Impact of China's currency valuation and labour cost on the US in a trade and exchange rate model

https://doi.org/10.1016/j.najef.2013.03.001Get rights and content

Highlights

  • Under free trade, a low income country has comparative advantage in trade.

  • Efficiency gains from this enhance growth and household welfare in both economies.

  • China's comparative advantage and US trade deficit will both be lower under Yuan revaluation and full price adjustment.

  • Higher production cost and prices in China then reduce household welfare in China and trade imbalance of the US.

  • Also higher relative GDP of China lowers the current account imbalance in the US.

Abstract

Ricardian dynamic general equilibrium analyses show that under free trade arrangements a low income country with lower wage cost and large endowment of labour has comparative advantage in trade. Efficiency gains from this enhance economic growth and welfare of households simultaneously in both low income and advanced economies. Theoretical predictions are empirically validated here with structural VAR analysis based on quarterly data over the time period 1995:1 to 2009:1 on China's relative wage cost, interest rate differential, real effective exchange rate (REER), relative GDP and the US current account balance. It is shown how the relative prices of labour, capital and the currency affect the economic activity in China and current account balance in the US. With free capital inflows and outflows and restrictions on labour mobility, comparative advantage of China and the trade deficit of the US will both be minimised if China allows real appreciation of the Yuan and complete adjustment in prices. Higher production cost and prices in China could reduce welfare of Chinese households and the trade imbalance of the US, while higher relative GDP of China lowers the current account balance for the US.

Introduction

International economic landscape has changed dramatically after the comparative advantage in producing goods and the direction of trade changed significantly in the recent years. Interest has increased in understanding the new economic links between advanced economies and the emerging economies such as China that were able to grow at a reasonable space even during the financial crises and recessions of 2008/09. With a large current account surplus and apparently appreciating exchange rate, how do policies in China influence more advanced economies such as the US, have become the focus of attention in the recent studies (see [Corden, 2009], [Xu, 2011]). Large current account surplus of China impacts not only on the real effective exchange rate with its trading partners but also on the world real interest rate and the international relative prices of traded commodities and thereby on the current account deficit of the US. How do the relative prices set in this way affect the relative demand between China and the US and thereby create trade imbalances between the two countries, is an issue this paper aims to explore using a dynamic trade model supported by empirical analysis.

The Chinese Yuan continues to remain under valued and a large body of the literature concentrates on studying the relation between exchange rate movements and the trade balance (see Bahmani-Oskooee & Ratha, 2010). According to WTO's current trade profile, US imports more than three times from China than it exports to China; nearly 17 percent of US total imports originate from China whereas only 5.6 percent of US exports go to China. Absolute price differentials and relative price volatility increase with exchange rate volatility (Imbs, Mumtaz, Ravn, & Rey, 2010). Granville, Mallick, and Zeng (2011) explore price and exchange rate linkages between China and the G3 (US, Euro-area and Japan), showing that the price effect in China possibly due to lower cost is found to dominate the exchange rate effect on the US import prices. This suggests that we need to evaluate the relative impacts of exchange rate and production costs on the external balance in the US using a general equilibrium trade model with a monetary structure. The monetary linkage has been emphasised in these two groups of economies in the literature (see, for example, Cargill & Parker, 2004).

In order to address these underlying linkages of trade flows between two countries, we develop a neoclassical dynamic general equilibrium model based on the major developments in the literature.2 We show that under free trade arrangements a low income country with lower wage cost and large endowment of labour has comparative advantage in trade, which improves welfare in both low income and advanced economies.

Theoretical predictions are empirically supported via a structural VAR analysis based on quarterly data over the time period 1995:1 to 2009:1 using China's relative wage cost, interest rate differential, real effective exchange rate (REER), relative GDP and the US current account balance. To understand the dynamics of trade and exchange rate between China and the US, a structural vector error correction model (VECM) is formulated as suggested in Fry and Pagan (2011) in order to derive long-run estimates, impulse responses and variance decompositions. It is shown how the relative prices of labour, capital and the currency affect the economic activity in China and current account balance in the US. With free capital flows and restrictions on labour mobility, comparative advantage of China and the trade deficit of the US will both be minimised if China allows real appreciation of the Yuan and complete adjustment in prices. Higher production cost and prices in China will reduce welfare of Chinese households and the trade imbalance of the US.

The rest of the paper is organized as follows. Section 2 presents the dynamic model of trade followed by analytical results in Section 3, and data, estimation methodology and empirical results in Section 4, variance decomposition analysis in Section 5 and conclusions and the policy implications in Section 6.

Section snippets

Two country dynamic model of trade and exchange rate

Traditional Ricardian, Hecksher–Ohlin, Stopler–Samuelson trade theories suggest that the pattern of trade is dominated by factor endowments, trade is beneficial for all trading partners and factor prices tend to equalise across the globe with free and liberal trade (Bhagwati, 1964). Generally economists since Ricardo have argued for removing tariff barriers to enhance welfare of all trading nations from specialisation according to the comparative advantage in production. As Johsnon (1951–52)

Analytical results of optimisation

Since the infinite horizon problem is analytically intractable, the model is solved using the first order intertemporal optimisation conditions for any two time intervals as these optimality should hold for any other periods. First order conditions for households with respect to consumption, imports, leisure and shadow prices for t and t + 1 periods are:

Ci,t:αiθt(Ctαi1Mtβiltγi)=λtPi,t(1+tci)Ci,t+1:αiθt+1(Ct+1αi1Mt+1βilt+1γi)=λt+1Pi,t+1(1+tci)Mi,t:βiθt(CtαiMtβi1ltγi)=λtPj,t(1+tmi)Mi,t+1:βiθt+1(C

Empirical analysis on trade and exchange rate

We examine time series data for China and the US on wages, interest rates, exchange rates, GDP, current account balance and the US trade decifit to find empirical evidence on above theoretical analysis. A structural VAR model estimated in line of Sim (1980) and Bernanke (1986) with restrictions appropriate to theoretical derivations (see Fry & Pagan, 2011 for an uptodate review on this). We limit our analysis to five variables that include relative wage between China and the US (rwcu), interest

Variance decomposition

Let us start from the reduced form:

Xt=A0+A1Xt1+etfrom successive iteration this reduces to

EtXt+n=(I+A1+A12+A13+......+A1n1)A0+A1nXt+etForecast error is given by(et+n+A1et+n1+A12et+n2+......+A1n1et+1)A0+A1nXtXt+nEtXt+n=i=0n1φi(i)ϵt+niTaking only one equation

wt+nEtwt+n=φ11(0)ϵwt+n+φ11(1)ϵwt+n1+...+φ11(n1)ϵwt+1+φ12(0)ϵrt+n+φ12(1)ϵrt+n1+...+φ12(n1)ϵrt+1

+φ12(0)ϵet+n + φ12(1)ϵet+n−1 + . . . + φ12(n  1)ϵet+1

+φ12(0)ϵyt+n + φ12(1)ϵyt+n−1 + . . . + φ12(n  1)ϵyt+1

+φ12(0)ϵcat+n + φ12(1)ϵcat+n−1 + . . . + φ12(n  1)ϵcat+1

Conclusion

Role of real and nominal exchange rates in flows of goods and capital are evaluated theoretically using the Ricardian comparative static and dynamic general equilibrium models. Under free trade arrangements a low income country with lower wage cost and large endowment of labour has comparative advantage in trade and accumulates foreign and domestic capital. Efficiency gains from free trade enhance economic growth and welfare of households simultaneously in both low income and advanced

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    The authors are grateful to the two anonymous reviewers for their very useful comments, which helped improve the paper considerably. We also acknowledge the comments on an earlier version of the paper by the discussant, Keunsuk Chung, and participants at the CES session during the ASSA Annual Meetings, 7–9 January, 2011.

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