http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1745862Processing Trade,Exchange Rates and China's Bilateral Trade BalancesAbstract:This paper analyzed the role of processing trade in China's bilateral trade balances and theimpact of the yuan's appreciation on processing trade.The analysis is based on a panel data coveringChina's 51 major trading partners from 1993-2008.The empirical analysis shows that:(1)processingtrade accounted for 100%of China's overall trade surplus and could explain most of China's bilateraltrade balances;(2)China's processing trade shows a significant regional bias.While China hasmaintained a surplus with all G-7 countries in processing trade,it has run a significant deficit withmost of East Asian economies;(3)East Asian economies are major sources and account for 77%ofChina's processing imports.The econometric analysis reveals that processing imports from East Asianis eleven times of that from other regions;(4)the response of processing imports to the yuan'sappreciation differs with that of normal trade.Specifically,a 10%real appreciation of the yuan willreduce rather than increase China's processing imports by 3.9%.Given that processing exports willdecrease 9.6%for the same appreciation and China's trade surplus is mainly generated fromprocessing trade,a moderate appreciation of the yuan would have a very limited impact on China'strade balance.Key Words:Processing Trade,Exchange Rates,ChinaIntroductionGlobal imbalances have been argued as one of major reasons responsible for the global financial crisisand the subsequent economic recession in the US and European countries.In searching for the roots ofglobal imbalances,most of debates and studies focus on macro factors such as insufficient domesticconsumption in China,low saving rates in the US and the inflexibility of China's exchange rateregime.With a record high of US$349 billion surplus in goods and services in 2008,China has beenurged to boost its domestic consumption and re-value the yuan to mitigate the trade surplus forrebalancing the global economy.On the other hand,little attention has been given to micro factors,such as the structures of trade,the proliferations of cross-country production fragmentation andproduction networks developed in East Asia.With unprecedented liberalization in trade and capitalmobility,these micro factors have re-shaped trade patterns,transformed implications of trade statistics,and affected bilateral trade balances.Therefore,it is imperative to analyze China's trade balances in abroad context and assess the importance of the structure variables in determining trade pattems andbilateral trade balances.China's trade differs with conventional international trade modeled in standard textbooks.First of all,foreign invested firms produced more than half of China's exports.In some commodities such aselectronics and information communication technology (ICT),foreign invested firms have dominatedChina's exports and accounted for more than 80%of the exports (Xing,2010).Besides low labor cost,advanced technology and production know-how associated with foreign direct investment (FDI).brand names and distribution networks of multinational enterprises (MNE)all contributed to the rapidexpansion of China's exports.In other words,it is the combination of foreign capital and technologywith China's rich labor endowments that has been powering the sustained high growth of China'sexports.In conventional trade theory,however,all technologies determining comparative advantagesor needed for utilizing abundant resources are assumed indigenous and existing.Secondly,processing trade accounted for more than 41%of China's total trade.In terms of the scale ofprocessing trade and the range of commodities involved,the significance of processing trade inChina's extemal trade is unmatched.The extraordinary high share extension of cross-countryproduction fragmentation into China,and the development of production networks in East Asia.Processing trade reversed conventional trade pattems such that developing countries,say China,export high-tech products while industrialized countries like the US imports high-tech goods.Forinstance,China has a comparative advantage in labor intensive products.However,according to anOECD report,China has surpassed the US and Japan and emerged as the leading exporting country ofICT(2005,OECD).Moreover,with processing trade,bilateral trade balances between a country usedas an export-platform and destination markets of final products are inflated,as the former needs toimport a large amount of intermediate inputs from third countries for processed exports.A typical example of processing trade is the trade of iPhones between China and the US.iPhones,themost trendy and advanced mobile,are exclusively assembled in China.All parts and components usedfor iPhones are produced in Germany,Japan,Korea,Taiwan and the US,then shipped to China forassembling the ready to use final products,which are exported to the US and other markets.In termsof conventional trade statistics,the production fragmentation and networks involved in manufacturingiPhones have created a non-traditional trade pattem:iPhones invented by the US company Apple areexported to the US from China,which does not have a comparative advantage in producing smartphones at all.It is estimated that iPhone trade contributed US$1.9 billion to the trade deficit of the USwith China in 2009.Measured in value-added created by Chinese workers assembling iPhones,however,the US would have US$48 million surplus from the iPhone trade with China.This meansthat the deficit was simply a transfer from the third countries,which supply parts and components toFoxconn,an exclusive iPhone assembler located in Shenzhen,China (Xing and Deter,2010).There is a plethora of studies on China's processing trade (e.g,Aziz and Li,2007;Koopma,Wang,andWei,2008;Thorbecke,2010;Thorbecke and Smith,2010;Ahmed,2009).All of these studiesprimarily concentrated on the relationship between the yuan's exchange rates and the volume ofprocessing trade and based on time series data.One of the pitfalls in the existing literature is that therole of production networks in East Asian and geographic factors were ignored.It is imperative toinclude factors representing production networks and regional factors in examining the determinationof China's processing trade because assembling parts into finished products is one of the of processingtrade is a result of China's integration with the world economy,the production processes.MNEaffiliated Chinese firms are major players of processing trade,and most of processing importsoriginate from East Asian economies.This study attempts to investigate China's processing trade in abroad framework with emphasis on both regional factors and the yuan's exchange rates.It is based ona panel data covering China's bilateral processing trade with 51 trading partners from 1993 to 2008.These trading partners accounted for 99%of China's processing trade.The panel data allows us toaddress the regional factor in processing trade.The simply descriptive analysis show that,processing trade accounted for 100%of China's tradesurplus and explained most of China's bilateral trade balances with its major trading partners.Bydecomposing processing imports according to their origins,we found that China is one of the majorsources of the processing imports and counted for 16.8%.This is the first empirical study thatuncovered the role of China in supplying processing imports.The result has very importantimplications for assessing the value added of China's processing exports and the effectiveness of thevalue added tax rebates implemented by the Chinese goverment for promoting exports.Foridentifying major factors that determine processing exports and imports,an augmented gravity modelwith country-dummies was estimated.The estimates of the gravity model suggest that China'sprocessing trade has a significant regional bias.The processing exports to the East Asian Economiesare three times higher than that to other regions while the processing imports from the East Asianeconomies are more than eleven times higher.With regards to exchange rates,the estimates suggestthat the real appreciation of the yuan would reduce not only China's processing exports but alsoprocessing imports.Specifically,a 10%real appreciation will lead to 9.6%decrease in processingexports and 3.9%drop in processing imports.This result is consistent with the fact that processingimports serve as intermediate inputs of processed exports.If processing exports fall,processingimports should fall too.Literature ReviewWithout advanced technology,brand names and global marketing networks,it is difficult for productsof developing countries to penetrate the world market,in particular the market of industrializedcountries.Processing trade provides a shortcut for developing countries to join the internationaldivision of labors and utilize their abundant labor forces.Processing trade involves importing partsand components from abroad as intermediate inputs,processing and assembling these intermediateinputs into finished products,and eventually re-exporting processed products to the global market viainternational distribution and retail networks of MNEs.Trade liberalization and declinedtransportation costs have greatly facilitated the development of cross-country productionfragmentation and production process specializations.China's economic reform in the last threedecades has provided opportunities for MNEs to integrate China into their production networks andutilize China as a low cost assembling base.Processed exports are made of both imported and domestically produced parts and components.Theshare of domestically made contents determines the domestic contribution in the value added ofexports and the extent of various policy impacts on the trade volume.To calculate the share ofdomestic contents in China's processing exports,Koopman,Wang and Wei(2008)applied theinput-output method to estimate domestic contents in China's exports by sectors.They found that theshare of domestic valued added is high in normal exports about 88 to 95%,but low in processingexports between 18 to 26%.Local firms engaging in processing trade are generally exposed toproduction know-how and product designs of foreign companies.Processing trade also functions as aneffective channel for knowledge spillovers,which contributed substantially to the productivity growthof domestic firms.Using firm level data,Yu (2010)showed that processing trade has been asignificant channel for technology spillovers to local Chinese companies.Most studies on China's processing trade focus on the nexus of real exchange rates and trade balances.Garcia-Herrero and Koivu (2009)used co-integration techniques to estimate the long-run elasticitiesof China's processing exports and imports to real exchange rates.Based on monthly time series datafrom 1994 to 2005,they showed that China's processing exports would be expected to decrease 1.3%for every 1%appreciation of the yuan,and processing imports would decrease too when the yuanappreciates.Chung,Chinn,and Fuijii (2009)investigated this similar issue over a relatively longer period,between1980 to 2006.They converted monthly data into quarterly by simple averaging,and estimated bothprocessing export and import equations with the dynamic OLS regression.Their empirical findingscontradict the expectation of the conventional theory,indicating that China's processing exports wouldincrease 1.86 to 2.68%for every 1%real appreciation of the yuan rather than decrease.Aziz and Li (2007)analyzed the dynamic changes of the export elasticity to real exchange rates from1995 to 2006.They found that the price elasticity of China's exports increased over time.Afterdecomposing exports into non-processing and processing exports,they showed that the price elasticityof processing export increase significantly while that of the non-processing exports remainedunchanged.Rising domestic content of processing trade was argued as a critical factor affecting theevolution of the export elasticity.摘要：本文分析了加工贸易在中国的双边贸易平衡中的作用和人民币升值对加工贸易的影响。从1993-2008的面板数据来进行分析。实证分析表明：(1)加工贸易占中国的总体贸易顺差的100%，这就解释了中国的双边贸易平衡中大部分的内容：(2)中国的加工贸易显示了一个重要的区域性的偏见。尽管中国一直与所有七大工业国成员国在加工贸易中一直保持着贸易顺差，它使得大多数东亚经济体运行中存在一个可观的赤字：(3)东亚经济体是中国价格贸易的主要来源，占中国77%的加工进口额。计量经济学的分析表明，来自东亚的进口是其他地区进口总额的11倍：(4④)对人民币升值对正常贸易相应的进口处理的影响。具体地说，人民币的升值达到10%，将会使得中国的加工进口减少下降3.9%而绝不是增加。鉴于相同的升值和中国的贸易顺差主要来自加工贸易，处理出口将会下降9.6%，人民币适度升值会对中国的贸易平衡有一个很有限的影响。关键词：加工贸易、汇率、中国引言全球失衡己被认为是全球金融危机和随后在美国和欧洲国家的经济衰退主要原因之一。为了寻找全球失衡的根源，大多数的争论和研究主要集中在宏观因素上，如中国的内需不足，在美国