The effects of a RMB devaluation on ASEAN economies

This paper examines the effect of a depreciation of the Chinese renminbi on the ASEAN economies, focusing in particular, on the resulting pattern of competitive advantage and effect on t

The Effects of a RMB Devaluation on ASEAN Economies: An Applied General

Equilibrium Approach

By Robert R Teh Jr

Director Trade, Industry and Services

Introduction

There is growing complexity in the economic relationship between ASEAN and China On the one hand, China is a major competitor to ASEAN both as an investment destination and as a major producer of labour-intensive manufactures But on the other hand, China’s maintenance of the renminbi during the height of the Asian crisis was a major reason why the crisis did not precipitate an even more devastating meltdown in the region

This paper examines the effect of a depreciation of the Chinese renminbi on the ASEAN economies, focusing in particular, on the resulting pattern of competitive advantage and effect on the market share of ASEAN economies in major export markets - US, the EU and Japan To the extent that a devaluation of the renminbi serves as a proxy for the trade rivalry between ASEAN and China, the outcome of the simulation should provide some answers to the state of the economic relationship between them

Ever since the Asian crisis broke out in mid-1997, China's maintenance of the value of the renminbi has served as a regional anchor preventing what could possibly have been successive rounds of competitive devaluations There was, however, an implicit trade-off being made by China - geo-political gain from maintaining the renminbi as against the loss of export markets, as much cheaper goods from the crisis-plagued region compete with Chinese goods However, now as export performance stalls and as growth slows in China’s domestic economy, the cost of delaying the devaluation may be steadily rising The threat of regional currency instability may have also ebbed with the beginning of economic recovery

in the crisis countries, making it less likely that a renminbi devaluation would be followed by beggar-thy-neighbour responses elsewhere in the region

To provide a quantitative analysis of the likely impact of such a devaluation on the ASEAN economies, this paper uses the Global Trade Analysis Project (GTAP) model to simulate several devaluation scenarios The first part of this paper describes the GTAP model and examines some of the difficulties involved in using applied general equilibrium models to simulate macroeconomic crises and devaluation scenarios The second part of the paper describes the procedures employed to simulate the Asian crisis and subsequently the renminbi devaluation The third part discusses the results of the simulation The results suggest that while a renminbi devaluation only has a small effect on total ASEAN exports, there is substantial sectoral impact on ASEAN exports of textiles and apparel as well as other manufactures This suggests that individual ASEAN countries may experience a significant negative impact since textiles and other manufactures are a bigger proportion of the trade of countries like Indonesia, the Philippines and Thailand Furthermore, a renminbi devaluation has large spillover effects on Japan, which could precipitate competitive devaluation pressures on the rest of the region Finally, it is also important to factor in the possible rise of protectionist sentiment in the US, which has experienced strained relations with China, and which suffers a large imbalance in the trade account in the face of a significant renminbi devaluation The results of the simulations tend to support the view that while ASEAN and China

compete directly in export markets and as investment destination, the degree of competition may be less than what conventional wisdom suggests The last part of the paper suggests further extensions of the study

Maybe as a final caveat, it is important to note that this paper is focussed exclusively on the trade effects

of a renminbi devaluation It abstracts from issues of macroeconomic stability and adjustment and the resulting impact on foreign investors of a realistic realignment of China’s currency To the extent that a renminbi devaluation is seen as a commercial response to deteriorating export performance, then the framework of the analysis conducted here is probably appropriate for the purpose on hand But if the realignment of the currency is seen as part of a larger policy commitment to economic reform in China, and couple this with the likely accession of China to the WTO sometime in the year 2000, then this static analysis will likely underestimate the likely toll for ASEAN As part of a larger package of reform measures, a renminbi devaluation could re-energise foreign investor interest in China and produce dramatic increases in economic efficiency and long-term export competitiveness that we would be unable

to capture in the simulations conducted with the GTAP model

The GTAP Model

To simulate the effects of a renminbi devaluation, this paper makes use of the Global Trade Analysis Project (GTAP) model developed by Hertel and Associates and which is described in detail in Hertel

1997 The advantage of using this model is that it has been widely used for simulating a number of important global trade scenarios, such as a new round of WTO negotiations and global energy use and climate change Hence it is already familiar to a large number of international trade economists and applied general equilibrium modellers and provides a widely shared platform for investigating international trade issues

Regional Household

In each region, there is a regional household whose Cobb-Douglas preferences are defined over composite private expenditures, composite public sector expenditures and savings The regional household derives income from ownership and sales of primary factors of production - capital, skilled and unskilled labour, land and natural resources It turns out that the intertemporal, extended linear expenditure system could be derived from an equivalent, static maximisation problem, in which savings enters the utility function (Howe, 1975) This result provides a justification for the inclusion of savings in the regional utility function

Demand

Private expenditures are governed by a Constant Difference of Elasticity (CDE) function which was first proposed by Hanoch (1975) The CDE function has the desirable property that the resulting preferences are not homothetic and is more parsimonious in its parameter requirements than functional flexible forms

It can also be shown that the CES and the Cobb-Douglas are special cases of the CDE function Government expenditures are governed by a Cobb-Douglas preference function Finally, there is inter-industry demand whose technical specifications are described by the usual input-output matrix

Production

Production is assumed to be described by a multi-level production function (see Figure 1) The upper nest is a Leontief-type production function involving value added and intermediate inputs The technical coefficients of this top-level nest are generated from the Social Accounting Matrix (SAM) constructed for each region Value added is produced through a Constant Elasticity of Substitution (CES) function of the five primary factors of production Each intermediate input is in turn produced using domestic and imported components (the so-called Armington assumption) with the technical process described by a CES function Finally, imported components are a mix of imports from the other regions in the global model with the technical process again described by a CES function

Households own all factor supplies - land, natural resources, capital, skilled and unskilled labor and sell their services to firms In the GTAP model, sluggishness of some factors is allowed so that it is possible for factor prices not to be equalised within a region Firms are supposed to sell output and purchase inputs (whether primary factors or intermediates) in competitive markets Hence, firms make no economic profits

Prices and Taxes

The GTAP model allows for factor taxes, production and consumption taxes, export taxes and import tariffs which are in turn distinguished by production sector, by agent (regional household, firm, government) and by region

Savings and Investment

Given the Cobb-Douglas assumption about preferences of the regional household, savings are a constant proportion of regional household income The pool of savings is what becomes available for investments There is a capital goods sector in each region, which produces the investment goods The rate of return on capital goods is assumed to be inversely related to the stock of capital The allocation of

investment across regions and sectors is done in such a way that expected regional rates of return change by the same percentage In the model, the pooling of savings and the global allocation of investment is done costlessly

Aggregation

We have used a smaller 9 region and 10-sector aggregation of the larger 45 region and 50-sector GTAP model The data employed in the study is version 4 which uses 1995 data as the benchmark The data is described in greater detail in McDougall, R et al (1999)

The 9 regions used in our simulation are ASEAN, the US, EU, Japan, China, Korea, Rest of Asia, the Common Economic Relations (CER) and the Rest of the World The GTAP database does not include all ASEAN countries, and hence, ASEAN in this paper covers only Indonesia, Malaysia, Philippines, Singapore, Thailand and Viet Nam In this paper, "China" includes both the People's Republic of China (PRC) and Hong Kong This reflects not only the political reality that Hong Kong is now part of the PRC but also the level of economic integration between Hong Kong and the PRC It is important to highlight that the inclusion of Hong Kong with the PRC implies that the renminbi devaluation is also accompanied

by a devaluation of the Hong Kong dollar by the same amount Now the likelihood of Hong Kong abandoning its currency board increases with the size of the renminbi devaluation, in which case, lumping Hong Kong and the PRC together may make sense only for large devaluation scenarios For small devaluations of the renminbi, therefore, this paper may tend to overstate the likely impacts

Other regions include the US, Japan and the EU which represent the biggest export markets of ASEAN and China Korea is given particular attention because it is an important crisis country The other three regions, which complete the aggregation employed in this paper are the Common Economic Relations comprised of Australia and New Zealand, Rest of Asia and the Rest of the World

The 10 sectors are food, vegetable oils and fats, other agricultural products, extractive industries, textiles, chemicals, electronics and machinery, motor vehicles, other manufactures and services The particular aggregation employed highlights important sectors of interest to the ASEAN countries The mapping from the 45 country and 50 sector grouping of GTAP to our 9x10 model appears in Annex 1

Simulating a Devaluation

Applied general equilibrium models are "real" models of the economy in which monetary and financial variables do not enter Hence macroeconomic variables are normally not integrated into AGE models and if they are, ad hoc methods are typically used to introduce macroeconomic shocks or variables into AGE models

There are several ways in which macroeconomic shocks can be introduced in applied general equilibrium models One would be to impose the shocks exogenously by changing real prices or investment flows

Another procedure would be to build explicitly dynamic models that allow interaction between expectations and investments In this paper, we take the first approach and shock the standard GTAP

model by adjusting the real exchange rate

There are a number of possible prices in the GTAP model that could be used as the real exchange rate

The Armington assumption is usually made in AGE models, which implies, that foreign and domestic

products are never perfectly substitutable So to take an example, domestic food is not identical to

foreign-produced food and hence, their prices will differ even in the absence of other taxes and tariffs

Hence, one possible real exchange rate to use would be the ratio of the index of exportable and

importable prices However, in the context of the GTAP model, a more useful price to shock in order to

simulate the effect of a devaluation is the relative price of the country's factors of production This is more

consistent with the macroeconomic consequences of a nominal devaluation since the ultimate adjustment entails changes in the prices of factors of production A nominal devaluation that is followed

by an equi-proportionate increase in the prices of primary factors of production would have no real effects

Thus in the paper, we have simulated the renminbi devaluation and the Asian crisis devaluation with

changes in the prices of primary factors of production

Baseline Scenario

The benchmark year used for release 4 of the GTAP database is 1995 However, this is not what we

want to use for our baseline scenario since we must start with the Asian crisis of 1997 and attempt to

mimic the resulting outcomes

This is done by reducing prices of all primary factors in ASEAN and Korea by the same rate as the real

devaluation of the currencies in those countries (see Table 1) While the devaluation of the ASEAN and

Korean currencies have been enormous, ranging from 67% to 15%, the crisis-affected countries have

also seen an appreciable change in prices eroding a significant amount of the currency devaluation For

example, while Indonesia has experienced a drop of nearly 67% in the value of the rupiah, price inflation

ran at 61% in 1998 virtually wiping out any competitive edge gained from the currency depreciation As a

consequence, the real rate of depreciation for both ASEAN and Korea have been much lower In the

case of ASEAN the computed average rate of real devaluation is only about 14.3% while it is only 8.8%

for Korea

TABLE 1

Nominal Devaluation and Rates of Inflation in ASEAN and Korea, 1997-99

Devaluation

CPI Inflation

Real Devaluation

8 0%

14.3%

Indonesia Malaysia Philippines

Singapore Thailand Vietnam

67.4%

33.6%

33.4%

14.9%

32.7%

21.2%

15.7%

1.7%

13.7%

10.9%

-0.1%

-25.6%

-17.7%

-13.2%

-19.0%

-10.3%

Source: World Economic Outlook (May 1999).

In the paper, the prices of all primary factors of production are reduced by the amount of real devaluation

in each region Prices of skilled and unskilled labor, capital, land and natural resources are reduced by

14.3% in ASEAN and by 8.8% in Korea It would be preferable to have differential changes in factor

prices since there is considerable evidence to suggest that the impact of the Asian crisis on unskilled

labor was much more severe than to skilled workers or owners of land However, we lack the detailed

information on how factor prices have changed in each region and have therefore chosen to reduce them

all by the same amount

There is also an important complication created by the way we have chosen to introduce the real

devaluation in the GTAP model Factor prices are made exogenous and reduced by the real devaluation

experienced by the region

Accompanying the real devaluation, we have also added a shock to total factor productivity to mimic,

among other things, the near collapse of the banking sector in the crisis-affected countries While it is

difficult to provide estimates of how much the banking crisis in Asia has affected the long-run growth

potential of the region, it is important to take these supply shocks into account because they affect the

short to medium term response of the producers in the crisis-affected countries The output shock

assumption has also been used in other AGE simulation of the Asian crisis In this paper, we have made

the productivity shocks equal to the actual GDP contraction experienced in ASEAN and Korea in 1998

This was equal to -5.5% for Korea while the GDP-weighted average for ASEAN was -4.3% (see Table 2)

The output shock has the effect of dampening the export response to the initial real devaluation This is

consistent with one of the important stylised features of the Asian crisis, which saw exports in US dollar

terms languish, despite the sharp fall in regional currencies

TABLE 2

Output Shock in ASEAN and Korea

ASEAN Indonesia

-4.3%

-13 7%

Malaysia Philippines Singapore Thailand Vietnam

-6.8%

-0.5%

1.5%

-8.0%

3.5%

Korea -5.5%

Source: World Economic Outlook (May 1999)

Baseline Measures of GDP and Export Performance

The resulting global pattern of trade after the real devaluation and output shocks in ASEAN and Korea is our baseline scenario We can compare this Asian Crisis baseline with the 1995 benchmark of the GTAP database For Gross Domestic Product (GDP), we see that the Asian crisis simulation we have employed has probably understated the actual contraction in GDP experienced by the crisis countries ASEAN’s GDP falls by 7.42% to US $ 568.0 billion while Korea’s GDP contracts by 16.2% to US $ 378.2 billion This compares with the latest IMF estimates of 1998 GDP for the two regions concerned - US $ 446.6 billion for ASEAN and US $ 310.1 billion for Korea The simulation also suggests that there is very little spillover effects of the Asian Crisis on other regional economies One should probably not place too much weight on the lack of a contagion effect in the simulations since AGE models are real models and

do not have a central role for financial variables

TABLE 3

Impact of Asian Crisis on Regional GDP (Simulation Result)

ASEAN 613,444.4 567,953.6 -7.42%

USA 7,126,432.0 7,159,306.5 0.46%

Japan 5,091,655.0 5,125,799.5 0.67%

EU 8,209,777.0 8,250,170.0 0.49%

China 813,366.7 815,950.1 0.32%

Korea 451,163.3 378,228.3 -16.17%

Rest of

Asia 710,279.0 713,595.5 0.47%

CER 405,301.8 404,579.6 -0.18%

ROW 4,892,905.0 4,904,165.0 0.23%

TOTAL 28,314,324.2 28,314,324.2 28,314,324.2 28,319,748.5 28,319,748.5 28,319,748.5 0 00 0.02% 02% 02%

Table 4 shows the world market share of all regions in the baseline scenario (Asian Crisis) ASEAN and China are still relatively small players in the world market with ASEAN representing 6.9% of world exports and China making up 5.0% of world exports However, they are significant market participants in some important products ASEAN is a major player in vegetable oils (20.9% of world exports) and other agricultural products (15.1% of world exports) while China has a huge share of textiles and apparel (17.9%) and a significant share of other manufactures (7.8%)

Figure 2 shows the sectoral composition of ASEAN exports More than a third of ASEAN exports are exports of electrical appliances and machinery; other major export sectors are other manufactures and services

FIGURE 2:SECTORAL COMPOSITION OF ASEAN EXPORTS

TABLE 4

Baseline (Asian Crisis) Structure of World Exports

In Per Cent

(Simulation Result)

Rest

of Asia

Vegetable Oil 20.90 22.10 0.10 21.70 2.30 0.00 1.50 0.60 30.70 Other

Agricultural

Products

Textiles and

Motor Vehicles 1.40 14.10 15.60 49.60 0.60 1.50 1.00 0.30 15.90 Electrical and

Other

Table 5 shows the market share of ASEAN and China in several key markets ASEAN has a larger

market share than China in the three markets, with the lead being most pronounced in the Japanese

market ASEAN exports have significant market share in food, vegetable oils, other agricultural products

and electrical appliances and machinery On the other hand, Chinese exports have significant market

share in textiles and apparel and other manufactures

TABLE 5

Market Share of ASEAN and China in Selected Markets

(Asian Crisis Simulation Result)

ASEAN China ASEAN China ASEAN China

Vegetable Oil 33.7% 0.3% 12.5% 1.2% 13.4% 5.6%

Other

Agricultural

Products

26.6% 1.9% 7.5% 1.5% 26.4% 8.1%

Extractive

Textiles & Apparel 12.9% 20.6% 4.2% 8.7% 9.4% 55.9%

Motor Vehicles 1.2% 0.8% 0.4% 0.1% 1.1% 1.3%

Electrical and

Machinery 15.2% 5.8% 4.1% 3.0% 21.0% 10.1%

Other

Manufactures 7.1% 15.0% 2.4% 4.1% 14.0% 17.2%

TOTAL 8.8% 8.8% 8.8% 7.6% 7.6% 7.6% 2.9% 2.9% 2.9% 2.7% 2.7% 2.7% 16.3% 16.3% 16.3% 11.3% 11.3% 11.3%

Renminbi Devaluation Simulation Results

We now turn to examine how a renminbi devaluation would affect this baseline scenario We simulate a

series of real devaluation scenarios: low (10%) and high (25%) There is strong non-linearity in the

simulation results with the trade impact becoming more pronounced for devaluation scenarios of 25% or

more Some of the general conclusions that can be drawn from the simulation results are the following

(see Table 6):

a Chinese exports respond strongly to a renminbi devaluation as exports rises by 33.9% with a

10% devaluation and more than double with a 25% devaluation

b The share of Chinese exports in world trade rises to 6.7% with a 10% devaluation and to 10.8%

with a 25% devaluation

c The biggest winners in absolute terms are Chinese exports of textiles and other manufactures

Their share of world trade rises to 36.6% and 17.5% respectively with a 25% renminbi

devaluation

d The biggest winners in percentage terms are Chinese exports of motor vehicles, electrical

appliances and machinery and other manufactures

e The biggest losers from the renminbi devaluation are the EU, Japan, the CER and the US This

follows from the rapid expansion of Chinese exports in those sectors in which the EU, Japan

and the US are major exporters

f ASEAN experiences only a moderate impact from a renminbi devaluation Exports contract by

1.02% with a 10% devaluation and by 3.2% with a 25% devaluation However, individual

ASEAN countries who are major exporters of textiles and apparel and other manufactures may

suffer disproportionately more

g Global trade still expands as a result of a renminbi devaluation despite the fall in exports from all

other regions

Table 6 shows the changes in export values in the aftermath of a renminbi devaluation China’s exports

leap by US $ 96.6 billion (a 33.9% increase) in the wake of a 10% devaluation while ASEAN’s total

exports decline by nearly US $ 4.0 billion (a 1.02% fall) A 25% devaluation of the renminbi more than

doubles Chinese exports by US $ 341.17 billion (a 119.7% increase) and reduces ASEAN exports by US

$ 12.5 billion (or a 3.2% decline)

TABLE 6

Change in Regional Exports from Renminbi Devaluation

(Simulation Result)

REGION TEN PERCENT DEVALUATION TWENTY- TWENTY -FIVE PERCENT FIVE PERCENT

DEVALUATION

billion -3.18%

-12.5 billion