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This paper is an empirical investigation of the effect of RMB-JPY volatility on Japan-China trade with a special emphasis on the impacts of the reform of the RMB exchange rate regime implemented on July 21, 2005. We estimated two types of volatility measures (one based on the ARCH model and the other the usual standard deviation) utilizing daily data from Jan. 2002 through Dec. 2011 and examined both short-run and long-run effects of this volatility on exports of each country to the other with an ARDL approach. The results indicate that Japan's exports to China are not affected by the exchange rate volatility, but China's exports to Japan are negatively influenced during the reform period. Furthermore, the level of the exchange rate has no influence on Japanese exports, but it has a significant impact on Chinese exports. This asymmetric result may be due to differences in the depth of financial markets and in the maturity of exporters of the two countries.

On July 21, 2005 China scrapped the de facto dollar peg and adopted a managed floating system linked to a basket of major currencies. At the time of this reform, the maximum daily rate of change in the RMB-USD exchange rate was set at 0.3% per day, but it was expanded to 0.5% on May 21, 2007 and further to 1.0% on April 16, 2012. These expansions in the admissible range of exchange rate changes lead to potentially higher volatility which may have adverse effects on future uncertainty to export/import industries. Hence arises a question whether this has deterred Japan-China trade. The purpose of this paper is to analyze the effects of exchange rate volatility on trade2 between Japan and her largest trading partner, China.3 This is carried out in relation to the reform of the exchange rate regime of July 2005. We are especially interested in investigating whether or not the reform made the effects of volatility on trade stronger. There is a massive body of literature which analyzes empirically as well as theoretically the relationship between the exchange rate volatility and trade. Major results of theoretical analyses include: (1) a rise in the exchange rate volatility increases the firm's cost of risk bearing, reducing trade if the firm does not have a sufficient means of hedging opportunities in a futures market (see e.g. Clark, 1973, Ethier, 1973 and Hooper and Kohlhagen, 1978); (2) if the exchange rate volatility lowers future profitability, the firm may attempt to compensate by increasing production and sales, resulting in a larger quantity of trade (see e.g. Franke, 1991 and Sercu and Vanhulle, 1992); (3) the effects of exchange rate volatility on trade are dependent on interactions among many different variables such that the final result is indeterminate (see e.g. De Grauwe, 1988 and Dellas and Zilberfarb, 1993). Thus, there are a wide and conflicting variety of theoretical results and there is apparently no consensus at all on the theoretical relationship between the exchange rate volatility and trade. It is a generally accepted view that “the direction and magnitude of the impact of exchange rate volatility on trade becomes an empirical issue.” (Chit et al., 2010, p. 243). Empirical studies have devised various measures of exchange rate volatility, utilized different sets of data such as aggregate trade data, bilateral trade data, and sectoral trade data, and applied various statistical methods, e.g. OLS, co-integration analysis, error correction model, panel analysis, among others. Empirical results are also very diverse, producing no unified view on the issue.4 Most empirical works have so far involved advanced economies, but recently researchers have chosen to study developing as well as emerging countries. Poon et al. (2005) examine aggregate export data of five Asian countries (Indonesia, Japan, South Korea, Singapore, and Thailand) and report that the exports of Indonesia and Thailand are positively affected by the exchange rate volatility in the long run and that the export of Singapore is also positively affected in the short run. According to Choudhry (2008), the exchange rate volatility exerts a significantly positive effect on the real export by Canada, Japan, and New Zealand to the U.K. On the other hand, Arize et al. (2008) conclude that the exchange rate volatility has a significantly negative effect on the export by eight Latin American countries both in the short and the long run. Similarly Chit et al. (2010) produce evidence on the negative effect of volatility on trade in five emerging East Asian Countries (China, Indonesia, Malaysia, the Philippines and Thailand). Hall et al. (2010) looked at ten emerging market countries and eleven developing countries with the result that export of developing countries is negatively impacted by exchange rate volatility, but that there was no significant relationship between export and volatility in emerging market countries. After all there seem to be many studies reporting a significantly negative relationship between exchange rate volatility and trade (Arize et al., 2000, Arize et al., 2003, Doganlar, 2002 and Baak et al., 2007). However, there are some with the opposite result (McKenzie and Brooks, 1997, Doyle, 2001 and Bredin et al., 2003) and there are yet others with ambiguous results (Aristotelous, 2001 and Tenreyro, 2007). Thus, we need to gather more evidence on this relationship by examining specific countries and industries. We focus on the bilateral trade between Japan and China which has been rarely studied so far.5 An analysis of the bilateral data has a few advantages relative to that of the aggregated data. Firstly, aggregate data may cloud the picture by summing over different responses, namely positive and negative relationships may cancel each other out in the aggregate data. Use of bilateral trade data is free from such an aggregation bias. Secondly, when a country's trade with the rest of the world is analyzed, the effective exchange rate of this country is adopted, but this also tends to ignore changes in individual exchange rates. The bilateral exchange rate can be exploited if one looks at the bilateral trade, which will give a more precise result on the effect of volatility on trade, enabling us to draw more specific implications from the analysis. Papers which examine the effect of exchange rate volatility on the bilateral trade between Japan and China are An and Huang (2009) and Nishimura (2010). The former collected quarterly data from 1994.Q1 to 2009.Q1 and applied Johansen co-integration tests to analyze the long-run relationship between the RMB-JPY (number of RMB per JPY) volatility and real exports/imports. Their analysis indicates that an increase in the exchange rate volatility exerts a negative effect on bilateral trade in the long run. The latter employs monthly data from January 1999 to June 2008 and estimated an error correction model to analyze the effect of RMB-JPY volatility on China's real exports to Japan. His result is that China's export to Japan is not affected by the changes in the exchange rate in the short run, but that its volatility has a negative impact on trade.6 In relation to the preceding studies summarized above, this paper has possibly three areas of contribution. In the first place, the new contribution lies in the focus on the reform of the exchange rate regime initiated in July 2005. Almost all the past studies examining China (see footnote 4) do not consider the effects that this reform may have had on her trade. An empirical analysis of these effects would provide important background information to the future liberalization and internationalization of RMB. In the second place, we analyze both the short-run and long-run effects of the exchange rate volatility on trade. An and Huang (2009) examine only the long-run relations, while Nishimura (2010) analyzes only the short-run effects. Others who analyze both short-run and long-run relationships often report conflicting results on different time spans. In this paper we adopt the Autoregressive Distributed Lag (ARDL) approach which is capable of carrying out co-integration tests irrespective of the order of integration. Consequently we can carry out both the short-run and long-run analyses of the effects of the RMB-JPY exchange rate on Japan-China trade.7 Thirdly, since available data was in short supply so far in this field of study, most economists have used aggregated trade data between one country and the rest of the world (McKenzie, 1999). Studies with sectoral trade data are relatively few, thus our analysis with such data constitutes an important contribution to the literature. This paper is structured as follows. In Section 2, the model specification of this paper is laid out. Section 3 explains derivation of two exchange rate volatility measures. Section 4 is an exposition of the ARDL approach and we present the estimation results in Section 5. Section 6 concludes the paper.

In this paper we have analyzed the effects of the volatility in the RMB-JPY rate on Japan-China trade with a special emphasis on the period after July 2005 when the exchange rate regime was reformed. Our sample period is from Jan. 2002 which is after China's accession to WTO to Dec. 2011 and we collected 120 monthly observations. We computed two measures of exchange rate volatility: the one is derived by AR-EGARCH model and the other is simply standard deviations of daily exchange rate changes during a given month. We then applied the ARDL approach to estimate short-run and long-run effects of various variables on China's and Japan's exports to each other. Our results indicate that Japan's exports to China are not affected by the volatility, but that China's exports to Japan were negatively affected by the volatility during the reform period. Therefore, China's reform of the exchange rate regime had adversary effects on her exports to Japan when the volatility was high. In other words, Chinese exporters are more prone to the exchange risk than Japanese counterparts. Next, the level of the RMB-JPY rate does not influence Japanese exports to China, but Chinese exports to Japan are affected by this level. In general, therefore, Chinese exports are subject to influences from the exchange rate. A rise in the volatility constitutes a higher exchange risk, which can be mitigated by hedging activities. Relative to more advanced nations, China has fewer such opportunities. Japan has had experiences of floating exchange rates since February 1973. Japan was often faced with phases of rapid JPY appreciation and had to develop new means of exchange risk hedging. It is only recently that China's currency gained any flexibility, hence the only risk hedging available is to use the forward market contracts. However, the depth of this forward market is far from sufficient.22 These differences in the depth of derivatives markets and in the risk management by firms seem to underlie the empirical results of this paper. That we cannot have the next three things at the same time is a well-known property of international finance: (1) completely free mobility of capital across borders (2) stability of the exchange rate and (3) independent monetary policy. The Chinese government has sacrificed the free international mobility of capital in order to preserve the stability of the exchange rate and independence of monetary policy. Recent policy changes in China regarding the RMB-USD rate include widening of the daily variability to 1% on April 16, 2012 and direct transactions between JPY and RMB in both Tokyo and Shanghai markets on June 1, 2012. As for the future liberalization of international capital flows, a special team at the Financial Survey and Statistics Department of People's Bank of China has published in February 2012 a roadmap of liberalization in the short, medium, and long run. These developments by the Chinese authorities seem to introduce wider flexibility in the exchange rate by allowing more free international capital flows while retaining the independence in their monetary policy. This is exactly the path many advanced economies took since the early 1970s. Implementation of these new policy moves will lead to increasing volatility in the RMB exchange rates. According to the results of this paper, this rise in exchange risk may have adverse effects on China's exports and hence China's economy in general. But, this will in turn have negative implications for Japanese exports to China. In any case, China has to develop a more flexible foreign exchange market which is accompanied by deep financial markets to provide better hedging opportunities to exporters and importers. Chinese firms are well advised to rationalize their operations and to improve international competitiveness by more active R&D in new technology. We have analyzed the effect of the exchange rate volatility on bilateral trade between China and Japan. It is found that the volatility has a negative impact on China's export to Japan after the exchange rate reform of July 2005. This may be partly explained by China's export destination was shifted from countries with high exchange rate volatility to those with low volatility. Analysis of bilateral trade cannot capture such a movement in a multi-country trade framework. In this vein, Hayakawa and Kimura (2009) present a very interesting result that intra-East Asia trade is discouraged by exchange rate volatility more seriously than trade in other regions. East and South East Asian countries seem to have developed closely linked production networks. Then, the effect of the exchange rate volatility on trade must take incorporate such close linkages. Such considerations are the important next step in our future analysis.