Does US quantitative easing affect exchange rate pass‐through in China?

• Author: Puyang Sun,Xinyu Hou,Jingjia Zhang
• Published date: 01 January 2018
• DOI: http://doi.org/10.1111/twec.12576
• Date: 01 January 2018

ORIGINAL ARTICLE

Does US quantitative easing affect exchange rate

pass-through in China?

Puyang Sun

1,2

|

Xinyu Hou

1,2

|

Jingjia Zhang

2,3

1

School of Economics & Research Center on Multinational Corporations, Nankai University, Tianjin, China

2

Collaborative Innovation Center for China Economy, Nankai University, Tianjin, China

3

APEC Research Institution, Nankai University, Tianjin, China

1

|

INTRODUCTION

The puzzle of the exchange rate disconnect has generated a vast body of literature, discussing why

large movements in exchange rates have small effects on the prices of internationally traded goods.

However, no such empirical study has taken into account one of the most salient policy influences

on international trade, which is the quantitative easing (QE) policy of the United States. Using liq-

uidity operations, large-scale asset purchases of unconventional assets for the Federal Reserve and

purchases of US Treasury securities, US QE1-2 affects not only the exchange rate of the US dollar

itself, but also the exchange rates worldwide (Bouraoui, 2015; Fratzscher, Lo Duca, & Straub,

2013). Through the exchange rate channel, the international spillover of US QE policy changes the

pass-through of Chinese exporters. The majority of exporters (more than 90%) in China uses the

US dollar as the currency of settlement, while nearly all trading transactions in China are measured

by the US dollar in customs statistics, which means the bilateral exchange rate between China and

its trade partners is closely related to the influence of US QE policy. Also, the exchange rate of

Chinese trade partners is simultaneously affected by US QE policy. However, such influence dif-

fers across export destinations, leading to different effects on the price adjustment behaviour of

Chinese exporters. In this paper, we show that the QE policy plays an important role in changing

the exchange rate pass-through of Chinese exporters.

Using detailed disaggregated trade data, we find that the US QE policy results in a lower

exchange rate pass-through of Chinese exporters. In addition, the more the exchange rate in the

export destination appreciates than the Chinese yuan, the stronger this effect becomes. Conse-

quently, Chinese firms exporting to destinations with higher appreciation than China have low er

exchange rate pass-through, providing a new channel that limits the effect of exchange rate pass-

through on export prices.

To guide our empirical strategy, we develop a theoretical framework to study the forces that

jointly determine a firm’s decision to react to US QE policy and to set markups in each destination

of its exports. The two building blocks of our theoretical framework are an oligopolistic competi-

tion model of variable markups following Amiti, Itshkhoki, and Konings (2014) and a reduced

form model of exchange rate reaction to QE policy (Fratzscher et al., 2013). These two ingredients

DOI: 10.1111/twec.12576

242

|

©2017 John Wiley & Sons Ltd wileyonlinelibrary.com/journal/twec World Econ. 2018;41:242–261.

allow us to capture the key patterns in the data, and their interaction generates new insights into

the spillover effect of US QE policy on Chinese exporters. In equilibrium, the spillover effect of US

QE policy on the exchange rate of each destination and the export market share are two key ele-

ments that influence Chinese exporters. The theory further predicts that these two elements form a

sufficient statistic for the response of export price, with an exchange rate marginal reaction to the

QE policy proxy for the spillover of US QE policy and market-share proxy for markup elasticity.

We test the predictions of the theory with a rich data set of Chinese exporters for 2007–11,

including export destinations and detailed products. Using the US QE policy index from the Fed-

eral Reserve balance sheet (Fratzscher et al., 2013), we further test the spillover effect of QE pol-

icy on the exchange rates of different destinations, which is a key firm characteristic in our

analysis.

Our main empirical specification, as suggested by the theory, relates export price to the destina-

tion-specific US QE policy spillover on exchange rate for Chinese firms capturing the QE policy

spillover channel and the destination-specific market share capturing the markup channel. We esti-

mate the cross-sectional relationship between exporters’responses and their determinants within

industries and destinations, holding constant the general equilibrium forces common to all firms.

Our methodological contribution is to target the spillover of US QE policy on the exchange rate

through the general equilibrium procedure. The coefficients of Chinese exporters in this relation-

ship can be directly estimated without imposing strong partial equilibrium or exogeneity assump-

tions. The theory further provides closed-form expressions for these coefficients, which allows us

to directly test for the structural mechanism emphasised in the model.

The results provide strong support for the theory. First, we show that US QE policy spillover

on the global exchange rate is an important channel to reduce the exchange rate pass-through to

the price of Chinese exporters, with each additional 10 percentage points’gap of response between

China and its export destination decreasing the pass-through by more than 0.292 percentage points.

Second, we show that this effect is heterogeneous among firms exporting to different destinations.

Exporters with destinations appreciating more than China have lower exchange rate pass-through

due to the increase in market share for Chinese exporters. Finally, we find that firm-level charac-

teristics, such as ownership, also lead to different influence on the response of Chinese exporters

to the spillover of US QE policy.

Quantitatively, these results are large. Firm exports to its destination with zero influence from

US QE policy have almost complete pass-through (99.46%). In contrast, a firm with QE policy

influence on its destination has a pass-through of 93.13%, with the spillover of US QE policy on

exchange rate contributing about 6.36% to this variation in the exchange rate pass-through to its

export price. These results have important implications since the pass-through of Chinese exporters

is significantly influenced by the spillover of US QE policy on the exchange rate of their destina-

tions.

Our paper is related to two strands of recent literature. First, it relates to the recent and growing

literature on the spillover effect of US QE policy, including its influence on the exchange rate

(Eichengreen and Gupta, 2013; Fratzscher et al., 2013), on capital flow (Eichengreen, 2013; Lore-

dana, 2012; Rogers, Scotti, & Wright, 2014), on imported inflation (Bhattarai, Eggertsson, &

Gafarov, 2015; Chen, Filardo, He, & Zhu, 2012; Morgan, 2011) and on monetary policy of other

countries (Spantig, 2012). Among these studies, a small body of literature relates to the spillover

of US QE policy on the exchange rate of other countries. Recent work, for example, Bouraoui

(2015), Eichengreen and Gupta (2014), and Volz (2012), has documented convincing facts regard-

ing the influence of US QE policy on the exchange rate of emerging markets, with most emerging

markets allowing the real exchange rate to appreciate during the period of QE policy. Different

SUN ET AL.

|

243