VoxEU Column Exchange Rates

Investigating the effect of exchange-rate changes in Japan, China, east Asia, and Europe

Policymakers everywhere are concerned about currency wars. Are quantitative easing and managed exchange rates bad for the global economy? This column looks at the hard empirical evidence, arguing that, in fact, Japan is behaving rather responsibly and that other strong economies have themselves benefited from undervalued currencies. That said, it is true that politicians’ short time horizons often lead to stealthy policy and large swings in exchange rates. Economists should therefore aim to promote longer-run cosmopolitan interests rather than shorter-run nationalistic agendas where possible.

Policymakers are concerned about currency wars and competitive devaluations. Many complain that trading partners are artificially lowering their exchange rates through quantitative easing and managed exchange rates in order to gain price competitiveness for their exporters.

Rodrik (2008) finds that exchange-rate undervaluation also increases economic growth. He reports that exchange-rate undervaluation increases the share of the tradeable sector in total output. He then argues that the tradeable sector in developing countries tends to be inefficiently small because of government or market failures. He thus concludes that an undervalued exchange rate that increases the size of the tradeable sector will stimulate growth.

However, as Larrain (2013) observes, currency wars are a zero-sum game. While some countries gain from undervalued exchange rates, others lose. He states that countries that are committed to open markets and flexible exchange rates experience appreciating exchange rates and falling exports while countries that manage their exchange rates, such as China, do not.

Discussions on exchange-rate policy and currency wars should be informed by hard evidence. Economists at Japan’s Research Institute for Economy, Trade and Industry and collaborating institutions have thus investigated the effects of exchange-rate changes in Japan, China, east Asia, and other countries. I summarise some of the key findings below, and then attempt to draw policy conclusions.

The strong yen and the Japanese economic debacle

The Japanese real effective exchange rate appreciated 30% between June 2007 and March 2009. Japanese real exports fell 40% over this period, industrial production dropped 35% and the Nikkei index lost more than 80% of its value. The yen remained strong for the next five years and exports, industrial production and stock prices did not regain their pre-crisis values.

I report (2012) that the appreciation of the yen caused exports to fall significantly, especially for the automobile sector. I also find that the strong yen caused yen export prices to fall much more than yen costs in the automobile and electronics sectors. Finally, I show that the endaka – when the value of the yen is high compared to other currencies – caused stock prices in these two industries to plummet. Since the automobile and electronics industries have long been the flagships of the Japanese economy, this evidence indicates that the strong yen since the global financial crisis has materially contributed to the economic debacle in Japan.

The yen then began depreciating on 13 November 2012 when Prime Minister Noda announced that he would call new elections. Investors correctly anticipated that the elections would lead to Japan adopting a more dovish monetary policy. Over the next three months, the yen depreciated 17% against the US dollar and the Nikkei index gained 28%. These gains were led by the automobile and electronics sectors.

Why did Japan tolerate a punishingly strong yen for so long? One reason, as the Financial Times discusses, is that unlike most countries Japan followed through on a G20 agreement in November 2008 to eschew currency wars. Japan believed that, as a surplus nation, it had a responsibility to prevent competitive devaluations.

Exchange rates and east Asian production networks

Japan’s surplus has since turned to deficit. Other east Asian countries, however, continue to run large surpluses. This is especially true in what is called ‘processing trade’. Processing trade involves east Asian countries shipping parts and components to China for assembly and re-export. According to China Customs Statistics data, China’s global surplus in processing trade equaled $366 billion in 2011 and $382 billion in 2012. China’s surplus is actually larger however. As Xing (2012) notes, more than 15% of China’s imports for processing in recent years are actually produced in China. They are then round-tripped out of China and back in in order to take advantage of favourable tax provisions. In an economic sense, goods produced in China are not imports into China. If we subtract 15% of imports for processing from China’s surplus to correct for these goods produced in China, its surplus in processing trade in 2012 exceeded $450 billion.

Figure 1 shows that China has been running deficits in processing trade of about $100 billion with east Asian supply-chain countries and surpluses of $100 billion with Europe, $165 billion with the U.S., and more than $200 billion with Hong Kong. Since processed exports to Hong Kong are primarily re-exported to advanced economies, China’s surpluses with the West are actually much larger. Using U.S. data that treat Chinese exports transshipped through Hong Kong as coming from China, China’s surplus with the US equaled $295 billion in 2011 and exceeded $300 billion in 2012.

Figure 1 implies that, in a value-added sense, the surplus in processing trade is an east Asian and not just a Chinese phenomenon. Taiwan, South Korea, and ASEAN countries provide more than $100 billion in parts and components each year that goes into the final products. Nevertheless, China’s high investment levels in recent years have allowed it to source more and more intermediate goods domestically. As its supply chains have become deeper, China's value-added in processing trade has increased. If we measure value added in processing trade as the difference between processed exports and imports for processing, China’s value-added is now about 50%.

Figure 1. China’s balance in processing trade with its trading partners

Note: ASEAN includes Malaysia, the Philippines, and Thailand. Europe includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Luxembourg, the Netherlands, Italy, Portugal, Spain, Sweden and the UK.

Source: China Customs Statistics.

Given that both China and east Asia have high value-added in processing trade, it is not surprising that recent research indicates that exchange rates in both China and east Asia matter for processed exports. For instance Ahmed (2009) reports that a 10% appreciation of the renminbi relative to non-east Asian countries would reduce China’s processed exports by 17% and that a 10% appreciation in east Asian supply chain countries against non-east Asian countries would reduce China’s processed exports by 15%. He thus concludes that the fall in processed exports would be much larger if exchange rates throughout emerging Asia appreciated together. Yamashita (2011) finds that a 10% appreciation of the renminbi relative to importing countries would decrease exports by 12.4% and a 10% appreciation of the renminbi relative to east Asian supply-chain countries would reduce Chinese exports by 11.5%. If the large surpluses (in a value-added sense) that both China and east Asia are running against OECD countries caused a generalised appreciation in Asia, Yamashita’s results imply that processed exports would drop significantly. Thorbecke (2011) finds that a 10% appreciation of either the renminbi or of the currencies of east Asian supply-chain countries would reduce processed exports by about 17%. These results imply that a concerted appreciation across the value chain would significantly reduce processed exports.

China manages its exchange rate. Henning and Katada (2011) and others have shown that currencies in east Asian supply chain countries now move closely with the renminbi. If the renminbi were to appreciate, other east Asian currencies would likely appreciate also. Such a generalised appreciation in the region would help to rebalance its burgeoning surplus with the West. This would be helpful to countries such as Portugal and Italy that have faced stiff competition from China in consumer goods (see Eichengreen and Wyplosz 2012).

Germany: A five-star economy with a three-star exchange rate

Figure 2 suggests that, while Eurozone countries face competition from China in consumer goods, they face even more competition from Germany. The same is true for other major categories of German exports such as capital goods. In recent work (2012), Atsuyuki Kato and I have investigated how exchange rate changes affect Germany’s exports both to the Eurozone and to the world. This is important because, as Peter Bofinger notes, Germany is a five-star economy with a three-star exchange rate. It is a strong, export-led economy whose exchange rate has been held down because it is linked to other weaker Eurozone economies.

Figure 2. The value of Germany’s and China’s consumer-goods exports to the Eurozone.

Note: Eurozone importing countries exclude Germany.

Source: CEPII-CHELEM database.

We found that, for the unit labour cost deflated real effective exchange rate, long-run elasticities are precisely estimated and equal to 0.6. Steen and Ross (2013) reported that the exchange rate for Germany is undervalued by 15%. If this is true, our findings imply that Germany’s steady state exports are 10% more than they would if Germany did not have the benefit of a weaker exchange rate. We also found much higher elasticities for German exports to the Eurozone than for German exports outside of the Eurozone. Finally, we found that for capital-goods exports, elasticities equal only 0.2 or 0.3. These low elasticities reflect the fact that Germany’s capital-goods exports are high-quality goods that compete more on quality than on price. For consumer-goods exports, on the other hand, elasticities range from 0.7 to 1.0. For consumer-goods exports to the Eurozone, elasticities are higher (between 0.9 and 1.5).

Since unit labour costs in Germany fell about 25-30% relative to unit labour costs in other Eurozone countries after 1999, we should expect a large increase in consumer-goods exports from Germany to the Eurozone. Figure 2 confirms that this happened. While other factors contributed to this rise, our research indicates that one key factor was the real depreciation of the German exchange rate. There was also a surge in total exports from Germany to the Eurozone.

This rapid increase in exports from Germany to the Eurozone in turn contributed to current-account imbalances between Germany and the southern European countries. As others have noted, correcting these imbalances will be difficult because these countries share a common currency.

Policy implications

There are a few policy implications that follow from the results discussed above. First, if as in the case of Japan a country’s economy has been decimated by an overvalued exchange rate, it is not engaging in a currency war when it pursues expansionary monetary policy. One could argue that this is how a responsible central bank should respond. Second, surpluses of $500 billion in processing trade between east Asia and the West may prove unsustainable. If so, rather than waiting for another economic crisis, policymakers in Asia should consider allowing a concerted appreciation. Although this would reduce exports to the West, it would increase the purchasing power of consumers in Asia and re-channel exports to the region. Third, while German workers and firms should be commended for raising productivity and reducing unit labour costs, they have also benefited from an undervalued exchange rate. This fact should produce humility in German policymakers as they interact with policymakers in countries still reeling from the economic crisis.

The results discussed above indicate that exchange rates exert first-order effects on economic outcomes. Unfortunately, exchange rate policy is often implemented by politicians with short time horizons. They pursue stealth devaluations to gain competitive advantage and contribute to large swings in the exchange rate. It is not naïve to believe that better arrangements are possible. Economists should focus on how the international monetary system can be reformed to promote longer-run cosmopolitan interests rather than short-run nationalistic agendas.


Ahmed, S (2009), “Are Chinese Exports Sensitive to Changes in the Exchange Rate?”, International Finance Discussion Papers No. 987, Federal Reserve Board, Washington DC.

Eichengreen, B and C Wyplosz (2012), “Kenen on the Euro,” VoxEU.org, 21 December.

Henning, C R and S N Katada (2011), “Cooperation without Institutions: The Case of East Asian Currency Arrangements,” mimeo, American University.

Larrain, F (2013), “QE Takes a Toll on Emerging Economies,” Financial Times 4 February.

Rodrik, D (2008), “The Real Exchange Rate and Economic Growth,” Brookings Papers on Economic Activity, Fall, 365-412.

Steen, M and A Ross (2013), “First Shot Fired in New Round of Currency Wars,” Financial Times 23 January.

Thorbecke, W (2012), “The Contribution of the Yen Appreciation since 2007 to the Japanese Economic Debacle,” CEPII Working Paper No. 31, Centre D’Etudes Prospectives et D’Information Internationales, Paris.

Thorbecke, W (2011), “Investigating the Effect of Exchange Rate Changes on China’s Processed Exports”,  Journal of the Japanese and International Economies, 25, 33-46.

Thorbecke, W and A Kato (2012), “The Effect of Exchange Rate Changes on Germany’s Exports,” RIETI Discussion Paper 12-E-03, Research Institute of Economy, Trade and Industry, Tokyo.

Xing, Y (2012), “Processing Trade, Exchange Rates, and China’s Bilateral Trade Balances,” Journal of Asian Economics, 23, 540-47.

Yamashita, N (2011), “The Currency of the People’s Republic of China and Production Fragmentation,” ADBI Working Paper No. 327, Asian Development Bank Institute, Tokyo.