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Value-added in China’s export sector and China’s exposure to a global slump

by Brad Setser
August 10, 2008

Mark Thoma linked to a VoxEU article summarizing new work by Robert Koopman, Zhi Wang and Shang-Jin Wei on the “Chinese value-added” of China’s exports. They find that the Chinese value-added in China’s export sector is about 50% of the total, higher than some past estimates. They also find that the domestic value-added in China’s export sector has been more or less constant over the past few years. It was 48.7% in 2002 and 50.6% in 2007 (see their Table 1). That surprised me. World Bank and IMF work (see this paper by Li Cui and Murtaza Syed, or this summary of their work) highlighting the migration of the electronics components industry to China led me to expect the value-added in China’s export sector would be rising over time.

Koopman, Wang and Wei argue that one implication of their finding is that exchange rate appreciation will have a smaller impact on China’s trade surplus than is sometimes argued:

“Our best estimate suggests that the share of domestic content in China’s exports is about 50%, which is much lower than most other countries. This implies that a given exchange rate appreciation is likely to have a smaller effect on China’s trade surplus than for other countries.”

I would put it a bit differently. Exchange rate appreciation should have a smaller impact on China than on countries with similarly sized export sector and higher-domestic value-added. But given China’s geographic size, China’s export sector is actually quite large relative to its economy. If the “Chinese content” of China’s goods export sector is around 50%, goods exports account for between 17 and 18% of China’s GDP. Exports of goods and services account for about 12% of US GDP — and that number hasn’t been adjusted for imported content in US exports (Boeing, for example, imports components from around the world, so the US content of US aircraft exports isn’t 100%) so it isn’t really comparable to the adjusted Chinese data. I consequently would expect that exchange rate appreciation would potentially have a bigger impact on China’s trade balance than on the United States’ trade balance …

The Koopman, Wang and Wei data also lets us estimate just how China’s exposure to the world economic cycle has changed over the past few years. I assumed that 50% of the value of China’s exports comes from embedded imports and thus subtracted 50% of China’s exports from both China’s export data and its import data. That provides, I think, a rough estimate of the value-added in China’s export sector as well as the goods China imports for domestic consumption. I then scaled everything to China’s GDP (calculated on a rolling 4q basis — the quarterly jumps in GDP contribute to some of bumpiness of the data). The results are rather interesting, I think.

china-value-added-in-exports-1.JPG

A few things jumped out:

First, the exports to GDP ratio rose rapidly from 2002 to 2005 and then started to level off.

Second, the big rise in China’s trade surplus has come from a fall in China’s imports (relative to China’s GDP) that started in 2005. It reflects the curbs on domestic bank lending and investment China introduced in 2004 to avoid overheating (while keeping the exchange rate undervalued). It also reflects – according to Jon Anderson of UBS — the substitution of domestic Chinese steel and chemical production for imported steel and chemicals. Someone should write a paper arguing that China really is a Latin economy from the 1960s, and its recent growth stems as much from import-substitution (with inefficient sectors supported by an undervalued exchange rate rather than tariffs) as from export promotion …

Third, “adjusted” exports to GDP are much higher than in 2000-01, so China should be more exposed to a synchronized slowdown in the US and Europe now than it was then.

What if Koopman, Wang and Wei are off, and the value-added in China’s export-sector has been rising over time. I don’t have any particular reason to believe this. But I did want to see how sensitive the data is to my core assumption. Suppose the value-added in China’s export sector rose from 30% in 2003 to 50% in 2007, as more and more component production moved to China. If that’s true, then the rise in China’s trade surplus stems from the combination of a rise in Chinese value-added in the export sector and a slowdown in import growth.

china-value-added-in-exports-2.JPG

Either way, though, China’s export sector is now substantially larger, relative to its economy, than the US export sector. Its exposure to a broader global slowdown where it can no longer offset the slump in sales to the US with rising sales to Europe is real.

That doesn’t change the nature of China’s current policy choice. It could, at one extreme, keep the RMB from rising to help counter the slump in global demand for Chinese products while trying to limit domestic inflation entirely by restraining domestic demand. That basically means following the 2004 script in a less benign global environment. Or China could continue to allow RMB appreciation to limit inflation and relax its existing restraints on domestic demand to try to offset the (expected) fall in global demand for Chinese goods.

4 Comments

  • Posted by Rien Huizer

    Interesting. One way of looking t the implications would be to see a China as a single actor, with an exports-pushing mechanism (the high priority for growth in modern employment) facing decreasing spending capacity in ints exportmarkets. Its natural reaction (if facing no budget constraints for losses itself, would be to become more competitive, either by increasing customer value, lowering prices or both, in order to displace competitor sales. That would be an interesting game, specially if this non-recession takes a couple of years or more.
    A more realistic and less caricatural view would be that this increase in value is often just a relocation and deepening of production within MNCs, transfer of non- MNC factories from Taiwan plus the result of the completion of large scale upgrading/expansion of heavy industry (steel, chemicals).
    In that case there could still be quite a bit of the former type (the jobs must be created) but also decreasing much more pressure on other Asian locations to become more competitive.
    A third view could be that China has reached critical scale for a host of supporting industries (for instance, there is now a large car industry, the leading car-airco maker neds 1.5 million units pa to justify a new factory (wage cost is not critical, that plant could even be in Japan and easily in Korea) If the various car production centers in China are now large enough to justify a standard plant, ll of these planst can suddenly also be upscaled to export t a very competitive cost. That might then avoid the need to build a second plant in fast growing East-Thailand. A simple example but there could be thousands.
    But it shows that Chin has now two outlets for surplus labor, expanding in the latest stages of export production, and substituting component exports. If this is done inefficiently and under state guidance, it may look a little like Argentina in the old dys, but it is more likely that it is the same process Korea went through in the 1970s or simply MNC logic. In both cases that would not necessarily be the bad od import-subtitution..

  • Posted by AC

    The past week the dollar strengthened substantially. And I read somewhere that the Chinese will step up efforts to fight hot money inflow (eg. 30% penalty on illegal inflow, if it is found). I am wondering if this latter news had any effect on the dollar strength. Hot money inflow is a way of carry trade financed in dollar. The pullback of such trade would make the dollar stronger.

  • Posted by JKH

    bws – the following may be a slightly different way of looking at it, although I don’t know if it’s right:

    Assume 50 per cent of China’s export value equates to embedded imports. You could think of this amount of exports and imports as the “currency hedged” trade position – i.e., in loose terms, hedged against RMB currency appreciation. E.g. it would reasonably hedged if these exports and imports were all denominated in US dollars; less so perhaps to the degree there is a currency mix. But in general, on this portion of trade flows, the lower RMB value of export revenues would tend to be offset by the lower RMB cost of embedded imports. RMB exposure at the macro level would tend to be immunized on the “hedged” trade position as defined. Exporters would not be forced to raise their prices as much on this portion of trade, for a given RMB appreciation.

    Then define the “un-hedged” trade position as total gross trade flows less the “hedged” position. This might also be referred to as the “value-added” trade position. By construction, the exchange rate sensitivity of the “un-hedged” position should equal the exchange rate sensitivity of the total trade position.

    The “un-hedged” trade position has its own trade surplus, which is equivalent in size to the total trade surplus. This may be a little bit artificial, in that it associates the trade surplus, an aggregate net measure, with some specific gross components. But it seems like a reasonable decomposition for purposes of looking at foreign exchange risk.

    The “un-hedged” trade position could be broken down further into the trade surplus plus the rest. This could be viewed as the “value-added” mismatched position (trade surplus) plus the “value-added” matched position.

    The size of the un-hedged position and its components should then be assessed for foreign exchange risk relative to the size of GDP. Foreign exchange risk for GDP will then be a function of the size of the total un-hedged position and the profile of its mismatched and matched components, relative to GDP.

    This seems to be roughly consistent with your own interpretation, regarding the importance of the size of China’s export sector to the conclusion of the article. Also, (correct me if I’m wrong), it seems to fit in the sense that your value-added percentage transformation in the second graph appears to preserve the size of the actual trade surplus by construction. I think the gap between your export value added and non-processing imports is what I’ve called the “un-hedged” trade surplus, which is equivalent to the actual (total) trade surplus.

    Moreover, given the equivalence of the “un-hedged” trade surplus and the actual (total) trade surplus, it suggests in a strange way that the FX sensitivity of the trade surplus on its own is somewhat independent of the issue of import or domestic content. The size and proportion of the trade surplus, relative to total trade flows, represents a sort of upper bound for the embedded import content of exports and a lower bound for the domestic content. Again, I think this reinforces your modified statement regarding the conclusion of the paper. If this is a reasonable approach to FX risk on trade, what I haven’t started to consider is the relative GDP exposure to FX risk for each of the two components of the “un-hedged” trade position. Each adds some FX sensitivity, but I’m not sure how to think about that.

    This is all very roundabout, perhaps, but the general idea seems consist with your statement:

    “Exchange rate appreciation should have a smaller impact on China than on countries with similarly sized export sector and higher-domestic value-added. But given China’s geographic size, China’s export sector is actually quite large relative to its economy.”

    (I put this together quite quickly; may well have goofed some point of logic. E.g. it would see, not work very well to the degree that imports were invoiced in currencies that were implicitly pegged to the RMB. I don’t know enough about the trade flows to know this. But it seems to contradict the starting premise of the article’s assumption about trade FX sensitivity.)

  • Posted by bsetser

    JKH — yes, my transformation preserves the trade surplus, which strikes me as setting a minimum for the “value-added” in China’s export sector. And you are right to think that the share of exports that comes from imported components can be thought of as currency hedged, and with the “value added” component having exposure to the RMB/ $ and RMB/ euro (and thus indirectly to the euro/$0. the import side has RMB/ $ exposure, but also has a lot of commodity price exposure.

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