China’s Gradual Opening to Trade Naughton notes (page 378) “in perhaps no other sector of the economy has the pattern of sustained incremental and cumulative reform been as obvious and the outcomes so unambiguously positive for the Chinese economy as in the foreign trade sector,” The chart to the right says a lot. China was largely closed to trade at the beginning of reform. One aspect of this starting point is that at the beginning of reform, there were large potential gains from trade for China. Trade growth was steady and accelerated after the late 1990s.

Potential Gains from Trade Opening

1. Productivity gains from specialization according to comparative advantage (switch workers from production of

steel to the production of textiles)

2. Productivity gains from adoption of new technology and knowledge transfers (from foreign joint ventures)

3. Productivity gains from taking advantage of scale economies (expanding production to not only serve domestic

markets but foreign markets as well.)

4. Consumer gains from appearance of new products, greater product variety, and increased competition

Potential Dangers from Trade Opening

1. Losers from trade according to comparative advantage (recall Heckscher-Ohlin Theory and the Factor Price

Equilization Theorem)

2. “Spiritual Pollution” from foreign ideology (e.g. Christians and Hollywood)

3. World Price shocks

Reasons for Opening

1. Lessons from the Great Leap Forward (losses from efforts to be self sufficient)

2. “Learning Truth from Facts” – Advances made by Singapore, Hong Kong, and Taiwan

3. Failure of PRC oil exports to earn sufficient foreign exchange to finance imports needed to supplement planned

production

Early Moves to Open the Trade Sector (1978 to early 1990s)

1. Special Economic Zones (“One Country, Two Systems”)

In 1979, Chinese government officials visited Singapore, an exported driven city state. Using the Singapore model, starting in

1980, China opened several SEZs in southern China close to Hong Kong (and Taiwan). Producers in these zones could import

materials and components free of many

regulations and tariffs. The Chinese government

also provided substantial subsidies for

infrastructure. In 1984, China established similar

arrangements in 14 other coastal cities. This fits

in with other policies noted along with the term

“One Country – Two Systems”.

2. The Double Air Lock (see Naughton around pages 380-381) From 1986 to the mid 1990s, China used a dual currency system. Chinese could legally hold and transact only in RMB (people’s

money). Foreigners and imported products could use Foreign Exchange Certificates. And, only state companies (12 FTCs) that

were approved and part of the economic plan

had the right to engage in trade. Domestic

prices remained set by the government and

were insulated from world prices.

a. One Country – Two Currencies

b. Monopolization of Trading

Companies

Throughout the 1980s China continued to restrict the rights to engage in trade. Still, that was an increase in the number of firms allows to conduct international trade, from 12 in 1978 to 5000 in 1988. At the beginning of the reform an enterprise could only export through one of the 12 state trading companies. The state trading company would earn foreign exchange and pay the enterprise in Chinese RMB. Any profits remained with the state trading company. Over time, enterprises were allowed to contract with a larger set of trading companies and would receive portions of the profits from trading.

1978-93: Dual exchange rate (FEC & RMB) From 1986 to the mid 1990s, China used a dual currency system. Chinese could legally hold and transact only in RMB (people’s money).

Foreigners and imported products could use Foreign Exchange Certificates.

RMB

FEC

Exchange Rate Devaluation

Like most other planned “socialist” economies, the China’s exchange rate was overvalued at the beginning of the reform. The

overvalued exchange rate subsidized the importation of capital goods needed for the economic plan. It also led to an excess

demand for foreign currency, a rigid system of controls, limitations on who could legally hold foreign exchange, and a vibrant

black market.

During the 1980s, Exporters were helped by a substantial devaluation of the official exchange rate, from 1.5RMB/$ in 1981 to 8.3RMB/$ in

1995. While China did experience higher rates of inflation than the US, the IMF states that this represents 70% devaluation in real terms.

Naughton doesn’t focus on exchange rates, however the discussion of trade policy must keep in mind the exchange rate set by the

central government (pegged to the US$). This rate is always operating in the background to influence trade. In summary, the Chinese

exchange rate was set such that

RMB is overvalued until around 1998-2000.

RMB is undervalued from around 200-2002- present

Equilibrium Rate

(Dr. H’s Quesstimate

Tariffs

Tariffs actually increased during the early 1980s. This was part of a longer term strategy of first turning non tariff barriers into

tariff barriers (tariffication), and then, reducing the tariffs en route to ultimate membership in the WTO (finished in 12/2003).

While China’s tariffs were high in the early 1980s, they were not unusually high for a developing country.

Exports (1989-1995)

1. After 1979, exports grew rapidly as

existing opportunities were exploited

more fully and the need of earn foreign

exchange was given priority.

2. The major export of china was

originally petroleum.

3. The trend shifted from natural-

resource based products to labor-

intensive products (apparels, toys).

Early Trade Patterns (1980s-1995)

Note from the data above that early in the reforms, the trade pattern between the US and China fits with our stereotype of trade based on

comparative advantages arising from differences in factor endowments. China is abundantly endowed with labor and exported products

requiring labor intensive production. This includes textiles, toys, and lower level electronic goods assembly. China’s exports of petroleum

continued to fall.

The US exported goods requiring land intensive production (wheat) or capital intensive production (aircraft and computers). Also note the

volatility of some of China’s imports (wheat, cotton).

Modern Trade Patterns.

Note the emergence of higher tech assembly products (computer and communication equipment) among China’s leading exports. This

reflects the emergence of “export processing” oriented trade…a worldwide trend. (Refer to the links to export processing). The final

assembly of these products includes components imported from other countries and so the export numbers overstate China’s contribution

(the assembly) to the value of the product. For example, China takes $300 of imported computer components, assembles a computer in

China, and exports the computer for $500. In this example, China’s contribution to the product is $200, but the export is entered as a $500

export.

Chinese Imports from the US reveal an interesting point: The largest categories of US exports to China are aerospace, “waste and scrap”

and electronic components. This pattern still reflects US comparative advantage in capital intensive products, and also the US abundant

endowment of recycled waste (cardboard, aluminum, and steel from junked autos).