Exchange Rate and International Outsourcing: Would Chinese Yuan Appreciate Against U.S. Dollar? Chu Ping Lo K.C. Fung Chelsea C. Lin Shih-Hsun Hsu

1. Introduction We live in a world of both specialization and globalization. Encouraged by innovation in computer, communication and transportation technology, firms tend to specialize in particular stages or components of production, exporting them to other countries for further processing or input. Grossman and Helpman (2005) noted: Firms seem to be subcontracting an ever expanding set of activities, ranging from product design to assembly, from research and development to marketing, distribution, and after-sale services. Some firms have gone so far as to become “virtual” manufacturers, owning designs for many products but making almost nothing themselves.

China: Factory of the World China has the fastest economic growth in the world (e.g., three times larger than U.S.). It is widely expected that China will continue this high economic growth rate for the next two decades or so. Steady trade surplus Enormous flooding inflow of FDI Successfully controlled inflation in the 2000’s. Instead: China has repeatedly devalued its currency as a means of promoting trade and FDI (foreign direct investment) in the 1980s and early 1990s. Zhang (1996) argues that a key reason for China’s continuous currency devaluation is to reduce the price distortion and promote exports. Wang (1993) has found that there is a positive relationship between the currency of China and its exports. Brada et al. (1993) also found that devaluation of the yuan serves to improve its balance of trade. China’s yuan should appreciate?

Source: International Financial Statistics, various Issues (Zhang, 1996)

Figure 2. Trade performances in China

Why China needs to keep a low-cost environment? Naughton (1996) and Fung (1998) show that China’s trade is heavily dependent on enterprises from other economies and a substantial amount of China’s trade is conducted by foreign- invented enterprises. A high degree of trade related to foreign investment: foreign firms conducted 56.2 percent of China’s imports and 54.8 percent of exports in A high incidence of re-exports through Hong Kong: an average of 53 percent of Chinese exports was re-exported through Hong Kong over the period (Feenstra et al., 2002).

More critical reason for currency undervaluation? In 2004, China had about three hundred millions of laborers in the agriculture, and at least more than two hundred million agricultural workers are “redundant” in the long run (v.s. U.S.). In 2004, there is about 66M worker in state-owned-business. Therefore, China has incentives, and is under great pressure, to devalue its currency in order to encourage international outsourcing activities for accommodating these redundant laborers.

2. The Model Labor is a unique production factor in a world of North-South. The labor in the North is skilled, while the labor in the South is relative unskilled. Consumers are assumed to have homogeneous preferences on all differentiated goods. The demand function for a representative final-good is given by (1), where is price of the final good and is a given parameter.

Incomplete contract Firms in the North generate the high-tech inputs but outsource the low-tech inputs domestically or abroad. If the specialized low-tech inputs are bad quality, the output of the final-goods will be zero. Otherwise, the output is given by Assume that the wage rate in the North is, and the wage rate in the South is in term of the currency of the North. Let’s assume that the exchange rate is exogenously determined by the government of the South, which usually pegs its currency against the North’s currency. (2), where.

Profit Maximization : When low-tech input is produced in the North If the low-tech inputs are produced in the North, the profit of the final-good producer is given by With respect to each output, the first order conditions show that the optimal price for the final-good producer is given by Substituting (4) into (3), we get the profits of the final-good producer as (3) (4) (5)

Profit Maximization : When low-tech input is outsourced to the South The North and the South bargain over the surplus from the relationship after that the South can provide good quality low-tech inputs. With this ex-post Nash bargaining, supposed that is attributed to the South, and the remaining surplus, is attributed to the the North, where. The firm in the North is to maximize. The low-tech producer in the South is to maximize. The F.O.Cs of the joint profits yield an equilibrium as Combining the F.O.C. and (6), we obtain the optimal price of the final good as (6) (7)

Profit of the Northern firm after Outsourcing Combining (6), and (7), we obtain the profit of the Northern firm as For a profit-maximization firm in the North, the strategy of international outsourcing is preferred if. Comparing (5) to (8), we find that international outsourcing is carried out if We have. is nonincreasing in z for. (Antra`s, 2004). We also have. (8) (9), where.

Figure 2. Equilibrium in the Choice of Location *The low-tech input is produced in the South if, otherwise in the North.

3. Redundant Labor and Currency Manipulation Full employment in the North. Assume there are substantial amount of redundant laborers in the South reside in agriculture sector or in state-owned business. International outsourcing activities (i.e., offshore production) from the North to the South provide jobs for the South’s redundant laborers. Therefore, we argue that the South might tend to encourage international outsourcing activities to both accommodate these redundant laborers and to become more industrialized. Table 1. Labor Supply in China Source: National Bureau of Statistics of China. (In Million) Total labor Supply Labor Supply in State-owned Enterprise Labor Supply in Agricultural & Fishery

Relative share in world value-Added World income equals world output on all goods, so that Assume the labor demand in the South increases with a lower outsourcing threshold, that is,. Let be the fraction of industries with and be the corresponding probability density function. The relative share of world income can be expressed as: Here we denote as the output of the South’s homogeneous sector (say agricultural sector) in world income E. Rewrite (10) as to express the relative wage rate of the North to the South as: (10) (11)

Elasticity of labor demand Obstfeld and Rogoff (2004) find that a decrease in the trade deficit to GDP of 1% requires a decrease in the exchange rate somewhere between 7% and 10% in the U.S. Olivier, et al. (2005) estimate, supposed that the U.S. export to GDP is about 10%, that a reduction of the ratio of the trade deficit to GDP of 1% requires a depreciation of 15%. It is feasible to argue that the change in the ration of trade deficit to GDP is equivalent to the change in employment. Denote as the elasticity of labor demand with respect to exchange rate in the South. The estimate of U.S. elasticity of labor demand with exchange rate ranges from 0.07 (implied from Olivier, et al., 2005) to 0.14 (implied by Obstfeld and Rogoff, 2004). Assume.

Figure 3. The South manipulatively undervalues its currency *When the South devalues its currency (i.e., a smaller ), the curve shifts downward to the new equilibrium with a lower threshold,, where.

Hypothesis A smaller (i.e., depreciation) leads to a lower outsourcing threshold (i.e., a smaller ). It turns out the South acquires a larger share of world income as in equation (10). Meanwhile, the total employment in the South increases with a lower outsourcing threshold (i.e., ). The South could turn its redundant labor into productive by undervalued currency, but maybe at the sacrifice of its real income.

4. Conclusions A South that has large amount redundant labor tends to undervalue its currency to attract more international outsourcing activities from the North to accommodate its redundant laborers. The South as a whole benefits from the international outsourcing activities because it binds itself tighter into the global value-chain. This is the reason why usually the South resists currency appreciation even though its currency is expected to appreciate.