Before you start complaining, note that China news has been really slow recently. The only stuff going on relates to export product quality, and I am getting really bored with that topic. To be honest, I was never too excited talking about lead paint in the first place.

So I was so bored last night that I took home the latest Asian Development Bank Outlook report, which has been in the news lately with respect to inflation and growth numbers. The report is free for download on the ADB website, if you are so inclined.

Always trying for a different angle, I looked specifically at two sections: China (of course) and a part entitled “Export Dynamics in East Asia” which is just as exciting as it sounds.

The China section contained no huge surprises. The country is growing too quickly and Beijing is finding it difficult trying to manage growth appropriate to specific development goals. Nothing new here, although every time I read about the myriad policy levers that have been pulled (reserve requirements, interest rates, real estate regs) to slow down the economy, to no avail, I get a little nervous.

A couple of specifics. The report discusses two of the most obvious hot spots, or possibly bubbles if you want to go there: real estate and the stock market. This is enough to worry about by itself, but another concern is that many in the PRC have leveraged themselves in order to invest in those markets. If one or both of those markets were to run into significant problems, there are potentially a lot of folks out there who would default on those notes, pushing some banks into dangerous territory. Living in China since 1999, I am quite familiar with the problem of Non-performing Loans (NPLs) and what it takes to clean up banks’ balance sheets. It ain’t pretty, people.

Another issue, and a perennial favorite for China groupies: federalism. Again, this is not a new issue, and in fact is an ancient struggle in this country. However, for those who are not familiar with Chinese history and still see this place as having some sort of monolithic central government, pay attention to this. Despite many years of policy changes and an attempt to assert control over provincial and local governments, Beijing‘s ability to restrain fixed asset investment at the local level remains limited. One stat on this: for the January to June period this year, investment administered by local governments grew by 28.1%, which was half that of the equivalent central government rate. Investment continues to directly benefit local governments, and so we keep getting new factories and shopping malls. 11.5% GDP growth rate in the first half of this year. Yikes!

OK, enough for the China section. On to something even more dry and uninteresting. The section of the ADB report dealing with exports in East Asia is essentially a paper that analyzes “the influence of real exchange rate changes on export performance in 1990 – 2006.” This is interesting for a number of reasons, but for those who follow U.S.-China relations, this is actually important stuff.

Here’s the argument. East Asian economic growth has been characterized by rapid increases in manufacturing-based exports. In the old days, this meant setting up a factory in Japan, which proceeded to build a widget, which was then shipped to the U.S. to be sold to an end user. These days, technology allows MNCs to fragment production so that different stages can take place in different locations, while the whole operation is supported via service links (e.g. logistics operations). The last piece of the puzzle was trade liberalization, which reduced costs and allowed market entry, and has encouraged this unbundling of production phases.

In China, large increases in imports of parts and components have occurred alongside rapid exports of finished manufacturing goods. A lot of these imports have originated from elsewhere in Asia. This is all just another way to say that China has become a manufacturing center, sucking up parts from Asia and sending off finished goods to the U.S. and EU.

Nothing new there, except you tend to hear about a lot of Asian countries these days that are moving closer politically and economically to China as their exports to the PRC increase. This makes sense, but we should not lose sight of the fact that these parts and components manufacturers that sell to China are just as dependent on demand from the U.S. and EU as is China, and any significant macroeconomic instability in the West will eventually have effects back down the supply chain.

So what effect is there on all this from fluctuations in exchange rates? Pretty straightforward: if a currency depreciates, then the imports of those parts and components become more expensive, while the export of finished goods become cheaper. In an economy where the percentage of imported parts and components in finished goods exports is sufficiently high, the rising costs of imports could offset the gains in export demand due to a currency drop.

The ADB report goes on to explain why exchange rate fluctuation may not, therefore, be as significant a factor in decisions on where to locate facilities. Empirical studies are then reviewed, and the results for China (and elsewhere in Asia) suggest that over time, as product fragmentation has increased, the effect of exchange rate changes on exports has decreased.

Two significant things to take away from all this. First, other factors, such as logistics and skilled labor resources, infrastructure, and the general business climate are perhaps more important than we think. Even closer to home for me, what contributes heavily to a supportive business climate? Things like rule of law and protection of intellectual property.

Second, when the rhetoric over exchange rate values and the US-China trade imbalance heat up over the next few months, let’s remember that a mild appreciation of the RMB is not going to mean a corresponding change in export flows.

If anyone has read through this entire post, congratulations on not having a life. Moreover, here’s the painful part: the conclusions regarding the effects of exchange rate fluctuations? Old news, you already knew this stuff. However, this is the first paper I’ve read that cites real numbers and real studies, so for me it solidified my thinking on this issue. I wonder if U.S. Senators Schumer and Graham have read the ADB paper?

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