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Appendix III Import Demand in China

Author(s):
David Burton, Wanda Tseng, Kalpana Kochhar, Hoe Khor, and Dubravko Mihaljek
Published Date:
September 1994
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Since the inception of the process of opening up to the outside world in the late 1970s, the rote of external trade in China’s economy has grown dramatically.106 China’s foreign trade over the past 15 years has been characterized by an emphasis on the promotion of exports to generate foreign exchange, coupled with a relatively restrictive and managed import regime—although, as discussed in Section II, the trade system has been progressively liberalized. Despite this emphasis, however, the average growth rates of exports and imports between 1980 and 1992 were broadly similar—export growth averaged 28 percent, while imports grew at an average rate of 23 percent. The share of total trade in China’s GNP, as well as China’s share in total world trade, has risen sharply.

Three features are discernible from an examination of the development of China’s imports during 1978–92. First, the share of food items declined markedly, as did the share of other primary products. Correspondingly, the share of capital (machinery and transportation equipment) and intermediate goods rose steadily, from 25 percent of total imports in 1980 to nearly 40 percent in 1992 (Chart 14). The share of consumer goods fluctuated, probably associated with the tightening and loosening of import controls, but remained under 5 percent throughout the 1980–92 period.

Chart 14.Commodity Composition of Imports

(In percent of total imports)

Source: Almanac of China’s Foreign Economic Relations and Trade, 1992/93.

Second, the role of the import plan has declined steadily throughout the reform period. In the early years, the bulk of China’s imports were undertaken in accordance with the trade plan, which was used to ensure adequate supplies of food, raw materials, and intermediate and capital goods. Quantities imported were determined largely through a “gap-filling” exercise, rather than on the basis of relative prices or quality. In the early 1980s, over 80 percent of food and intermediate goods were imported under this plan. By 1991, only one half of food imports and two thirds of intermediate and capital goods imports were covered by the import plan.107 However, notwithstanding the reduction in the role of the plan, China’s import structure exhibited significant management and control on the part of the authorities. Moreover, the exchange system was used until very recently to control importers’ access to foreign exchange and influence the composition of imports.

Third, China’s trade flows—especially its imports—have exhibited considerable volatility in connection with the macroeconomic cycles and the concomitant intensification and relaxation of import controls (Chart 15). During upswings in the cycles, imports would rise rapidly, leading to a widening trade deficit and a deterioration in the balance of payments. The subsequent clampdowns on credit, investment, and imports would lead to sharp declines in imports.

Chart 15.Exports, Imports, and Foreign Exchange Reserves

Sources: Chinese authorities; and IMF staff estimates.

The aim of this study is to estimate the long- and short-run determinants of China’s imports by applying the cointegration and error-correction approach to time series analysis. In the next part of this appendix, the issues involved in specifying and estimating an import function for China are outlined, and results of diagnostic tests of the data are provided. In succeeding parts, the results of the estimation procedure are discussed, and a summary and conclusions are presented.

Issues in the Specification and Estimation of an Import Function

Model Specification

Traditionally, import demand models have specified imports as functions of relative price and activity variables, such as GNP or industrial production. However, for many developing countries, foreign exchange constraints can be an important factor in the determination of imports. Government policy in the face of foreign exchange shortages can include changes in the exchange rate and the imposition of tariffs or quantitative import restrictions, which affect both the relative price of imports—and more directly—the volume of imports. Thus, it has been argued that a variable such as foreign exchange reserves or foreign exchange earnings should be used as an additional explanatory variable in the import function (Hemphill (1974), Saracoglu and Zaidi (1986), and Moran (1989)).

Hemphill (1974) explicitly specifies a quadratic cost function defining the cost of adjusting actual imports to the long-run desired level of imports, in order to justify the use of a partial adjustment model. His theoretical rationale for including foreign exchange reserves in the import function is that, in general, most developing countries experience an almost persistent excess demand for foreign exchange. Thus, changes in relative prices and activity affect imports only indirectly through changes in foreign exchange earnings. In the presence of quantitative restrictions, import demand can change with no change in relative prices or activity, reflecting instead changes in the restrictiveness of import controls.

Moran (1989) specifies an import model that includes both traditional activity and relative price variables, as well as indicators of import “capacity,” such as foreign exchange reserves. The present study follows Moran’s generalization of Hemphill’s model by including relative prices, activity, and foreign exchange reserves as explanatory variables in the determination of import volumes. The function estimated below can be seen as the import decision rule of the authorities, rather than as a “pure” import demand function. The estimated function takes the following form:

where M is the value of imports, Pm is the price of imports in domestic currency, Y is an index of real economic activity, P is the domestic price level, and FX is the level of foreign exchange reserves.

Estimation Procedure

The model has been estimated using an approach to cointegration and error correction developed by Engle and Granger (1987) and Johansen (1988). The idea behind the concept of cointegration is that, even though level variables are individually nonstationary, special linear combinations of these variables can be stationary. In these cases, the long-run components of the series cancel each other out to produce a stationary series; these variables are then said to be cointegrated. The cointegration of variables implies that there is an adjustment process that prevents the deviations from the long-run relationship from becoming larger and larger. This process is referred to as the error-correction mechanism. Johansen (1988) and Johansen and Juselius (1990) have argued that, in a multivariate model, more than one cointegrating relationship may exist. They have developed a maximum likelihood estimation procedure that fully captures the long-run relationships among the variables and provides estimates of all possible cointegrating vectors.108

Quarterly data from 1981 to 1991 have been used in this study. Data for the value of imports, foreign exchange reserves, and the exchange rate have been obtained from the IMF’s International Financial Statistics; the unit value index for imports in U.S. dollars has been calculated by Brender (1992); and data on industrial production and retail prices have been provided by the Chinese authorities.

Before estimation, the data were tested for unit roots, and the pattern of Granger causality between the variables was examined. Unit root tests (Table 18) indicate that import volumes (m), foreign exchange reserves (r), industrial output (y), and relative prices (p) are integrated of order 1 (in shorthand notation, I (1)). Chart 16 plots these variables.

Table 18.Unit Root Tests
Variables(k.n)1ADF2 (k.n)p-value3
m43.1–2.0650.59
r43.1–3.0780.23
y43.1–2.6120.39
p43.1–2.2600.48
Δm42.1–6.7740.00
Δr42.1–4.9800.00
Δy42.1–8.2560.00
Δp42.1–7.8400.00

k denotes the degree of freedom, and n denotes the number of 1(I) series to be tested.

Augmented Dickey-Fuller test.

The p-values are the probabilities of accepting the null hypothesis.

k denotes the degree of freedom, and n denotes the number of 1(I) series to be tested.

Augmented Dickey-Fuller test.

The p-values are the probabilities of accepting the null hypothesis.

Chart 16.Indices of Imports, Industrial Production, Foreign Exchange Reserves, and Relative Prices

(Base year=100; logarithmic scale)

Source: IMF staff estimates.

The results of the Granger causality tests of the variables in the model are shown in Table 19.

Table 19.Granger Causality Tests
NullHypothesis1LM(3,27)2p-value
Δrdoes not → Δm3.2910.04
Δmdoes not → Δr1.1440.35
Δydoes not → Δm2.8090.06
Δmdoes not → Δy4.1810.01
Δpdoes not → Δm1.9720.14
Δmdoes not → Δp1.2340.32

x → y denotes that, using Granger’s methodology, x causes y. The p-values represent the probabilities of accepting the null hypothesis.

Lagrange multiplier test.

x → y denotes that, using Granger’s methodology, x causes y. The p-values represent the probabilities of accepting the null hypothesis.

Lagrange multiplier test.

With respect to the implied relationship between imports and foreign exchange reserves, use of the Granger test indicates that the current period change in imports is caused by lagged values of the change in foreign exchange reserves. This would suggest that changes in foreign exchange reserves triggered the tightening or relaxation of import controls.

The data also suggest that there is a feedback relationship between imports and industrial output. Given the large share of intermediate and capital goods in China’s imports and the use of quantitative controls to restrict imports and influence their composition, it is not surprising to find causality flowing from imports to industrial production.

Finally, the data indicate only a weak causal relationship in either direction between relative prices and imports. It is not surprising to find that the Granger test does not show that China’s imports “cause” relative prices; the failure of relative prices to cause imports on the basis of that test may be explained by the relatively significant, albeit declining, role of the import plan. It is possible, of course, that there is a statistically significant contemporaneous relationship between relative prices and imports.

Cointegration Analysis Using Johansen’s Approach

Estimating the Long-Run Relationship

Johansen (1988) and Johansen and Juselius (1990) have shown how to calculate maximum likelihood estimators for the coefficients of all possible cointegrating vectors.109 They have also presented two likelihood ratio tests of the number of possible cointegrating vectors among the variables of interest. This study uses these to test for the number of cointegrating vectors for imports, industrial output, foreign exchange reserves, and relative prices; it concludes that there exist two cointegrating vectors among these variables. The coefficients of one of these vectors have the expected signs; based on this vector, the long-run elasticity of imports with respect to industrial output is 0.5, while that with respect to relative prices is about –0.3.110 The foreign reserve elasticity of imports is estimated to be about 0.3, suggesting that, in the long run, imports depend positively on the level of foreign exchange reserves.

Short-Run Behavior of Imports

This study utilized a general-to-specific model selection technique to get the error-correction model. The unrestricted model was specified as

where EC denotes the error-correction term based on the cointegration regression using Johansen’s approach. A testing-down procedure is used in which insignificant lags are dropped, and the following parsimonious representation is obtained:

The estimation results are reported in Table 20.

Table 20.Estimated Error-Correction Model
VariablesEstimated

coefficient
Standard

error
t-statisticp-value
constant–0.980.67–1.470.15
Δr–0.340.18–1.890.07
Δy1.770.762.340.03
Δp–0.680.32–2.170.04
EC(–1)–0.150.11–1.390.17
R2 = .76, Adjusted R2 = 0.71, Durbin-Watson statistic = 2.09
R2 = .76, Adjusted R2 = 0.71, Durbin-Watson statistic = 2.09

The estimated parameters suggest that the short-run behavior of imports is dominated by developments in industrial production. In particular, the short-run elasticity of imports with respect to industrial production is considerably higher than its long-run value. One possible interpretation of this result is that, in the short run, and in the absence of domestically available substitutes, an increase in economic activity tends to lead to a surge in imports, particularly of intermediate and capital goods. The lower long-run elasticity suggests that import substitution may be significant over longer periods of time.

The results also suggest that, contrary to the long-run results, a decline in foreign exchange reserves leads to a rise in imports in the short term. These dynamics can be explained by the fact that the upswing of a cycle usually corresponds to a conscious decision by the authorities to ease access to foreign exchange for imports, reflecting the continued reliance on administrative means to control imports. The significant negative relationship between changes in relative prices and import demand in the short run suggests that, in line with the increasing market orientation of the economy, import demand is quite sensitive to price changes.

Summary and Conclusions

This appendix has examined China’s imports as a function of real activity, relative prices, and foreign exchange reserves—the latter as a proxy for the use of quantitative import controls. The diagnostic causality tests suggest that foreign exchange reserves do “Granger cause” imports. Using a cointegration and error-correction methodology, this model separates the underlying long-run from the short-run relationships among the variables. Based on Johansen’s approach and the likelihood ratio tests, one cointegrating vector with the expected signs is found. The results suggest that the output elasticity of imports is considerably smaller in the long run than in the short run, implying that some import substitution has taken place over time in China. They also show that imports depend positively on the level of foreign exchange reserves and negatively on relative prices in both the short and long run. The short-run relationship between imports and foreign exchange reserves is consistent with the import and exchange regimes that prevailed during the period under study, which relied in part on administrative means to limit imports. The results also suggest that relative prices have played an important role in influencing import demand, even in the short run.

References

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106For a more detailed discussion of China’s reforms and the process of integration into the global economy, see Bell, Khor, and Kochhar (1993), For details of China’s foreign trade regime and issues in foreign trade reform, see World Bank (1994) and Section II above.
107The mandatory import plan was abolished in 1994 and replaced by a guidance plan.
108A fuller description of the methodology underlying cointegration and error-correction analysis, as well as technical details regarding the diagnostic tests, is contained in Appendix IV and in Yuan and Kochhar (1994).
109A brief discussion of the Johansen methodology can be found in Annex I) to Yuan and Kochhar (1994). Other examples of studies using Johansen’s approach are Coe and Moghadam (1993). and Hall (1989).
110Brender (1992) estimated import functions using sectorally disaggregated quarterly data from 1981 to 1990 and found higher income elasticities (ranging from 1.22 to 1.47) than in this paper and somewhat higher price elasticities (ranging between –0.36 and –0.6). He found that, in a sample of commodities that excludes advanced technology machinery and electronic goods, imports depend positively on foreign reserves. Sekiguchi (1990) used annual data from 1960 to 1986 and found an income elasticity of imports of 0.87, with the price elasticity not statistically significant from zero. However, as his sample spans the period before and after the inception in 1978 of market-oriented reforms and opening up to the outside world, a comparison between his results and this study’s is not appropriate.

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