Testing Purchasing Power Parity with China and Estimating Transaction Costs

Given China’s growing global economic significance, assessing the integration of its goods markets with key trading partners is crucial. This study examines the validity of purchasing power parity (PPP), a vital indicator of market integration, between China and its 73 trading partners across Asia, Africa, and the Latin America and Caribbean (LAC) region. We employ the three-regime threshold autoregressive (TAR) cointegration methodology developed by Maki and Kitasaka [Residual-based tests for cointegration in three-regime TAR models. Empirical Economics, 48, 1013–1054], which models the nonlinear price adjustments driven by transaction costs. Using monthly data over the past two decades, our empirical results provide evidence for threshold cointegration with a three-regime adjustment process, thus supporting PPP for 41 of the 73 country pairs, albeit predominantly in its weak form. We quantify proportional transaction costs, leveraging the estimated thresholds, revealing significant cross-country variations and threshold asymmetries between import and export arbitrage costs. Subsequent cross-sectional analysis indicates that these transaction costs are significantly positively correlated with geographical distance from China and significantly negatively correlated with the trading partners’ levels of economic freedom. These findings highlight varying degrees of market integration between China and its partners. They offer important policy implications for fostering deeper economic cooperation and targeted reductions in trade frictions through infrastructure development and enhancing economic freedom.