Chapter 1. Introduction

In the last two decades, China has shown a spectacular growth in its share of world trade. Although China has already become third largest exporter in the world, a relatively balanced trade account remained in China until recent years. China's trade surplus dramatically increased from approximately 32 billion US dollars, or 1.7% of China's GDP in 2004, to nearly 180 billion US dollars, close to 7% of China's GDP in 2006.

In particular, among those trades between China and other countries around the world, the one between China and the US should be the most representative. From 1984 to 2002, there is 7.4 times rise in US total exports to China, from 3 billion US dollars to 22 billion US dollars. By comparison, the total imports of the US from China increased 40.8 times from 3.1 billion US dollars to 125.2 billion US dollars during this period.

Since the similar things as between China and the US happened between China and increasing countries, there came a heated debate on the large size of trade surplus in China, because the issue had directly or indirectly caused some troubles in many countries. For example, the employment in the US manufacturing industry had not declined so much ever until a very large bilateral trade deficit with China. Besides, Europe and Japan had been struggling with weak economic growth due to the challenge by a rising China.

In the debate, many scholars claim that there exists a link between the Chinese currency, namely, RMB and international trade in China, and some of them even believe that the recent trade surplus of China can be explained by an overly depreciated exchange rate of RMB. The reason is that China could capitalize from external demand and spur a higher economic growth by maintaining an undervaluation of RMB. However, there are doubts that the exchange rate can be an effective tool to generate the trade surplus.

Following the debate on the issue of large trade surplus in China, increasing appropriate statistics became available, encouraging research on how related are the exchange rate of RMB and foreign trade in China. Much of the research has concentrated on assessing the equilibrium exchange rate which is best for China's trade, while much more of it has been contributed to if China should appreciate its currency - if there does exist a link between exchange rate and trade balance - to eliminate the enormous trade imbalance in the interest of economic growth of the whole world.

This paper, using cointegration analysis by Alicia and Tuuli (2007), empirically analyses how related are the exchange rate RMB and the trade balance in China. According to the results, China's trade surplus would shrink following a real appreciation of RMB, but the reduction would be limited. The relatively small impact, the size of the imbalance, is mainly explained by the unique price elasticity we find for imports, namely, Chinese imports appear to fall following a real appreciation. By estimating bilateral import equations, it is found that imports from other Asian countries fall, while those of some industrial countries, Germany in particular, increase, which might be explained by the vertical integration of Southeast Asia and China's key role in the regional production network.

The rest of the paper is arranged as follows. Part 2 covers literature review, where some analysis approaches from some scholars are presented, and hence some different conclusions are given. Part 3 describes the theoretical model and data used in the paper. Part 4 draws a conclusion on the theoretical model. Part 5 exhibits the appendix.

Chapter 2. Literature review

Many scholars did valuable research and gave instructive opinions on the relationship between exchange rate and the trade surplus in China. These opinions can be divided into two categories in terms of the influence exerted by exchange rate on China's trade balance. The first one finds that a currency appreciation could discourage the trade balance by decreasing exports, increasing imports or both. The other one give evidence that exchange rate should have no significant impact on China's trade account or even a positive one.

Zhang S G (2005) tested China's FDI function, which is regarding import and export and the flexibility of exchange rate. The cost of exchange rate appreciation was also estimated in different level, mainly including the decrease of foreign capital, exports and the GDP, and following higher unemployment rate. Most importantly, the author found that an appreciation of exchange rate will bring a remarkable effect to the magnitude of import and export, but it will last less than two years, and afterwards, disappear.

Lu X Q and Dai G Q (2005) drew a conclusion that the fluctuations of weighted real exchange rate in China exerted a marked influence on the import and export trade when the M-L condition was met with the working “J curve” effect, after investigating the relationship between fluctuations of weighted real exchange rate of RMB to some main foreign currencies and the import and export in a long-term range, from 1994 to 2003, with the cointegration vector autoregression technique.

After analyzing the relationship of China-the US trade and exchange rate of RMB, Chou (2000) found that the fluctuation of real exchange rate of RMB to dollar will bring China's export to the US a negative effect, that is, the export will decrease when there is a drastic fluctuation. Nevertheless, the paper discussed only the fluctuation of exchange rate, not the effect brought by the real exchange rate and nominal exchange rate to the trade between China and the US.

Cerra and Dayal-Gulati (1999), from a different angle, adopting an error correction model, estimated the price elasticities of exports and imports of China from 1983 to 1997 and found that there were a significantly negative one for exports and a significantly positive one for imports, and both increased with time.

Based on the previous analysis, Dees (2001) divided China's exports and imports into two groups, the processed and the remainder. It was discovered that, an appreciation of exchange rate will decrease exports in the long run. It was also reported that ordinary exports are more price sensitive, compared with processed ones. By contrast, in the short term, nothing but the demand of the world will influence exports.

Bénassy-Quéré and Lahrèche-Révil (2003) simulated the impact of a 10% real depreciation of RMB and concluded a growth in China's exports to OECD countries but a reduction in China's imports from rising Asian countries.

Eckaus (2004), from aggregate annual data for the period 1985-2002, found that the appreciation of RMB decreased China's exports to the US and the share of Chinese exports in total US imports.

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