assumed number of CE(S) None At most 1 At most 2 At most 3 Table 2 Johansen Co-integration Test of Multivector Rail 1% critical Maximum Eigenvalue statistics quantity eigenvalue 0.967924 86.00308* 54.68150 44.71556* 0.835920 41.28751* 35.45817 23.49624 0.695774 17.79127 19.93711 15.46979 0.163539 2.321477 6.634897 2.321477 1% critical quantity 32.71527 25.86121 18.52001 6.634897 The above results are obtained on the foundation of the linear trend of selected sequence and the intercept of co-integration equation. Under the significance level of 1%, both maximum eigenvalue test and trace statistic test of the model reject r=0, indicating a co-integration relationship existing among the four variables. While it is also noticed from the testing results that there is contradiction between the trace statistic test and the maximum eigenvalue test in a way that there are two co-integration vectors in accordance with the former while there is only one in line with testing result of the latter, and results of the two demonstrate that co-integration relationship is in existence. Table 3 Estimated results of Johansen Co-integration Test Co-integration expression LnB= -0.493882LnR+0.338082LnYC+6.835064LnYA (0.21795) 0.10569 0.42737 ( ) ( ) According to the above formula, in the 15 years from 1994 to 2008, there exists a negative correlation between real exchange rate of RMB and Sino-US trade balance while a positive one between real GDP of China and America and Sino-US trade balance. It is discovered from comparing influences of economic development of China and America on their trades that economic development of America enjoys a prominent function on Sino-US trade balance in a way that each 1% increase of American real GDP will generate an increment of 6.83% of Sino-US trade balance. Judging from the long-term equilibrium, the rising of RMB real exchange rate will not pose significant influence on trade balance of China and America. 3.4 Granger Causality Test Johansen Co-integration Test states that there is a long-term equilibrium relationship among variables. Granger Causality Test, which is conducted here to further test the relationship between Sino-US trade balance and other three explanatory variables, aims to investigate the estimating capacity of one explanatory variable on another with the basic thought as follows: For A and B, two variables subject to stationary random process, if a more accurate predicted value can be obtained by predicting A with 363 M & D FORUM previous and present data of A and B than the same conduction without previous and current data of B, B will be the Granger cause for A. Two lags are selected here to perform Granger Causality Test and see Table 4 for the causality between Sino-US trade balance and each influencing variables. Table 4 Granger Causality Test Results Null hypothesis Sample number F statistic LNR is not the Granger cause for LNB 2.15992 13 LNB is not the Granger cause for LNR 0.13140 LNYC is not the Granger cause for LNB 0.09168 13 LNB is not the Granger cause for LNYC 2.02350 LNYU is not the Granger cause for LNB 4.26781 13 LNB is not the Granger cause for LNYU 0.64381 Probability 0.17780 0.87872 0.91334 0.09168 0.05479 0.54835 According to the Granger Causality Test results, there is causality among American internal revenue, real exchange rate of RMB and Sino—US trade balance while Sino-US trade surplus marks the Granger cause for the increasing internal avenue, suggesting that trade balance surplus with America counts an important factor that promotes the increase of Chinese national income. 3.5 Analysis on each variable’s function on trade balance Error variance of a time sequence is the concurrent result of self disturbance and other disturbances of the system. Main thought of variance decomposition, the purpose of which is to study to which extent it can influence the subsequent changes of the whole system when an exogenous shock take place in a system, is to decompose fluctuation of each endogenous variable in the system into several components that relate to each equation shock according to their causes so as to learn the relative significance of various shocks on endogenous variables of the model. Variance decomposition enables us to learn the relative importance of each influencing factor on trade balance of the two nations. Period 1 2 3 4 5 6 7 8 9 10 Table 5 Variance decomposition results of Sino-US trade balance SE. LNB LNR LNYC 0.203079 100.0000 0.000000 0.000000 0.299365 95.28605 0.005505 0.112493 0.435996 91.98298 0.028700 1.039292 0.555757 86.09918 0.428118 0.931180 0.696633 75.08575 1.087064 0.600284 0.899590 63.17808 1.633097 0.367030 1.170459 51.67920 2.308367 0.263019 1.520050 40.88566 2.925220 0.275995 1.968176 31.31993 3.500942 0.389309 2.538783 23.19163 4.008069 0.581589 LNYU 0.000000 4.595949 6.949032 12.54152 23.22690 34.76179 45.78492 55.91312 64.78982 72.21811 Results of variable decomposition suggest that if the contribution rate of trade balance is not taken into consideration, influence of real GDP of America on Sino-US trade balance becomes prominent with time passing by in a way that its contribution rate on trade balance reaches over 20% after the four-year duration of lags; Despite that real exchange rate enjoys the tendency of further enhancement with time passing by, it does not generally pose significant influence on Sino-US trade balance. Impact of real GDP of China on Sino-US trade balance fluctuates within a small range with very little influence. To sum up, fluctuation of American real GDP marks the most significant reason influencing Sino-US trade balance. 364 M & D FORUM 4 Conclusion The paper establishes co-integration model of Sino-US trade balance and analyzes with approaches such as Granger Causality Test and variable decomposition etc. influences of related factors including exchange rate on Sino-US trade balance, demonstrating that: (1) There exists a long-term equilibrium relationship between Sino-US trade balance, national income of China, national income of America and the real exchange rate of RMB. (2) In the long run, favorable balance of trade between China and America, with rich flexibility (long-term flexibility is 6.83), enjoys significant positive correlation with internal income of America, indicating that the import demand of America resulted from its rapid economic growth will increase Sino-US trade surplus. (3) In the long term, influence of RMB exchange rate change on Sino-US trade balance produces some certain duration of lag without significant impact. Sino-US trade imbalance is the macro demonstration of the imbalanced economic structure, and China’s saving glut as well as deficit spending policy of America contributes to the trade deficit of America. In addition, exchange rate produces different mechanism of action on China, America and other countries. Big changes in the real exchange rate, primarily come from relative changes of CPI in the two nations, have not been witnessed from 1994 to July 2005. That is to say, instead of originates from nominal rate, influence of real exchange rate on trade comes from relative changes in inflation. (4) In the long term, national income growth of China, influence of which on trade balance is not notable, and not the Granger cause for Sino-US trade balance. In other words, trade deficit of America, which is largely due to domestic reasons in America, and is not likely to be improved by depending on economic growth in China. (5) Sino-US trade surplus is the Granger cause for the growth of national income in China, demonstrating that China’s economic growth remains primarily driven by investment and foreign trade. America, which has always been the leading target country for export of China, plays a crucial role in the economic development of our country. In a word, it is can be said that Sino-US trade balance surplus is resulted from functions of various elements such as characteristics of the international division of labor, domestic policies of both China and America and the feature of economic growth in China etc. Both reasonable and unreasonable factors exist in Sino-US trade imbalance. The reasonable factors are determined by the current characteristics of international division of labor. A major shift in global manufacturing industry is taking place under the influence of economic globalization, and China continues to maintain its status as the hub of global manufacturing industry. Most labor intensive industries of developed countries from Europe and America are shifting to China, directly resulting in large trade surplus between China and America. Unreasonable factors deserve our special attention and seeking for solutions. In addition to trade policies such as tariff and non-tariff policies that often mentioned, crucial unreasonable elements also include domestic economic policies both in China and America. There are three typical policies in America, namely, fiscal policy of high deficit, policy of high consumption and export control policy. However, China, whose current domestic saving rate is too high, enjoys insufficient domestic demand as well as low cost of human, resource and environment, directly leading to the fact that our national productions have to find ways out in foreign market and continuously increasing trade surplus. Therefore, aiming at the point of views discussed above, It is not necessary for China to reduce export and trade surplus on purpose, which runs against market laws with the reason that China’s pattern as the center for labor and manufacturing industry will not change currently as well as some time in the future, which is a reasonable element formed by the aforementioned market resources allocation. Moreover, intentionally reducing export is not conducive to countries of consumption. Import may be enhanced through proper appreciation of RMB, in particular, purchasing a large number of technologies at relatively low price and regulating domestic economic structure in an initiative manner at the stage of 365 M & D FORUM industrial updating in China. Furthermore, under the influence of US economic downturn and weakened external demand while domestic credit growth, price inflation of agricultural productions as well as elements of labor force, land and resources etc. and increasing inflationary pressure in China, we should accelerate domestic economic structure adjustment, making China the country whose economy increase is driven by internal demands. References [1]. Chen Ping, Xiong Xin. Empirical analysis on exchange fluctuation of importing country and China’s import and export. International Financial Research, 2002,(6) (in Chinese) [2]. Ma Dan, Xu Shaoqiang. Trade balance, trade structure and real effective exchange rate of RMB in China. The Journal of Quantitative and Technical Economics,2005,(6) (in Chinese) [3]. Pan Hongyu: Exchange Rate Volatility and China's exports to major trading partners. The Journal of Quantitative and Technical Economics,2007,(5) (in Chinese) [4]. Ba Shusong, Bo Wu, Zhu Yuanqian. Measurement and calculation of RMB effective exchange rate after reformation of exchange rate regime as well as analysis on its influence on international trade and foreign exchange reserves. International Finance Research,2007,(4) (in Chinese) [5]. Chou W.L. Exchange Rate Variability and China’s Exports. Journal of Comparative Economics ,2000,(28): 61~79 [6]. Marc Klau, San sau Fung. The new BIS effective exchange rate indices. BIS Quarterly Review, 2006,(3) [7]. Anil K. Lal, Thomas C. Lowinger: Nominal effective exchange rate and trade balance adjustment in South Asia countries, Journal of Asian Economics, 2002,(13):371~383. 366