Will Substantial Revaluation of Chinese Currency Be Helpful in Attenuating the United States’ Trade Deficit with China? New Evidence from the Dynamic Threshold Kink Model

ABSTRACT

This study explores the possible existence of threshold kink effects in the impact of the real dollar-renminbi exchange rate misalignment on the bilateral trade flows between the United States and China. Empirical results show a significant threshold effect, with differential effects of undervaluation and overvaluation. Specifically, our findings suggest that while an overvaluation of the Chinese currency over 2.83% will attenuate the United States’ trade deficit with China, an undervaluation greater than 4.04% will deepen it. This suggests that a revaluation of the renminbi against the dollar would be helpful in improving the United States trade balance with China.

KEYWORDS:

• China
• dynamic threshold kink model
• exchange rate misalignment
• nonlinearity
• the United States
• trade balance

Acknowledgments

The authors would like to thank warmly the two anonymous referees for their helpful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary material

Supplemental data for this article can be accessed online at https://doi.org/10.1080/08853908.2023.2236220

Correction Statement

This article has been corrected with minor changes. These changes do not impact the academic content of the article.

Notes

¹ Yu and Zhang (2019) and Weber and Shaikh (2021), for instance, argue that the main factors driving the persistent trade deficit between the United States and China are, inter alia, the decline in the United States’ saving, the difference in factor endowments, the use of the dollar as an international reserve currency, and not the extent of the Chinese currency misalignment.

² A potential candidate alternative approach, used for instance by You and Sarantis (2011), is the fundamental equilibrium exchange rate (FEER) approach. Nevertheless, Lòpez-Villavicencio, Mazier, and Saadaoui (2012) show that the two approaches are, in fact, closely related and converge toward the same equilibrium exchange rate in the long run. Of course, there are also other techniques such as the purchasing power parity (PPP) model, the natural real exchange rate (NATREX) model, the Penn effect model, and the ratio model. In estimating the RMB’s misalignment vis-à-vis the US dollar, Zhang and Chen (2014) rely on three models (the BEER, Penn effect, and ratio models) and show that the misalignment measure from the BEER model is the best.

³ In addition to those fundamentals, the literature on equilibrium exchange rates also discusses other potential regressors, such as fiscal variables or interest rate differentials (see Clark and MacDonald 1998; Fidora, Giordano, and Schmitz 2021; Miyamoto, Nguyen, and Sheremirov 2019). We have decided to restrict our regression to the three main economic fundamentals variables not only because data for these variables are available at the monthly frequency, but also because it is shown in a recent study by Ca’zorzi and Rubaszek (2023) that the BEER model with only three fundamentals outperforms alternative BEER specifications with more regressors.

⁴ For more details on the theoretical background of this model, see Corden (1994) and Lane and Milesi-Ferretti (2004).

⁵ All three explanatory variables included in Equation 1(1) $ln\left(RE{R}_t\right)={\alpha }_0+{\alpha }_{1}ln\left(NFA{T}_t\right)+{\alpha }_{2}ln\left(B{S}_t\right)+{\alpha }_{3}ln\left(TO{T}_t\right)+{\epsilon }_t$(1) are constructed in relative terms between China and the US since RER used here is a bilateral exchange rate which cannot be explained merely by a country’s own characteristics but should also reflect “foreign characteristics” (Phillips et al. 2013, 8). Qin and He (2011) and Fidora, Giordano, and Schmitz (2021), among others, have also used relative variables in their estimates of equilibrium exchange rates.

⁶ For other studies that try to assess the magnitude of RMB’s misalignment, see the review article by Cheung and He (2022).

⁷ For more details, please see Hansen (2017).

⁸ There might be, of course, other additional reasons for the persistent and growing United States trade deficit with China. These include, according to Yue and Zhang (2013, 80), “relocation of exports to China from elsewhere in Asia, measurement differences, overcounting Chinese exports to the United States while undercounting US exports to China, American consumption without saving, and US restriction of high-tech exports to China.” Other factors, such as the low saving and investment rates in the United States (Feldstein 2017; Stiglitz 2018), the use of the US dollar as an international money and reserve currency (Tu and Zhang 2019), and the shift in labor-intensive factories from other Asian countries to China (Lin and Wang 2018; Reinbold and Wen 2018), have also been advanced as possible causes for China’s huge bilateral trade surplus with the United States.

⁹ In Figures A1 and A2 in the online Appendix, we have also plotted, for each industry, the graphs of confidence interval construction for threshold in the case of under/overvaluation.