Study On The Currency Weights In The Currency Basket That RMB Is Managed Against

On the Jul. 21, 2005, People's Bank of China declared that the exchange rate regime of RMB would change from pegging USD into be managed against a basket of currencies, without publicizing the structure of the currency basket. As a result, RMB became the focus. The paper was conceived, compiled and finished under this background.China had born much pressure from America and Europe that required revalued RMB. Furthermore, the expectation that RMB would be appreciated made a huge number of inflow hot money. At this moment, it's still a puzzle whether the change of RMB's exchange rate regime would bring RMB closer to its effective real rate, whether it would keep stable RMB's rate and China's international trade and whether it would bridge RMB to independent floating rate. In this situation, this paper discussed the exchange rate regime of managing RMB against a basket of currencies.2 problems were included in the analysis. One is the chose of currency. There were 3 factors: trade, capital flow and exchange rate regimes of those currencies that would be the components of the basket. Trade was of course the most powerful effect in the FX market. As to capital flow, China hadn't opened its capital accounts, but we couldn't ignore the FDI and the escaped capital in China and even in other developing countries. Taking consideration of the exchange rate regimes of those would-be in-basket currencies is because of the mathematical reason. Many countries such as Korea, India were important trade partner of China, but there currencies were pegging to or partly related to US Dollar. If they were all in the basket, correlated variables couldn't deliver right conclusion. With integrated consideration of all these factors, the paper defined 6 currencies ---- USD, EUR, JPY, GBP, AUD and CAD.Another problem in the analysis was the optimal weights of these currencies in the basket. In the process of building the model, target function was the essence. Different countries had different targets of their exchange rate policies and they would adjust the targets in different phases. As a result, we must have a choice. In the relative documents, many issues had been chosen as the target function, like the stability of ERR, trade balance, the price of traded goods, and trade term and etc. Since international trade occupied a large part of China's GDP and there were many technical difficulties in the process of establishing model, this paper settled the stability of trade balance as the target function and correspondingly set up a multi-country model.In this model, the optimal weights were relevant to 2 variables. One was the proportion of the bilateral trade between China and a certain country in the China's aggregate international trade, the other was the elasticity of trade to exchange rate. In some rough studies, the optimal weights equaled to correspondent trade weights. That's why the public deemed that in the RMB's basket, USD, EUR and JPY should occupy 40%, 30% and 30% respectively. There was a new variable ---- elasticity appeared in the model above, the result was totally different accordingly. USD occupied more than 60%, JPY and EUR 13% respectively. In addition, GBP, AUD and CAD totaled over 10%.When calculating the elasticity, it's not appropriate to use the data in Internet directly. Since exchange rate was not the single reason for the volume of trade, even not the primary reason. Even if we got the real elasticity, the structure of currency basket would not be constant. With time goes by, it would also change. This paper focuses mainly in the fourth chapter, and also the characteristics of this study. Firstly, the method to the estimation of the model in this paper is simple; estimate the currency weights of the currency basket that RMB is managed against to a nicety, Contribute to the understanding of the current exchange rate forming system and to estimate the current RMB exchange rate. Secondly, the data in this paper is the latest monthly data, including the whole year of 2006 after the exchange rate regime reform, much different from the way which is very popular currently, using yearly data. And the integrity of data throughout the whole year makes the study period relatively complete. Finally, this paper compared the simulated exchange rate calculated by the estimated weight with realistic exchange rate. Then find out that they are very close. Therefore, it could be argued that the model is effective;the weight estimated in this paper is close to the truth. This paper employed both qualitative and quantitative methods to discuss the structure of the currency basket. Then compared the simulated rate calculated by the estimated weight with reality of the exchange rate. As the data in this paper is the latest, it is an innovation of this paper. We all wish the exchange rate regime reform successful in China.