As expected, the value of the yuan against the euro dominated discussions at Wednesday’s China-EU Summit. In the lead-up to the big day, China Business News asked some experts from the China side whether an undervalued yuan really was responsible for China’s growing trade surplus with Europe

A China-EU Summit is to be held this Wednesday between Chinese and EU officials to discuss key issues ranging from energy to trade, climate change, medicine, regional development, collaboration over the next ten years and investment opportunities in China for EU companies.

In the lead-up to the summit, China Business News talked to Li Gang, director of the European Department at the Ministry of Commerce Academy, Ha Jiming, Chief Economist at the China International Capital Corporation, He Fan, a researcher with the Institute of World Economics and Politics at the China Academy of Social Sciences, David Li, director of the Center for China in the World Economy (CCWE) at the Tsinghua University School of Economics and Management, and Liang Yanfen, director of the centre for WTO studies of the Chinese Academy of International Trade and Economic Cooperation.

China Business News: What are the major nations in China-EU trade, and what products are traded in the highest volume?
Liang Yanfen: Among the EU member countries, Germany, The Netherlands, the UK, France and Italy are China’s main trading partners. According to statistics from China customs, machinery, audio-visual equipment and accessories, metal products, and textiles and garments were the four main categories of exports to the EU in 2006. The main imports from the EU to China in 2006 were mechanical and electronic equipment, audio-visual equipment, cars, aviation equipment, ships and transportation equipment, and chemical products. Trade in these products best uses the strength of both sides.

CBN: What characterizes EU investment in China, and vice versa?
LY: The EU’s investment in China has grown continuously over recent years, as has Chinese investment in the EU. Europe’s investment in China is led by multinationals such as Nokia, BP, Shell, Alcatel and Siemens. By the end of 2006, the EU had invested in 25,450 projects in China worth a total of US$98.03 billion. The EU has become the fourth largest foreign investor in China. Although the total number of investment projects in China are lower than from the US and Japan, EU projects in China are larger on average and have a higher technical level. These projects are mainly concentrated in the production sector, with nuclear power plants, maglev and environmental projects at the pinnacle.

Apart from more conventional investment in trade, sea transport and banking, China’s investment in the EU has been broadened recently with Huawei, ZTE, TCL and Haier venturing into the continent. In 2005, China invested in 23 of the 25 EU member countries. Of the total investment, 27.4% was in wholesaling, retail and manufacturing, 17.1% in agriculture and fisheries, 12.7% in mining and 5.8% in transport and logistics.

CBN: The EU believes that China’s ballooning trade surplus is a result of the yuan parity rate (see explanation of yuan parity rate at the bottom of this article) and is therefore putting pressure on China on currency appreciation. Is this the fundamental problem underlying the China-EU trade surplus?
Li Gang: It is true that the parity rate has, to a certain extent, contributed to the imbalance in China-EU trade, but it is not the significant factor. This year has seen an appreciation of the yuan against the dollar but a slight depreciation against the euro. However, under the current situation, imports from the US have increased by 15% and imports from the EU have increased by 21%. Therefore, it is illogical to attribute the parity rate as the main reason for the China-EU trade imbalance.

He Fan: While many factors contribute to a ballooning China-EU trade surplus, the parity rate is not the ultimate cause. I believe there are several fundamental reasons that play a more prominent role in the ballooning trade surplus. First, China’s exports are unresponsive to changes in the parity rate in the sense that cheap labor and raw material costs are much more important determiners of the cost of Chinese goods. Second, China’s exports are increasingly depending on a new global trade phenomena, the so called intra-industry trade. As long as this global outsourcing and division of labor prevails, China’s processing trade will continue to increase, driving up the trade surplus. In addition, America’s economy is showing signs of deceleration, forcing many Chinese exporters to seek new markets. Therefore, the China-EU trade surplus cannot solely be explained by the parity rate.

David Li: I agree with the statement that there are other fundamental factors that have deepened China's trade surplus with the EU. Europe’s population is aging, while China has a younger economy with a higher savings rate. It is logical, economically speaking, that trade flows from countries with a higher savings rate to those with a lower savings rate. In addition, the trade imbalance is to a certain extent a result of closer trade and economic cooperation between China and Europe. For example, there are more Chinese auto makers importing high-end auto parts from Europe before exporting completed vehicles to Europe. Because trade is in both directions, but value has been added to the Chinese imports from Europe and then re-exported, it is clear that yuan appreciation alone will not fundamentally change the China-EU trade surplus.

Ha Jiming: Globalization has sought out China’s relatively cheap products, and its fast-growing productivity and labor capacity has meant that Chinese exports have risen significantly as a by-product of growing global trade. I also agree that a country’s savings rate plays a key role in its trade structure. China’s savings rate is 30%, which is considered high internationally and even 10% higher than Japan when it was in the process of industrialization. We also expect China’s savings rate to continue to rise, which is closely associated with the high birth rate 25 years ago. It is also a result of the national population policy that convinces the workforce it needs to save for retirement. Therefore, a well-structured social welfare and pension mechanism is needed to reduce China’s household savings rate. However, this needs time. Even if the yuan appreciates significantly, the trade imbalance will remain, or even increase, because of the relative savings rate. Yuan appreciation can only slightly improve this imbalance, at best.

CBN: Can one of you elaborate on the effects of intra-industry trade and processing trade on the China-EU trade structure?
LG: According to Chinese statistics, 95% of the China-EU trade surplus comes from processing trade, of which 81% is generated from foreign-funded processing trade subsidiaries. Judging from this perspective, it is not fair to solely use a trade surplus calculated on end-product trade as the foundation for determining trade interests and te trade balance for both sides.

In terms of trade in end-products, China has a trade surplus with the EU. However, the EU enjoys a trade surplus in service trade, plus great investment returns from its China investments. According to the latest China Trade in Services Report 2007, EU is the largest trade in services exporter to China but just the third largest trade in services importer from China, which makes it the largest source of China’s trade deficit in trade in services. In addition, 70% of EU companies invested in China are profitable, with an average investment return rate at 30% or above.

CBN: EU member states seem to have conflicting opinions about whether the euro should remain strong and whether the yuan should be pressured to appreciate. Why is this?
LYF: EU members have different opinions towards the parity rate issue. Germany, as a trade-surplus country, as well as Scandinavian countries, are not as concerned with the euro's appreciation as France and Italy, which are both countries with a trade deficit. This also shows that the opinions of various EU member states are related to their own national economic development.

CBN: It has been almost three years since the yuan parity rate reforms. How should we view the structural reforms of the parity rate and yuan appreciation?
HJM: We don’t think that the yuan should be appreciated significantly but we should consider allowing it to appreciate at a faster pace. I personally think the yuan should appreciate 5% or more every year, which would definitely help improve the international trade imbalance and relieve domestic inflation pressure. Current inflation is stimulated by rising prices for imported raw materials. Therefore, if the yuan appreciates faster, such inflation would be relieved.

Moreover, yuan appreciation can improve the efficiency of China’s foreign exchange policy. A stiffening parity rate will accelerate foreign exchange reserves. Although China has employed various measures to curb liquidity, the ballooning trade surplus continues to increase foreign exchange reserves. This is one of the key reasons why the M2 broad measure of money supply still increases at 18% or more, despite the central bank hiking reserve ratios and interest rates. As the market is positive towards yuan appreciation, a large amount of non-trade capital floods China.

However, because China’s social security mechanism is weak and there is large pressure on employment, China can not afford to let the yuan suddenly appreciate significantly.

HF: We recognize the need to allow the yuan to appreciate to relieve domestic inflation pressure and increase the flexibility of foreign exchange policy but the question of concern is how. The unexpected forex reform in 2005 affected Chinese companies in the sense that companies were not prepared so their investment and export plans had to be changed suddenly. Competitive Chinese companies should be able to tackle the changes bought by yuan appreciation. However, it is necessary to adjust the yuan parity rate gradually so companies can prepare to minimize the side-effects of a stronger yuan.

DL: It is possible to increase the parity rate’s variability, which will not generate great impact on exporters but can reduce the cost of imported raw materials.

CBN: More parity rate variability seems to be the theme in many of the speeches of central bank chairman Zhou Xiaochuan.
HJM: Increasing the variability of the yuan parity rate will not only reduce the short-term inflow of speculative capital but will also cultivate better competitiveness among Chinese companies. Only when there is a more flexible parity rate can the market be motivated to develop parity rate commodities and risk control tools.

CBN: How do we tackle the China-EU trade-surplus?
LG: Europe needs to reduce export restraints towards China, especially in the field of advanced technology.

HJM: Domestically, China needs to reduce its savings rate by establishing a well-structured social security mechanism, requesting Chinese companies to pay a higher tax on profits, encouraging consumption, optimizing the capital market and raising banking efficiency. Because of the lack of capital market and financing channels, companies usually save most of their profit for development, which significantly increases the corporate savings rate. In addition, export tax rebates on certain products should be reduced.

DL: We can also tackle obstacles at the trade policy level. For example, certain types of cheese made in France are not allowed to be imported to China, and China should consider opening this up. Europe’s cheese production costs are high, but China’s cheese consumption is relatively small. Therefore, we can consider allowing such imports.

HF: It is likely for China-EU trade to become more unbalanced in the future because exports from both China and many EU countries are dominated by manufacturing industries. Further developing intra-industry trade can create a win-win situation. The fashion industry, for example, sees that China’s strength lies in production and that Europe’s in brand and design. There is still much room for cooperation in this industry. Many Wenzhou fashion companies have started to hire European designers to design their products. The same principle applies to the automobile industry. In addition, there should be a better coordination and communication mechanism between China and the EU to prepare to deal with increasing trade conflict in the future.

CBN: Li Gang, as an experienced researcher in European trade, what is your forecast and expectation toward China-EU economic and trade cooperation?
LG: From cooperation on trade in products and services as well as investment, China-EU cooperation will be extended to cover sustainable development, energy safety and environmental protection. At the same time, China and the EU will collaborate more in the international arena, including development aid to Africa, Asia-EU cooperation and at the WTO.

We expect China-EU economic and trade relations will continue to grow quickly over the next few years. By 2010, it is estimated that the total trade volume between China and EU will amount to US$500 billion. In 2007, it will exceed US$300 billion. Trade in services, including transport and logistics, will grow faster.

This article first appeared in Chinese in China Business News on November 26, 2007. The China Perspective takes no responsibility for the accuracy of the original article.

TCP note: The yuan parity rate is set against the US dollar by the central bank and the effective exchange rate is allowed to fluctuate in daily trade by a maximum of 0.5% around the parity rate. Critics argue that the parity rate is an unofficial peg against the greenback; although the yuan officially floats against a basket of curencies, the parity rate is set against the US dollar. The currencies in the basket, and the respective weightings, have never been disclosed publicly.