THE ROLE OF EXCHANGE RATE IN SINO‐U.S. BILATERAL TRADE

I. INTRODUCTION Sino-U.S. bilateral trade has been growing dramatically over the past two decades. According to U.S. statistics, the bilateral trade volume jumped from $7.72 billion in 1985 to $231.43 billion in 2004, representing an average annual growth rate of 19.6%. More importantly, the pattern of trade between the United States and China has changed over time. China's trade surplus with the United States has increased steadily with the growing trade volume between the two countries, totaled only $0.01 billion in 1985, but grew to $33.79 in 1995 and jumped to $161.94 billion in 2004. As shown in Figure 1, China's imports from the United States have risen only slightly, while its exports to the United States have increased sharply since the mid-1990s. [FIGURE 1 OMITTED] China's exchange rate system has also changed over time. Before 1994, China used a fixed exchange rate system and a double-track exchange rate system, in succession. From 1994 to July 20, 2005, China pegged its currency (yuan or renminbi) to the U.S. currency at 8.27 yuan per dollar. Beginning July 21, 2005, China has adopted a managed floating exchange rate system based on a basket of currencies. The principal currencies in the basket include the U.S. dollar, euro, Japanese yen, and Korean won. The annual nominal and real exchange rates between China and the United States over 1970-2004 are shown in Figure 2. The real exchange rate is above the corresponding nominal exchange rate for most years over 1970-2004, indicating that the U.S. dollar is stronger in real terms than in nominal terms. [FIGURE 2 OMITTED] China's large trade surplus with the United States in recent years has led some critics to claim that the yuan is undervalued (e.g., Chang and Shao, 2004; Coudert and Couharde, 2004; Goldstein, 2003). Goldstein (2003) argued that the undervaluation of the yuan was 15%-25% in 2002. However, this opinion is countered by the fact that China's overall trade surplus (about $30 billion at the end of 2004) has not been as large as the surplus with the United States, which implies that China has trade deficits with other countries. China may import technology-intensive intermediate goods from its neighboring countries (such as Japan and South Korea), use them to produce final products with its cheap labor, and then export those goods to the United States. This trade pattern, called the third-country effect, was especially relevant in the 1990s when the U.S. dollar was strong against the currencies of the Asian countries. Since the Chinese yuan is pegged to the U.S. currency, the appreciation of the U.S. dollar against the Asian currencies implies that Chinese imports of technology-intensive intermediate and consumer goods from the Asian countries were cheaper than imports of these goods from the United States. China used the imported intermediate goods to produce final technology-intensive goods and exported them to the United States. This indicates that the pegged exchange rate system may be one of the factors that has caused China's trade surplus with the United States. Others believe that this bilateral trade pattern is simply due to the fact that the unit costs in China are relatively lower than those in the United States. The question of whether the bilateral exchange rate has played an important role in explaining Sino-U.S. trade imbalance problem is highly controversial. Cho and Koo (2004) found that the exchange rate between China and the United States does not have an important role in explaining the Sino-U.S. bilateral trade imbalance. By contrast, Brada, Kutan, and Zhou (1993) argued that the devaluation of Chinese yuan serves to improve China's balance of trade. The objective of this article is to examine the effects of the Sino-U.S. exchange rate and the weighted exchange rate between the United States and other Asian countries on the Sino-U.S. bilateral trade patterns. Specifically, this paper will (1) identify characteristics of bilateral trade between the United States and China and (2) evaluate the impact of Sino-U. …