Estimating Equilibrium Exchange Rate Of RMB

Having Compared and Appraised some advanced equilibrium exchange rate theory, the paper chooses Edwards's developing country model as theoretic guidance. Based on Edwards's model and using developing countries' empirical experience of equilibrium exchange rate for reference, the paper chooses major fundamentals that may be related to equilibrium exchange rate of RMB. Engle-Granger two-step cointegration analysis is performed on annual data from 1980 to 2003, and the model of equilibrium exchange rate of RMB is constructed. Insignificant variables are deleted from the model, and at last four variables that is cointegrated with RMB real exchange rate are found, they are openness, terms of trade, government consumption on nontradables, and net capital inflow. In order to get the "sustainable" or "permanent" values of the fundamentals approximately, we then use -the Hodrick-Prscott filter to smooth the economic fundamentals. The equilibrium exchange rate is derived and the misalignment is also calculated. Then some basic conclusion could be made: the real effective exchange rate of RMB has always fluctuated around equilibrium exchange rate, and experienced different overvaluation and undervaluation; after the reform of RMB exchange rate regime in 1994, the misalignment is not as serious as before, the real effective exchange rate is more and more close to equilibrium exchange rate; at present RMB exchange rate experiences undervaluation to a certain extent, and equilibrium exchange rate is forecasted that there will be a likely appreciation in the future, then the fixed exchange rate system pegging to U.S. dollar will lead to exchange rate misalignment in long periods. So the reform of the exchange rate system is very necessary and urgent. Improving current RMB exchange rate mechanism, really implementing a single, managed floating exchange rate system based on market demand and supply of foreign exchange, accelerating fostering the sound domestic financial market, then realizing floating exchange rate system finally.