Koo, Won W.

Zhuang, Renan

English

Research Papers in Economics

Western Economics Forum, Spring 2006 
  10
 
China’s Trade Surplus with the United States:  
The Role of Exchange Rates 
 
Won W. Koo and Renan Zhuang
1 
 
 
Introduction 
 
Bilateral trade between the United States and China has increased dramatically over the past two 
decades. In particular, China’s trade surplus with the United States has increased steadily with the 
growing trade volume between the two countries. According to the U.S. Census Bureau, China’s trade 
surplus with the United States rose from $0.01 billion in 1985 to $33.79 billion in 1995, and it jumped to 
$161.94 billion in 2004 (Figure 1). China’s imports from the United States have increased only slightly, 
while its exports to the United States have increased sharply since the mid 1990s. 
 
Figure 1. Bilateral trade value between China and the United States. 
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China's Imports
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China's Trade
Surplus
  
Source: U.S. Census Bureau. 
 
China’s recent trade surplus with the United States has led some economists to claim that the Yuan is 
undervalued (e.g., Goldstein 2003; Chang and Shao 2004; Coudert and Couharde 2004). However, this 
opinion is countered by the fact that China’s overall trade surplus (about $30 billion at the end of 2004) 
has not been as large as the surplus with the United States, which implies that China has trade deficits 
with other countries.  
 
China pegged its currency (Yuan or Renminbi) to the U.S. currency at 8.27 Yuan per dollar from 1994 
to July 20, 2005. From July 21, 2005, China has adopted a managed floating exchange rate system 
based on a basket of currencies. The principal currencies in the basket include the U.S. dollar, euro, 
                                                 
1 The authors are Professor and Director and Research Assistant Professor, Center for Agricultural Policy and 
Trade Studies, Department of Agribusiness and Applied Economics, North Dakota State University.   Western Economics Forum, Spring 2006 
  11
Japanese yen, and Korean won. Before 1994, China had used a fixed exchange rate system and a 
double-track exchange rate system in succession. 
 
The objectives of this paper are: (1) to identify characteristics of bilateral trade between the United 
States and China, (2) to examine the effects of exchange rates (exchange rate between the United 
States and China and exchange rates between the United States and other Asian countries) on trade 
flows between the two countries, and (3) to evaluate the roles of other factors (including bilateral trade 
value, market openness in the two countries, and the U.S. foreign exchange reserve) in bilateral trade 
between the countries.   
 
Characteristics of Sino-U.S. Bilateral Trade  
The characteristics of bilateral trade between the United States and China have changed over time. 
Prior to the early 1990s, the pattern was inter-industry trade on the basis of differences in resource 
endowments. The United States exported technology and capital intensive goods (e.g., machinery, 
equipment, and pharmaceutical products) to China and imported labor intensive goods (e.g., apparel, 
clothing, footwear, and furniture) from that country. However, intra-industry trade between the two 
countries has increased significantly since the mid-1990s. A major increase in China’s exports of high-
technology products demonstrates a surge in bilateral intra-industry trade based on product 
differentiation. 
 
In order to gain insight on the bilateral trade patterns, we examine Sino-U.S. bilateral trade in three 
sectors: agricultural commodities (AGR), middle-technology manufacturing commodities (MID), and 
high-technology manufacturing goods (HIGH). The sectors are established on the basis of standard 
international trade classification (SITC) code. The AGR sector includes foods, live animals, beverages, 
and tobacco.  The MID sector includes fertilizers, chemical materials, essential oils, and nonferrous 
metals. The HIGH sector includes metalworking machinery, transport equipment, medicinal and 
pharmaceutical products, and motor vehicles.  
 
As shown in Table 1, Chinese exports to the United States have increased for all three sectors over 
time. However, the country’s export value in the HIGH sector has grown at an increasing rate from 
$4.73 billion in 1989 to $121.12 billion in 2004. The share of China’s exports to the United States in the 
HIGH sector (percentage of China’s export value in the HIGH sector over China’s total export value) 
increased from 39% in 1989 to 62% in 2004. In contrast, the share of Chinese exports in the MID sector 
decreased from 56% in 1989 to 37% in 2004. The export share of the AGR sector decreased from 4% 
in 1989 to 1% in 2004. The changes in China’s exports indicate that the country’s increased trade 
surplus with the United States is due mainly to its rapid increase in HIGH sector exports.  
 
While U.S. exports to China in both the MID and HIGH sectors have increased over time, they have 
grown at a much slower pace as compared to the corresponding imports from China. The share of U.S. 
exports to China in the HIGH sector (percentage ratio of U.S. export value in the HIGH sector over its 
total export value) increased from 38% in 1989 to 51% in 2004. The share of U.S. exports in the MID 
sector increased slightly from 42% in 1989 to 45% in 2004. The export share of the AGR sector 
decreased from 20% in 1989 to 4% in 2004. The HIGH sector has taken the largest share in bilateral 
trade value between the two countries.  
 
Figure 2 shows that the U.S. trade balances with Japan and South Korea have deteriorated, due mainly 
to the appreciation of the U.S. dollar relative to the Japanese Yen and South Korea Won since the 
Asian financial crisis starting in 1997.  This is because goods produced in Japan and South Korea 
became relatively cheap in terms of the U.S. dollar, while goods produced in the United States became 
relatively expensive in these countries. China’s trade balances with Japan and South Korea have also 
deteriorated, since the Chinese Yuan was pegged to the U.S. dollar and appreciated against the Yen 
and Won. China has imported technology intensive inputs and/or processing technology from its 
neighboring countries and used them to produce final products which are exported to the United States Western Economics Forum, Spring 2006 
  12
(called the third country effect). This explains why China’s trade surplus with the U.S. in the HIGH 
sector has increased much faster than in other sectors.   
 
Table 1.  Sino - U.S. bilateral trade value by sectors (in billion US$). 
Year  China’s Exports to the U.S.  U.S. Exports to China 
  AGR MID HIGH AGR MID HIGH 
1989  0.50 6.76 4.73 1.19 2.42 2.20 
1990  0.55 8.69 5.98 0.54 2.08 2.19 
1991  0.49 10.68 7.81  0.41  3.02  2.85 
1992  0.67 13.97  11.02 0.34  2.64  4.48 
1993  0.61 16.86  14.06 0.37  2.08  6.32 
1994  0.54 19.36  18.87 0.42  3.29  5.58 
1995  0.61 21.10  23.80 1.71  4.60  5.44 
1996  0.68 23.21  27.65 0.89  4.71  6.37 
1997  0.76 27.94  33.87 0.58  4.83  7.40 
1998  0.76 30.46  39.89 0.82  4.28  9.15 
1999  0.89 34.38  46.54 0.41  4.57  8.14 
2000  1.06 41.09  57.86 0.50  6.52  9.25 
2001  1.19 42.96  58.20 0.53  6.86 11.84 
2002  1.56 50.37  73.36 0.59  7.92 13.54 
2003  2.04 59.10  91.21 0.93 12.89  14.59 
2004  2.40  73.17  121.12 1.39  15.63 17.68 
Source: U.S. Department of Commerce. 
 
 
Figure 2. Trade balance of the United States and China with Japan and Korea. 
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The U.S. Trade Balance with Japan
The U.S. Trade Balance with Korea
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China's Trade Balance with Korea
China's Trade Balance with Japan
Source: U.S. Department of Commerce and various issues of China Statistical Yearbook (Web site: 
http://www.stats.gov.cn/tjsj/ndsj/). 
 
Empirical Model and Estimation 
 
Empirically, we specify China’s export share in a sector as a function of price differences for goods in 
the sector between the two countries, U.S.-China exchange rate, weighted average exchange rates 
between the United States and other Asian countries, the reserves of U.S. foreign exchange, and 
factors indicating market openness in the United States and in China.  Since the annual time series 
data for prices of goods in individual sectors are not available, we use the bilateral trade value in each 
sector to represent the difference in prices between the two countries. We use the weighted average Western Economics Forum, Spring 2006 
  13
exchange rate between the United States and other Asian countries to examine the effects of these 
countries on U.S.-China bilateral trade (third country effect). Moreover, we use the lagged dependent 
variable to capture dynamics in bilateral trade. The model is in semi-log functional form with all the 
independent variables in natural logarithm form. 
 
Bilateral trade data reclassified according to Standard International Trade Classification (SITC) are 
obtained from the U.S. Department of Commerce online database (Web site: http://tse.export.gov) for 
the AGR, MID, and HIGH sectors. In order to obtain an appropriate number of observations for 
regression analysis, following a suggestion by Feenstra, Markusen, and Rose (2001), we have 
classified the sectors into SITC two digit industries: 14 industries for the AGR sector, 28 industries for 
the MID sector, and 13 industries for the HIGH sector.  The weighted average real exchange rate 
between the United States and the Asian countries is calculated by aggregating the real bilateral 
exchange rates with bilateral trade values as weights for the countries (Web site: 
http://www.ers.usda.gov/Data/exchangerates). Data for gross domestic products, GDP deflators, 
consumer price indices, and reserves of foreign exchange are obtained from the International Financial 
Statistics online database (Web site: http://ifs.apdi.net/imf/about.asp). 
 
The specification of our model has a potential endogeneity problem because the independent bilateral 
trade value variable could be correlated with the error term. To solve this problem, we use the error 
component two-stage least squares estimator (EC2SLS) developed by Baltagi (1981; 2001). Three 
instrumental variables are chosen. The first is the natural logarithm of the sum of real gross domestic 
products of the United States and China. According to studies using gravity type models (e.g., Glick 
and Rose 2001; Rose and Wincoop 2001), the sum of income between two trading countries is strongly 
correlated with trade volume between the countries, but tends to have no effect on the export share of a 
specific country. The second and the third instrumental variables are the natural logarithms of U.S. and 
China consumer price indices.  
 
Results and Discussion 
  
The estimation results
  are summarized in Table 2. All of the estimated coefficients have their expected 
signs and most of them are significantly different from zero, indicating that most of the independent 
variables are important factors in explaining increases in China’s export share.   
 
Table 2. EC2SLS estimation results (dependent variable is China’s export share). 
Independent Variables  Estimated 
Coefficient  Z-value 
U.S.-China exchange rate   0.125
b  2.29 
U.S. - Asian countries exchange rate   0.102
b  2.27 
Bilateral trade value   0.035
  1.25 
Market openness in China   -0.072
  -1.46 
Market openness in the U.S.   0.316
a  2.82 
U.S. foreign exchange   0.093
b  2.48 
Lagged China’s export share   0.453
a  11.49 
Intercept -0.048
  -0.12 
2 R   0.764 
Number of observations  825 
Note: a, b, and c represent significance levels of 1%, 5%, and 10%, respectively. 
 
The estimated coefficient for the U.S.-China real exchange rate variable (ln
ch us
t RE
, ) is 0.123, implying 
that a 1% increase of the real value of the U.S. dollar against Chinese Yuan would lead to an increase 
of at least 0.123% in China’s export share.  
 Western Economics Forum, Spring 2006 
  14
The estimated coefficient for the weighted average exchange rate between the United States and other 
Asian countries is 0.102, implying that a 1% increase in the real value of the U.S. dollar against 
currencies in other Asian countries would lead to an increase of at least 0.102% in China’s export 
share. Appreciation of the Chinese Yuan against currencies of other Asian countries means goods 
produced in the Asian countries will be relatively cheaper in China. As a result, China would increase its 
imports of technology intensive intermediate goods and/or processing technology from Asian countries 
and use them to produce final goods which the country exports to the United States, resulting in an 
increase of China’s export share.  U.S. market openness and the U.S. foreign exchange reserve are 
other important variables affecting China’s trade surplus with the United States.  
  
Conclusion 
 
Our study suggests that the pegged exchange rate system has contributed to China’s increased trade 
surplus with the United States. China has imported intermediate goods and/or processing technology 
from the Asian countries, produced final goods using its cheap labor, and exported those goods to the 
United States. This implies that the new Chinese exchange rate system, in which the Chinese Yuan is 
pegged to a basket of currencies, including the U.S. dollar, may reduce the effects of other Asian 
countries on U.S.-China bilateral trade (the third country effect), and thus may improve the U.S. 
bilateral trade balance with China. Our study also reveals that the U.S. bilateral trade balance could 
improve if the Chinese Yuan appreciates against the U.S. dollar. In addition, U.S. market openness and 
the U.S. foreign exchange are important factors in explaining increases in China’s trade surplus with 
the United States.  
 
References 
 
Baltagi, B.H.  1981. Simultaneous Equations with Error Components. Journal of Econometrics 17: 189-
200. 
 
Baltagi, B.H.  2001. Econometric Analysis of Panel Data, 2nd edition, John Wiley and Sons, NY. 
 
Chang, G.H. and Q. Shao. 2004.  How much is the Chinese currency undervalued? A quantitative 
estimation. China Economic Review 15:366-371. 
 
Coudert, V. and C. Couharde.  2004.  Real Equilibrium Exchange Rate in China: Is the Renminbi 
Undervalued? Paper presented in the 5th international conference of the Association of Public 
Economic Theory, Peking University, August 25-29. 
 
Feenstra, R.C., J.R. Markusen, and A.K. Rose.  2001. Using the Gravity Equation to Differentiate 
among Alternative Theories of Trade. Canadian Journal of Economics 34: 430-447. 
 
Glick, R. and A. K. Rose.  2001. Does a Currency Union Affect Trade? NBER working paper No. 8396. 
 
Goldstein, M.  2003. China’s Exchange Rate Regime. Testimony for U.S. House of Representatives, 
Institute for International Economics. 
 
Rose, A.K. and E. Wincoop.  2001. National Money as a Barrier to International Trade: the Real Case 
for Currency Union.  American Economic Review Papers and Proceedings 91:386-390. 
 

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Does a Currency Union Affect Trade? NBER working paper

Econometric Analysis of Panel Data, 2nd edition,

How much is the Chinese currency undervalued? A quantitative estimation.

National Money as a Barrier to International Trade: the Real Case for Currency Union. American Economic Review Papers and

Real Equilibrium Exchange Rate in China: Is the Renminbi Undervalued?

Simultaneous Equations with Error Components.

Using the Gravity Equation to Differentiate among Alternative Theories of Trade.

China’s Trade Surplus with the United States: The Role of Exchange Rates

China’s Trade Surplus with the United States: The Role of Exchange Rates

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