Analysis of the bilateral trade deficit of U.S. and China

BY

Yau Chun Fung 06009425

Cheung Hoi Yin, Anita

06006930 Applied Economics Major

An Honours Degree project Submitted to the School of Business in Partial Fulfilment

Of the Graduation Requirement for the Degree of Bachelor of Business Administration (Honours)

Hong Kong Baptist University Hong Kong

April 2009

Acknowledgement

We would like to take this opportunity to thank my supervisor, Professor Wong Kar Yiu, for his

expertise and patient advices offered on this project. He has provided invaluable advice and insightful

opinions during the course of this project. He kindly devoted his precious time in guiding me on the

paper. Without his help, the project would not be completed smoothly

Also, we would like to express our deepest thankfulness to my friends and classmates, who

encouraged and gave useful suggestions to us.

Cheung Hoi Yin Anita

Yau Chun Fung

Abstract

This paper is concerned with the problem of bilateral trade imbalance between the United States

and China. The United States stressed the undervaluation of Chinese currency as the major contributor

and urged China to revaluate its currency in order to solve the trade deficit. Some economists argue on

the statistical discrepancies of both countries’ statistics and think the truth of the trade deficit cannot be

revealed without adjusting the official trade figure. It is therefore needed to find out the causes of the

trade imbalance and to test which factors affect the trade account most.

Content

1. Introduction P.1

2. Background P.3

2. Literature Review P.4

3. Analysis P.6

I. Factors affecting the trade imbalance from other aspects P.9

II. Currency Manipulation problem P.13

III. Estimation of the Undervaluation of RMB P.15

IV. Concern over Chinese Currency Revaluation P.16

4. Methodology P.19

I. Presumption P.21

II. Data source P.21

III. Model P.22

IV. Expected result P.23

5. Empirical results P.24

I. Limitation P.27

7. Conclusion and recommendation P.28

References P.31

Appendix I P.32

Appendix II P.35

Appendix III P.39

1. Introduction:

China has been experiencing fast economic growth and has stepped forward on the global

economics stage in recent years. Yet, conflicts over the trade imbalance between the United States and

China become more controversial and have appeared in both academic and policy circles concerning the

reasons behind. Starting from 1980, United States has been facing a rising trade deficit, while China has

a steady growth in trade surplus after the Chinese government opened China market to the world with an

improving economic performance. But a more acute discussion has been started in 2001 when China

entered into the World Trade Organization. The United States complained the false original promise of

China’s entry into WTO on benefiting the U.S. economy. Supporters had insisted that creating jobs in

United States, increasing U.S. exports and improving the trade deficit with China were the major

benefits for China’s entry into WTO. Contrary to these predictions, China’s entry has failed to reduce its

trade surplus with the United States or increase overall U.S. employment.

The United States stressed the undervaluation of Chinese currency as the major contributor and

urged China to revaluate its currency in order to solve the trade deficit; for example, former US Treasury

Secretary Henry Paulson had urgently persuaded China to revalue the RMB significantly. Some

economists argue on the statistical discrepancies of both countries’ statistics and think the truth of the

trade deficit cannot be revealed without adjusting the official trade figure. It is worth knowing the real

causes of the trade imbalance and whether renminbi revaluation is a good method to improve the U.S.

trade deficit. Specifically, the main objectives of this paper are the followings:

(1) We will find out the causes of the statistical discrepancies between the two countries and

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the trend of data miscalculation

(2) We have to find out the factors that actually affects the U.S. trade deficit

(3) We will discuss the influence to the U.S. economy when renminbi appreciates

(4) We will find out some possible strategies that actually improve U.S. trade deficit.

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2. Background:

China is the largest developing countries; while U.S. is the most important countries in the world.

Therefore, huge aggregate demands encourage the development of the bilateral trade of China and U.S.

According to the 2008 figure, the amount of bilateral trade is 2526 hundred billion, which is about 90

times of the amount in 1978 year. In fact, the bilateral trades grow rapidly.

We can observe that the import of U.S. keep a strong growth; however, the export keep declining.

This phenomenon is getting worse after the economics recession in 2000.

The relationship of U.S. trade deficit and U.S. dollar index

We can see that the trade balance keep deficit from 1970 and the deficit become larger. That’s why

the issue is concerned by both countries.

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3. Literature review

The aim of this paper is to illustrate the idea of imbalanced trade between China and US, and to

evaluate the effectiveness of Renminbi revaluation. Scott (2007) stated the effect and the heavy price

that U.S. paid after China entered World Trade Organization in 2001, which stimulated the U.S. to put

the blame on China. The rise in U.S. trade deficit in recent years had displaced production that could

have supported many of the U.S. employment. However, when we collect the official trade data from the

both U.S. and China, a big discrepancy are revealed. Schindler and Beckett (2005) stated the

intermediation effect of China’s exports, like the re-exports trade of Hong Kong and other region, which

caused overestimation of China’s trade surplus. Martin (2007) has also stated declaration of place of

origin, under-voicing of Chinese importers to shirk the imports tariff due on shipment, different

calculation methods of trade statistics as the factor affecting the statistics.

Considering the factors causing the trade deficit, Zhang, Liu, Ping (2006) stated trade limitation of

the United States to restrict high valued goods exported to China which contributed greatly to the

imbalance. Besides, Engel (2006) mentioned that the saving behavior of the American is the important

factor. Also, the other obvious factor is the effect of U.S. government budget deficit. He believes that the

effect of tax cuts is responsible for the decline in U.S. national saving.

By Bayoumi, Lee, and Jayanthi( 2005), they think that foreign investors’ increase their (net)

demand for U.S. assets with a number of reason – the end of the Cold War, the internet revolution, and

the liberalization of international capital movements in most countries. Then, by increasing their demand

for U.S. assets from 30% to 40% of their wealth, foreigners have provided American residents with the

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needed funds to run the large deficits of the last few years. The other reason focused on the RER. In

most of his model on the U.S. current account imbalance, actual adjustment will depend on the pass

through coefficient, as well as on exchange rate policies followed by some important U.S. trade partners,

including China, Japan and other Asian countries.

China has been complained for currency manipulation to take trade advantage, an important policy

paper of U.S. Government Accountability Office (GAO) (2005) proved that China is not manipulating

its currency and the revaluation would create some negative influence to the U.S. economy. The paper

also summarized experts’ recommendation towards the percentage of Chinese currency revaluation.

Concerning the problem of cheap labor in China, Yang, Besnainou (2006) explained the low labor cost

as a natural tendency of Chinese economy because the GDP per capita and the living standard of China

is still low compared to other world powers . This proved China have not deliberately lowered its labor

cost to gain trade advantage.

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4. Analysis

I: Statistical discrepancies between China and US data

There is always a difference between the data of trade balance released by China and the U.S.

authorities (see Figure 1 in appendix II). The trade deficit calculated by the U.S. is always greater than

the trade surplus calculated by China. When referring to the following table which compares the

bilateral trade statistics between the two countries, we can discover the difference has been increasing

from 251 (hundred millions) in 1995 to 875 (hundred million) in 2007.

Table 1: the data difference of trade between

Year 1995 2000 2001 2002 2003 2004 2005 2006 2007 The trade deficit published from China Census

86 297 281 427 586 803 1142 1446 1666

The trade surplus published from US Census

338 838 831 1031 1240 1620 2017 2326 2562

Difference

252 541 550 604 654 817 857 880 896

Source: U.S. Census Bureau and Ministry Of Commerce, PRC (in hundred million dollar)

1. China’s re-export trade relationship with Hong Kong and other regions

One of the key reasons refers to intermediation. Although estimations vary, it is agreed that a large

portion of China’s exports arrive in the United States through the third party, i.e. China’s re-export trade

with Hong Kong and other regions. The intermediation of shipments has then increased the

discrepancies. The U.S. Customs count the value of imports by relying on the importers to state the

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country of origin. Some analysts believe that some importers have miscalculated a significant amount of

imports as Chinese good.

We will now take Hong Kong as an example to illustrate this idea. Much of the China’s export is

transported through Hong Kong to other parts of the world. Hong Kong mainly provides insurance,

transportation and customers-matching services, which creates a large sum of added-value cost to the

exported goods. The cost comes from the insurance and freight incurred transiting from the original

Chinese port to Hong Kong, the markup applied to goods while in Hong Kong and the additional value

of insurance and freight incurred by re-exporting goods to the final destination.

Schindler and Beckett (2005)1 stated Hong Kong has made the calculation of bilateral trade

complicated. United Nations in fact set up guidelines in creating trade statistics, which requires the

countries to record the place of origin of the imported goods and to record the final destination of the

exported goods. However, it is difficult to enact satisfactorily since it is not easy to determine the final

destination of indirect exports. China often does not know the final destination of the good or if goods

shipped to Hong Kong may remain there. Thus, even with the best intention, a country would inevitably

create errors in calculating the amount of trade. If a good is exported from China to the United States

through Hong Kong, it may mistakenly be reported by the China as an export to Hong Kong or

mistakenly reported by the United States as an import from Hong Kong. Such misreporting would

miscalculate the bilateral trade statistics and causes the significant statistical discrepancies between the

two countries. As a result, the Chinese export value will be less than the U.S. import value.

1 Schindler and Beckett (2005), “Adjusting Chinese Bilateral Trade Data: How Big is China’s Trade Surplus?”

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2. Underestimation of the service trade by the United States

Secondly, both China and U.S. have missed out the calculation of service trade in the bilateral trade

data. The merchandised trade of U.S. is experiencing a deficit; its service-trade is, however, in an

expanding manner. According to W.T.O., the services exported by the United States are the largest

among the world and it also attained the largest surplus in service trade, which comprised 18% of the

world’s total export of service. Travel, passenger fares, other transportation, royalties and license fees,

other private services, U.S. government services, transfers under U.S. military sales contracts and direct

defense Expenditures are the most important categories in term of services which has been announced

by the U.S. Census Bureau. The significant and crucial services, such as insurance, finance, consultancy

and technical support are not calculated as important independent categories due to the difficulties in

collecting those data. Therefore, we can assert that the surplus of service trade is underestimated by the

United States.

3. Different methods to calculate Exports and Imports

Thirdly, China and U.S. has used different methods to evaluate exports and imports which means

that direct comparison of the official trade balance report of the both countries is not accurate. China has

used “free on board” (F.O.B.) definition and “cost, insurance, and freight” (C.I.F.) definition to calculate

imports. The United States, however, has used the “freight along side” (F.A.S.) to count exports and a

customs definition to calculate imports. The different way of calculation thereby has made the

discrepancy larger. Martin (2007)2

2 Martin, M.F.,(2007) “What’s the Difference? — Comparing U.S. and Chinese Trade Data”

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4. Under-invoicing

Fourthly, some economists believe that Chinese importers have deliberately understated the import

value from the United States to shirk the import tariffs due on shipment. Due to the hidden pressure of

understating the imports value, it has made the Chinese official statistics to be smaller.

I. Factors affecting the trade imbalance

Apart from the regression analysis we will explain in the latter part, we will discuss the factors that

can be observed from the real life situation.

(1) The expanding trade surplus is in fact the shift of the Asian countries’ exports to China. After

the opening of China, especially in 1987, processing trade has been further encouraged. (See Figure 2

& 3 in Appendix II) China’s rapid processing trade mainly provided services to the United States, Japan,

Korea, Hong Kong and Taiwan. They aimed at lowering production cost and increasing the

competitiveness, so with the advantage of cheap labor in China, they decided to transfer the labor-

demanded fabricating steps to the mainland China. Those countries also set up a lot of foreign invested

companies in order to attain a more comprehensive flow of production. In 2006, foreign invested

enterprises exported 563.84 billion dollars and had 26.93% growth compared to the 2005, which

contributed to 58.18% of the country’s total exports value. On the other hand, the imports had achieved

472.6 billion dollars which had the growth of 21.96% and accounted for 59.7% of the total imports value.

The trade surplus created by the foreign invested enterprises was 91.2 billion dollars, which comprised

51.4% of China’s total trade surplus in 2006. Therefore, we can say that over half of the benefit is

received by the foreign invested enterprises and the trade benefit of China is not as large as the United

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States expected.

(2) Most countries commonly used substantial transformation3 to verify the country of origin for

import and export goods. The General Administration of Customs has announced the "Amendment to

the Rules for Non-Preferential Country of Origin" based on the "Regulations of the People's Republic of

China on The Country of Origin of Imports and Exports". One of the criteria for determining substantial

transformation refers to the value added content. The total value of the raw materials and related costs

incurred should be greater than or equal to 30% of the value of the final manufacturing products. So, if

China has contributed to over 30% of the goods’ added value process, the importing countries may

regard China as the country of origin. Thus, the benefit from trade surplus of China is obviously

overestimated by the United States.

(3) Apart from the reasons of migrating foreign labor-intensive processing industries to China,

market access is another significant factor that contributes to the trade deficit of the United States.

According to Zhang, Liu, Ping (2006)4, U.S. has adopted some trade limitation to restrict exports to

China, such as sanctions, exports controls and export finance limitation. Export control policies are used

to protect national security and control the growth rate of exports to China. Defense equipments,

high-technology products are the items that specially controlled even with great import demand from

China. The procedures of acquiring export licenses to China are very complicated and time- consuming,

thus, many companies which originally planned to export has given up finally. In 2006, the Boeing

Company was fined $15 million5 for its violation in export restriction to Arms Control Export Act,

3 “The Amendment To The Rules For Non-Preferential Country Of Origin Announced By The General Administration Of Customs” Notice No. 122 by Customs General Administration People's Republic of China, 6 December 2004, Hhttp://www.cwcccpa.com/articles/country0216.htmH 4 “中美貿易順差結構分析及對策研究”第一章, 張燕生 劉旭 平新喬, July 2006 5 “Boeing Fined $15 Million for a Chip” Associated Press, April 9, 2006

which regulates the sale of defense products to overseas interests. Boeing shipped commercial jets

overseas between 2000 and 2003, and 19 of the planes had sold to China, where the U.S. export of listed

defense items is highly prohibited. Boeing Company had actually paid millions in previous transactions.

In 1998, the company was fined $10 million for sharing technology in a space rocket venture and it paid

more than $4 million for transferring technology without an export license in 2001. We can conclude

that restrictions on those goods are rather broad and vague, which will definitely deter companies to

trade with China. The United States is good at producing high-technological products, which cannot be

replaced easily by other countries.

Restriction on these high valued goods has in fact hindered U.S. exports and increased the imbalance in

trade.

(4) As mentioned by the United States earlier, low labor cost is one of the causes to its trade deficit.

Yang, Besnainou (2006)6 mentioned China’s advantage in labor cost is natural tendency due to its low

living standard. Though China is undergoing improvement in GDP per capita and GDP growth rate, its

GDP per capita7 is still very low compared to other world powers. In 2008, China had $5300 and the

United States had $46000. The labor-intensive goods and cheap labor should therefore be the natural

phenomena to international trade.

(5) Last but not least, one of the important reasons of the huge trade deficit in goods is that the U.S.

saving rate is low. Charles and John (2006) claimed that the saving behavior of the American is a

important factor of trade deficit. Actually, the aggregate demand is greater than the aggregate supply is

the major reason of the huge trade deficit. According to the Keynesian four sector model, the difference

http://www.washingtonpost.com/wp-dyn/content/article/2006/04/08/AR2006040801450.html 6 “Is the Chinese currency undervalued?” Jiawen Yang, 2006 7 SOURCE: CIA World Factbook 2008 http://www.photius.com/rankings/economy/gdp_per_capita_2008_1.html

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between export and import must be equal to the difference of private saving and government saving.8

That means if saving is greater than investment, a trade surplus must be resulted. For example, the total

saving is bigger than total investment in the period 1960 – 1971, there is a trade surplus; however,

starting from 1972, investment is greater than savings in most of the years. According to report of

Federal Reserve Bank of ST. LOUIS, the personal saving rate is about 1% (See figure 4 in Appendix II).

In short, the low saving rate economics structure is the major reason of trade deficit.

8 Keynesian model: NX = (S-I) + (T-G)

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II. Currency Manipulation problem

The United States put the blame on China that causes its large trade deficit, the loss of

manufacturing jobs and general deflation in the industrial countries. China has undervalued its currency

and made its exports to be much cheaper than those in the United States, which will definitely harm their

local manufacturing company. Some economists also insisted that China has deliberately manipulated its

exchange rate and lower the labor wage to gain the advantages from trade.

According to the 1988 Trade Act, it has proposed the definition of “currency manipulation”. A

country is defined as currency manipulator when all of the conditions stated are satisfied, (1) is

manipulating the exchange rate for the purpose of gaining an unfair trade advantage or preventing

effective balance of payments adjustments, and (2) has a material global current account surplus and a

significant bilateral trade surplus with the United States. 9When we take a look at the China’s case, we

can see that China has not satisfied all the criteria. In Chart 1, we can see that although China had the

largest bilateral trade surplus with the United States, which accounted for 256,207 million dollars

surplus in 2007, it did not have material global current account surplus.

________________________________________________________________________________

Insert Figure 5

In Chart 6, we can find that China is not the country which ranks the highest in its current account

balance. The first position goes to Saudi Arabia, which is the major oil-exporting country.

____________________________________________________________________________

Insert Figure 6 _____________________________________________________________________________

9 “International Trade:Treasury Assessment have not found currency manipulation, but Concerns about exchange rates continue”, Government Accountability Office, April, 2005

13

Besides, China’s determination to maintain a fixed exchange rate regime in different economic

environment is another indicator to prove that China does not aim to gain trade advantage from the

United States. Since the financial reform of 1994, China has pegged the Renminbi to U.S. dollar. It

maintains this peg by buying and selling renminbi in exchange for foreign currencies, e.g. China may

purchase the excess supply of foreign exchange arises from increasing trade surpluses and maintain its

currency within a narrow range of exchange rate. In 2009, China’ central bank announced the foreign

exchange reserves10 has accumulated $1.9537 trillion by the end of March. Analysts believe 70% of its

total foreign exchange is U.S. dollar-denominated asset, including Treasury securities. When we take a

look at the figure, we may find that the average exchange rate is about 8.2 RMB to 1 dollar from 1996 to

2005, and a small increase in its exchange rate the years after.

During that period, several economic changes had occurred, such as the financial crisis in late

1990s. Many Asian countries were affected severely in the crisis and many of them had depreciated its

currency. China, however, had never tried to depreciate its currency so as to stay competitive with the

other Asian countries which had cheaper currencies. Rather, China has consistently adopted a stable

exchange rate to stabilize its economy, which means that China is not manipulating its currency to gain

trade advantage (GAO, 2005)

10 “China foreign exchange reserves at $1.954 trillion”, April 11, http://apnews.myway.com/article/20090411/D97G8G300.html

14

http://apnews.myway.com/article/20090411/D97G8G300.html

III. Estimation of the Undervaluation of RMB

Chinese currency has been believed to be undervalued for many years and a lot of economists have

tried different methodologies to estimate the percentage of RMB undervaluation. The result ranged from

a few percent to over 50 percent, and some stated that undervaluation cannot be determined and difficult

to access due to China’s fast economic changes.

__________________________________

Insert Figure 7

__________________________________

As we may see from the table that summarized the methodology and estimation by different experts,

the result varied a lot. This significant variation can be resulted from different methods to access the

undervaluation, but same approach can also attribute to a big difference. Like using the absolute version

of the Purchasing Power Parity approach created result of 40 percent (Bosworth); 22 percent (Chang);

15

35 percent (Frankel) and 56 percent (Big Mac Index). Another commonly used External Balance

approach has yielded estimation of 4-5 percent (Bottelier), 11 percent (Rahn) and 40 percent (Preeg).

Accessing RMB revaluation is challenging and whether it is undervalued cannot be reliably determined.

Treasury Assessment (2005) stated that the estimation requires analysis of key economic variables,

which is an uncertainty in China. ( Appendix I)

IV.Concern over Chinese Currency Revaluation

It is assumed by the U.S. that high-valued Chinese goods will make Chinese exports more

expensive and their exports to China cheaper, thus improve their trade balance. To determine whether

currency revaluation is a good solution, several factors have to be addressed.

Firstly, Mundell (2005) stressed that RMB revaluation cannot help to solve the U.S. trade deficit.

When the Chinese goods become more expensive, the American may turn to buy cheaper goods from

other lower-cost countries. It is possible that goods from those countries would replace China and

become another exports producer to export cheap goods to U.S. The decreased imports from China will

result in slightly higher priced imports from countries like Sri Lanka, Vietnam, and Bangladesh.

Revaluation can solve the bilateral trade deficit with China, but the overall trade imbalance problem

cannot be improved. Besides, American manufacturers who depend largely on Chinese imports have to

face higher production costs, and consumers will face higher price since producers may tend to shift

their costs.

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Secondly, the reduction in trade deficit depends on the elasticity of demand of the Chinese goods.

Some industry may continue to buy the same amount of Chinese imports for production, no matter the

price changes, whereas some may reduce greatly on their purchases. So, the less responsive of purchases

to the price increase, the less effective the improvement in the U.S. trade deficit. Also, there will be time

period required to let the adjustment take place. When the Chinese currency appreciates, the U.S.

producers or customers may need time to adjust their consumption practices. The trade deficit, in a short

run, cannot be adjusted, the appreciation may lead to changes in production and employment structure,

which will likely last for years.

Thirdly, appreciation of renminbi involves a magnified effect in the Asian market. Some analysts

believe that the East Asian countries have kept their currency weak against dollar in order to stay

competitive with the cheap goods in China. When Chinese currency appreciates, the East Asian

countries may adjust their exchange rate policy, either depreciate or appreciate, which will definitely

magnify the effect of revaluation to the U.S. economy. (GAO, 2005)

Fourthly, China’s banking and financial system is still immature and successive reforms have to be

taken place before the changes in the foreign exchange rate. Changing the foreign exchange rate will

pose a risk to China’s fragile banking system.11 China has been regarded as the major player in the

Asian market, moves on exchange rate will influence the policies and the foreign exchange rate of the

other countries. Therefore, maintaining the currency level of Renminbi can stabilize the Asian economy.

11 Experts: No quick action on forex, China Business Weekly, January 20,2004

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Fifthly, the appreciation of Chinese currency will affect the capital flow of China to U.S as China’s

investment in foreign exchange has been regarded as the major source to finance U.S trade deficit. China

has been investing in the foreign exchange market by buying American bonds in order to maintain its

currency level. China increased its U.S. treasury purchases by $12.2 billion in January 2009 and reached

$739.6 billion, nearly a quarter of the total. Krugman (2005)12 stated that China does not peg the

currency to dollar, China may stop buying U.S. bonds and interest rate would rise, which would be a

very bad news for housing if interest rate rise burst the bubble.

12 Paul Krugman:China unpegs itself, The New York Times, July 23, 2005

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5. Methodology

This paper aims at analyzing the true reason for the bilateral trade between China and U.S. The

analysis covers bilateral trade in good while services trade is not considered because of problems with

the data and many of the services traded involve returns to capital. In addition, merchandised trade

dominates a large percentage of the U.S. trade deficit.

As the argument of the U.S. trade deficit is not a new topic, there are many economists analyzing

the reason of the U.S. trade deficit. Also, many professionals tried to estimate how much percentage of

RMB should be appreciated in order to tackle the problem. It is undoubtedly an important topic for both

countries because it involves long term trade cooperation between the two world powers, therefore,

choose this topic for our report.

In our report, we will analyze the structure of the bilateral trade. It can be separated into three parts.

First of all, we will show the recent situation of the problem. Secondly, we will try to find out the

reasons of the bilateral trade. Besides, we will also try to analyze their arguments by analyzing the data

and trade policy of both countries. Finally, we will suggest the possible strategies to tackle the problem.

We have developed a model to illustrate the impact of bilateral trade with GDP and exchange rate.

In our regression model, GDP of China and U.S., and exchange rates in term of dollar of five

countries are included. According to the Keynesian model, GDP is one of the major factors affecting

imports, and therefore the data of GDP is collected. Also, according to BOFIT Discussion Paper (2007),

the real effective exchange rate was used; however, the real effective exchange rate includes the effect of

U.S. dollar and the rest of the world currencies. If we use the REER of China to analyze the bilateral

19

trade, some bias may result. To solve this problem, the five exchange rates including Renminbi (China),

Yen (Japan), CAD (Canada), Pound (United Kingdom), and DEM (Germany) are used. The reason is

that the countries can represent 60% of U.S. trade and therefore the exchange rates are the major factor

affecting the bilateral trade between China and U.S. Also, competition occurs among these countries.

However, the data of the variable, RGEMUS (DEM of Germany), is only available from 1984. And we

therefore made some adjustments in the period 1980 to 1983 by simulating the rate of change in Pound.

By refer to the theory of Purchasing Power Parity, we adjusted all exchange rates by CPI to reflect the

real purchase power. But it includes only 27 years data in our model as some figures are only available

from 1980. The data sets should have some technical estimation in order to assure the findings are

reliable. To estimate the impact on bilateral trade during the period 1980 – 2006, the GDP of both

countries and different exchange rate should be collected. Also, we want to put two variables in the

regression in order to represent the impact of the trade barrier (i.e. trade policy & tariffs) and the number

of foreign firms in China; however, we face a technical problem on that. First, we can’t quantify the

trade barriers (i.e. quota & restriction) successfully. Second, for the number of foreign firms in China,

the data is hard to collected and not sufficient. Thus, we have not used these two variables in the

regression model, but we try to explain the relationship between the two variables and the bilateral trade.

After all, all the data used in the model is primary and they are all adjusted by CPI in order to

avoid the effect of price level.

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I. Presumptions:

To simplify the models, some presumptions have been made. Firstly, the trade of each country is

inter-related and they are mutually influencing. Secondly, dependent variables and GDP variables are

expressed in US million dollars. Thirdly, the data is released from U.S. Census and we assume one’s

exports are the others’ imports in bilateral trade, ignoring the problem of statistical difference from the

two countries. Fourth, all data are expressed in real term adjusted by CPI. Finally, only five exchange

rates are included in the model. There are two reasons for including these exchange rates in this study.

One of the reasons is that these five countries are the top five trading partners of the United States.

Another reason is that many foreign enterprises in China, as mentioned before, are mainly from these

countries. According to U.S. Census report 2008, these countries represent 64.83% of U.S. Imports, and

60.31% of U.S. Exports in goods, as shown in table 1 in appendix III. Therefore, we choose the

exchange rate as an indictor to reflect the impact of the bilateral trade of U.S. and China.

II. Data source:

The bilateral trade between China and United State is collected from the official website of the U.S.

Census department. The nominal GDP of both countries is obtained from the official website of United

Nation. Every CPI which is used to deflate the nominal variables to obtain real terms is collected from

the Bank of Barclay. The nominal exchange rate of the five countries is obtained from the data base of

International Financial Statistic (IFS).

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III. Model:

Double-log model is needed to reduce the variances of independent variables. Econometric model is

constructed as followed:

lnX = RGEMUSRRMBUS

RUKUSRJPUSRCNUSCGDPlnln

lnlnlnln

65

43210

βββββββ

++++++

(1)

lnM =RGEMUSPRMBUS

RUKUSRJPUSRCNUSUSGDPlnln

lnlnlnln

65

43210

βββββββ

++++++

(2)

where,

X is the export in good from U.S. to China

M is the import in good from China to U.S.

CGDP and USGDP are real gross domestic product of China and U.S. respectively, with deflating

China CPI and U.S. CPI respectively.

RCNUS is real exchange rate of Canada in term of U.S. dollar.

RJPUS is real exchange rate of Japan in term of U.S. dollar.

RRMBUS is real exchange rate of China in term of U.S. dollar.

RUKUS is real exchange rate of United Kingdom in term of U.S. dollar.

RGEMUS is real exchange rate of DEM (Germany) in term of U.S. dollar.

By definition, the real exchange rate is defined as RER=E*P/Pf, where Pf is the foreign price level and

P is the domestic price level. In this study, CPI is used to represent the price level.

IV. The expected result:

In the equation (1), CGDP is expected to be positive as a higher GDP level represents a higher

demand of U.S. product, which improves U.S. export. And RRMBUS, which increasing number

represents RMB depreciation with respect to dollar, is expected to be negative with the U.S. export to

China. Besides, the other exchange rates, including RJPUS, RGEMUS, RCNUS and RUKUS, are

expected to be negative. It is because if those currencies depreciate (i.e. RMB is appreciate in term of

those currency), China will import more goods from those countries rather than from U.S. with a

cheaper price. Therefore, depreciation in other currencies will hurt the U.S. export of U.S.

Besides, in the equation (2), USGDP is expected to be positive as a higher GDP level represents

a higher demand of China product, which increases U.S. import.

Again, the RRMBUS is expected to be positive as an appreciation of U.S. implies more import. Besides,

the other exchange rates are expected to be negative. U.S. will import more good from other countries,

rather than from China, with a cheaper price. Therefore, the import of good from China should be lower.

In our expectation, we didn’t take the elasticity of trade into account and assume the normal goods

are traded between China and U.S. (i.e. Ed>1). The reason is that it is difficult to measure the impact of

exchange rate with elasticity. Instead of estimating the elasticity, we would like to prove whether the

elasticity can be explained after the regression result is obtained.

23

5. Empirical Results:

Table X:

Dependent Variables LogX LogM

Coefficient T-ratio Coefficient T-ratio

Constant 18.85604** 11.34387 -21.18191** -7.246667

LogCGDP 0.31552** 4.799276 NIL NIL

LogUSGDP NIL NIL 1.630823** 16.00702

LogRCNUS -0.399232 -1.751433 -0.677656** -4.442621

LogRJPUS -0.313176** -2.858576 0.067212 1.945676

LogRUKUS -0.048855** -0.262063 -0.147758 -1.098336

LogRRMBUS -0.516111** -5.622888 -0.242458** -3.097018

LogGEMUS 0.266899 1.756685 0.076582 0.728378

Independent

Variables

AR(1) 0.478537** 2.666269 0.351765** 1.920848

R-square 0.991594 0.996999

Adj. R-square 0.988325 0.995831

SEE 0.056605 0.038516

D.W. statistics 1.64395 1.743819

Observation 27 27

Notes: ***indicates significance at 1%. T-statistics are given in parentheses. AR(1) variable is used to correct the autocorrelation problem in the model

Table X shows the relationship among bilateral trade, China and U.S. GDP and exchange rate.

Most of the coefficients are statically significant and consistent with the expected signs. The

24

adjusted R2 are significant with the figure 0.988325.

In the equation (1), the dependent variable is the log value of U.S. export to China. Most of the

coefficients are significant with correct sign. It shows that China GDP leads to a higher U.S. export to

China. It is reasonable to obtain the result as what the Keynesian model mentioned before. Moreover,

the exchange rate of RMB in term of dollar shows a negative relationship with the U.S. export. It is also

understandable that the value of U.S. export to China will decrease with RMB depreciation. Besides, it

implied that the demand of U.S. exports to China is elastic. In reality, semiconductor, civilian aircraft

and soybeans13 are the three important items of the U.S. exports to China. The price sensitivity of those

items is comparatively high. Therefore, the result can be explained in the real situation. According to

Willem (2006), the elasticity of export is elastic in the bilateral trade. Besides, the depreciation of other

currencies will decrease the competitiveness of U.S. import goods, and China therefore import goods

from other countries, like Japan and Canada (i.e. the coefficients are -0.31 and -0.399 respectively). For

the exchange rate of Germany, the regression result shows an unexpected sign and insufficient. It may

cause from the insignificant sample size. The other reason is that Germany supplies material to U.S.14

Then, the lower exchange rate implies lower raw material cost and encourages U.S. exports.

In equation (2), the dependent variable is the log value of U.S. import from China. Most of the

coefficients are significant with correct sign. It shows that U.S. GDP lead to a higher U.S. import from

China. It can be explained by the Keynesian model. Moreover, the exchange rate of United Kingdom

and Canada satisfy our expectation with a negative sign. However, the exchange rate of Germany and

Japan do not satisfy our expectation with a positive sign. For the currency of Germany, an insufficient

13 Refer to the U.S. Census Bureau 2008 report. 14 Most of the Germany’s products are in engineering, especially in automobiles, machinery, metals, and chemical goods.

25

result is showed. An insignificant sample size may be the reason of that. Besides, for the currency of

Japan, the result is significant; however, the sign shows a positive sign rather than a negative sign which

we expected. It means that Yen depreciation will greater the U.S. import from China. One of the possible

reasons is the lower cost of material from Japan. Furthermore, a negative sign of the exchange rate of

RMB is resulted. It implies that the elasticity of imported goods from China to U.S. is in elastic. It

means that those imported goods are price inelastic, like food, cruel oil and clothing15. Therefore, it can

be explained by the real situation.

The issue of revaluating RMB has always been discussing. As U.S. always claimed that the

problem of trade deficit will be improved if RMB appreciate for a certain level (from the previous

discussion). In our regression result, it shows a negative sign of RMB. That means appreciation on RMB

will decrease imports from China to US and increase U.S. export to China. Therefore, the trade deficit

will improve.

15 From the data of U.S. Census department, cotton, computer and household items are the most three important imported goods from China.

26

I. Limitation of the Model Estimations

In this paper, the data of the bilateral trade value in year 1980 to 2003 are from official website of

U.S. Census; however, there is a statistical difference in both countries. Also, some data are not available,

i.e. the real exchange rate of RMB of 1980 and 1981. This cause estimation problem when we test the

hypothesis, there may have some biases in the estimation.

At first, we want to increase the sample size by choosing monthly or quarterly data; however, most

of the china data are only available in annual. Therefore, the result may not be sufficient with a

comparatively small sample size.

Another limitation comes from the data of exchange rate of RMB. The rate is not opened to the

public and therefore, the rate can’t reflect how RMB affecting the bilateral trade of U.S. and China.

Therefore, there may have some biases in the estimation.

Also, the effect of trading barriers is not included in the model, which is one of the important

variable for analyzing the import and export. Therefore, the result may not sufficient.

27

8. Conclusion and Recommendation

The trade deficit of U.S. is always a controversial issue. This paper analyzes the reason of

bilateral trade of U.S. and China. Several conclusions can be drawn in this paper.

(1) The development of trade between China and U.S. grows rapidly. According to the historical

data, the trade is not affected by the economics cycle of U.S. The major reason is that the price sensitive

of China imports goods (i.e. clothing, cruel oil) are comparatively low.

(2) Low saving rate is the major reason of the trade deficit. The economics structure of U.S. is

low saving and large investment. For example, the personal saving rate is low. Besides, the investment is

really high. According to the report of Morgan Stanley, the average investment is 150% of the saving in

U.S. Therefore, the domestic supply can’t satisfy the domestic demand, and then there is always a trade

deficit.

(3) U.S earns a huge benefit even facing a huge trade deficit. The export from the foreign

enterprises in China is about 58.18% of the total export in 2006. The phenomena implied that most of

the profit earned by the foreign enterprises. According to well-known economist Tse Kwok Chung, he

predicted that the retail price of the import goods which only valued 1 U.S. dollar is about 4 U.S. dollar.

That means 75% of this value chain is earned by U.S. firms and workers.

(4) The regression result shows that appreciation of RMB may improve the trade deficit;

however, many arguments claimed that appreciating of RMB is not efficient to improve trade deficit.

Many side effects will be resulted. For example, if China is forced to revalue RMB, then China will no

longer buy U.S. debt and therefore U.S. will lose the major source to finance its trade deficit (i.e.

Printing U.S. note can earn a sufficient amount of money).

28

And there are several recommendations we suggested:

Obviously, the issue is not only a simple economics question, but also a complicated political

problem. Many economists think that U.S. is worried about the rapid growth of China and therefore shift

the responsibility of imbalance global economy to China.We have some recommendation for both China

and U.S.

For China:

(1) China should keep a good relationship with U.S. by communicating and discussing some important

issues.

(2) China should maintain and improve the process of export. Try to balance the benefit of government

and private enterprises. To build a well-established trading system in order to give an excuse to U.S.

imposing trade barriers.

(3) China should enhance the internal aggregate demand. Then, China can keep a rapid growth without

relying export.

(4) China should build a good relationship with other countries. And therefore, the bargaining power on

discussing important international issue.

29

For U.S.:

(1) U.S. should co-operate with China to tackle the problem of trade deficit and should not treat China as

a competitive country.

(2) U.S. should improve the savings level, including the private saving and the government saving. In

fact, U.S. is a country with the largest debt. Basically, U.S. asset have the risk of not able to afford the

liability and face bankruptcy. Therefore, U.S. should improve the saving level in order to tackle the trade

deficit and the internal problem.

(3) U.S. should make a good use on its comparative advantage: Service and Technology. According to

the statistic of U.S. Census department, U.S. always has a trade surplus in service. Therefore, to improve

the current account, it should keep a strong growth on trade in service. Also, U.S. should not restrict

technology export. If we don’t consider the some political reasons, U.S. will gain a lot when it restricts

their technology export to the other countries (i.e. aircraft technology, Satellite technology and etc.). If

U.S. open the market and approve technology trading, U.S. trade deficit will improve in a sufficient

amount.

To sum up, U.S. always argues China make imbalance trade in the world. However, many

evidences show that China is not a key person to take responsibility on this issue. In fact, U.S. should

responsible for the imbalance trade itself.

30

31

8. Reference Schindler J.W. and Beckett D.H. (2005) Adjusting Chinese Bilateral Trade Data: How Big is China’s Trade Surplus?, International Finance Discussion Papers Number 831 Martin M.F.(2007), What’s the Difference? — Comparing U.S. and Chinese Trade Data, CRS Report for Congress “The Amendment To The Rules For Non-Preferential Country Of Origin Announced By The General Administration Of Customs”, Notice No. 122 by Customs General Administration People's Republic of China, Hhttp://www.cwcccpa.com/articles/country0216.htmH 張燕生、劉旭、平新喬: “中美貿易順差結構分析及對策研究”, (2006), 中國財政經濟出版社 Yang, J., Besnainou, I.B. (2006), Is the Chinese currency undervalued? International Research Journal of Finance and Economics Government Accountability Office (2005), International Trade: Treasury Assessment have not found currency manipulation, but Concerns about exchange rates continue Cheung Y.W., Chinn M.D., Fujii E, (2008) “China’s Current Account and Exchange Rate” Herrero A.G. and Koivu T., (2007), Can the Chinese trade surplus be reduced through exchange rate policy? Bank of Finland, Institute for Economies in Transition Discussion Paper Engel C.and Rogers J.H.., (2006) The U.S. current deficit and the expected share of world output. Working Paper 11921, National Bureau Of Economic Research Edwards S. (2005), Is the U.S. current account deficit sustainable? And if not, how costly is adjustment likely to be?, Working Paper 11541, National Bureau Of Economic Research Shi J. (2006), Are currency appreciation contractionary in China? Working paper 12551, National Bureau of economic research

Bayoumi,T. , Lee J., and Jayanthi, (2005) New Rates from New Weights, IMF Working Paper

Appendix I. Commonly Used Methods to Determine Equilibrium Exchange Rates Economists use various methods to analyze whether exchange rates are misaligned. In general, determining whether a country's currency is under-or overvalued involves first determining the country's equilibrium exchange rate as a reference or baseline. This is complex because estimating the equilibrium exchange rate requires information on what value the exchange rate would attain if it were consistent with a country's economic fundamentals at a particular point in time. Different approaches to estimating equilibrium exchange rates and under-and overvaluation can yield widely varying results, especially for developing countries, and even similar approaches can result in different outcomes depending upon which assumptions and economic judgments are used. Thus, estimates of undervaluation for China vary substantially--from 0 to 56 percent. This appendix outlines some of the methodologies commonly used to estimate the extent of undervaluation of the renminbi. Purchasing Power Parity (PPP) Approach One methodology commonly used to define equilibrium exchange rates and determine if a currency is under- or overvalued is the Purchasing Power Parity (PPP) approach. The PPP approach is rooted in the law of one price, which states that identical goods in different countries should trade at the same price. Thus, the equilibrium exchange rate is defined as the exchange rate at which the general level of prices will be the same in every country and is calculated as the ratio of the domestic and foreign price levels. The goods and services analyzed are typically those that make up the GDP of each country. In some cases, narrower units have formed the basis of PPP comparisons, such as the "Big Mac" index which is a widely cited shortcut version that analyzes one standardized good across countries. Unfortunately, the law of one price has limitations; it does not hold across nations of sharply differing levels of development and is biased toward finding undervaluation for low-income countries compared to their higher-income counterparts. Additionally, the approach ignores other important factors that lead to inequality in prices, such as trade barriers and nontraded goods. Many experts maintain that PPP measures are more useful for analyzing cost-of-living differences than inferring the extent of currency misalignment. A variation of the absolute PPP approach discussed above is the relative version of the PPP methodology, which is based on the hypothesis that changes in the exchange rate are determined by the difference between inflation rates in the two countries--or, equivalently, the real exchange rate between two currencies remains constant over time. The technique involves choosing a point in time that corresponds to equilibrium and then projecting the new equilibrium rate using the inflation differentials between countries. This analysis is based on trade-weighted exchange rate indexes because they are better indicators of overall competitiveness. One limitation of the approach is that it is very sensitive to the type of price index used for base calculations (e.g., the consumer price index vs. the producer price index), and the results depend on the time periods selected as the base year. The methodology also ignores structural changes in the economy that might cause the real exchange rate to change over time. Fundamental Equilibrium Exchange Rate (FEER) Approach TheFEER approach to assessing currency valuation is based on the relationship between the current account and capital flows. The FEER is defined as the exchange rate that will bring the current account balance (consistent with domestic full employment) into equality with the "normal" or sustainable capital account balance. Thus, it is the value of the exchange rate that is consistent with both internal and external economic equilibrium. The FEER calculation requires macroeconomic or trade models to

32

obtain the current account position that is consistent with internal balance, known as the "trend" current account. The second stage involves determining the real exchange rate changes necessary to ensure balance between medium-term capital flows and the trend current account. Within this framework, the equilibrium exchange rate is deemed "fundamental" in the sense that it is related to the fundamental economic determinants over the medium term. Significant limitations of this approach are that it requires extensive modeling to capture the major trade relationships and economic judgments that are criticized by some as ad hoc (including a decision about "normal" or sustainable capital flow levels) and that it relies on estimates of the sensitivity of demand to prices that are difficult to make. In addition, changes in the structure of the economy that affect the current account and the equilibrium exchange rate may introduce further uncertainty in the estimates. This is important in China's case because many economic conditions and institutions are rapidly changing in the move toward a market-based economy. Also, this approach is difficult to apply to China because of limitations in the quality of Chinese statistics. Macroeconomic Balance Approach This methodology is based on the premise that there is an appropriate current account position (external balance) associated with the equilibrium savings and investment balance within a country (internal balance). Once the full employment savings-investment position is established and its associated current account is determined, this approach uses estimated trade models to determine how much the real exchange rate would have to change to generate the required external balance. The approach is related to the PEER concept because the equilibrium exchange rate is associated with internal and external economic balances. Similar to the FEER, this methodology also requires considerable modeling and economic judgment, and the results are highly sensitive to variations in key parameters. The IMF notes that in its macroeconomic balance modeling approach assumptions are used to assess the current account positions and exchange rates that may not be entirely appropriate for developing countries. Moreover, the IMF industrial country methodology largely abstracts from the impact that structural policies and adjustments could have on the equilibrium savings investment position. Again, this is important in China's case because of the many structural adjustments the country is currently undergoing. External Balance Approach Similar to the FEER and Macroeconomic Balance approaches, this method is based on the premise that there is an appropriate external account position. That is, there is a particular level of the current account that balances the "normal" capital flows so that there is no change in international reserves. It differs from these two approaches in that it does not consider internal equilibrium. This approach involves determining the sustainable external account balance--meaning one appropriate for a country's economic situation. Once the relevant external balance is identified, estimated trade models or rule-of-thumb relationships are used to determine the exchange rate change needed to generate the target outcome. This method is highly dependent upon which portion of China's external balances is considered. For example, the selection of China's current account balance might lead to a finding that the renminbi is not significantly undervalued, while the broader basic balance might lead to a finding of substantial undervaluation. The approach also relies on elasticities that are difficult to estimate or rules of thumb that are not analytically precise. Moreover, the approach does not include an explicit consideration of a country's internal economic equilibrium situation, such as whether the country is at full employment. Behavioral Equilibrium Exchange Rate (BEER) Approach Under this approach, equilibrium exchange rates are determined through observing long-run

33

relationships between real exchange rates and the economic variables that determine them. That is, the BEER approach uses econometric relationships to model the equilibrium exchange rate, based on predicted economic relationships derived from an array of relevant theories. Misalignment of a currency is measured as the difference between the actual exchange rate and that predicted by the model variables. However, the determinants of exchange rates and their links to any underlying notion of economic fundamentals are neither well understood nor easily predicted. Thus, many complex BEER models do not predict exchange rates any better than simpler techniques. The BEER approach also uses a number of simplifying assumptions and precludes the identification of many other key parameters important to explaining the economic system. This makes it difficult to judge the plausibility of its estimates. Qualitative Approaches Some analysts do not formally define an equilibrium exchange rate, but look at trends in certain data to determine whether or not a country's currency is misaligned. One of the most widely cited trends used to infer currency misalignment is foreign exchange reserve growth. Some observers have noted that China has been accumulating reserves at a rapid pace and conclude that the renminbi must be undervalued. While it is true that China's foreign exchange growth has outpaced all other countries, with the exception of Japan, using China's reserve accumulations as a measure of currency misalignment has limitations. For example, some analysts have noted that a significant portion of the capital inflow into China has been short-term speculative money, triggered by expectations of a renminbi appreciation. Given China's commitment to a fixed exchange rate regime, the government must absorb this excess foreign exchange. Moreover, if China removes restrictions on capital account transactions, as many have been advocating, some analysts believe the currency may depreciate due to capital outflow. Thus, while rapid reserve growth indicates upward pressure on the currency, it does not necessarily suggest by itself that the current value of the renminbi is lower than its long-run equilibrium value.

34

35

Appendix II Figure 1: The statistical difference of trade from the U.S. and China

The statistical difference of trade from the US and China

0

500

1000

1500

2000

2500

3000

'1995 '2000 '2001 '2002 '2003 '2004 '2005 '2006 '2007

Year

US

dol

lar

(in

hund

red

mil

lion

)

0

200

400

600

800

1000

Sta

tist

ics

diff

eren

ce

The trade deficit published from China Census The trade surplus published from US Census Difference Figure 2: The ordinary imports and imports for processing

Ordinary imports and imports for processing,USD 100 million

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

importsordinary

importsprocess

36

Figure 3: The ordinary and processed exports

Orginary and Processed exports,USD 100 million

0

1000

2000

3000

4000

5000

6000

7000

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Expordinary

Exportsprocess

Figure 4: U.S. personal saving rate

37

Figure 5: Largest Bilateral merchandise Trade Balance with U.S. 2008

-300,000

-250,000

-200,000

-150,000

-100,000

-50,000

0

Trade Balance

(in million dollar)

China Japan Mexico Canada FederalRepublic

ofGermany

Germany Nigeria Venezuela SaudiArabia

Ireland

Largest Bilateral Merchandise Trade Balance with The United States in 2007

Largest Bilateral Merchandise Trade Balance with United States Figure 6: Global current account balance as percent of GDP for selected economics

Global Current Account Balance as Percent of GDP for Selected Economies,2008

-10 -5 0 5 10 15 20 25 30 35

United States

Brazil

United Kingdom

France

Mexico

Korea, South

Canada

Japan

Netherlands

Germany

Taiwan Province of China

China

Venezuela

Saudi Arabia

Percent of GDP

Figure 7: GAO, policy paper, April, 2005

38

39

Appendix III Table 1: The values given are for Imports and Exports added together. These Countries represent 64.83% of U.S. Imports, and 60.31% of U.S. Exports in goods. Year To Date

Total in Total in

Billions Billions

Country Name of U.S. $ of U.S. $

HCanada H 36.60 596.47

HChina H 30.29 409.25

HMexico H 24.42 367.45

HJapan H 14.37 205.83

HFederal Republic of Germany H 11.02 152.29

HUnited Kingdom H 7.53 112.39

HFrance H 5.65 73.18

HKorea, South H 5.14 82.88

HNetherlands H 4.46 61.36

HBrazil H 4.34 63.37