The roles of vehicle currency and real effective exchange rate in China's trade with the whole EU

Abstract

Devaluation of domestic currency is traditionally believed to foster a country’s trade balance. Innumerable papers have attempted to scrutinize the exchange rate-trade balance nexus in many countries across the globe, yet their conclusions diverge as they utilize different data, time frames, and methods. Most of them share the same weakness: disregarding the role of vehicle currency. Even though the literature about China is relatively large, no study has scrutinized the asymmetric impacts of vehicle currency and real effective exchange rate on China’s total trade balance with the entire EU. This research gap is especially notable in the circumstances that the EU has surpassed the USA to become China’s largest trading partner, and USD is the vehicle currency heavily employed in China-EU trade. This article aims to fill the aforesaid gap by applying the nonlinear ARDL method to investigate how USD as a vehicle currency, alongside real effective exchange rate, asymmetrically influences China’s trade balance with the whole EU. The empirical results indicate both long-run and short-run asymmetries in all models, and China’s trade balance reacts differently to the two kinds of exchange rates. The findings are robust in the EU-28 and EU-27 cases, and some useful implications are provided for policy-makers.