To what extent RMB undervaluation affects the US trade deficits?

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To what extent RMB undervaluation affects the

US trade deficits?

Supervisor: Stephanie Chan

Name:

Weiwei Du

Student Number:

10374671

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Abstract

Together with the recent revaluation for RMB, the trade deficit between China and US remains large, this challenges the traditional theory on International Economics. On the basis of introducing about the current situation of the bilateral trade between China and US, this paper firstly illustrates the opinions from different perspectives, and then extracts several significant factors to conduct an OLS multiple regression model on the basis of both non-robust and non-robust standard errors. The result appears that the appreciation on RMB can reduce the trade deficit between the two nations, but its influence is obviously very limited by some other factors, such as national income of two countries, US fiscal deficit and US interest rate.

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Over past three decades, China has experienced an outstanding economic growth since it implemented the open-door policy in the late 1970s. Since then, the trading volume between the US and China has been significantly increased during past few decades. In fact, US is the most important trading partner of China, and China is one of the major trading partners of US as well. According to the record of Central Intelligence Agency in 2013, the share of the US market in the Chinese exports was 16.7%, far exceeding that Japan market (6.8%) and South Korea market (4.1%). Thus I would like to choose US, which is the most important trading partner of China to do the following analysis.

As Figure 1 shows below, it is clear to see a substantial increase of trade deficits US - China trade over the period from 1994 to 2014. During past two decades, US trade deficits with China have become increasingly larger since US imports from China were far greater than its exports to China.

Figure 1. Seasonally adjusted trade balances during 1994 and 2014 (Based on U.S exports minus US imports, in million dollars)

Source: US Department of Commerce

In terms of the data from US Department of Commerce, the level of US trade deficits stood at 29,505.1 million dollars in 1993. Up to the end of 2014, the amount of trade deficits rose to 343,078.8 million dollars as it is illustrated in Figure 1. (Census, 2014). In terms to

-400.000,00 -300.000,00 -200.000,00 -100.000,00 0,00 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14

Trade balance

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the historical record of trade deficit, it is reasonable to predict that as the expansion of the bilateral trade between China and US, the amount of trade deficit will expand further.

Many US policy makers and trade unions claim that undervaluation of RMB (Chinese currency) fuels China’s exports to the US, therefore it is considered to be a cause of the large trade deficits. However, the fluctuations of the exchange rates during past two decades do not support the argument from US policy makers and trade unions.

The fluctuation of exchange rate of RMB during the past twenty years can be divided into three periods. As Figure 2.illustrates below, the first period started from 1994 to 2000, when RMB appreciated quite rapidly. During this period, RMB was pegged to the US dollar

8.28 RMB per dollar with very limited fluctuations. After that, RMB experienced a slight

depreciation from 2000 to 2005. Within this period, RMB exchange rate appreciated around 1.2%. The third period is 2005 to the present. During this period, RMB exchange rate regime moved to a managed float to a basket of currencies, which made the RMB exchange rate get more flexible and evidently appreciate. Since then, the RMB has largely appreciated further from 8.18 before the revaluation to 6.14 RMB per dollar at the end of 2014, which is and appreciation of over 30%.

Figure 2. Historical exchange rates from 1994 to 2014 (CNY per dollar)

Source: OANDA 8,35 8,28 8,18 6,14 5,50 6,00 6,50 7,00 7,50 8,00 8,50 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 20 14

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Despite the appreciation on RMB especially after 2005, the US trade deficits didn’t fall as expected but continued increasing around 15,000 million dollars in 2005 to about 35,000 million dollars in 2014 as shown in Figure 1.

The purpose of this thesis is to analyze to what extent RMB undervaluation affects the US trade deficits and what other factors may play the important roles behind this huge trade deficit.

2 Literature review

Since this economic issue has been harshly debated recently, economists have produced a substantial number of papers on the issue. The earlier studies have not reached a consensus on this issue. The literature can be grouped into two different directions according to their research results. One group has found a positive impact of RMB exchange rate on US trade deficit. Another group has indicated that RMB exchange rate does not have a significant effect on improving US trade deficit.

The view that the RMB appreciation may reduce the trade deficit of US is relatively widespread in previous researches. Narayan’s research (2006), the results support that the real exchange rate of RMB has significant impact on China’s trade balance based on the monthly data for the period November 1979 to September 2002. In his research, he found that the long-run and short-run elasticity on the real exchange rate are positive and statistically significant, which indicating that the real exchange rate devaluation can help to improve US trade balance.

Further, Cline’s (2010) research based on an OLS regression model consisting of dependent variable of China’s trade surplus as a percentage of GDP, explanatory variables of real exchange rate, the GDP growth differential between China and world and a time trend variable. The regression result did provide empirical support to the view that China’s exchange rate does matter importantly for improving US trade deficit since the coefficient of exchange rate is not significant. His another results of the OLS regression model that consisting of same variables as the former one except using the GDP growth differential between China and US also showed that the strength of the RMB matters for the bilateral

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trade balance between the US and China as well. At 2010 scale, a 10% real exchange rate appreciation would reduce US trade surplus by about 250 billion dollar to 170 billion dollar.

However, there are several studies with the opposite opinion.

Baak (2008) examined RMB exchange rate effects on Chinese trade balance based on empirical tests with the quarterly data covering the period from the second quarter of 1986 to the second quarter of 2006 and argued that the exchange rates have contributed in Chinese exports expansion to US, but not to have any influences on the US exports to China. However, he found that the coefficient value of the real GDP (Gross Domestic Product) is positive and bigger than the coefficient value of exchange rate; implying income elasticity is higher than price elasticity in the export. In particular, the GDP of importing country is treated as one of the economic variables that consisted in the function of volume of exports from one country to the other. Besides, when much literature dealing with quarterly or annual data, the real GDP of the importing country is commonly applied as a proxy measure for economic activity of the importing country. Theoretically, in most countries, the international trade represents a significant share of GDP. Thus, GDP can be considered as another important of factor that may affect the trade imbalances.

Zhang, Fung and Kummer (2006) examined the effects of different levels of Chinese real exchange rates on both Chinese and the US economy. They concluded that the US trade deficit will not improve if they continue to rely on Chinese goods for its domestic consumption and cannot find other foreign goods as substitutes for Chinese goods. Besides, as Zhang, Fung and Kummer mentioned in the paper, there are two main causes should be considered besides the real exchange rate that may affect the trade balance. Those are US fiscal deficits, US interest rates since that fiscal deficit and low savings will lead to large imports, hence the trade deficit in terms of a national accounting identity as the economic theories suggested. Then Kim and Roubini (2008) have studied whether the budget deficit causes trade deficit. On the basis of the identity of current account equals to the difference between national saving and investment, saving can be furtherly divided into private saving and government saving (or government budget balance), Kim and Roubini found that government deficit shocks improve the current account. And Feldstein (2008) argued that the low US national saving due to the low interest rate is the fundamental cause of the US trade deficit and the primary factor that will cause a decline in the deficit is an increase in the US interest rate. As Gorden (2009) also argued in the paper, the exchange rate is not the cause of

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bilateral trade surplus of China. Instead, the trade surplus of China is mainly due to the rise in the excess of savings over investment.

According to the empirical analysis did by Zhang and Yue (2013) on the basis of monthly exchange rate of RMB per dollar and the US trade deficit with China from June 1985 to August 2012 rejects the popular misperception that Chinese government’s manipulation of the undervalued RMB is the cause of the growing US trade deficit. Instead, they found two facts that support the idea that Chinese exchange rate plays only a limited role in reducing the US trade deficit, which does not result in the large US trade deficit. First, the price of exports from China has not increased much after the appreciation in RMB, which means the costs to import from China does not increase either. So we cannot expect US imports to fall as the RMB appreciates. Second, China has been the fastest-growing market for US exports over the past decade and until 2011, China became the third largest export market for the US. US companies sold goods to China never cited the exchange rate as a competitive barrier.

Besides, Groenewold and He’s (2007) research also states that changes in the value of the RMB are not predicted to make much inroad into the trade imbalance between the US and China based on a range of computations. According to the reduced-form equation for the trade balance among China, US and a third country, they employed OLS regression and found that the improvement in the trade balance would be very modest unless there were a very large revaluation on RMB. As Groenwold and He mentioned that a 50% revaluation is likely to improve the trade balance by only about 37%.

To summarize, the exchange rate of RMB against dollar could be a factor that affect the trade deficit of US, but there are several additional factors should be taken into consideration according to above literature reviews. As suggested by Baak, real GDP matters for trade balance more significantly than real exchange rate as thecoefficient value of the real GDP is positive and bigger than the coefficient value of exchange rate. Besides, Zhang, Fung, Kummer (2006) pointed out that US fiscal deficits and interest rate might also affect the bilateral trade balance between China and US, and their opinion is supported by the research conducted by Kim, Roubini (2008) and Feldstein (2008).

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3 Empirical analysis - OLS Regression model

3.1 Collection of data

To examine the impacts of the exchange rates of RMB on the bilateral trade balance between China and US, in accordance with other variables, we adopt an OLS multiple regression model, which is widely applied in previous research papers. The basic approach is to estimate a log linear equation that allows the coefficients to be interpreted as elasticity with US trade balance as the dependent variable (Narayan, 2006), and with macroeconomic variables as the explanatory variables. The data are collected on quarterly basis for the period from the first quarter of 1994 to the fourth quarter of 2014.

3.1.1 Dependent variable

The data on quarterly bilateral trade between China and the US, which is the main dependent variable in my model, 𝑇𝑇𝑇𝑇_𝑡𝑡 as the ratio of Chinese exports to US over its imports from US at time t come from the Economic Indicator Database (United States Census Bureau, US Department of Commerce) in millions of dollars on a nominal basis. The main concern of using the ratio of exports to imports instead of the net exports as the dependent variable is that the ratio enables us to transform the variables in logarithmic form (Narayan, 2006). And the data of imports and exports are seasonally adjusted.

3.1.2 Independent variables

In terms of the earlier studies reviewed before, there are several related independent variables need to be taken into consideration.

First, the real exchange rate RMB per dollar, which plays a vital role in a country’s level of trade and is defined as 𝑆𝑆_𝑡𝑡 in the multiple regression model. The real exchange rate is calculated from the nominal exchange rate and CPI in two countries. Note that an increase in the real exchange rate represents an appreciation of the US dollar against RMB. The nominal exchange rate data come from OANDA, on a quarterly basis.

Second, national and foreign income referred to GDP of US and China, which are denoted as 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑆𝑆_𝑡𝑡 and 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺_𝑡𝑡 in dollars. As large amounts of previous empirical research applied, trade balance can be written as the function of national income, foreign income and

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level of exchange rate. In theory, most countries allow the international trade represents a significant share of GDP. Thus the change on GDP affects the trade balance.

Third, the level of fiscal deficit and the level of interest rate in US, those are symbolized as 𝐺𝐺_𝑡𝑡 and 𝑅𝑅_{𝑖𝑖𝑡𝑡} in the model. Numerous economists have investigated the relationship between the trade deficit, fiscal deficit level and interest rates. As Zhang et al (2006) mentioned in their paper, the US trade deficit is the result of many basic US problems. Among them are large fiscal deficits and low interest rates. And these factors might have more contribution to the US trade deficit than the effect of the RMB, which is concluded by Groenewold and He (2007). In addition, on the basis of economic theories, fiscal deficit and low savings will imply large imports, as well as trade deficit, in accordance to a national accounting identity. Thus, the trade deficit situation will continue if the fiscal deficit and low savings do not improve.

The last one is the error term, which is denoted as 𝜔𝜔_𝑡𝑡, which represents the amount at which the equation may differ during the empirical analysis.

3.2 The multiple OLS regression model

Based on above analysis, the components should be considered as the explanatory variables, the multiple regression model is formed as below:

𝑙𝑙𝑙𝑙𝑇𝑇𝑇𝑇𝑖𝑖𝑡𝑡 = 𝛼𝛼𝑖𝑖+ 𝛽𝛽1𝑙𝑙𝑙𝑙𝑆𝑆𝑡𝑡 + 𝛽𝛽2𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑡𝑡 + 𝛽𝛽3𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑆𝑆𝑡𝑡+ 𝛽𝛽4𝑙𝑙𝑙𝑙𝐺𝐺𝑡𝑡+ 𝛽𝛽5𝑙𝑙𝑙𝑙𝑅𝑅𝑡𝑡+ 𝜔𝜔𝑡𝑡

3.2.1 Preliminary estimation of the coefficients of explanatory variables

𝛽𝛽1 > 0: The real exchange rate 𝑆𝑆𝑖𝑖𝑡𝑡 decreasing means RMB appreciates; this will

benefit US exports and worsen US imports. Therefore, the trade balance ratio will change as the same direction of real exchange rate.

𝛽𝛽2 < 0: The national income of China (GDPCN) increases will lead to an increase in

China’s imports thus 𝑇𝑇𝑇𝑇_{𝑖𝑖𝑡𝑡} will decline. That means that the changes of GDPCN and 𝑇𝑇𝑇𝑇_𝑡𝑡 are in the opposite directions.

𝛽𝛽3 > 0: The increase in US national income will encourage the imports of US, which

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𝛽𝛽4 > 0: The increase in US fiscal deficit will improve the current account, which

means it will lead to a rise in 𝑇𝑇𝑇𝑇_𝑡𝑡.

𝛽𝛽5 > 0: The interest rate in US has positive effect on trade deficit. That is increases

results in a rise in US trade deficits as well.

3.3 Empirical results from multiple regression model

Figure 3. Empirical results of multiple regression model (Non-Robust)

Variables Coefficient t-statistics p-values

𝑙𝑙𝑙𝑙𝑆𝑆𝑖𝑖𝑡𝑡 -1.1 -1.617 0.110 𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑆𝑆𝑖𝑖𝑡𝑡 0.519 1.199 0.234 𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑡𝑡 𝑙𝑙𝑙𝑙𝐺𝐺𝑖𝑖𝑡𝑡 𝑙𝑙𝑙𝑙𝑅𝑅𝑖𝑖𝑡𝑡 Constant -0.231 0.447 0.982 -8.419 -3.073 7.289 3.796 -2.052 0.003 0.000 0.000 0.044 R2 _{= 0.837} F = 78.079 Prob(F-statistic) = 0.000

In terms of above results, we can write the multiple regression function as:

𝑙𝑙𝑙𝑙𝑇𝑇𝑇𝑇𝑖𝑖𝑡𝑡 = −8.419 − 1.1𝑙𝑙𝑙𝑙𝑆𝑆𝑖𝑖𝑡𝑡− 0.231𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑡𝑡 + 0.519𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑆𝑆𝑖𝑖𝑡𝑡+ 0.447𝑙𝑙𝑙𝑙𝐺𝐺𝑖𝑖𝑡𝑡

+ 0.982𝑙𝑙𝑙𝑙𝑅𝑅𝑖𝑖𝑡𝑡

From the results of multiple regression model, we can see that 𝑙𝑙𝑙𝑙𝑆𝑆_{𝑖𝑖𝑡𝑡} cannot pass the t-test. This result implies that real exchange rate is not a significant factor that affects the trade deficit, which is identical with conclusions addressed by Baak (2008), Zhang (2006), Zhang (2013) and Groenewold (2007). Nevertheless, the coefficient of US GDP cannot pass the t-test either, which is not consistent with Baak’s (2008) result that states GDP of importing country is one of the important economic variables should be considered in the function of volume of exports from one country to another. It is easy to see that the coefficient of determination 𝑅𝑅2 is quite high at 83.7%. This high level of 𝑅𝑅2 implies the fitting efficiency is

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highly correlated.

However, as noted by Stock and Watson in Introduction to econometrics (2012), a regression estimator is said to be robust if it is still reliable in the presence of outliers and its standard error is said to be robust if it is still reliable when the regression errors are heteroskedastic. Besides, it turns out that non-robust standard errors of robust estimators may be severely biased. An alternative and highly appealing method of reducing the effects of heteroskedasticity is to employ robust standard errors. OLS assumes that errors are both independent and identically distributed. Robust standard errors relax either or both of those assumptions. Moreover, with this approach, the regression model is estimated using OLS but an alternative method of estimating the standard errors is employed that does not assume homoscedasticity. Hence, when heteroskedasticity is present, robust standard errors tend to be more trustworthy. Therefore, followed by above OLS multiple regression model on the basis of non-robust standard errors, there will be an additional OLS regression based on robust standard errors.

Figure 4. Empirical results of multiple regression model (Robust)

Variables Coefficient t-statistics p-values

𝑙𝑙𝑙𝑙𝑆𝑆𝑖𝑖𝑡𝑡 -1.1 0.641 0.090 𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑆𝑆𝑖𝑖𝑡𝑡 0.519 1.63 0.108 𝑙𝑙𝑙𝑙𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝑖𝑖𝑡𝑡 𝑙𝑙𝑙𝑙𝐺𝐺𝑖𝑖𝑡𝑡 𝑙𝑙𝑙𝑙𝑅𝑅𝑖𝑖𝑡𝑡 Constant -0.231 0.447 0.982 -8.419 2.60 7.51 -4.27 -2.38 0.001 0.000 0.000 0.020 R2 _{= 0.837} F = 72.04 Prob(F-statistic) = 0.000

Comparing the results with the earlier regression, it is noted that the use of robust standard errors does not change coefficient estimates, but the test statistics will give reasonably accurate p-values since the standard errors are changed. Generally, the p-values of all coefficients are lower than the estimation with non-robust standard errors.

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estimation before as well. With both non-robust and robust standard errors, the p-values of the coefficient on China’s GDP are smaller than the alpha level of 0.05, which indicates that it is statistically significant at 5% significance level. It indicates that when logarithm of Chinese national income increases by 1%, the logarithm of trade balance ratio decreases by 0.231%. This result expresses that China’s exports declines while imports rises. Besides, this amount of ratio is much smaller than 0.519 %, which helps to identify that the US national income has much more effect on the bilateral trade between China and US than that of Chinese national income.

The analysis on coefficients of US GDP can also be treated as elasticity of US national income is 𝛽𝛽₃ =0.519. This positive value is consistent with the former estimation. But this result is not statistically significant with either non-robust or robust estimations. This result implies1% increase of US GDP turns out to raise the trade deficit between China and US by 0.519% while 1% increases of the Chinese GDP decreases the trade deficit by 0.231%. This indicates that the US GDP plays the decisive role in US demand of consumption of imported products. On the other hand, US are largely relying on Chinese exports. Comparing to the US, the elasticity of Chinese national income is only -0.231, which absolute value only counts for 1

2 of US elasticity of national income. This result explains the level of Chinese

national income has much less impact on trade balance than that of US national income. The coefficient of fiscal deficit in US is 𝛽𝛽₄ =0.447. This result is matched to the preliminary estimation, which indicates that as the fiscal deficit rises by 1%, the trade balance grows by 0.447% as well. As Kim and Roubini (2008) tested in their model, government purchases started to increase and the trade deficit also started to improve. This means, positive government purchases shocks improve the trade deficit strongly and persistently (Kim & Roubini, 2008). In theory, the fiscal deficit is the different between government spending (𝐺𝐺_𝑡𝑡) and government’s tax revenue (𝑇𝑇_𝑡𝑡) (Fiscal deficit =𝐺𝐺_𝑡𝑡− 𝑇𝑇_𝑡𝑡), thus the rise in government spending will increase fiscal deficit and to improve the trade deficit.

The coefficient of US interest rate is 𝛽𝛽₅ =0.982, which is positively related to trade deficit. This result is identical with the Feldstein’s research result. That is, the higher the level of interest rate, the smaller the amount of trade deficit. According to the regression result above, when US interest rate increases by 1%, its trade deficit will decrease by 0.982%. As Feldstein (2008) stated, a trade surplus requires savings to exceed investment, which implies

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some combination of relatively higher saving and/or lower investment by business, government and households. Thus, US government needs to raise the interest rate to improve the US trade deficit.

The coefficient of real exchange rate 𝛽𝛽₁= −0.574, which is the only coefficient that is inconsistent with the above estimation. And it is not statistically significant either with non-robust or robust standard errors. Assuming the appreciation on RMB can release the trade deficit from China against US and thus lead to the balance of trade. Then, the changes of 𝑙𝑙𝑙𝑙𝑆𝑆_𝑡𝑡 and 𝑇𝑇𝑇𝑇_𝑡𝑡 should be in the same direction, that is 𝛽𝛽₁ >0. However, the actual value of this coefficient is negative, which is differing from the assumption. The value of coefficient on real exchange rate indicates that 1% depreciation of the RMB against the dollar decreases the bilateral trade deficit by 0.574%. In terms of it, it is possible to conclude that the trade deficit US experienced for a long time should not be blamed to undervaluation of RMB. In other words, the large appreciation on RMB is helpless to reverse the trade deficit that US faces.

4 Conclusion

The trade deficit is not a sign of a weak or strong economy if it is temporary. However, the large and persists trade deficit may imply a fundamental disequilibrium in the countries accounting balance. For many years, the US trade deficit has been increasing with China (Kim, M., 2014).

This paper analyzed to what extent the exchange rate between RMB and dollar has the significant impacts on the bilateral trade deficit of US over period 1994 to 2014. In fact, the impacts of all variables, such as real exchange rate, GDP of China and US, level of fiscal deficit in US and level of interest rate in US were measured by including them as explanatory variables in the OLS multiple regression model with both non-robust and robust standard errors.

The OLS regression results suggest that the appreciation on RMB does not have a significant impact on improving trade deficit between China and US. However, we found several other factors have more effective impacts on the bilateral trade balance.

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These relative factors are GDP from China and US, fiscal deficit level in US and the US interest rate. According to the empirical results, GDP from US has much more significant impact on improving US trade deficit. Besides, both fiscal deficit level of US and the interest rate have positive effects on decreasing the level of US trade deficit.

These findings imply that the economic boom in the US for the last decades has contributed much more than other variables to the huge increase in its bilateral trade deficit with China.

To conclude, the large US trade deficit in the bilateral trade with China should not only blame to the undervaluation on RMB, but also to GDP of two nations, US fiscal deficit level as well as US interest rate. From this perspective, the large US trade deficit cause more by its domestic problem than by China.

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To what extent RMB undervaluation affects the US trade deficits?