FOCUS

China in the Global Economy

   The rise of China has been the most outstanding phenomenon in the world economy over the last ten years. China has become the world’s third largest trading power, the second host-country for foreign direct investment, and the second holder of international official reserves.

  The CEPII’s research has amply shown that China’s trade expansion is the result of its strong involvement in the international segmentation of production processes. China has become an assembly country and international processing activities account for 55% of its exports. Production sharing with industrialised Asian economies (Japan, Taiwan, South-Korea, Hongkong) has allowed China to diversify its exports rapidly from textiles to electronics, as industrial firms have transferred the final, labour intensive, stages of production to their affiliates on the mainland. Foreign affiliates in China account for an ever-increasing share of China’s trade (almost 60% in 2004).

   This integration in Asian production networks also accounts for the rapid technological upgrading of China’s trade. The overwhelming share of China’s high-tech exports (75% in 2002) is handled by firms with foreign capital: most of China’s high-tech imports come from Asian countries (70% in 2002) and consist of parts and components. China has thus taken advantage of the globalisation process. But China’s rising importance in world markets, including in technology-intensive products, should not hide the dualism that characterises its manufacturing industries.

   China's internationally competitive industries, which benefit from foreign capital and technology, remain distinct from its traditional industries. They are also largely based on assembly activities, using foreign components. In contrast, China's traditional industries are run by wholly Chinese-owned entreprises and lag significantly behind international competition.

   China’s emergence has also led to the reorganisation of production in Asia and has fostered regional integration. China’s exports of final goods to the US and the EU have expanded rapidly and have given rise to large trade surpluses, while East Asian advanced economies have lost ground in Western markets and have increased their exports of intermediate goods and capital goods to China.

   Overall, the rising share of China’s exports in world markets, together with the accumulation of massive foreign reserves, has harboured increasing suspicions about the potential misalignment of the Chinese currency. Since 1994, the Chinese authorities have maintained a fixed exchange rate regime against the dollar. The bilateral real exchange rate of the yuan has also been rather stable, despite rapid productivity gains and the accumulation of net foreign assets. Yet, a consistent, effective appreciation was recorded up to 2003.

   In order to investigate both the hypothetical misalignment of the yuan and its global impact, the CEPII has developed a project for evaluating real exchange rate misalignments within the Group of Twenty (made up of the G7 countries and large emerging economies). It can be concluded that by the end of 2001, the yuan was indeed undervalued, a situation that has probably continued in the following years. For the time being, it has not been possible to detect Balassa-Samuelson effects in China, probably because of the structural segmentation of the labour market. As a consequence, the effective undervaluation of the yuan is rather limited (5% in 2001), when measured using Chinese data. However, if China were to behave as other major economies (the G20 countries), the yuan would have been undervalued by 16% in 2001. Moreover, the Chinese yuan appears to be especially undervalued against the US dollar, which is also a consequence of the peg on the dollar.

   Pushing the analysis further, this work suggests that the dollar/euro exchange rate would have been close to equilibrium in 2003, had the yuan and other Asian currencies also been close to their equilibrium level. It also shows that the lack of adjustment in China and more generally in Asia tended to magnify the dollar overvaluation in 2001, and to a lesser extent in 2003.

   The diagnosis of Chinese undervaluation is therefore controversial. The country’s exchange rate policy is under pressure, as both official and business constituencies put forward disparate arguments: overheating of the economy, ongoing catching-up that calls for real exchange-rate appreciation, “unfair” cost advantages benefiting the country, or capital controls that artificially back-up the exchange rate regime.

   However, the peg on the dollar has served the country well regarding its economic performance over the last two years. China has achieved strong growth with moderate inflation, and a modest current account surplus. Furthermore, it does not suffer from overall pent-up demand. Its over-investment can better be cured by domestic demand management. The prospect of an appreciation of the real exchange rate is a long-run phenomenon that will come out of a rise in non-traded goods prices accompanying more balanced growth. Due to concerns about the pitfalls inherent in reforming its domestic financial system, however China will rightly open its capital accounts with great care. It will not consider changing the peg too soon and too abruptly.

   Bibliography
   AGLIETTA, M. & RZEPKOWSKI, B. "The Asian Central Banks and the Dollar" La Lettre du CEPII, N°230, January 2004
   BÉNASSY-QUÉRÉ, A. & LAHRÈCHE-RÉVIL, A. "Trade Linkages and Exchange Rates in Asia : The Case of China" CEPII Working Paper N°2003-21, December 2003
   BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A. & LEMOINE, F. "A qui profite le yuan ?" Les Echos, 28 octobre 2003. (Who Takes Advantage of the Yuan?)
   BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A. & LEMOINE, F. "Changement et continuité : le régime de change de la Chine" Politique étrangère 2/2004, été 2004, p.285-297 (Change and Continuation: the Chinese Exchange-Rate Regime)
   BÉNASSY-QUÉRÉ, A., LAHRÈCHE-RÉVIL, A. & LEMOINE, F. "Should the yuan be re-evalued?" La Lettre du CEPII N°227, October 2004
   BÉNASSY-QUÉRÉ, A., MIGNON, V. & LAHRÈCHE-RÉVIL, A.. "Le yuan et le G20" Revue d’économie financière N°77, 2004, p. 127-146. (The Yuan and the Group of Twenty)
   BÉNASSY-QUÉRÉ, A., MIGNON, V., LAHRÈCHE-RÉVIL, A. & DURAN-VIGNERON, P. "Real Equilibrium Exchange Rates: a G20 Panel Cointegration Approach" In: BERGSTEN, F. & WILLIAMSON, J. Eds. "Dollar Adjustment: How Far? Against What?" IIE, November 2004, p. 69-91
   BÉNASSY-QUÉRÉ, A., MIGNON, V., LAHRÈCHE-RÉVIL, A.. & DURAN-VIGNERON, P. "Burden Sharing and Exchange-Rate Misalignments within the Group of Twenty" CEPII Working Paper, N° 2004-13 September 2004
   COUDERT, V., COUHARDE, C. "Real Equilibrium Exchange Rate in China" CEPII Working Paper N°2005-01, January 2005
   LEMOINE, F. "China's Integration in International Production Network" In: BENDE-NABENDE, A. Ed. "International Trade, Capital Flows and Economic Development in East Asia" Aldershot : Ashgate, 2003, p. 121-149
   LEMOINE, F. & ÜNAL KESENCI, D. "Assembly Trade and Technology Transfer: the Case of China" World Development, 2004, vol. 32, n°5, pp. 829-850
   LEMOINE, F. & ÜNAL KESENCI, D. "Investissements étrangers et rattrapage technologique" Revue d'économie financière N°77, 2004 (Foreign Investments and Technological Catching Up)
   LEMOINE, F. & ÜNAL KESENCI, D. "Trade and Technology Transfers: a Comparative Study of Turkey, India and China" CEPII Working Paper N°2003-16, November 2003
   RZEPKOWSKI, B. "Speculating on the Yuan" La Lettre du CEPII N°234, May 2004

ON THE RESEARCH AGENDA

The INGENUE 2 Model

   The initial goal of the INGENUE project was to analyse quantitatively international flows and growth dynamics induced by the differential ageing of the various regions of the world. To this end, a long-term model for the world economy was built jointly by the CEPII, the CEPREMAP and the OFCE. The model describes a multi-region world along the lines of models developed by Obstfeld and Rogoff [1996], in which the structure of each regional economy is similar to that of other applied, overlapping-generations, general equilibrium models (such as Auerbach and Kotlikoff [1987]).

   Several studies were performed with the first version of the INGENUE model, notably in order to analyse the macroeconomic consequences of pension reforms in Europe. Nevertheless, the first version of the model had several shortcomings and it was decided to build a new version. The INGENUE 2 model is now operational and displays several major improvements. In particular, the world is divided into ten regions (compared to six in the previous model) and the demographic part of the model is now built on our own demographic forecasts, based on UN data. The baseline scenario describes the macroeconomic and demographic evolution of the ten regions during the first half of the 21st century.

   Several studies based on the new model are on the research agenda of the INGENUE team. Among them, a reassessment of the macroeconomic implications of the pension reforms in Europe is scheduled. Our purpose is also to shed some light on the debate about immigration into Western Europe. To this end, we will study the macroeconomic consequences of several labour migration scenarios, from the Southern Mediterranean countries especially into Western Europe. The worldwide consequences of a faster increase of total factor productivity (than the one selected in the baseline scenario) in China and India, in particular, will also be forecast.

   With the INGENUE model, we should be able to provide insight into the “standard” macroeconomic consequences of such scenarios (for instance, GDP growth, investment and saving dynamics) but the model also allows us to study the long run consequences for the public pension systems in the different regions.

A Quantitative Assessment of the Impact of the Doha Development Agenda (DDA)

   The agreement reached in Geneva last summer re-launched the WTO’s multilateral negotiations. Following on from work already carried out using Computable General Equilibria for assessing trade liberalisation, the CEPII has launched a study which aims to evaluate fully the economic impact of the trade round in the field of agriculture (market access, domestic support, export subsidies), of market access in industry and services, as well as in the field of trade facilitation.

   Compared to studies which have already been undertaken on this subject, this work will make it possible to assess the overall impact of the multilateral negotiations based on the use of detailed information regarding the bound, MFN, as well as preferential tariffs. Also, we aim at providing realistic simulations of the effects of an agreement on trade facilitation.

   In addition to providing results for the EU25 as a whole and for its main trade partners, the study will provide significantly detailed results for 89 European regions. Accordingly, the economic adjustments which will follow on from trade openness may be tackled and accompanied at the regional level.

Institutional Determinants of Foreign Direct Investment

   Since the late 1990s, the literature on economic development has been renewed by focusing on the quality of domestic institutions as a key explanation of cross-country differences in both growth rates and income per capita (see IMF, 2003 and Acemoglu et al.,2004, for recent surveys). The degree of protection of civil and property rights, the level of economic and political freedom, as well as low levels of corruption have been shown, in particular, to be associated with higher prosperity.

   At the same time, there has been a growing interest in the determinants of foreign direct investment (FDI) in developing countries, as FDI is considered as the most stable component of capital flows to developing countries and can also be a vehicle for technological progress through the use and dissemination of improved production techniques. Not surprisingly, a number of authors have therefore also studied the link between institutions and FDI. Such a link could be seen as one channel through which institutions promote development in the modern era.

   In this study, we contribute to the literature on the determinants of FDI in developing countries, and re-evaluate the role of the quality of institutions on FDI. We improve upon the existing literature in several ways. First, we re-examine the role of governance infrastructure in the host and in the source country, by estimating a gravity equation for bilateral FDI stocks that includes governance indicators for the two countries. Second, we tackle multicollinearity and endogeneity biases by systematically comparing estimations with and without GDP per capita which is likely to be correlated to various measures of institutional quality. This is done by using two-stage estimations, and by instrumenting governance variables when necessary. Third, we look into the detail of institutions by using a new database constructed by the French Ministry of Finance’s network in 52 foreign countries. This database is used to point out in some detail relevant institutional features. For comparability, we look for the most proximate variables in existing databases and compare results when these are used. When possible, panel data estimations are also carried out. Finally, we study the impact of institutional distance on bilateral FDI.

A New Assessment of the Impact of Regional Agreements on Trade Patterns: The Case of the EU

   The influence of regional agreements on trade patterns has been the primary subject of the huge literature using gravity equations to study bilateral volumes of trade. There are dozens of papers in this literature dating back to the early seventies, that is soon after the gravity equation had been applied to international trade for the first time. Researchers have investigated almost all possible regional trading agreements (RTA), looking for positive deviations from the “norm of trade” given by gravity.

   For a while, technical progress in this area has mostly consisted in adding covariates to the set of explanatory variables, in order to provide better control for unobserved characteristics of the bilateral trade between two countries. This is indeed important for the assessment of the impact of an RTA, which usually involves a large proportion of contiguous countries. Omitting this variable, while putting an RTA dummy in a cross-section regression can generate fallacious, positive estimates of trade policy due to an omitted-variable bias.

   More recently, decisive progress has been made in the link between the empirical gravity equation and the different modelling frameworks available in trade theory. Many authors have had tried to take into account the remoteness of trading partners, that is not only their bilateral distance, but also their location with respect to third countries. The improved link with theory should allow such problems to be sorted out by radically improving the norm of trade to which exchanges within an RTA is compared.

   Yet, even with such progress, the reference group to which members of an RTA are compared must be considered. We envision solving this reference group issue using two different methods. First, as what has already been done in the border effect literature, we will consider international trade inside an RTA, not with respect to trade with third countries solely, but will compare these two flows to a third one: trade within countries, which seems to be the natural benchmark of a perfectly integrated economy. Second, we will apply score matching techniques, recently introduced in the trade literature. This involves a two step procedure. In the first step, the probability of becoming a member of the RTA is actually modelled, and in the second step, the trade volumes of actual RTA members are compared to a counterfactual consisting of the most proximate countries possible. That is the situation of a country which is likely to enter the RTA in question, but then does not.

DATABASES

The Worldwide Distribution of Ad Valorem Equivalent, Applied Tariff Duties for Agricultural Products

   The MAcMap-HS6 database, built in cooperation with the ITC (UNCTAD-WTO, Geneva), provides an exhaustive and consistent assessment of ad valorem equivalent (AVE) applied duties for 5,111 products (at the six-digit level of the Harmonised System covering agricultural and non-agricultural products), for 163 countries with 208 partners, taking into account all preferential agreements (see Bouët, A., Decreux, Y., Fontagné, L., Jean, S. & Laborde, D. CEPII Working Paper N° 2004-22). Ad valorem tariffs are taken into account, but so are specific, mixed and compound tariffs, as well as tariff rate quotas. This unique database allows the landscape of world protection to be characterised in detail, not only in terms of average levels, but also in terms of distribution. This is illustrated in the graph below, which represents the worldwide, cumulative distribution of AVE tariff duties for agricultural products in 2001, based on the measurement of AVE protection applied by each country to each partner, separately for each product (for a similar graph on non-agricultural products, see Bouët et al., op.cit.). This is done using two different metrics. The first one (the red curve) measures the share of world agricultural imports facing less than a given level of AVE tariff. The graph below shows, for instance, that approximately 40% of world agricultural imports are free of duty.

   But imports are not independent of protection, and it is likely that the remaining 60% of world agricultural imports that face non-zero duties would be larger, were protection to be removed. This is why the distribution is also characterised using the MAcMap weighting scheme. This weighting scheme is built up in MAcMap for the sake of aggregation, based on a clustering of countries into five reference groups, gathering similar countries in terms of GDP and openness. Instead of bilateral flows from the importer to the exporter, MAcMap weights are calculated as trade flows from the exporter towards the reference group the importer belongs to. The endogeneity bias is thus minimised. Using this weighting scheme, the share of duty-free imports for agricultural products worldwide appears to be only slightly above 30%.

   The way this distribution is measured thus makes a significant difference. Whatever the metric used, however, this graph highlights the strong skewness of protection across the world, with a small proportion of world products and markets accounting for a large part of world average protection. This is especially clear in agriculture, and this finding suggests that granting even limited flexibility (as measured through the number of goods) can strongly undermine the impact of any liberalisation agreement.

Worldwide Cumulative Frequency of Ad Valorem Equivalent, Applied Tariff Duties for Agricultural Products, 2001
(% of world imports or of world reference group imports)

EVENTS

Tax Competition in the EU25

   The lively debate on tax competition in the European Union illustrates a vast academic literature discussing the risk of a sub-optimal production of public goods (including inter-personal redistribution), in a world where capital is perfectly mobile whereas labour, especially low-skilled labour, is not. This risk is to be balanced against the gains from putting some pressure on national governments to raise public sector efficiency.    The issue of tax harmonisation was re-launched by the European Commission’s proposal, in 2001, to move towards a harmonisation and a consolidation of corporate tax bases within the European Union, and more recently by EU enlargement to low-tax countries. The CEPII and its Business Club felt that the existing theoretical as well as empirical literature on the subject were perhaps not used enough in the policy debate. This was the prime reason for bringing together high-level researchers working on these issues at both the academic and the policy-relevant levels. The conference took place in Prague on December 16-17, 2004, hosted by CERGE-EI. It was organised within the TAXBEN project held under the 6th Framework Programme of the European Commission, and also received support from the CEPII’s Business Club and from the Institut CDC pour la Recherche.

   During the first day the results of the academic literature were examined on the basis of four different themes: the scope for tax competition, the impact of taxation on the location of firms, tax avoidance and the scope for tax harmonisation. Detailed analyses of the nature of tax competition, on its extent, on its consequences as well as on the scope for tax harmonisation were provided by: Alexander Klemm (Institute for Fiscal Studies, London), Patrick Artus (IXIS, Paris), Clements Fuest (University of Cologne), Jouko Ylä-Liedenpohja (University of Tampere), Ruud de Mooij (CPB, The Hague), Amina Lahrèche-Révil (CEPII), Marius Brülhart (University of Lausanne), Andreas Haufler (University of Munich), Sam Bucovetsky (University of York) and Jacques Thisse (CORE, Université Catholique de Louvain).

   The second day was devoted to policy issues. It started with a view of taxation in the EU15 and in new member states. Then, the pros and cons of the EC proposal (concerning the harmonisation and consolidation of tax bases) were discussed. Henk Vording (University of Leiden), Ludomir Lizal (CERGE-EI, Prague), Witold Orlowski (NOBE, Warsaw) and Olev Raju (University of Tartu) provided EU-wide as well as country views of tax strategies in the EU. Carola Maggiulli (DG Taxud), presented the European Commission two-tier proposal issued in 2001. Marcel Gérard (Fucam, University of Mons) discussed the proposal through illustrative simulations. The day ended with a roundtable discussion on tax coordination which brought together Thiess Buettner (Munich University), Steve Bond (Institute for Fiscal Studies, London), Michaela Erbenova (Czech National Bank, Prague), Daniele Franco (Banca d’Italia, Rome), Witold Orlowski (NOBE, Warsaw) and Jean Pisani-Ferry (University Paris-Dauphine). Lionel Fontagné (CEPII) was the moderator.

   Productivity and Monetary Policy

   The 4th Economic Policy Forum, organised by the CEPII, the Banque de France and the IDEP, took place on the 19 January, 2005 at the Banque de France.

   The meeting was focused on the policy implications of a (stable) rise in the productivity growth rate, in the light of the recent experience of the US economy. The invited speakers were Professor Alan Blinder (Princeton University), Christian Noyer (Banque de France Governor) and Olivier Garnier (Director of the Strategy and Research Department, SGAM).

   Prof. Blinder identified three different conceptual issues: i) the rise in productivity growth is recognized by everyone: in this case the money supply should grow at the same rate as productivity. An expansionary monetary policy should not then be inflationary since demand effects are completely offset by supply ones. ii) The rise in productivity growth is recognized only by the Central Bank: nominal wages do not increase faster than usual, the Central Bank faces a (pleasant) choice between lower unemployment and lower inflation. iii) The rise in productivity growth is recognized by no one: the Central Bank does not provide enough liquidity, employment falls. Prof. Blinder argued that the US experience of the 1990’s was somewhat comparable to the second case above.

   Governor Noyer stressed that, generally, productivity shocks are identified with a lag. However, the monetary authority should avoid making the opposite mistake, which proves to be even more costly: i.e. identifying a shock that did not occur. Thus, from a normative point of view, he suggested that a “ pragmatic practice” should be favoured, relying on the monitoring of a broad set of inflationary sources.

   Olivier Garnier stressed that Central Bankers should not only be concerned with the impact of productivity growth on inflation. In the medium term, in fact, a productivity shock may result in a wedge between the actual real interest rate and the ‘natural’ real interest rate. The gap between the two might be a cause for financial imbalances (i.e. asset price bubbles, over-investment and under-savings), albeit with contained inflation.

The CEPII Business Club's Meetings

   Series of meetings on China: Fault Lines in the Chinese Economy and Society

   For 25 years or so, China has been one of the world’s fastest growing economies and its population has experienced an unprecedented rise in average living standards. For the most part, this has gone together with social stability and political continuity, particularly over the 15 years since June 1989, when the military cleared the centre of Beijing by force and the “Party elders” dismissed then the General Secretary of the Party. To the extent that there is a causal relationship between them, the massive reduction in poverty in the train of economic growth has enhanced social stability. However, historically the relationship between economic growth and stability has not been one-way (see Huntington, 1968). The dramatic economic performance has also been accompanied by the appearance of fault lines running through the society, with development producing stresses and strains of varying magnitudes. Among others, these include the emergence of wide and visible economic inequalities, a sharp rise in unemployment, as well as the appearance of a large population of migrants in towns and cities who are treated as “outsiders”. Furthermore, protests and defiance of authority, albeit localised, are a commonplace.

   This meeting, held on 14 January 2005, opened the CEPII Business Club’s series of conferences on China. Dr. Athar Hussain, Deputy Director of the Asia Research Centre of the London School of Economics has been researching the Chinese economy for more than 20 years. He has frequently visited China, Hong Kong and Taiwan and has been a counsellor to the government of the People’s Republic of China, as well as to several international organisations such as the World Bank, the Asian Development Bank and the United Nations Programme on Development. He is a member of the group of experts nominated by the World Bank to see through: i) reform projects of state enterprises and; ii) the reorganisation of the electricity industry. Dr Hussain is presently a counsellor to a British government project on unemployment insurance in China.

   Dr Hussain set out the various sources of tensions which are accompanying China’s economic development: the aggravation of income inequalities, massive migration and urbanisation, a banking system saddled with bad debts, ethnic divisions, environmental degradation, as well as the coexistence of single-party rule and a market economy. He concluded by outlining the probabilities of a crisis and the government’s capacity to manage it.

   Low Cost, Low Fare

   There are ever-more “low cost” airline companies and the price wars they have triggered across the world are fiercer and fiercer, leading to risks of a major restructuring of the air transport sector and its allied services, with on-line reservations becoming the rule.

   Tougher competition is however not limited to the airline companies. Rail companies are also now offering “low cost” TGV trains, with attractive prices.

   This is likely to lead to a complete reorganisation of transport systems over the next fifteen years, in France, in Europe and throughout the world, benefiting new customers.

   Are “low cost” / “low fare” services at a long-standing turning point which will lead these sectors to restructure? Or will some of the low cost companies go out of business, as has already happened to Aeris and Air Lib?

   On 9 February 2005, the CEPII’s Business Club invited several experts to discuss these issues. Michel Lénez (Air France) analysed the new environment facing air travel, and its consequences for all transport activities and for users. Antoine Cachin (ITAC) and Stéphane Fargette (Easyjet) also gave the points of view of “low cost” carriers and of passengers.

IMF in Theory: Sovereign Debts, Judicialisation and Multilateralism
No 2004- 21 December

   The paper argues that the successive regimes for restructuring sovereign debts have been shaped by the linkages existing between three institutional functions: information gathering and economic expertise, then third-party mediation, and lastly policy enforcement, also called conditionality. While these functions were integrated within the Fund during the 1980s’ debt crisis, mediation has now been outsourced, under the pressure of the demand by the private sector for a thorough judicialisation of the restructuring process. Two responses to this demand have been formulated: the creation of a supra-national “bankruptcy court”; and the reliance upon national courts, specifically those under the jurisdiction of which the initial debt contracts had been signed.

To mark the 100th anniversary issue of Economie Internationale, the CEPII is very pleased to welcome contributions by leading authors in international economics and by key policymakers.

No 100, 4th Quarter 2004

Présentation
Lionel Fontagné

Declining international inequality and economic divergence: Reviewing the evidence through different lenses
François Bourguignon, Victoria Levin & David Rosenblatt

Croissance endogène et réduction de la pauvreté
Philippe Aghion & Beatriz Armendariz de Aghion

Global imbalances and the lessons of Bretton Woods
Barry Eichengreen

The dollar/euro exchange rate
John Williamson

Architecture financière internationale: au-delà des institutions de Bretton Woods
Michel Aglietta

Recent developments in macroeconomic analysis: Reviving the case for stabilisation policies
Jean-Philippe Cotis

New perspectives on the benefits of exporting
David Greenaway & Richard Anthony Kneller

The dilemma of globalisation: A German perspective
Hans-Werner Sinn