The role of processing trade in exporters' responses to exchange rate: Evidence from China

• DOI: http://doi.org/10.1111/twec.12909
• Date: 01 June 2020
• Published date: 01 June 2020
• Author: Chao Song,Yiqing Xie

World Econ. 2020;43:1521–1543. wileyonlinelibrary.com/journal/twec

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1521

© 2019 John Wiley & Sons Ltd

Received: 6 April 2019

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Revised: 2 October 2019

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Accepted: 10 October 2019

DOI: 10.1111/twec.12909

ORIGINAL ARTICLE

The role of processing trade in exporters' responses

to exchange rate: Evidence from China

YiqingXie1

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ChaoSong2

1Institute of China Studies, Shanghai Academy of Social Sciences, Shanghai, China

2Shanghai Municipal Development and Reform Commission, Shanghai, China

KEYWORDS

China, exchange rate elasticities, processing trade, tax/tariff reduction

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INTRODUCTION

Exchange rate is an international macroeconomic variable for firms. Variations of exchange rates in-

fluence costs and profits of firms, and further their export decisions through relative price changes of

foreign and domestic intermediate inputs and final goods. For exporters who are usually considered

with high productivity, variations of exchange rates would directly affect their comparative advantage

in the global market and lead them to change export prices and quantities. How the changes of ex-

change rates affect firm-level export decisions raises more and more research attention with the avail-

ability of firm- and product-level data from advanced economies. Hellerstein (2008) and Goldberg

and Hellerstein (2013) used US beer market transaction data, Gopinath and Itskhoki (2010) explored

US imports data, Berman, Martin, and Mayer (2012) applied French data, and Amiti, Itskhoki, and

Konings (2014) studied Belgian export data to analyse different aspects of exchange rate pass-through

that linked firm-level micro export activities with the international macro variable—exchange rate.

Among them, total factor productivity, markup, cost of intermediate inputs and local distribution cost

are the key factors for the incomplete exchange rate pass-through at the firm level.

Compared to the evidence from advanced economies, Li, Ma, and Xu (2015) used Chinese Customs

and firm-level data and found that Chinese firms’ exchange rate elasticity of export price (only 4.1%)

is much smaller than that of the advanced economies. Li and Zhao (2016) suggested that the low

export price exchange rate pass-through of Chinese exporters may come from a “forward-looking”

nature; that is, firms take expectations of future exchange rate changes into account when they make

pricing decisions.

Different from the previous findings, this paper shows that the specific mode of international trade

prevailing in developing countries—processing trade—makes exporters behave differently in re-

sponse to any changes in the exchange rate. Processing trade allows an exporter to adjust more on

export price and stabilise its export quantity when exchange rate fluctuates.1 It brings advantage to

1 Bouvet et al. (2017) also found similar results when they compared the tariff pass-through to the exchange rate pass-through,

but did not discuss what makes the processing-trade exporters different.

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XIE and SOnG

exporters with relatively lower productivity and less market power in developing countries from the

preferential (relative to ordinary trade) policies designed for processing trade.

This paper considers the difference in the effects of real exchange rate on firm-level export behaviours

between ordinary-trade firms and processing-trade firms theoretically and empirically. We extend the

export decision model in Berman et al. (2012) by involving tax/tariff concession (one type of preferential

policies) for processing-trade firms. Processing-trade exporters enjoy more import tariff reduction and/

or more tax cut from exporting, and therefore, they adjust the marginal cost with an advantage compar-

ing to ordinary-trade firms when exchange rate varies. As a result, processing-trade firms usually have

higher exchange rate elasticity of export price (adjust export price more) and lower exchange rate elas-

ticity of export quantity (change export quantity less) in contrast to ordinary-trade firms.

We combine the Chinese firm-level data collected by China's National Bureau of Statistics and the

product-level Chinese Customs data set from China's General Administration of Customs from 2000 to

2007 to test the theoretical predictions and find strong empirical supports. When exchange rate increases

by 10%—that is, Chinese yuan (CNY) depreciates by 10%—Chinese ordinary-trade firms will increase

its export price denominated in CNY only by 0.23%, while for processing-trade exporters, the export

price adjustment is more than doubled (by 0.49%). Accordingly, export quantity is much more stable for

processing-trade firms, with 10% depreciation in CNY, processing-trade exporters can gain additional

1.97% in export quantity with 4.54% increase for ordinary-trade firms. If we look into the rationale for the

price and quantity adjustment difference between these two modes of trade, different tax rebate policies

and the use of imported intermediate inputs can explain different responses of export price well.

This paper contributes to the literature in at least the following three ways. First, compared to the

previous studies on the exchange rate pass-through, this paper considers a phenomenal feature of inter-

national trade in developing countries which simultaneously have a large number of processing-trade

firms as well as ordinary-trade firms. The importance of the mode of processing trade was revealed

in the trade liberalisation literature by Yu (2015) and is revisited in this paper on the transmission of

international macro variables (real exchange rate) to firm-level micro export decisions.

Second, this paper enriches the understanding of economic growth of any country that has applied

and is applying the export-oriented industrialisation strategy including China. China is the world's

largest exporter and 2nd largest importer. Besides her international trade volume, unlike advanced

economies, China has a large number of both processing-trade firms and ordinary-trade firms. The mi-

cro-level Chinese data represent the export-oriented industrialisation economy very well. Meanwhile,

CNY is one of the important currencies in the international transactions, and therefore, its exchange

rate fluctuations are relevant to export decisions.

Last, we discover that the design, implementation and enforcement of a policy can create additional

cost advantage for some (not all) firms, which could further lead to significant pricing difference es-

pecially for less productive firms struggling in the international market with tough competition. A just

policy may be preferential and not necessarily fair to all exporters.

The remainder of this paper is organised as follows. Section 2 illustrates the processing trade in

developing countries. Section 3 develops an exchange pass-through model that includes tax/tariff

concession of processing-trade firms. Section 4 describes the Chinese data and the summary statistics.

Section 5 shows the empirical results. Section 6 concludes.

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PROCESSING TRADE IN DEVELOPING COUNTRIES

In the international trade literature, firms compete to survive in their domestic market first; when they

get more productive, they self-select into exporting market (Melitz, 2003). Exporters only export a