The impact of China’s exchange-rate policy on trade in Asia

Alicia García-Herrero, Tuuli Koivu 16 April 2010



The amazingly rapid rise in China’s exports, to a large extent at the cost of other countries’ market shares, has heightened the discussion about China’s exchange rate. The question really is whether such an export boom can at least partly be explained by an undervalued currency.

Assessing whether a currency is undervalued or overvalued is always difficult, but this is especially true for the renminbi due to China’s important role as final processor in global supply chains. In fact, China’s decisions concerning its exchange rate are not only important worldwide, given China’s major exporting power, but also for those countries linked to China through production chains, mainly East Asian countries.

In fact, Figure 1 shows, China has become a key export destination for many East Asian economies. As one of the most dramatic examples, one quarter of Korea’s total exports go to China, either to its domestic market or, more often, to China’s processing sector and then to the final markets in other countries.

Figure 1. Asian economies’ exports to China and Hong Kong, percent of total exports

Source: IMF Direction of Trade, the data for Taiwan from the Bureau of Foreign Trade

In recent research (Garcia-Herrero and Koivu 2008 and 2010), we analyse empirically how China´s exchange rate affects its foreign trade. While we can confirm the expected result that exports would fall with a real effective exchange-rate appreciation, Chinese imports actually react to exchange-rate fluctuations in an unexpected way; imports also fall when the currency appreciates. As we shall show by estimating bilateral import equations for China´s main trading partners, this is explained by China’s key role as importer of parts and components from other East Asian countries. In fact, a reduction in China’s exports due to exchange-rate appreciation also implies a fall in China’s imports of investment goods as well as parts and components for the exporting sector. Furthermore, we cannot find evidence that East Asian countries could offset this negative impact of renminbi appreciation on their exports by increasing exports to other countries. This implies that China’s decisions regarding its exchange rate have major impacts on other economies in the region.

The exchange rate and China’s imports

Several studies have recently analysed factors behind China’s foreign trade (see for example Marquez and Schindler 2006, Shu and Yip 2006, Aziz and Li 2007, Cheung et al. 2008, Garcia-Herrero and Koivu 2008 and 2010, and Thorbecke and Smith 2009). According to these papers, Chinese exports have been driven to a large extent by increasing demand, in particular since China’s WTO accession in December 2001 (Table 1). The studies also confirm that Chinese exports are price elastic; an appreciation of renminbi implies a drop in China’s exports.

Somewhat surprisingly however, several studies report that imports also fall – instead of rising – when the renminbi real effective exchange rate appreciates (Marquez and Schindler 2006, Cheung et al. 2008, and Garcia-Herrero and Koivu 2008 and 2010). For example, Garcia-Herrero and Koivu (2010) find that a 10% appreciation would lead to a decline of 6% in imports of processing (Table 1). Ordinary imports would decline even more.

Table 1. Long-run impacts of real effective exchange rate and world demand on China’s exports and imports

  Ordinary exports Processed exports Ordinary imports Imports for processing
Impact of 10% appreciation of China’s reer -13% -11% -17% -6%
Impact of 1% increase in world demand +1.6% +1.5% +1.9% +0.3%


Source: Garcia-Herrero and Koivu (2008)

When looking at the imports more closely, one notices that it is mainly imports from other Asian countries that decrease when the renminbi appreciates (Table 2). This counterintuitive result points to the importance of being a key part of the global production chain. In fact, a currency appreciation that causes a decrease in the export sector’s competitiveness also implies a decline in demand for investment goods, imported parts, and components for that sector. This result also has a strong implication worth noting, namely that China´s export goods are becoming more of a complement to the production of goods in other Asian economies than a substitute.

Table 2. Long-run impacts of bilateral real exchange rate and demand on China’s imports from its major trading partners

China’s imports from
Impact of 10% appreciation of China’s bilateral rer
Impact of 1% increase in China’s demand

Note: Values in parentheses are not statistically significant.
Source: Garcia-Herrero and Koivu (2008)

Fierce competition or fruitful cooperation?

Existing studies illustrate that China’s rise has crowded outexports from most other economies. This is despite the fact that, in Asia in particular, the negative impact of China’s rise as major export economy has been partly offset by China’s increasing imports from nearby economies (Eichengreen et al. 2007, Greenaway et al. 2008). China’s rising imports reflect partly the fact that in a relatively short period of time China has become a major export platform for goods produced not only in mainland China but also via international production chains. This is reflected in the dual nature of China´s bilateral trade balances; in surplus with most developed economies – mostly European countries and the US – and in deficit with nearly all Asian countries (Graph 2).

Graph 2. Selected countries’ bilateral trade balance with China, % of each country’s GDP

Source: IMF Direction of Trade, CEIC

Our empirical finding that a renminbi real appreciation decreases both China’s imports and exports could, of course, imply that a renminbi appreciation would encourage other Asian countries to compete directly with China in third markets by bypassing China as a processing country. Our results, however, do not confirm this idea (Garcia-Herrero and Koivu 2008 and 2010). It seems that a renminbi real effective appreciation would lead to a decline in total exports from many East Asian economies (Table 3). In other words, exports from other Asian countries seem to be more of a complementary than a substitute to Chinese products.

Table 3. Long-run impacts of China’s real effective exchange rate (REER), country’s REER, and world demand on East Asian countries’ total exports

Exporting country
Hong Kong
Impact of 10% appreciation of China’s REER
Impact of 10% appreciation of country’s REER
Impact of 1% increase in world demand

Note: Values in parentheses are not statistically significant. Source: Garcia-Herrero and Koivu (2010)

Due to the tight production chains in East Asia, a renminbi appreciation reducing imports from the rest of Asia to China should thus be a concern for many Asian countries. The fact that exports from other East Asian countries are complementary to Chinese products is clearly related to the increasing importance of China in the production chain, whereby China controls the purchases, reducing the likelihood of being bypassed by others.

Implications for China’s exchange-rate policy

Our findings clearly indicate that China’s exchange-rate policy is not only relevant from the point of view of China´s major export destinations – such as the US and Europe – but also for those linked to China through the global production chains. In particular, the other East Asian countries exporting parts and components to China would tend to be negatively affected by a renminbi appreciation. This implies that the complementarity of exports from the other East Asian countries to Chinese products is today probably larger than the competition between these countries in goods’ final markets.

The fact that Chinese imports may fall – instead of rising – with exchange-rate appreciation also has an importance consequence. Even though a renminbi appreciation will reduce Chinese exports the impact on China’s trade surplus is limited as imports to China will also fall. Such a fall in imports would have major consequences for the wider region, as China mainly imports from other East Asian countries. For this reason, China’s exchange-rate policy is not only relevant for the developed world but also for the rest of Asia. This result is very much in line with the recent calls from other Asian countries at different international forums for China to continue to take a cautious approach to exchange-rate policy.

Authors' note: The opinions expressed in this article are the authors’ and not necessarily those of the BBVA or the Bank of Finland.


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Topics:  Exchange rates International trade

Tags:  China, East Asia, exchange-rate policy