WP 12-4 MARCH Spillover Effects of Exchange Rates: A Study of the Renminbi. Abstract

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1 Working Paer Series WP 12-4 MARCH 2012 Sillover Effects of Exchange Rates: A Study of the Renminbi Aaditya Mattoo, Prachi Mishra, and Arvind Subramanian Abstract This aer estimates the imact of China s exchange rate changes on exorts of cometitor countries in third markets, which we call the sillover effect. We use recent theory to develo an identification strategy in which cometition between China and its develoing country cometitors in secific roducts and destinations lays a key role. We exloit the variation afforded by disaggregated trade data across exorters, imorters, roduct, and time to estimate this sillover effect. We find robust evidence of a statistically and quantitatively significant sillover effect. Our estimates suggest that, on average, a 10 ercent areciation of China s real exchange rate boosts a develoing country s exorts of a tyical 4-digit Harmonized System (HS) roduct category to third markets by about 1.5 to 2 ercent. The magnitude of the sillover effect varies systematically with roduct characteristics as imlied by theory. Keywords: exchange rates, exorts, China, sillover JEL codes: F13, F14, O53 Aaditya Mattoo works with the Develoment Economics Research Grou, World Bank. amattoo@worldbank. org. Prachi Mishra works in the Research Deartment of the International Monetary Fund. mishra@imf.org. Arvind Subramanian is an economist at the Peterson Institute for International Economics. asubramanian@iie. com. Note: The views exressed in this aer are those of the authors and do not necessarily reresent those of the International Monetary Fund (IMF), World Bank, and Peterson Institute for International Economics, or olicies of those organizations. We are grateful to George Akerlof, Olivier Blanchard, Andy Berg, Elhanan Helman, Gita Goinath, Amit Khandelwal, Maurice Obstfeld, Hui Tong, and Shang-Jin Wei as well as seminar articiants at the American Economic Association Meetings (Chicago), Georgetown University, IMF, Peterson Institute for International Economics, and World Bank for helful comments and discussions. We are articularly grateful to Rob Feenstra for very detailed suggestions and advice. Martin Kessler and Ujjal Basu Roy rovided excellent research assistance. All remaining errors are our own. Coyright 2012 by the Peterson Institute for International Economics. All rights reserved. No art of this working aer may be reroduced or utilized in any form or by any means, electronic or mechanical, including hotocoying, recording, or by information storage or retrieval system, without ermission from the Institute Massachusetts Avenue, NW Washington, DC Tel: (202) Fax: (202)

2 INTRODUCTION Studying the effects of exchange rates is a hardy erennial of international macroeconomics. But nearly all the emirical research is focused on the imact of exchange rate changes on the country exeriencing or undertaking them. 1 There is less evidence quantifying the effect of exchange rate movements on the exorts of cometitor countries, a classic case of sillover that in its adverse manifestation is dubbed the beggar-thyneighbor effect. This aer examines the sillover effect of movements in China s exchange rate on exorts of other develoing countries in third country markets. The Chinese currency rovides a suitable oortunity to study the sillover dimension for three reasons. China, by virtue of being the world s largest exorter of goods, is likely to have quantitatively more significant cometitive consequences for other countries than nearly any other exorter. Second, China is also a highly diversified exorter so that it otentially cometes with a broad range of countries and across the roduct sectrum. Finally, reflecting China s dominant size and encomassing scoe, its exchange rate olicy has been one of the most controversial asects of international macroeconomics during the 2000s. More recently, it has been in the sotlight because of the consequences of a ossibly undervalued renminbi on demand and outut in industrial countries, exeriencing high unemloyment and excess caacity. The sillover effect is estimated with the hel of highly disaggregated trade data which facilitates the use of a novel methodology to exloit the variation across exorters, imorters, roducts, and time. We use disaggregated trade data at the 6-digit level sanning 124 develoing country exorters and 57 large imorters over the eriod Our emirical aroach is motivated by an analytical framework that we develo based on Feenstra, Obstfeld, and Russ (2011). The framework suggests an identification strategy that relies on the following reasoning: The more a country cometes with China in a third market, the more a given dereciation of the renminbi is likely to hurt its exorts in that market. We develo indices of cometition between China and its cometing exorting countries at the exorter-imorter-roduct level to imlement this strategy. The emirical secification, with a battery of very general fixed effects that control for all observable and unobservable imorter-exorter-roduct, imorter-exorter-time, exorter-roduct-time, and imorter-roduct-time varying characteristics, hels us overcome to a large extent the roblems of omitted variables that lague estimation of trade-exchange rate equations using aggregated data. Moreover, our estimates are less suscetible to reverse causality concerns, as exorts, measured at a disaggregated level are 1. This is generally true of the older, voluminous literature on the trade consequences of exchange rates (Goldstein and Khan (1985) rovide a survey and other contributions include Hooer, Johnson, and Marquez (2000) and Thursby and Thursby (1987)). It is also true of the more recent micro-literature on trade and exchange rates (Dekle and Ryoo (2007); Das, Roberts, and Tybout (2001); Forbes (2002); Berman, Martin, and Mayer (2012)). It is also a characteristic of the recent literature on the growth consequences of exchange rates (Dooley, Folkerts-Landau, and Garber (2003); Rodrik (2008); and Johnson, Ostry, and Subramanian (2010)).

3 unlikely to affect a macroeconomic variable like the exchange rate more so when the latter is the exchange rate of another country, China. 2 We find robust evidence for the existence of a statistically and economically significant sillover effect. In articular, exorts to third markets of countries with a greater degree of cometition with China tend to rise and fall significantly more as the renminbi areciates and dereciates. Our estimates suggest that a 10 ercent areciation of the renminbi increases a develoing country s exorts at the roduct-level on average by about 1.5 to 2 ercent. For high indices of cometition, the increase could be as large as 6 ercent. The results imly that going forward, an areciation of the renminbi could rovide a substantial boost to develoing country exorts. Our sillover estimates are robust to a variety of statistical tests, to alternative measures of exchange rates, to alternative disaggregation of the trade data, and also across exorting and imorting regions. They are also robust to incororating the effect of cometition from countries (other than China) whose currencies move with the renminbi. We also find that the magnitude of the sillover effect is consistent with the redictions from the analytical framework. For examle, as imlied by theory, the sillover effect is greater for homogenous roducts with greater substitution ossibilities than differentiated roducts. Further, the sillover effect is attenuated for roducts that rely more on foreign inuts (and hence have a lower degree of Chinese domestic value added). A few recent studies examine the effects of China s exort erformance on other Asian countries but do not focus on exchange rates (Hanson and Robertson 2008, Eichengreen, Rhee, and Tong 2004, and Ahearne et al 2003; the latter two use an augmented gravity framework and find some evidence of Chinese exorts crowding out other Asian exorts). A few other aers examine the imact of exchange rate changes but on variables other than trade. 3 For examle, Eichengreen and Tong (2011) have recently estimated the effect of renminbi revaluation on stock market valuations of foreign firms. 4 There is no study so far on the effect of exchange rate changes on exorts of other countries, even though this has been a central international concern going back to Robinson (1947) and the exerience of the cometitive devaluations rior to and during the Great Deression. ANALYTICAL FRAMEWORK In order to develo an analytical framework for our emirical exercise, we use the model in Feenstra, Obstfeld, and Russ (2011). The setting is as follows. There are countries, and different goods. Each country roduces a range of distinct varieties of each good. There is a constant elasticity of substitution () consumtion index for the reresentative consumer in country. Goods are differentiated not only by their 2. See Engel (2009) for a discussion of how hard it is econometrically to searate out the effect of exchange rates on trade. 3. Yet another strand in the China-related literature has been to exlain the determinants of China s real exchange rate (Wei and Zhang 2011). 4. Eichengreen and Tong (2011) find that renminbi areciation has a ositive effect on stock rices of firms in sectors cometing with China, which is consistent with the findings in this aer.

4 characteristics, also by their country of origin (Armington assumtion), with a constant elasticity of substitution between domestically roduced and foreign varieties of good ( ), and a constant elasticity of substitution between different varieties of good originating in different exorters ( ). The same elasticity alies to different varieties of good roduced domestically. Feenstra, Obstfeld, and Russ (2011) show that we can exress country s imorts from country (equivalent to exorts of country i to country j) of a articular good, defined at the Harmonized System (HS) 6-digit level,, as follows (equation 11 in their aer). (1) 1 That is, the roortion imort demand ( ) of total consumtion in, deends on three sets of comonents: 5 the reference weight consumers in attach to imorts of good g from country, ; the rice of g imorts by from,, relative to the rice index of all imorts, ; and the elasticity of substitution between imorted varieties of, ; the reference weight consumers in j attach to domestically roduced units of good, ; the rice index of all imorts by,, relative to the domestic rice of good, ; and the elasticity of substitution between the home and foreign varieties of good, ; the reference weight consumers in attach to consumtion of the good, ; the rice index of the good,, relative to the rice index of all goods in, ; and the elasticity of substitution between different goods,. We first establish the effect of a change in China s exchange rate changes vis-à-vis country,, on country s imorts of a articular good from country, what we define as the sillover effect. We can exress this as a chain effect, consisting of the effects of: the change in the Chinese exchange rate on the rice of the Chinese good, the change in the rice of the Chinese good on the foreign rice index, and the change in the foreign rice index on demand for good from country : (2) Now consider each term in the chain starting from the third term. Taking logs of equation 1 and differentiating with resect to under the assumtion that a change in has a negligible effect on the aggregate rice index for good in country, we get: 6 5. Note that we use imorts and exorts interchangeably throughout this aer, based on the simle identity that imorts of a country A from another country, say, B are exactly the exorts of B to A. In the emirical section, we use data reorted by imorting countries, which is generally regarded as more reliable than exort data.

5 (3) This imlies that the elasticity of demand for imorts of good from country with resect to the foreign rice index is simly the difference between the elasticity of substitution between imorted varieties of,, and the elasticity of substitution between home and foreign varieties,. From Feenstra, Obstfeld, and Russ (2011), we have the rice index for imorted goods,, (their equation 5): (4) Taking logs, differentiating with resect to the rice of the Chinese good in the market,, and simlifying, we get: (5) This imlies that the elasticity of the foreign rice index for good with resect to the rice of the Chinese good is equal to the exenditure on the Chinese good as a share of exenditure on all imorts of,. We assume that the rice of the Chinese good in the market,, deends on the rice in China,, the exchange rate, (defined in renminbi/imorter currency), and an exonent which catures the extent of roduct-secific exchange rate ass-through from rices in China to,. (6) 1/ Differentiating with resect to the exchange rate,, we have: (7) Substituting from equations 3, 5, and 7 in equation 2, we get: (8) 6. This is an innocuous assumtion from the emirical ersective because any additional terms for examle aggregate destination-secific rices will be absorbed in the very general fixed effects.

6 Equation 8 imlies that a change in the Chinese exchange rate will have a non-zero effect on imort demand for good only if (1) the elasticity of substitution across imorted varieties is different from that between imorted and domestic varieties, (2) Chinese share in total imorts of that good is strictly ositive, and (3) the exchange rate ass-through is non-zero. 7 Given our assumtion regarding the symmetric elasticity of substitution between imorted varieties,, the effect of a change in China s exchange rate changes vis-à-vis country,, on country s imorts of a good from country,, does not deend on any exorter attribute. This makes equation 8 less amenable to emirical analysis. For examle, if in order to test the rediction in equation 8, we were to regress the imort demand at the exorter-imorter-roduct level on the Chinese exchange rate vis-à-vis the imorting country, we would not be able to include destination country fixed effects. We could, of course, strive to include all the relevant destination country attributes exlicitly, but the effect of the exchange rate would not be estimated recisely because we would inevitably fail to control for certain unobserved sources of variation at the destination country (or destination-year) level. One way to have such more general controls is to introduce more variation for examle, across exorters in the right hand side of equation 8. This would allow imorter demand at the exorter-imorterroduct level to be regressed on a term that had all three sources of variation, which in turn would allow the inclusion of general fixed effects in the regression. To find such variation across exorters, we consider country s imorts,, from country of a articular bundle of goods, defined at a higher level of aggregation. In our emirical analysis, we use trade data at the HS 6-digit level. Therefore is defined at the HS 6-digit level. Country s imorts of (at, say, the HS 4-digit level) can be exressed as: (9) G denotes the number of HS 6-digit lines in the roduct category. Taking logs and differentiating with resect to the exchange rate, and simlifying we get 8 (10) This equation is intuitive because it catures the interlay between two ingredients that together determine the sillover effect of China s exchange rate: the first is the relative imortance of China as a source of imorts of a good in the imorting country, ; the second is the relative imortance of that good ( ) in the exorts of the cometitor country. More formally, the elasticity of, say, Brazil s exorts to at 7. Note that in Broda and Weinstein (2006),, i.e., the elasticities of substitution between imorted varieties equals the elasticity of substitution between home and foreign varieties. In our framework, if, in resonse to a renminbi dereciation, consumers in country reduce their demand for varieties of good roduced at home and hence there is no sillover effect. 8. See the aendix for the intermediate stes in deriving equation 10.

7 the HS 4-digit category with resect to China s exchange rate vis-à-vis is related to the weighted average of China's share in total imorts in each constituent 6-digit category which Brazil exorts, where the weights are Brazil s exorts in the corresonding 6-digit category as a share of its total exorts in the 4-digit category. Further, we also assume that the elasticities of substitution and the ass-through are constant for all 6- Cj Cj digit lines within the relevant 4-digit category, i.e., g, g g. Then equation 10 can be rewritten to give us an exression for the sillover effect,, (11) V Iij *[ Cj * ( )] G ij V Vg Cj where Iij [( ) * sg ] is what we call the value-based index of cometition (VBI) with China for good ij V g 1 g exorted from i to j. For examle, if the HS 4-digit category, shirts, consisted of only two items, cotton shirts and non-cotton shirts, then our measure is simly the share of China in country j s imorts of each tye of shirt, weighted by the imortance of each tye of shirt in country i s shirt exorts to j. Equation 11 suggests that the elasticity of exorts of a tyical roduct to the imorting country deends on: the index of cometition; the two elasticities of substitution, and ω; and the extent of ass-through,. Under some additional symmetry assumtions, we can also comute an alternative index of cometition where we rely on the overla between China s exorts and those of country, at the extensive margin. We first assume that for each 6-digit category that exorts to within a 4-digit category, it exorts the same ij amount. If exorts N 6-digit categories in the relevant 4-digit category to, then the first term in equation ij 10 simlifies to 1 / N. Next assume that in each 6 digit category within the relevant 4-digit category where Cj Cj Cj ij exorts to, China exorts either a fixed share, s or nothing. sg s for N, Ch lines or zero otherwise. Cj ij Then summing the second ratio over the relevant 6 digit lines gives us s * N, Ch. As above, we also assume that the elasticities of substitution and the ass-through are constant for all 6-digit lines within the relevant four digit category, i.e., Cj Cj g, g g. So that in this secial case, equation 11 can be written as: (12) C I ij Cj Cj [ s * * ( )] where I C ij N is what we call the count-based index (CBI) of cometition. The notion of cometition N ij, Ch ij in the CBI is based on whether or not China and its cometitor commonly exort a articular good (the extensive margin), and unlike the VBI, ignores the magnitudes of exorts.

8 ESTIMATION STRATEGY Equations 11 and 12 motivate the estimation of the sillover effect. They imly two key redictions which we can take to the data: (1) sillover effect is less than or equal to zero and (2) the magnitude of this effect deends on the index of cometition between China and its cometing exorters. Higher is the degree of cometition, larger is the magnitude of the sillover effect. Our identification strategy relies on the following intuition. Take two countries, Malawi and Brazil. Assume that Brazil faces a greater degree of cometition with China in the US market for a articular roduct. When the renminbi dereciates vis-à-vis the US dollar, exorts from Brazil to the United States for that roduct will fall more than exorts from Malawi to the United States (figure 1). Figure1 Identification strategy China Renminbi/$ Exorts Z (US) X (Malawi) Exorts Exorts Y (Brazil) Source: Author s calculations. This identification strategy yields the following estimating equation: (13) ln ln where is the value of exorts of HS 4-digit roduct from country to country. is the Chinese exchange rate vis-à-vis measured in renminbi er unit of s currency. is an index of cometition between Chinese exorts and those of its cometitors as described in the analytical section. Note that the index does not have a time subscrit which we exlain below. The interaction term combines the exchange rate between China and the imorting country (say the renminbi-dollar exchange rate) and the index of cometition between the exorter and China in the imorting country. Econometrically, an advantage of the formulation in equation 13 is that we can control for a wide range of omitted variables through a set of very general fixed effects. In fact, in our core estimations, we emloy all

9 three-way combinations of imorter, exorter, roduct, and time fixed effects. The term catures any imorter, roduct, and time varying characteristics: One examle would be fiscal suort for the car industry in the United States. Similarly, the term catures any exorter, roduct, and time-varying characteristics; for examle, a roductivity shock in Bangladesh that heled textile exorts. Note that these fixed effects also encomass all country-time shocks both on the imorter and exorter side such as the business cycle in each country. The term catures any bilateral time-varying determinants of exorts: for examle, currency unions, and exchange rate egs against articular currencies. The term catures bilateral roduct-secific characteristics: for examle, all re-existing referential trade agreements that have roduct-secific tariffs and other barriers. The only factors that are not controlled for are olicies of the imorting country that vary by source country and roduct and time (for examle, changes over time in roduct-secific referential tariffs). 9 Finally, it is worth noting that our estimation strategy also controls for any ossible effect on cometitor countries stemming from roductivity or other develoments in China, whether exogenous or induced by exchange rates: If these are time-varying and roduct-secific, they will be absorbed in the and fixed effects. Furthermore, our estimating equation is less suscetible to reverse causality from exorts to exchange rates for two reasons: Our deendent variable, disaggregated exorts, is less likely to affect a macroeconomic variable like the exchange rate; moreover, the latter is the exchange rate of another country. What about reverse causality from the exorts to the index of cometition? Our count-based index, while derived from theory under symmetry assumtions, has the emirical virtue of being based on the extensive margin and not being measured in value terms; hence being less related to the left hand side variable and less afflicted by reverse causality roblem. Our value-based index is otentially more vulnerable to the reverse causality roblem because it is exressed in values, like the deendent variable. To minimize such endogeneity concerns, we comute both indices for the initial eriod of the samle (i.e., for the year 2000). DATA We focus on the eriod , during which concerns about China s exchange rate olicy have been most debated. For this eriod, we comile disaggregated data on bilateral exorts from the UN Comtrade database. We collect data reorted by the imorting countries, which is generally regarded as more reliable than data on exorts (i.e., exorts from i to j are measured by imorts of j from i). The data are for roughly 6000 non-oil HS 6-digit lines covering digit roducts. We cover the 57 major imorting countries (making sure that we include all countries that together accounted for over 95 ercent of total exorts of develoing countries) and 124 develoing country exorters which are otentially in cometition with China (summary statistics are rovided in aendix table 1 and the list of imorting and exorting countries covered in aendix table 2). 10 The list of develoing countries is based on World Bank country classification, and is comrised of all low and middle income countries (2010 GNI er caita of $12,275 or less). 9. The lack of a comrehensive database on trade olicies at the imorter-exorter-roduct-time level makes it difficult to control for such effects. 10. In rincile, we could include all exorting countries in our samle. We choose to restrict the analysis to develoing country exorters, largely due to comutational constraints. However, this restricted choice also stems from the fact that

10 The trade data are reorted in current US dollars, and are deflated by the US Consumer Price Index (CPI). We recognize that ideally we would use bilateral rice indices to deflate trade between different country airs but such bilateral deflators are not available. However, the resence of the very general fixed effects has the consequence also of imlicitly deflating the trade data. The data are imlicitly deflated by rices that vary by imorter, roduct, and time; by imorter, roduct, and exorter; and by exorter, roduct, and time. They are, however, not deflated by rices that vary along all four dimensions (imorter, exorter, roduct, and time). Exchange rate data are from the International Monetary Fund s (IMF s) International Financial Statistics (IFS) database. In the theoretical framework, the key rice that determines the transmission mechanism of exchange rate changes is the rice in the imorting market charged by Chinese exorters. Equation 6 suggests that this rice is determined by the domestic rice of the good in China, the China-imorter bilateral exchange rate and the ass-through. Since we arameterize the ass-through, the relevant changes to focus on are those stemming from changes in domestic rices in China and the exchange rate. Hence, our bilateral exchange rate is deflated by China s CPI. Before we resent the econometric results, it is worth looking at some basic data. Figure 2 lots China s average index of cometition (where the average is over all exorters and roducts). The index is measured in two ways consistent with the discussion in the analytical section. Both the VBI and the CBI rise over time, consistent with China becoming a bigger and more diverse exorter. The CBI shows in articular that by 2008, on average, China occuied nearly all the roduct sace of other develoing country exorters. Figures 3a and 3b lot the same indices but disaggregated by region. These charts show that China s overla with all regions has risen steadily over time, with the level of the overla greatest with other exorters in Asia (over 95 ercent in 2008 for the CBI), and least with Euroe and Central Asia. RESULTS Main Findings and Robustness All results are resented for both variations of our cometition index. In table 1, we resent the baseline results. Our core samle has nearly 3.6 million observations. Columns 1 through 4 use the value-based index while columns 5 through 8 use the count-based index. In both cases, the number of fixed effects rogressively increase across the secifications, with a comrehensive set of fixed effects in columns 4 and 8, making the secification a very demanding one. These will constitute our core secifications. All regressions are clustered at the imorter-exorter-roduct level. We find that the coefficient on the interaction term between the Chinese exchange rate and the index of cometition is consistently negative and significant at the 1 ercent confidence level. In other words, a dereciation of the Chinese exchange rate vis-à-vis, say, the dollar, is associated with a greater reduction in a develoing countries comete more with China than industrial countries do: The average index of cometition between the former set and China is about 0.4 and 0.9, resectively for the value-based and count-based indices of cometition. The corresonding numbers for industrial countries are 0.1 and 0.7, resectively.

11 develoing country s exorts of a articular roduct to the United States, the more that country is in cometition with China in that roduct in the United States. We subject this core secification to a series of robustness checks in table 2 through table 6. In table 2, column 1, we dro outliers, defined as the to and bottom 1 ercentile of observations. The key coefficient is negative and statistically significant with the magnitudes close to those for the larger core samle. In column 2 through column 4, we cluster the standard errors at the exorter-imorter-year, exorter-roduct-year, and imorter-roduct year levels, and the statistical significance of the coefficients remain unchanged. 11 Our core secification uses annual data. To test whether the results hold for the medium run, we use a long difference aroach suggested by Acemoglu and Johnson (2007). Thus, in column 5, we use observations only for 2000 and 2008 and find that the results remain similar to the baseline, with the magnitude of the interaction coefficient increasing by a little. In columns 6 and 7, to make sure that the results are not driven by the choice of year for measuring the index of cometition, we measure the index for the years 2001 and 2002, resectively. In column 8, we use an alternative measure of cometition the exort similarity index due to Finger and Kreinin (1979). 12 Thus, for a wide range of robustness tests, the core results remain unaltered, both in the sense that the coefficients are stable and consistently significant at the 1 ercent confidence level. In table 3, we test for robustness to alternative measures of the exchange rate variable. In our analytical framework, we assumed that the rice of Chinese goods in the imorting country market is determined by a simle relationshi between domestic rices in China and exchange rate ass-through. Based on the framework, in our core secifications we deflate the nominal bilateral exchange rate (between China and the 11. Clustering the standard errors at a higher level of aggregation (imorter-exorter, imorter-roduct, or exorter-roduct) also does not alter the significance of our findings. X ijgt X Cjgt 12. The Finger-Kreinin index can be exressed as: FK ijt g min[, ] X ijgt X g g Cjgt where g X ijgt X ijgt Share of roduct g in total exorts from i to j at the 4 - digit level X Cjgt Share of roduct g in total exorts from China to j at the 4 - digit level. X g Cjgt The results are also robust to using the alternative formulation of the Finger-Kreinin Index defined as and the weighted Finger-Krenin Index defined as 1

12 imorting country) by Chinese rices. The imlicit assumtion here is that Chinese roducers take account of changes in the bilateral exchange rate and average domestic inflation to determine exort rices. However, there could be alternative ways Chinese roducers and exorters determine their destination-secific exort rices. Chinese roducers could be influenced just by the nominal bilateral exchange rate ( ) or by the real bilateral exchange rate ( / ), with and denoting rices in imorting country and China resectively. The secifications corresonding to these two ways of measuring the exchange rate are in columns 1 and 2 (for the VBI) and columns 6 and 7 (for the CBI). In both cases, the results are robust, although the magnitudes decline relative to the core secification. Yet other models of ricing behavior could involve Chinese roducers looking at changes in their multilateral cometitiveness in determining destination-secific exort rices. In this case, the relevant exchange rate is not destination secific but a multilateral one that is identical across all imorters ( ) where stands for China s multilateral exchange rate and hence without a subscrit). 13 We reestimate the core regression to cater to these ossibilities by using the IMF s effective exchange rate as the relevant measure with the nominal rate in columns 3 and 8, and the real rate in columns 4 and 9. Again, the coefficients are correctly signed and significant at the 1 ercent confidence level. Interestingly, these coefficients are substantially greater than for the core secification. In all these secifications, exchange rates are measured as the relative rice of two different currencies. An alternative way of measuring real exchange rates sometimes called the internal real exchange rate is as the relative rice of tradables to non-tradables within a country. This exchange rate is available from the Penn World Tables from the series that measures the rice level of GDP. 14 In columns 5 and 10, we use this measure of China s real exchange rate. Again, we find that the coefficient on the interaction term is significant at the 1 ercent level, and is greater in magnitude than in the core secification. 15 One otential omitted variable issue arises in regard to our core secification. Our finding that the tyical develoing country s exorts are adversely affected when China s currency dereciates has not yet addressed an imortant question: What if other countries resond to China s dereciation by devaluing their own currencies? In table 4, we control for this ossibility. Among the develoing countries which are the to exorters, we identify those whose currencies are most closely correlated with that of China (in real terms) during the eriod We interact the exchange rates of each of these countries with the resective 13. Note that in this case, the exchange rate varies across time and the index varies across imorter, exorter, and roduct so that the interaction term exloits the variation across all four dimensions. 14. A higher rice level is associated with a higher rice of non-tradables and hence signifies an areciation of the real exchange rate (see Rogoff 1996). This exchange rate variable, like the IMF s nominal and effective exchange rate series, is a multilateral variable, and hence varies only by time and not across imorters. 15. Note that an increase in all the effective exchange rate measures in columns 3 through 5, and 8 through 10 denotes an areciation (unlike in columns 1 and 2, and 6 and 7, and our baseline exchange rate measures in tables 1 and 2). Hence, a ositive coefficient on the interaction terms in these columns is consistent with our main findings. 16. We include the to 10 exorters (after China) based on total exorts between 2000 and Develoing countries index of cometition with other non-significant exorters is likely to be much smaller, and hence exchange rate movements in these countries is less likely to dislace exorts of other develoing countries.

13 index of cometition of each with the exorting country, where the index is defined as analogous to that of China in equations 11 and 12. In columns 1 and 4, we include countries whose exchange rates have a correlation coefficient relative to the renminbi that is greater than 0.7. So we add two additional regressors to the core secification. In each case, the regressor is the interaction between the country s exchange rate and that country s index of cometition. In columns 2 and 5, we reeat this rocedure to include countries whose correlation coefficients with the renminbi are more than 0.4. In columns 3 and 6, the threshold correlation coefficient is 0.3. For resentational reasons, we only show the imact on the main coefficient of interest, namely that relating to China. This coefficient remains significant at the 1 ercent confidence level, although it is slightly reduced in magnitude. Overall, these results suggest that our main finding related to the sillover effect of the Chinese exchange rate remains strong and robust to inclusion of ossible omitted variables. Thus, exorters cometing with China suffer because of a renminbi dereciation and not (or not just) because they are adversely affected by the dereciation of currencies that closely track the renminbi. An interesting related finding is that we do find statistically significant and negative coefficients on the interaction terms for the other countries (not shown). Therefore, the sillover effect we estimate is not secific to China, and is more general. Unsurrisingly, the indices of cometition are much lower for all the other countries. Therefore, the magnitude of the sillover effect which is given by the coefficient multilied by the index is much smaller for the other countries than for China. 17 In table 5, we test for robustness across exorters, defined in geograhic terms. We slit the samle into four regions and find that the results hold across all. The coefficients on the China sillover effect are greater for Asia than for sub-saharan Africa but it is difficult to say whether these differences are due to the fact of suly conditions in the exorting region or due to differences in the roduct comosition of their exorts and/or their geograhic destination. 18 In table 6, we check if the results are robust to the degree of roduct disaggregation. In the core secification, the data are at the HS 4-digit level. In table 6, we use data at the HS 2-digit level. The indices of cometition are measured by aggregating across 6-digit lines within the 2-digit category. The samle size shrinks from over 3.6 million to about 860,000 observations. But the interaction term remains negative and significant. Overall, the results in table 1 through table 6 confirm the redictions from the analytical framework. The elasticity of develoing country exorts with resect to Chinese exchange rate is consistently and robustly negative. Further, this elasticity deends on the index of cometition: A given dereciation of the renminbi is associated with a bigger reduction in develoing country exorts the higher this index. 17. See the Results section for detailed discussion on the magnitudes of the coefficients. 18. The differences are also statistically significant (based on a estimating a stacked secification with trile interaction terms with regional dummies). We find some suggestive evidence that the differences between Asia and sub-saharan Africa, for examle, may be due to the fact that the latters exorts tend to be less homogenous than those of Asia. We also tested for robustness across imorters, defined in terms of advanced and other countries, and the results hold for each category of imorters.

14 Sillover Effect and Product Characteristics Equations 11 and 12 suggest that the sillover effect should vary according to two roduct attributes: elasticity of substitution ( ) between different imorted varieties and exchange rate ass through ( ). Higher the values of and, the larger should be the sillover effect. First, we analyze how the sillover effect varies by the degree of substitution between roducts. We artition the data into homogenous (i.e., those with a greater degree of substitutability) and differentiated roducts based on Rauch s (1999) classification. 19 As shown in table 7, columns 1, 2, 4, and 5, we find that the coefficients on the interaction between the index of cometition and exchange rates are higher in magnitude for homogenous roducts vis-à-vis differentiated ones. Columns 3 and 6 confirm that the differences between the coefficients for the two tyes of goods are statistically significant. The differences are substantial: For the count-based and value-based indices, the coefficients on homogenous goods are about 20 and 40 ercent greater, resectively, than for differentiated goods. Second, we exlore how the sillover effect is related to a likely determinant of Chinese exchange rate ass-through the imorted intermediate content of Chinese exorts. One of the key features of Chinese manufacturing exorts has been the extent to which they have relied on foreign intermediate inuts. The greater the reliance on foreign inuts (lower the domestic value added), the more an exchange rate dereciation will increase inut costs and hence damen the cometitive advantage from a dereciation. In other words, a greater reliance on foreign inuts is analytically analogous to a lower ass-through, which theory redicts will damen the sillover effect. We test this roosition in the data. We use the classification in Kooman, Wang, and Wei (forthcoming) to divide our data into two samles: those characterized by a high degree of foreign inuts and those with a low degree. 20 In table 8 we estimate our core secification for each of these samles. We find that, consistent with theory, our sillover effect is in fact damened for roducts with a high degree of foreign inuts (comare columns 2 versus 1, and 5 versus 4). Columns 3 and 6 confirm that the differences between the two samles are statistically different: The coefficient on the core interaction term is about 13 ercent greater (in absolute value) for the samle with the lower degree of foreign intermediate inuts in the case of the value-based index and 10 ercent greater for the count-based index Note that Rauch s classification is available at the Standard International Trade Classification (SITC) 4-digit; we concord it to HS 6-digit level using standard concordance tables, and then artition the data into homogenous and differentiated using Rauch s liberal classification (reference riced goods are included in the homogenous category). We then aggregate the data to the HS 4-digit level. 20. The classification of sectors by domestic value added is restricted to manufacturing, and is based on International Standard Industrial Classification (ISIC) data which we concorded with HS 4-digit data. 21. The same result holds for an alternative classification by share of rocessing exorts (with high domestic value added roducts being those with low share of rocessing) due to Kooman, Wang, and Wei (forthcoming).

15 Discussion of Magnitudes Recall that the sillover effect we estimate in equation 13 is given by: Our estimations identify which we can multily by the relevant value of the index of cometition to obtain the average sillover effect. The range of estimates for different combinations of the two indices of cometition and estimates of are shown in table 9. For the baseline estimate of our elasticity (columns 4 and 8 in table 1) and for the median index of cometition, we get a total sillover effect of 0.14 and 0.20 for the value- and count-based indices resectively. The estimates imly that a 10 ercent dereciation/areciation of the renminbi is associated with a reduction/increase in develoing country exorts at the roduct level to a third market of about 1.5 to 2 ercent. For countries that are in the 90th ercentile in terms of cometition with China, the range of baseline estimates increases to 2 to 3 ercent for the two indices. If we use the higher values of corresonding to multilateral measure of exchange rates, for examle (column 5 in table 3), the magnitude of the estimates increases substantially. For the indices of cometition in the 90th ercentile, the sillover effect could be as high as 6 ercent for a 10 ercent change in the renminbi. 22 How do our emirical estimates comare with those suggested by the analytical framework? Equations 11 and 12 yield theoretical magnitudes for the sillover effect. From the existing literature, we can obtain estimated values for each of the arameters. Of course, there is wide variation in each of these, but some ballark estimates are the following: 3, 1, 0.4 and s The estimates of (the elasticity of substitution between imorted goods, or the micro-armington elasticity) and (the elasticity of substitution between domestic and imorted goods, or the macro-armington elasticity) are based on Feenstra, Obstfeld, and Russ (2011). The ass-through coefficient ( ) is an average of the estimates from Cama and Goldberg (2005) for industrial countries and the estimates of Goinath, Itskhoki, and Rigobon (2011) for the United States. 23 The average share of China, s, in the markets of each of the imorting countries is obtained from our data. Combining these estimates with the average value of the index of cometition for the value ( ) and count-based ( ) indices from our data (of 0.4 and 0.9, resectively), yield a magnitude of the third-market 22. Note that even using the estimates from table 4, where we control for movements in other currencies, the sillover effect of China s exchange rate movements is in the range of 1 to 2 ercent. We also conduct another exercise where we assume that a movement in the renminbi is followed by movements in other correlated currencies. Based on our estimates from table 4, the overall sillover effect of movements in all these currencies is also in the range of 1 to 2 ercent. This is due to the fact that sillover effect of other currencies is much smaller in magnitude than China s. Although the coefficients on the interaction terms are similar, the indices of cometition are much smaller for the other countries. These results are available uon request. 23. Goldberg and Knetter (1997) and Goldberg and Hellerstein (2008) also rovide evidence on ass-through and its decline over time. Xing (2010) looks secifically at ass-through of Chinese exchange rates to imort rices in the United States and Jaan, and estimates ass-through coefficients of 0.23 and 0.56 for the United States and Jaan resectively.

16 effect of 0.32 for the value-based index and 0.29 for the count-based index. Therefore, theory aears to redict a sillover effect of about 0.3. For the count-based index, the theoretical and our baseline emirical estimates ( 0.2) are not far aart. For the value-based index, our baseline emirical estimates are below those derived from theory (0.14 versus 0.32). There are two ossible exlanations. Residual measurement errors would imart a natural attenuation bias to the econometric estimates. Second, the values of the elasticity of substitution that we use to derive the theoretical rediction are based on Feenstra, Obstfeld, and Russ (2011), who estimate the elasticity for goods at a level of disaggregation close to the HS 10-digit level. Our data on the other hand are at HS 4-digit so that the relevant elasticity for our urose could be well below the value of three that we use here. 24 Such a lower value would bring our emirical estimates closer to those based on theory. Overall, the baseline estimates in this aer suggest that a 10 ercent dereciation/areciation in the renminbi exchange rate vis-à-vis an imorting country decreases/increases on average develoing country exorts by about 1.5 to 2 ercent. Given the 30 ercent areciation of China s real exchange rate vis-à-vis the US dollar over , our findings suggest that this could have been associated with about a 4.5 to 6 ercent increase in the tyical develoing country s exorts to the United States, with much greater effects for countries in closer cometition with China. CONCLUSION To our knowledge, this aer is the first attemt to quantify the effect of exchange rate changes on the exorts of cometitor countries to third markets the sillover effect that both exloits the rich variation afforded by disaggregated trade data and does so in a manner that is motivated by and consistent with theory. We study the case of China and find that its exchange rate changes can have significant and robust sillover effects. These findings may have imortant olicy imlications for develoing countries and for the multilateral system if exchange rate movements (or the lack thereof) stem from olicy actions. Since we have found that the resulting sillover effects are significant, one country s olicies can then otentially have substantial exort imlications for other countries. Imortantly, we would emhasize that this aer identifies recisely, and in a robust way, a very secific mechanism of influence from exchange rates to trade (the sillover effect of Chinese exchange rate movements on exorts of cometitor countries to third markets). There could be other beneficial effects on develoing country exorts to China which we do not measure. For examle, a dereciation of the renminbi could increase develoing country exorts of raw materials and intermediate goods to China to be used in the roduction of China s exorts to third countries. Similarly, if China s dereciation boosts its own growth, that could increase its demand for all goods and services, which could also lead to greater develoing country 24. Broda and Weinstein (2006) argue that with more disaggregated data, one is likely to find higher estimates of the elasticity of substitution.

17 exorts. Thus, the effect of China s exchange rate on overall exorts of other countries remains an oen question. Finally, we have not directly estimated any effects of China s exchange rate movements on its own exorts. Further research is needed to recisely identify all these other effects. REFERENCES Acemoglu, Daron, and Simon Johnson Disease and Develoment: The Effect of Life Exectancy on Economic Growth. Journal of Political Economy 115, no. 6: Ahearne, Alan, John Fernald, Prakash Lougani, and John Schindler China and Emerging Asia: Comrades or Cometitors? International Finance Discussion Paer No Washington: Federal Reserve Board. Berman, Nicolas, Philie Martin, and Thierry Mayer How do different exorters react to exchange rate changes? Theory, emirics and aggregate imlications. Quarterly Journal of Economics 127, no. 1: Broda, Christian, and David E. Weinstein Globalization and the Gains from Variety. Quarterly Journal of Economics 121, no. 2: Cama, Jose Manuel, and Linda S. Goldberg Exchange Rate Pass-Through into Imort Prices. The Review of Economics and Statistics 87, no. 4 (December): Das, S., M. Roberts, and J. Tybout Market Entry Costs, Producer Heterogeneity, and Exort Dynamics. NBER Working Paer No Cambridge, MA: National Bureau of Economic Research. Dekle, Robert, and Heajin H. Ryoo Exchange rate fluctuations, financing constraints, hedging, and exorts: Evidence from firm level data. Journal of International Financial Markets, Institutions and Money 17: Dooley, Michael P., David Folkerts-Landau, and Peter Garber An Essay on the Revived Bretton Woods System. NBER Working Paer No Cambridge, MA: National Bureau of Economic Research. Eichengreen, B., Y. Rhee, and H. Tong The Imact of China on the Exorts of Other Asian Countries. NBER Working Paer no Cambridge, MA: National Bureau of Economic Research. Eichengreen, Barry, and Hui Tong The External Imact of China s Exchange Rate Policy: Evidence from Firm Level Data. IMF Working Paer 155. Washington: International Monetary Fund. Engel, Charles Exchange Rate Policies. Federal Reserve Bank of Dallas Staff Paer. Feenstra, Robert C., Maurice Obstfeld, and Katheryn N. Russ In Search of the Armington Elasticity. University of California, Berkeley and University of California, Davis. Mimeo. Finger, J. Michael, and Mordechai E. Kreinin A Measure of 'Exort Similarity' and Its Possible Uses. Economic Journal, 89 (December): Forbes, K How Do Large Dereciations Affect Firm Performance. NBER Working Paer No Cambridge, MA: National Bureau of Economic Research.

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