The role of processing trade in exporters' responses to exchange rate: Evidence from China.

Processing trade is an important exporting mode for many countries developed by the export‐oriented industrialisation such as 1960s Japan, 1990s Korea and 2000s China. Exporters who rely on processing trade for foreign profits do not enjoy much market power, and hence care more about exchange rate changes. We develop a model to illustrate how processing trade affects exporters' responses to exchange rate fluctuations. The model suggests that the elasticity of export price with respect to exchange rate for processing‐trade exporters is greater than that of the ordinary‐trade exporters, while the elasticity of export quantity of processing‐trade exporters is smaller compared to their ordinary‐trade counterparts. Most developing countries' governments offer processing‐trade exporters better tax/tariff reduction policy to encourage exporting, which grants processing‐trade exporters additional advantage to adjust more on export price and less on quantity when facing changes in exchange rate and therefore causes their different responses to exchange rate fluctuations. We find strong empirical supports by studying the data from China, which is the largest developing country and biggest processing‐trade exporter. [ABSTRACT FROM AUTHOR]