Beggar-thy-Neighbor Effects of Currency Undervaluation: Is China the Tip of the Iceberg?

This paper examines empirically one of the most popular views in international economics, yet barely tested: undervaluation of the currency is a “beggar-thy-neighbor” policy. It assesses simultaneously the two closely related implications of the beggar-thy-neighbor view: (i) undervaluation of the domestic currency improves the domestic trade balance; and most importantly, (ii) undervaluation of the domestic currency negatively impacts the other countries’ trade balances. Starting from the traditional imperfect substitutes model, we propose an empirical framework allowing the estimation of both the internal and external impacts of currency undervaluation. This framework is then applied to a panel of 62 advanced and emerging markets over the period 1990-2007. The results give strong support to the beggar-thy-neighbor hypothesis. We find that currency undervaluation is robustly and significantly associated with an improvement of the domestic trade balance. We also find that countries that keep their currencies undervalued tend to negatively impact the other countries’ trade balances. Finally, our estimates suggest that the external effect of China’s renminbi, which has been the focus of the profession thus far, might be “the tip of the iceberg”: the latter two results carry over when China’s trade data are excluded from the analysis.