Persistent global imbalances are raising concerns about the sustainability of the global recovery and longer-term growth. Global imbalances owe in part to the pattern of exchange rates and demand across major countries. A proper appreciation of the influence of exchange rates and demand on global imbalances requires that we take into account an important feature of Asia’s trade – cross-border supply chains or “vertical integration”. While traditionally Asian exporters used to specialise in final products, increasingly they have started to specialise in certain stages of the production process.
Much of the public debate over rebalancing focuses on the US-China trade imbalance. Vertical integration, however, means that China’s gross exports to the US can overstate China’s exposure to US demand, because these exports also reflect the value of intermediate goods that China imports from other Asian economies to use as inputs in its production of exports. Moreover, by using intermediate inputs from other countries in exports, an exporting country’s price competitiveness depends not only on the value of its own currency, but also on the value of its suppliers’ currencies.
The Asian supply network is increasingly centred on China
For Asia excluding China, the share of intermediate goods exports to China in total exports has doubled over the last decade. By contrast, the share of direct consumer goods exports to the US and the Eurozone has declined (Figure 1).
Figure 1. Asia (excl. China): Exports to G2 and China (in percentage of total exports)
A closer look at trade between country pairs underscores the profound role of China in regional trade.
- China ultimately accounts for about half of all imports of intermediate inputs in Asia; this share has doubled since 1995.1
The figure includes China’s direct imports, and the indirect trade flows for intermediate goods that its imports generate. That is, if China imports a disk drive from Thailand that is made using parts from Singapore, China’s purchase of the disk drive can be said to indirectly cause Thailand’s imports of parts from Singapore. These calculations are done using JETRO’s Asian Input-Output table – a very detailed source of information that allows us to trace the final sources of supply and demand. In other words, for many of its Asian trading partners China has become the single most important destination of intermediate goods exports.
- China now accounts for 20-25% of all capital goods exports from Japan and Korea, a fourfold increase from a decade earlier.
But China’s role as a supplier of intermediates has also rapidly grown.
- China now accounts for nearly 30% of intermediate goods exports within Asia, up from 15% a decade earlier.
On net, however, China buys more than it sells; it has consistently run deficits in intermediate goods trade with all its major Asian trading partners.
Japan still plays an important role in the regional supply chain. Japan is the second most important source of intermediate inputs after China. Japan runs intermediate-goods surpluses with all its major Asian trading partners, including Korea, Taipei, China, and China. It is the single most important supplier to China, accounting for over a third of China’s intermediate goods imports from Asia. For many high-end electronics and capital goods, in particular, Japanese supply may not be easily replaceable by other countries in the short run.
The supply chain and exchange-rate movement
Vertical integration in Asia affects the impact of exchange rate movements on the competitiveness of Asian economies. Because of supply chains, intermediate inputs often account for a significant share of exporters’ total cost. For example, during 2005-2008 the share of imported value added in exports ranged from about 10% in Japan to about 40% in smaller open economies, such as Malaysia.2
As such, the standard view of the exchange rate’s effect on competitiveness must be substantially modified. The point is that the cost of imported intermediates – and thus the competitiveness of the nation’s exports – depends on the exchange rates of intermediates-supplying countries as well.
The integrated effective exchange rate
Thorbecke (2010) proposed the concept of an “integrated effective exchange rate” to explicitly capture this supply-chain effect on cost competitiveness. In our work (Unteroberdoerster 2011), we implement this by combining the conventional real effective exchange rate with a measure that captures the supply-chain features. Specifically, we use the bilateral real exchange rates between the country’s supplier economies and its final destination markets; the weights equal the supplying economies’ share in the country’s imported value added. To illustrate this, suppose Thailand exports to only one destination (US), but imports components from Japan and China. The integrated effective exchange rate would use the Thai-US exchange rate on the export side and a weighted average of the Japanese and Chinese exchange rates and the US.
This example shows that the main difference with respect to the conventional effective exchange rate is that integrated effective exchange rate also accounts for the supplier economies’ exchange-rate movements vis-à-vis those export markets.
This difference means that movements in the conventional real effective exchange rate can differ markedly from those of the integrated effective exchange rate (Figure 2).
Figure 2. Standard and integrated real effective exchange rate (REER) (2000 = 100)
Sources: Institute of Development Economics, Japan External Trade Research Organization, Asian Input Output Tables, 2000, United Nations, Comtrade database; IMF, Information Notice System database, and staff calculations.
- In the case of China, for example, the integrated exchange rate has appreciated more slowly in recent years than the conventional effective exchange rate.
The reason is that currencies of important supplier economies to China, in particular Korea, have depreciated. The depreciation of suppliers’ currencies has reduced the cost of inputs embedded in China’s exports.
- In the case of Korea, the conventional effective exchange rate shows a depreciation of about 25% since the global financial crisis, but its integrated exchange rate has depreciated much less.
The reason is that the currencies of key suppliers, including Japan, have appreciated and thus raised the cost of inputs embedded in Korea’s exports.
- Japan’s integrated exchange rate, by contrast, tracks more closely the conventional one, reflecting the relatively high local content in Japanese exports.
Measurement of global imbalances
Accounting for the internationalisation of supply chains also affects the way we measure global demand imbalances. For example, when we redistribute the imported inputs embedded in China’s exports to the US to Asian economies supplying these inputs and calculate trade flows based on value added, we find that China’s share in Asia’s trade surplus to the US shrinks, from about 62% to 54% on average for 2005-2008, whereas that of most other Asian economies increases.
All this implies that because of the high degree of production sharing in Asia, a durable reduction in imbalances would require adjustment across all major Asian economies and currencies. It would be misleading to focus on bilateral imbalances and exchange rates.
This article is based on a study by the authors (Unteroberdoerster et al. 2011). The article represents the views of the authors alone and not those of the IMF, its Board, or its management.
Hummels, D, J Ishii, and K Yi (2001), “The Nature and Growth of Vertical Specialization in World Trade”, Journal of International Economics, 54:75-96.
International Monetary Fund (2011a), World Economic Outlook (Washington, April).
International Monetary Fund, 2011b, Regional Economic Outlook: Asia and Pacific (Washington, April).
Koopman, R, Z Wang, and S Wei (2010), “Give Credit Where Credit Is Due: Tracing Value Added in Global Production Chains”, NBER Working Paper 16426.
Powers, W, Z Wang, and S Wei (2009), “Value Chains in East Asian Production Networks”, USITC Working Paper No. 2009-10 (October).
Thorbecke. W (2010), “Investigating the Effect of Exchange Rate Changes on China’s Processed Exports”, ADBI Conference Paper, November.
Unteroberdoerster, Olaf, Adil Mohommad, Jade Vichyanond (2011),“Implications of Asia’s Regional Supply Chain for Rebalancing Growth” Chapter 3, Regional Economic Outlook: Asia and Pacific, April.
1 Asian input-output tables are provided by the Japan External Trade Organization (JETRO). A detailed description of the methodology to update these tables and calculate direct and indirect trade exposures can be found in the technical appendix of our paper (Unteroberdoerster et al. 2011).
2 To the extent they cover similar countries, these estimates are comparable with other studies, including Hummels et al. (2001) for OECD countries; Koopmans and others (2010) using GTAP data; or Powers et al. (2009) using Asian input-output tables for 1990 and 2000.