China's Role in Global Production and its FX Policy
The revaluation of the renminbi (RMB) on 21 July 2005 prompted much discussion but there are some misunderstandings about the economic fundamentals of the RMB. One of the most serious is that the Chinese economy has already become too dependent on exports and needs to shift to the domestic sector to drive growth. China’s 36 per cent exports-to-gross domestic product (GDP) ratio is often cited as evidence to support this claim and if the statistic is taken at face value, China’s ratio is much higher than most other big economies.
However, China’s exports-GDP ratio is largely a statistical illusion. The total value of Chinese exports is huge, topping US$590bn in 2004, yet up to 50 per cent of this is actually the value of intermediate and semi-finished products imported from other countries. If the ‘double accounting’ of the import content is stripped out, China’s export-GDP ratio is around 18 per cent – slightly below the average level for countries that can be compared with China. Since the most conventional method of compiling trade statistics is based on gross rather than value-added terms, many other countries also have the same problem of ‘double accounting’. But where a country stands in the global value-added chain makes a huge difference to the extent of the problem. The US, Japan and some European industrialised countries, for instance, are at the top end of the chain. They are engaged in designing, producing and then exporting key components (e.g. Intel chips and Rolls-Royce aeroplane engines) that account for the bulk of the total value of the finished products. China is the opposite, mainly participating in the final stage of global production chains – the assembly and processing of imported components and other intermediate inputs into finished products (e.g. mobile phones, notebook personal computers and Nike shoes) before distributing them to end-users around the world. The value being added in China is much lower and the finished products coming out of China have an exceptionally high import content.
Globalisation, the information technology (IT) revolution and economic deregulation in developing countries in the 1990s led to a major shift in production, trade and investment flows. The new patterns of global production and trade are no longer as simple as the Richardo and Hecksher-Ohlin models – countries specialise in producing and then export certain products where they have a comparative advantage and import those they don’t. The revolution in technology and IT makes it possible for manufacturers to break up the production process into separate stages and locate them in the countries where they can be completed most efficiently.
New strategic thinking by the multinationals has created global supply chains. What used to be made in different workshops inside one factory in one country is now produced by subsidiaries or sub-contractors around the world. The multinationals are taking full advantage of each country’s resources and comparative advantages. This trend has had a profound impact on trade patterns. A country can now specialise not just in making the products that match its resources but also in individual stages of the production chain previously seen as having no comparative advantage. This has boosted productivity and income growth in many countries. It also means a specialisation-driven reduction in product costs and therefore lower rates of inflation, especially at the consumer end. International fragmentation of production processes has also boosted cross-country flows of intermediate goods. Economists at Australian National University recently estimated that parts, components and other intermediate inputs account for more than 45 per cent of Asia’s overall trade. The ratio is as high as 70 per cent in IT, electronics and other office machinery.
With its massive labour pool, open-door policy and improving infrastructure, China has emerged as an ideal place for assembly, processing and other labour-intensive stages of global production networks over the past decade. World Trade Organization-derived deregulation has increased the confidence the multinationals have in China and encouraged them to relocate labour-intensive production there. By the end of 2004, foreign manufacturers had set up more than 300,000 factories in China, most of them engaging in assembly and processing of imported components and intermediate inputs for export.
The total value of processed exports has risen rapidly over the last decade, reaching US$350bn, or about 60 per cent of China’s total exports in 2004. However, official figures suggest that the value of imported components is as much as 80 per cent of the total value of the processed exports. A Japanese notebook factory operating in China, for instance, will bring in Intel chips from the US, liquid crystal display screens from Korea and other components from its parent companies in Japan for final assembly and processing. The finished product has a total value of about US$1,000, which is recorded as an export from China to the US. However, the imported parts and components may represent up to US$800 of the value. This type of statistic grossly exaggerates China’s export value and if China’s exports-GDP ratio was measured on a value-added basis it would not be at all exceptional.
Source: CEICManufacturers in Asia were the first to shift the labour-intensive stages of their production networks to China to capitalise on its low labour and infrastructure costs. Over the past decade they have set up more than 300,000 plants and factories in the coastal areas. Most of these foreign-invested enterprises (FIEs) are involved in the assembly and processing of imported components for re-export, particularly to industrialised markets.
This process has helped Asian FIEs in China play an important role in boosting triangular trade flows between the rest of Asia, China and the industrialised countries. In recent years, more than 60 per cent of China’s component imports have originated from Korea, Taiwan and other countries in the region and a further 20 per cent from Japan. However, only 20 per cent of the finished products have been exported to Asia, 18 per cent to Japan and the remaining 60 per cent or so to the rest of the world. China has become the final stage for Asian production networks that supply a wide range of products to the world.
The formation of Asian production networks has had the following consequences:
Processing and assembly are the keys to China’s export miracle. Apart from giving a massive boost to total exports it has also significantly changed the country’s export structure. The export surge has been driven mainly by strong growth in electronics and machinery. Indeed, electronics and machinery’s share of China’s total exports doubled between 2000 and 2004, topping 47 per cent in 2004. FIEs from Taiwan, Singapore, Korea and Japan are playing a key role, with official figures suggesting that more than 70 per cent of the country’s electronics and IT exports are produced by FIEs. A large proportion of these exports has a higher-than-average import content, implying that the FIEs concentrate on the assembly of semi-finished products.
A popular view is that these exports are low value-added and should no longer be encouraged. Instead, the argument goes, the government should selectively promote hi-tech value-added exports. This view is fundamentally flawed because how China trades with the rest of the world can only be determined by its key comparative advantage – abundant labour supply. With at least 200 million surplus rural workers who need to be absorbed by non-farming sectors, China should and will continue to engage in labour-intensive production and trade. While it dominates the textile and footwear export markets, China is also well positioned to participate in the labour-intensive stage of the production networks for almost all industries.
China is effectively exporting labour services. So the goods processed with imported materials are only the vehicles carrying the services of the Chinese labour to the world markets. The value-added in China – around 20 per cent once the ‘double accounting’ has been stripped out – represents the cost of labour. Having a channel to expand the export of labour services is crucial to sustaining China’s development, which centres on shifting rural surplus labour into industrial and tertiary sectors. Given the sheer size of its surplus labour force, China has no choice but to expand the export of its labour services to create jobs.
Theoretically, the only other way this could be achieved is through massive emigration of the Chinese labour force to the rest of the world, especially to industrialised countries with high wages. This option is unlikely to be welcomed by developed countries. Expanding labour-intensive production and exports is the best way for China to absorb its rural surplus labour and improve the living standards of the majority of the population that is still living in countryside. This is also a less painful way for the rest of the world to cope with China’s emergence.
China’s market-oriented reforms have led to a breakdown in the artificial wall between rural areas and cities. It is both desirable and necessary for China to find a way to absorb surplus rural labour. Given the sheer size of the surplus, China must address this issue in a global context. In other words, China will have to further expand its share of labour-intensive global production networks to sell more of its labour services to the world markets. To do so, China should and is likely to keep the RMB’s effective exchange rate competitive in the foreseeable future. This intention is reflected in China’s recent currency reforms. The announcement by the People’s Bank of China (PBOC) on 21 July 2005 effectively changed the RMB’s de facto peg against the US dollar (US$) into ‘a managed float system based on market supply and demand with reference to a basket of currencies’.
The changes include:
The new regime is not a basket peg but it has some elements of the basket, band and crawl (BBC) rule. The basket will only be a reference for the PBOC to form its view on where the RMB’s parity rate should or shouldn’t be. In fact, there is no indication that the RMB’s movement has been tracking its trade-weighted index since the de-pegging. PBOC Governor Zhou Xiaochuan said that the US dollar, euro, yen and won were the main components of the currency basket. Other currencies in the basket include the Australian dollar, the Thai baht, the Canadian dollar, the Malaysian ringgit, the Russian rouble, the Singapore dollar and sterling. While this makes it clear that the exchange will be set via a trade-weighted basket – those mentioned are all among China’s top-15 trade partners – the actual weightings of the currencies were not disclosed. This implies that keeping the RMB’s effective exchange rate stable will be one of the key policy objectives of the new regime.
The criteria for selecting the currencies was given as ‘those with annual trade volume of more than US$10bn are very important, and those with annual trade volume of above US$5bn can’t be neglected.’ China’s official trade figures suggest that there are 18 countries and regions whose trade with China exceeded US$5bn in 2004. However, countries at the bottom of the list (with a trade volume with China smaller than that of Thailand) are probably excluded from the basket. Governor Zhou didn’t mention the Hong Kong dollar (HK$) or the Taiwan dollar (TW$). Even factoring in Hong Kong’s re-exports, Hong Kong’s actual trade with the mainland is still above that of Thailand. Taiwan is also the mainland’s fifth-largest trade partner and the third-biggest source of foreign direct investment (FDI). So both the HK$ and TW$ should be in the RMB basket. That said, since most Taiwan-mainland trade is conducted in US$ and Hong Kong is also pegged against the greenback, it is also possible that the PBOC has given a bigger weight to the US$ rather than including the TW$ and HK$ in the basket.