Why China's exporters may be right to resist yuan revaluation
The Commerce Ministry has long resisted international calls for a revaluation of the yuan, insisting that currency appreciation would devastate China's export industries.
Most economists reject this argument, saying a rise in the yuan would inflict little, if any, damage on exporters.
On closer examination, however, it turns out that the economists may be wrong and that the ministry could have a point after all.
Traditionally, economists have argued that changes in the yuan's exchange rate have only a relatively small impact on the health of the country's exports.
The reason is that such a large portion of China's exports consists of goods that are assembled on the mainland from imported components. As the first chart below shows, last year this 'processing trade' made up roughly half of all China's exports.
As a result, the domestic content in China's exports is low. Take electronics as an example. Each year, the country exports millions of sophisticated electronic gadgets. But the most valuable components all tend to be imported: processors and hard disks from Japan, liquid-crystal display screens from South Korea, and just about everything else from Taiwan. China contributes only the cheapest, most commoditised components and the final assembly. As a result, the value added by the mainland to the final product can be as little as 5 per cent or less.
That means a rise in the value of the yuan should have only a minimal impact on the cost of many Chinese exports. Yuan appreciation will raise the cost of domestically sourced products and bump up the labour cost of assembly. But these make up only a small fraction of the overall cost of the exported goods. The major portion - the imported components - will be unaffected.
As a result, say the economic analysts, yuan appreciation should have little or no impact on China's processing-trade exports.
Except that there is a big flaw in their argument.
The vast majority of the components China imports for assembly and re-export come from other East Asian economies. Two-thirds come from Korea, Taiwan and the countries of Southeast Asia, with most of the rest imported from Japan.
Three-quarters of the assembled goods are then shipped to Europe and the United States.
So the economists' argument works if the yuan appreciates in isolation. But if other East Asian currencies also rise alongside the appreciating yuan, their reasoning breaks down. In that event, the cost of the imported components would rise, too, significantly increasing the US dollar or euro price of the final products, which would erode demand in the developed markets and hurt China's export industries.
Unfortunately, there are indications that this is exactly what will happen if the yuan appreciates. In recent years, governments and central banks around the region have intervened in the foreign exchange markets to hold down the value of their currencies relative to the yuan so they don't lose any competitive advantage to China.
That policy has come at a price. It has exaggerated the local currency costs of key commodities and stoked inflationary pressures. As a result, it is highly likely that if Beijing allows the yuan to strengthen in the near future, other Asian governments will heave a sigh of relief and let their currencies rise, too.
That's what happened in 2005. As the second chart below shows, when China revalued the yuan last time around, currencies as far apart as the Korean won and the Malaysian ringgit rose in parallel.
If the same happens now, it will help governments across the region contain domestic price increases.
But when it comes to China's processing-trade exports, it will mean cost increases not just at the mainland assembly point but along the entire supply chain.
In a research paper published last month, Willem Thorbecke, a senior research fellow at the Asian Development Bank Institute in Tokyo, estimated that a 1 per cent appreciation of the yuan in isolation would lead to a 1 per cent decline in China's processing-trade exports.
In contrast, a 1 per cent currency appreciation across East Asia's supply chain would trigger a 3 per cent slump in China's shipments.
With the foreign exchange market now pricing in a 2 per cent appreciation of the yuan over the next six months, the impact on China's export industries could be almost as severe as the Commerce Ministry has long insisted.