How Competitive Is China?

Newly developed indicators suggest eroding international competitiveness.

The standard measure of competitiveness is the real effective exchange rate,

r = e + p – p*

Where e is the log nominal exchange rate (in foreign currency units per home currency), and p is the price level (foreign denoted by *), measured by the price of output.

This bilateral measure, examined in several previous posts (e.g., [1]), makes sense if domestic factors of production are solely used to goods that are exported. However, intermediate goods make an increasing share of world trade (net trade is 70-75% of gross goods trade, according to Johnson).

Bems and Johnson (2012) argue that one should examine the relative price of the output that is actually traded – that is the value added incorporated by a given country. An alternative view, propounded by Bayoumi, Saito and Turunen (2013), holds that trade in goods is relevant, and so one is interested in the price of the final good that is traded, taking into cost savings that arise from offshoring. In both cases, it turns out that taking into account the trade in intermediate goods is important.

Figure 1: Real effective exchange rates for China, standard IMF (blue), approximation to Bems-Johnson (red), and trade in goods (green), defined so up is an appreciation. Not exact formulation as weights do not vary by year, as in Bems-Johnson. Source: Bayoumi, Saito, Turunen (2013).

The trade in tasks approach yields roughly a 45% appreciation of the CNY by sample end, as opposed to about 22% by the conventional approach (caveat: “eyeballed” from the graph). The trade in goods approach, taking into account the decrease in prices of imported inputs, shows a lower amount of appreciation versus the trade is tasks approach – about 33%.

Which one is a more relevant measure? I don’t think there is a clear cut answer. If one is concerned about the amount of valued added output being imported from a given country, then the Bems-Johnson approach appears more relevant. However, if for some reason one were particularly interested in the goods that happened to have the final stage of production take place in a given country, then the “trade in goods” approach takes on more prominence.

It happens that according to both measures, the yuan has appreciated. It remains unclear whether that appreciation is sufficient to effect global rebalancing of aggregate demand toward the advanced economies, despite the fact the degree of appreciation is more pronounced than conveyed by the conventional real effective exchange rate indicator. That being said, the reduction in the Chinese trade balance is suggestive [1].

This piece is cross-posted from Econbrowser with permission.