The determination of foreign exchange rates in transition economies and implications for growth: The case of Poland and the People's Republic of China

This study investigates the behavior of nominal and real exchange rates and the relationship between real exchange rate misalignment and economic performance in two transition economies, Poland and China. Differences in exchange rate determination and implications for growth are expected because of the very different transition strategies adopted: shock therapy in Poland vs. gradualism in the PRC. These two strategies differ in the speed and the sequencing of liberalizing the economy. Three models of exchange rate determination are employed to study the Polish zloty and the Chinese yuan exchange rates vis-a-vis the U.S. dollar: the random walk model and the two asset-approach models, the sticky-price monetary model and the portfolio balance model.; The estimation of the models indicates, first, while the two asset-approach models were not expected to perform well in countries with underdeveloped capital markets, the importance of money in both asset-approach models of exchange rate determination is clearly conformed. Second, the exchange rate may also be explained well in both countries by a simple random walk model. Third, these three models explain the movement of zloty/dollar exchange rate better than the movement of yuan/dollar exchange rate, confirming the view that the zloty/dollar exchange rate, under the shock-therapy transition approach, moves more similarly to a free-market exchange rate. Finally, real exchange rate misalignment generally negatively affects economic performance for Poland and China, especially in the case of Poland.