Measurement Of RMB Real Exchange Rate Misalignment

The question of an equilibrium exchange rate has always been a debatable issue. Along with rapid growth of the Chinese economy over the past two decades, a number of studies have been undertaken to investigate whether or not the RMB exchange rate is at its long run'equilibrium'level. Because the equilibrium exchange rate affects the competitiveness of a country's economy, these studies have focused on whether or not the real exchange rate is misaligned with respect to its long-run equilibrium level. One of the main reasons for this concern is that effective management of the exchange rate system could help a country's economy achieve internal and external balance. Otherwise, it could negatively influence the stability of a country's financial economy, possibly resulting in regional financial crises. Consequently, to measure the extent of misalignment of RMB objectively and study the effect of the misalignment on international trade competitiveness are related to an accurate and reasonable evaluation of China's exchange rate polices carried out in the past decades, and can provide a decision-making basis for the future reform of China's exchange rate regime.This study estimates time varying values of the equilibrium real effective exchange rate(EREER) and associated exchange rate misalignments for China in recent years (from the first quarter of 1999 to fourth quarter of 2010). The study focuses on the reduced-form equilibrium real exchange rate(ERER) model for developing countries presented by Elbadawi (1994) and follows Edwards'(1989, 1994) work on models of exchange rate determination. We identify the terms of trade, openness, government expenditure, productivity and money supply as important explanatory variables of the RMB long-run equilibrium value.We use the Johansen-Juselius(1990) co-integration procedure to analyse our data.Using the ERER model, our results show there is a cointegrating relationship between the real effective exchange rate and its economic fundamentals. Subsequently, compare to other previous studies discussed in Chapter 1, our restricted error-correction model suggests that the extent of the misalignment is not very large, moving in a narrow band of plus and minus 12 percent of the long-run equilibrium level during the sample period. Focusing on the RMB real exchange rate misalignment in recent years, our result shows that the RMB was undervalued by an average of 6.7 percent during the period of 2005Q3-2010Q1. Furthermore, our short-run empirical error correction model indicates that, on average, the real exchange rate reaches its long-run equilibrium level quickly.At last, export market share index is taken as the proxy of international competitiveness, and Granger Causality Test is performed between RMB real exchange rate misalignment and China export market share index. We find that a negative correlation is between RMB real exchange rate misalignment and China's international competitiveness, and RMB real exchange rate misalignment is the Granger reason of China's international competitiveness, overvalue of RMB real exchange rate will do harm to China's international competitiveness.