Exchange Rate and Trade Imbalance

1. Exchange Rate and Trade Imbalance Shang-Jin Wei Columbia University Business School Chazen Institute of International Business

2. Exchange Rate and Trade • Separate effect on trade vs effect on trade balance • A country’s trade balance is tightly linked to a country’s current account balance, which, as a matter of accounting identity, has to be equal to the difference in the country’s national savings and national investment, or the country’s net capital outflows

3. Since others have discussed extensively about the effect of exchange rate on trade, I will concentrate my remarks on trade balance • The intense discussion in the policy circles on the so-called current account imbalances

4. What causes trade (or current account) imbalance? Candidate explanations: Nominal exchange rate policy Structural factors that affect savings (and investment)

5. What causes trade (or current account) imbalance? Candidate explanations: Nominal exchange rate policy Most talked about but perhaps least relevant structural factors that affect savings (and investment) Uneven financial development Uneven social safety net A rise in the sex ratio in certain countries Trade reforms in certain countries

6. The role of nominal exchange rate policy • Common confusion • Real exchange rate vs nominal exchange rate • If nominal exchange rate is fixed, relative inflation rates across countries could still cause the RER to adjust • Can one engineer a sustained departure of the real exchange rate (RER) from its long-run equilibrium? • Maybe for 2-3 years for an over-valued RER • Key: goods prices (and nominal wages) are sticky downward • However, very hard to maintain an under-valued RER for the same duration because prices can go up more easily than down. • The literature in empirical international finance suggests that the RER converges to the equilibrium level relatively quickly. This is especially true if the required correction is an increase in the value of the RER

7. Example: In the short run, trade balance responds to change in exchange rate

8. However, in the medium-run and long-run, the link is much weaker • Japanese yen is on a floating exchange rate regime • Japan has not intervened in the exchange rate market since 2004 (until more recently) • Yet, Japanese trade balance and current account have been in surplus in most years

9. This tells us a few things: • Despite the short-term correlation between nominal exchange rate and real exchange rate, the medium-term correlation is close to zero • There are likely structural factors in the Japanese economy that cause the country to run a trade (and current account) surplus • A flexible exchange rate does not guarantee the disappearance of a trade surplus (or deficit)

10. The role of nominal exchange rate policy • What about international evidence on a change in the nominal exchange rate regime? • Does a change in the exchange rate regime from a peg to a floating system speed up the current account adjustment? • Menzie Chinn and S.J. Wei, 2012, “A faith-based initiative meets the evidence: Does a more flexible exchange rate facilitate current account adjustment”? Review of Economics and Statistics

11. No strong and robust support for the notion that a more flexible exchange rate regime produces a faster convergence of current account to its long-run equilibrium • True for both developing and developed countries • True after excluding China from the sample • Reference: Chinn and Wei, 2012, RESTAT

12. Structural factors underlying trade imbalance • A rise in the sex ratio • A wave of major trade reforms • Uneven financial development across countries • Uneven social safety net across countries

13. Sex ratio imbalance and current account imbalance • A rise in the sex ratio for the pre-marital age cohort in several countries (e.g. Singapore, Vietnam, Korea, China) takes place about the same time as a rise in these countries’ trade surplus and current account surplus

14. What’s the connection between the sex ratio and trade balance? • Why did the rise in the sex ratio in China start around 2002 (just when its current account surplus became more prominent)? • How strong can the effect be?

15. Percentage of Chinese counties with Ultrasound B machinessource: Chen, Li, Meng (2010) • What’s the connection between the sex ratio and trade balance? • Competitive savings for the marriage market • Why did the rise in the sex ratio in China start from 2002? • spread of ultrasound B + family planning policy • How strong can the effect be? • A strong biological urge implies a strong economic effect (50% of the increase in Chinese savings since 1990) Sex ratio and saving rate in China: 1975- 2005

16. More Rigorous Evidence from households and regions in China • “The competitive savings motive: evidence from rising sex ratios and savings rates in China” • S.J. Wei and X.B. Zhang, Journal of Political Economy, 2011 • Household-level evidence • Saving for children a key reason for savings, especially when having a son • A combination of having an unmarried son and living in a region with a high sex ratio -> high savings rate • Cross regional evidence • Quantitative effect: 50-60% of the rise in savings • The rise in the sex ratio also triggers a rise in the corporate savings rate • So national savings becomes higher Sex ratio and saving rate in China: 1975- 2005

17. Trade reforms and trade balance • Counter-intuitive result • Or a case of a general equilibrium effect overturns a partial equilibrium intuition • Partial equilibrium intuition: • Example: When China reduces import barriers, its imports would go up and trade surplus would go down • General equilibrium result: • When China reduces import barriers, this puts downward pressure on domestic return to capital, and hence an incentive to send part of the domestic savings to foreign countries. This means it would increase trade surplus. • This is accomplished by having the exports to expand at a faster rate than imports

18. Trade reforms and trade balance • Logic : • China is a labor abundant country • It has strong comparative advantage in labor-intensive products • Trade reforms reduce the domestic price of capital intensive good • This tends to reduce the domestic return to capital (“The Stolper-Samuelson theorem”) • … and creates an incentive for capital outflows (or a rise in the current account surplus) Reference: Ju, Shi, and Wei, 2012, “trade reforms and current account imbalances: does the general equilibrium effect overturn the partial equilibrium intuition?”

19. More than a coincidence: China’s WTO accession and the rise of its current account surplus

20. Interestingly, the same conceptual framework indicates that the end of the MFA quotas in the U.S. per se has a tendency for the U.S. to increase its trade deficit: • End of MFA quotas reduces the prices of garments/textiles (labor intensive products) • This by itself tends to raise the return to capital in the U.S. (again, the Stolper-Samuelson theorem) • … and creates an incentive for the US to import capital (i.e., to run a current account deficit)

21. Cross country evidence • Identify trade reform episodes • A reduction in average tariff rate by 3 pct pts or more within 2 years • An increase in imports/GDP by 3 pct pts within 3 years • Check if k-intensity has increased • Check if CA/GDP has increased

22. Trade reforms that tend to reduce a country’s capital intensity tends to generate a current account surplus

23. Some implications • Asking a labor abundant country to do more market access reforms could induce the country to have a bigger not a smaller trade surplus • The part of trade balance generated by trade reforms tend to die out once the reforms are completed

24. There are other structural factors that could also generate a current account imbalance • Uneven financial development • Uneven social safety net • …

25. Policy Lessons • Exchange rate policy may have played a smaller role in the patterns of trade (current account) imbalances than commonly assumed • Not all trade imbalances need a policy correction • For example, some trade imbalances may be generated by efficient trade reforms • Some trade imbalances are socially inefficient, but exchange rate is not the appropriate tool for correction • For example, the part of trade imbalance generated by a sex ratio imbalance is indeed inefficient, but the exchange rate correction could make things worse

26. For references or detailed presentation of the theories and evidence discussed here, one might check out • www.nber.org/~wei