Rmb Exchange Rate Misalignment And Exchange Rate Reform

Since Asia financial crisis in 1997, RMB has been paid close attention. Economists and policy designers have been caring about whether RMB is in misalignment and where the reform of RMB mechanism should go. In this paper, I mean to give a comprehensive and rescannable assessment on RMB exchange rate based on some advanced equilibrium exchange rate theory. The different theories on equilibrium exchange rate are discussed. With the model of BEER developed by Ronald MacDonald(1998), co integration analysis and the yearly data from 1981 to 2000, I estimates the equilibrium exchange rate of RMB and analyzes the misalignment of RMB empirically. Considering the practice of China and data availability, we establish the following model:where TOT is terms of trade, PROD is the productivity of China, Open is openness, and FOEX is foreign exchange. The signs above right-hand-side variables denote the partial derivatives. Because of the scarcity of data for co integration, we have to choose two from these four fundamentals to make co integration with real exchange rate of RMB(REER). At last we get the following equation:LREER=9.7547+2.4486LPROD-1.8561LOPENBut we do not find the co integration relationship between the other two fundamentals and the RMB exchange rate. We ascribe the poor result to the scarcity of data.With the seasonally data from 1994 to 2001 and the same method, we made another co integration. But for the data availability, the fundamentals we choose are a little different from the last one and we get a new model as follows:where GDP is the gross domestic product, NFA is net foreign asset, M2 is the money supply, and SURPLUS is the trade surplus. For we get more data in this model, theresult is more convincing. Johansen's maximum likelihood estimation proved the co integration relationship between these four fundamentals and the RMB exchange rate. The following equilibrium exchange rate equation is produced:LREER=16.32+1.74LGDPSA-2.78LM2SA+0.19LNFASA+0.000383SURPLUSSA+0.0656TRENDAll of the coefficients are correctly signed; the equilibrium exchange rate appreciates in the long run if productivity, trade surplus and net foreign assets increase, or money supply M2 tightens. The equilibrium exchange rate BEER is derived and the misalignment is the difference between BEER and REER. The result suggests there is almost no overvaluation during the Asian financial crisis in RMB exchange rate and no undervaluation after 2000. But there is misalignment during 1980's and the first half of 1990's in RMB exchange rate.Then we analyzed the cause of misalignment and the effect of devaluation of RMB on China's economy. We find that in China, the effect of exchange rate adjustment is much weaker than the reform of exchange mechanism. According to our analysis and the target of the reform of RMB exchange rate regime, the following measures could be considered in these 3-5 years. Monetary authority should take measures to increase flexibility of RMB exchange rate. The central bank should decrease their intervention frequency little by little. The exchange rate floating band should be expanded gradually to a reasonable level. And the foreign exchange market should be developed more soundly.