China's exports, export tax rebates and exchange rate policy

• Date: 01 May 2018
• Published date: 01 May 2018
• DOI: http://doi.org/10.1111/twec.12570

ORIGINAL ARTICLE

China’s exports, export tax rebates and exchange

rate policy

Zhenhui Xu

1,2

1

Georgia College and State University, Milledgeville, GA, USA

2

Hunan University, Changsha, China

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INTRODUCTION

China’s exchange rate policy is a contentious and widely debated issue, rooted in China’s

postreform export-oriented development strategy. As a result of export promotion policies imple-

mented after economic reforms, China’s exports soared, growing by more than 206 times from US

$18 billion in 1980 to US$2.3 trillion in 2014. In 20 of the 25 years between 1990 and 2014,

China registered a trade surplus, increasing from US$9 billion in 1990 to more than US$435 bil-

lion in 2014. And in almost all of those years, China experienced a current account surplus, grow-

ing from US$12 billion in 1990 to more than US$277 billion in 2014.

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There are ample studies in the literature analysing the factors behind China’s decades-long

export growth and external imbalance. Some studies (e.g., Bai, Hsieh, & Qian, 2006; Rodrik,

2006; Bosworth & Collins, 2008; and Brandt, Biesebroeck, & Zhang, 2009) credit China’s impres-

sive export growth to rising productivity in the manufacturing sector, advancing export structures

and sophistications, and implementing successful industrial policies. Other researchers, however,

attribute China’s export growth and the growing annual trade and current account surpluses to the

exchange rate policy. These studies (e.g., Dunaway & Li, 2005; Cline & Williamson, 2009; and

Goldstein & Lardy, 2009) argue that that China directly or indirectly supports its export sector by

maintaining an exchange rate policy that overly undervalues the currency, and they call on China

to abandon such a practice. Other studies (e.g., Goldstein, 2003; Goldstein & Lardy, 2003; Prasad,

Rumbaugh, & Wang, 2005; Frankel, 2005; Goodfriend & Prasad, 2006; Roubini, 2007) urge

China to make even more drastic changes by departing from its pegged exchange rate policy and

allowing the RMB to float freely.

The debate on China’s exchange rate policy is not limited to academia. For instance, US manu-

facturers, unions and politicians have long claimed that China manipulates its currency and that

Chinese firms gain an unfair advantage over foreign counterparts. In January 2009, US Treasury

Secretary Tim Geithner wrote three times to the Senate Finance Committee that President Obama

would aggressively use all diplomatic avenues available to him to seek a change in China’s

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The only exception is 1993, when China’s imports exceeded exports. The trade deficit in that year led to a current account

deficit of US$11.6 billion.

DOI: 10.1111/twec.12570

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©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:1288–1308.

currency practices.

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Reacting to China’s growing trade surplus with the United States, the US Sen-

ate passed a bill (S. 1619) in 2011 calling on the Treasury to identify misaligned currencies and

take actions to correct the misalignment. More recently, during his 2016 presidential campaign,

President Trump vowed to name China a currency manipulator.

In defending its exchange rate policy, however, the Chinese government often cites its contribu-

tion to the global economy by resisting the internal pressure to devalue the RMB during the Asian

financial crisis. China’s decision to maintain the value of RMB during the Asian financial crisis

helped prevent the potential danger that a competitive devaluation could have brought to the world

economy. By not devaluating, the RMB appreciated in real terms despite the declining domestic

price level. Although this put China at a comparative disadvantage in world markets during this

difficult time, statistics show that China’s exports not only did not fall but actually increased from

a precrisis level of US$151 billion in 1996 to US$183 billion in 1997, and they continued to grow

to US$184 billion in 1998 and US$195 billion in 1999.

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This unusual experience during the Asian

financial crisis raises an interesting question of why China’s exports continued to rise despite a

competitive disadvantage that China created by allowing the RMB to appreciate in real terms.

This paper contributes to the literature by offering an explanation for this atypical phe-

nomenon.

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Based on a traditional export demand model, we test our hypothesis that the counteract-

ing effects of another export promotion policy—China’s export tax rebates (ETR) policy—have

diminished the effectiveness of real exchange rates in facilitating the resolution of trade imbalance s

under the current pegged exchange rate regime. Our empirical results support the hypothesis. We

find that both RMB real depreciations and the ETR policy have positive effects on exports. But

the ETR policy has a larger effect on foreign demand for China’s exports than real exchange rates

have in general. During the Asian financial crisis, RMB real appreciations negatively affected Chi-

na’s exports, but these negative effects were mitigated by the positive effects of ETR. Further,

since export tax rebates are coupled to the performance of overall exports, we also find evidence

of a long-run relationship between the ETR policy and China’s exports. These results suggest that

under the current pegged exchange rate regime with limited corrections, real exchange rate move-

ments alone cannot resolve China’s growing external imbalances, especially when there are market

imperfections. The policy implication from the analysis is that China needs to redirect its decades-

long export-oriented development strategy to one that emphasises domestic demand-oriented

development and to replace the current pegged exchange rate regime with a market-oriented more

flexible exchange rate regime.

The choice of exchange rate regime depends on many characteristics of an economy. Large

countries tend to prefer more flexible exchange rate regimes because they are relatively more inde-

pendent and less willing to subject their domestic goals to the rigidities of a fixed exchange rate

with a foreign currency. For decades, however, China has adopted a fixed exchange rate system,

pegging the RMB to the US dollar first and a basket of currencies later, and it has not made sub-

stantive adjustments to the exchange rate policy. At the 6th China-EU Business Summit in Brus-

sels on 6 October 2010, Chinese Premier Wen Jiabao conceded that drastic RMB appreciations

2

“Geithner’s China Bash,”The Wall Street Journal, 24 January 2009.

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According to China Statistical Yearbook, China’s trade surplus rose from US$12.2 billion in 1996 to US$40.4 billion in

1997 and US$43.5 billion in 1998 but settled down to US$29.2 billion in 1999 and US$24.1 billion in 2000. Correspond-

ingly, China’s current account surplus also increased from US$7.2 billion in 1996 to US$37 billion in 1997, US$31.5 bil-

lion in 1998, US$21.1 billion in 1999 and US$20.4 billion in 2000.

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It is worth noting that a large percentage of China’s exports are manufactured goods. The price elasticity of demand for

exports of manufactured goods is typically high (see, e.g., Goldstein & Khan, 1985).

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