Exchange Rate and International Outsourcing: Would Chinese Yuan Appreciate Against U.S. Dollar?

1. Exchange Rate and International Outsourcing: Would Chinese Yuan Appreciate Against U.S. Dollar? Chu Ping Lo K.C. Fung Chelsea C. Lin Shih-Hsun Hsu

2. 1. Introduction • We live in a world of both specialization and globalization. • Encouraged by innovation in computer, communication and transportation technology, firms tend to specialize in particular stages or components of production, exporting them to other countries for further processing or input. • Grossman and Helpman (2005) noted: Firms seem to be subcontracting an ever expanding set of activities, ranging from product design to assembly, from research and development to marketing, distribution, and after-sale services. Some firms have gone so far as to become “virtual” manufacturers, owning designs for many products but making almost nothing themselves.

3. China: Factory of the World China’s yuan should appreciate? • China has the fastest economic growth in the world (e.g., three times larger than U.S.). • It is widely expected that China will continue this high economic growth rate for the next two decades or so. • Steady trade surplus • Enormous flooding inflow of FDI • Successfully controlled inflation in the 2000’s. Instead: • China has repeatedly devalued its currency as a means of promoting trade and FDI (foreign direct investment) in the 1980s and early 1990s. • Zhang (1996) argues that a key reason for China’s continuous currency devaluation is to reduce the price distortion and promote exports. • Wang (1993) has found that there is a positive relationship between the currency of China and its exports. • Brada et al. (1993) also found that devaluation of the yuan serves to improve its balance of trade.

4. Source: International Financial Statistics, various Issues (Zhang, 1996)

5. Figure 2. Trade performances in China

6. Why China needs to keep a low-cost environment? • Naughton (1996) and Fung (1998) show that China’s trade is heavily dependent on enterprises from other economies and a substantial amount of China’s trade is conducted by foreign-invented enterprises. • A high degree of trade related to foreign investment: foreign firms conducted 56.2 percent of China’s imports and 54.8 percent of exports in 2003. • A high incidence of re-exports through Hong Kong: an average of 53 percent of Chinese exports was re-exported through Hong Kong over the period 1988-1998 (Feenstra et al., 2002).

7. More critical reason for currency undervaluation? • In 2004, China had about three hundred millions of laborers in the agriculture, and at least more than two hundred million agricultural workers are “redundant” in the long run (v.s. U.S.). • In 2004, there is about 66M worker in state-owned-business. • Therefore, China has incentives, and is under great pressure, to devalue its currency in order to encourage international outsourcing activities for accommodating these redundant laborers.

8. 2. The Model • Labor is a unique production factor in a world of North-South. • The labor in the North is skilled, while the labor in the South is relative unskilled. • Consumers are assumed to have homogeneous preferences on all differentiated goods. • The demand function for a representative final-good is given by (1) , where is price of the final good and is a given parameter.

9. Incomplete contract • Firms in the North generate the high-tech inputs but outsource the low-tech inputs domestically or abroad. If the specialized low-tech inputs are bad quality, the output of the final-goods will be zero. Otherwise, the output is given by • Assume that the wage rate in the North is , and the wage rate in the South is in term of the currency of the North. • Let’s assume that the exchange rate is exogenously determined by the government of the South, which usually pegs its currency against the North’s currency. (2) , where .

10. Profit Maximization :When low-tech input is produced in the North • If the low-tech inputs are produced in the North, the profit of the final-good producer is given by • With respect to each output, the first order conditions show that the optimal price for the final-good producer is given by • Substituting (4) into (3), we get the profits of the final-good producer as (3) (4) (5)

11. Profit Maximization :When low-tech input is outsourced to the South • The North and the South bargain over the surplus from the relationship after that the South can provide good quality low-tech inputs. • With this ex-post Nash bargaining, supposed that is attributed to the South, and the remaining surplus, is attributed to the the North, where . • The firm in the North is to maximize . • The low-tech producer in the South is to maximize . • The F.O.Cs of the joint profits yield an equilibrium as • Combining the F.O.C. and (6), we obtain the optimal price of the final good as (6) (7)

12. Profit of the Northern firm after Outsourcing • Combining (6), and (7), we obtain the profit of the Northern firm as • For a profit-maximization firm in the North, the strategy of international outsourcing is preferred if . • Comparing (5) to (8), we find that international outsourcing is carried out if • We have . • is nonincreasing in z for . (Antra`s, 2004). • We also have . (8) (9) , where .

13. Figure 2. Equilibrium in the Choice of Location *The low-tech input is produced in the South if , otherwise in the North.

14. 3. Redundant Labor and Currency Manipulation • Full employment in the North. • Assume there are substantial amount of redundant laborers in the South reside in agriculture sector or in state-owned business. • International outsourcing activities (i.e., offshore production) from the North to the South provide jobs for the South’s redundant laborers. • Therefore, we argue that the South might tend to encourage international outsourcing activities to both accommodate these redundant laborers and to become more industrialized. Table 1. Labor Supply in China Source: National Bureau of Statistics of China.

15. Relative share in world value-Added • World income equals world output on all goods, so that • Assume the labor demand in the South increases with a lower outsourcing threshold, that is, . • Let be the fraction of industries with and be the corresponding probability density function. • The relative share of world income can be expressed as: • Here we denote as the output of the South’s homogeneous sector (say agricultural sector) in world income E. • Rewrite (10) as to express the relative wage rate of the North to the South as: (10) (11)

16. Elasticity of labor demand • Obstfeld and Rogoff (2004) find that a decrease in the trade deficit to GDP of 1% requires a decrease in the exchange rate somewhere between 7% and 10% in the U.S. • Olivier, et al. (2005) estimate, supposed that the U.S. export to GDP is about 10%, that a reduction of the ratio of the trade deficit to GDP of 1% requires a depreciation of 15%. • It is feasible to argue that the change in the ration of trade deficit to GDP is equivalent to the change in employment. • Denote as the elasticity of labor demand with respect to exchange rate in the South. • The estimate of U.S. elasticity of labor demand with exchange rate ranges from 0.07 (implied from Olivier, et al., 2005) to 0.14 (implied by Obstfeld and Rogoff, 2004). • Assume .

17. Figure 3. The South manipulatively undervalues its currency *When the South devalues its currency (i.e., a smaller ), the curve shifts downward to the new equilibrium with a lower threshold , , where .

18. Hypothesis • A smaller (i.e., depreciation) leads to a lower outsourcing threshold (i.e., a smaller ). • It turns out the South acquires a larger share of world income as in equation (10). • Meanwhile, the total employment in the South increases with a lower outsourcing threshold (i.e., ). • The South could turn its redundant labor into productive by undervalued currency, but maybe at the sacrifice of its real income.

19. 4. Conclusions • A South that has large amount redundant labor tends to undervalue its currency to attract more international outsourcing activities from the North to accommodate its redundant laborers. • The South as a whole benefits from the international outsourcing activities because it binds itself tighter into the global value-chain. This is the reason why usually the South resists currency appreciation even though its currency is expected to appreciate.