China’s Exchange Rate Regime

Getting it right

Presented by: Fei Huo

Supervised by: Prof. Joseph Francois

Overview

Motivation

Is the renminbi misaligned? (Measure of currency’s misalignment)

Empirical approach to renminbi’s misalignment (cross-section data)

Survey of the misalignment of the renminbi

Conclusions

Motivation

Huge appreciation pressure on renminbi

High inflation in year 2007 and 2008

The primary aim is to analyze how China’s current exchange rate system affect its economy. China’s exchange rate regime is naturally the pivot of this research

Is the renminbi misaligned?

some signs of undervaluation of the renminbi :

1. China’s rising current account

2. China’s rising foreign exchange reserves

3. An appreciation pressure in the foreign market

4. A depreciation of the real effective exchange rate

China’s Foreign Exchange Reserves in 2008

China's Foreign Exchange Reserves in 2008

1.4

1.5

1.6

1.7

1.8

1.9

2

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Month

tril.

dolla

r

Foreign Exchange Reserves

China’s Real Effective Exchange Rate

Real Effective Exchange Rate

0

75

150

01/01

07/01

01/02

07/02

01/03

07/03

01/04

07/04

01/05

07/05

01/06

07/06

01/07

07/07

01/08

07/08

effective exchange rate

Year 2000=100

Data source: BIS

Measurement of Currency Misalignment

PPP/Balassa-Samuelson Effect

Fundamental Equilibrium Exchange Rate Model

Behavioral Equilibrium Exchange Rate Model

…

Estimate of the renminbi’s equilibrium exchange(Literature Review)

ERER stands for equilibrium real exchange real model (see Edwards 1989). EER stands here for the equilibrium exchange rate (multilateral); dollar stands for the bilateral one.

Empirical approach to renminbi’s misalignment I

A simple model (Coudert and Couharde, 2005) is used to estimate renminbi’s misalignment, which is based on a Purchasing Power Parity (PPP) criterion revised by the Balassa-Samuelson effect. This simple model is a cross-section regression, which takes PPP GDP per capita as a proxy variable for the relative productivity differentials between the tradable goods sector and the nontradable goods sector. This regression could be express in symbols as:

iUSi

USi u

GDP

GDPLog

P

PLog

10

Relative price levels and GDP per capita compared to the Untied States in year 2006 (all countries)/ Basic Model

China

-2-1

.5-1

-.5

0.5

-6 -4 -2 0 2relative PPP GDP per capita

relative Price Level Fitted values

Data are taken in logarithmic form.

Source: IMF World Economic Outlook Database, author’s calculation with Stata 10.0

Empirical approach to renminbi’s misalignment II

Sub- sample 1: PPP GDP is bigger than 3 per cent of the Untied States’ level.

Sub- sample 2: PPP GDP is smaller than 70 per cent of the Untied States’ level.

Sub- sample 3: PPP GDP is between the 3 per cent and 70 per cent of the Untied States’ level.

Relative price levels and GDP per capita compared to the Untied States in year 2006 (using different samples)/ Basic Model

China

-2-1

.5-1

-.5

0

-6 -4 -2 0relative PPP GDP per capita

relative Price Level Fitted values

China

-2-1

.5-1

-.5

0.5

-4 -3 -2 -1 0 1relative PPP GDP per capita

relative Price Level Fitted values

China

-2-1

.5-1

-.5

0.5

-6 -4 -2 0 2relative PPP GDP per capita

relative Price Level Fitted values

China-2

-1.5

-1-.

50

-4 -3 -2 -1 0relative PPP GDP per capita

relative Price Level Fitted values

All countries Sub 1

Sub 2 Sub 3

Estimate for year 2006 (Basic model)

Revised Model

Now we revise the basic model above and add a new quadratic term into the equation because the data seem to have a U-form (quadratic function), which is nonlinear. Therefore, the equation could be expressed in symbols as:

iUSi

USi

USi u

GDP

GDPLog

GDP

GDPLog

P

PLog

2

210

Relative price levels and GDP per capita compared to the Untied States in year 2006 (all countries)/ Revised Model

China

-2-1

.5-1

-.5

0.5

-6 -4 -2 0 2relative PPP GDP per capita

relative Price Level Fitted values

Data are taken in logarithmic form.

Source: IMF World Economic Outlook Database, author’s calculation with Stata 10.0

Relative price levels and GDP per capita compared to the Untied States in year 2006 (using different samples)/ Revised Model

China

-2-1

.5-1

-.5

0.5

-6 -4 -2 0 2relative PPP GDP per capita

relative Price Level Fitted values

China

-2-1

.5-1

-.5

0.5

-4 -3 -2 -1 0 1relative PPP GDP per capita

relative Price Level Fitted values

China

-2-1

.5-1

-.5

0

-4 -3 -2 -1 0relative PPP GDP per capita

relative Price Level Fitted values

China

-2-1

.5-1

-.5

0

-6 -4 -2 0relative PPP GDP per capita

relative Price Level Fitted values

All countries Sub 1

Sub 2 Sub 3

Estimate for year 2006 (Revised model)

Renminbi’s misalignment from year 2005 to 2008

Revised Model

-8%

-6%

-4%

-2%

0%

2%

4%2005 2006 2007 2008

Year

Mis

alig

nm

ent

all countries sub-sample 1 sub-sample 2 sub-sample 3

Basic Model

-30%

-25%

-20%

-15%

-10%

-5%

0%2005 2006 2007 2008

Year

Mis

alig

nm

ent

all countries sub-sample 1 sub-sample 2 sub-sample 3

Source: IMF World Economic Outlook Database, author’s calculation with MS-Excel .

Comparison of different models, using different samples

All countires sample

-30%

-20%

-10%

0%

10%2005 2006 2007 2008

Year

Mis

alig

nm

ent

Basic Model Revised Model

Sub-sample 1

-15%

-10%

-5%

0%

5%2005 2006 2007 2008

Year

Mis

alig

nm

ent

Basic Model Revised Model

Sub-sample 2

-25%-20%-15%-10%-5%0%5%

2005 2006 2007 2008

Year

Mis

alig

nm

ent

Basic Model Revised Model

Sub-sample 3

-15%

-10%

-5%

0%2005 2006 2007 2008

Year

Mis

alig

nm

ent

Basi c Model Revi sed Model

Source: IMF World Economic Outlook Database, author’s calculation with MS-Excel .

Comments on the estimate

This empirical approach could give a rough insight. However, it might not be precise, especially the extent of renminbi’s undervaluation.

From the aspect of the statistics, only one-year data are used and this kind of estimates results only has limited explanatory ability. Furthermore, this approach relies on the international price level comparisons, which are difficult to measure.

Actually, it could be also difficult to measure the extent of renminbi’s misalignment, even if other more complicated models are used, given the margin of uncertainty surrounding underlying parameters and the dynamic features of China’s economy .

Anyway, this kind of cross-section approach still has its reference value and could describe the renminbi’s misalignment.

Survey of the misalignment of the renminbi

The renminbi’s undervaluation is caused by China’s exchange rate policies and has a great effect not only on China’s economy but also on other countries’. An undervalued exchange rate will lead to a lot of problems, among which the major one is excess liquidity. The excess liquidity is partially a consequence of the large trade surplus caused by the undervalued renminbi under China’s fixed exchange rate polices; and the excess liquidity is also a sign of the inflation. In addition, China’s current exchange rate policies seem to result in the ineffectiveness of its monetary policy, even if China has reformed its exchange rate system in year 2005.

Major external cause of the excess liquidity

Mundell-Fleming Model: Current account surplus under the fixed exchange rate regime

New changes in economic situations

In the second half of year 2008, China’s central bank had repeatedly reduced the prime rate and the required reserve ratio for commercial banks to increase the liquidity, so that China’s economic growth could be stimulated and the large effects of the global financial crisis could be reduced. However, in year 2009, People's Bank of China has begun to recoup funds by open market operations. In February, it has issued three-month central bank bills for three weeks continuously and its value reached up to 35 billion renminbis, which implied that China started to be concerned about the excess liquidity. Meanwhile, investors generally suspect that the money supply increased by China’s government has not flowed into the real economy, but the speculative capital markets, which is also what China’s government worries. In addition, China’s foreign exchange reserve reached up to 1953.74 billion dollars in March, with the increase by 2.18 per cent, compared with that in February. China’s foreign exchange reserve has hit its historical high, even if it decreased in the first two months of the year 2009.

Conclusions China’s high inflation from year 2007 to 2008 was mainly caused by the exc

ess liquidity and the Balassa-Samuelson effect; and China’s serious problem of the excess liquidity, which resulted from the international imbalance, was the consequences of an unsuitable exchange rate regime.

The research above implies the necessity of the further reform of China’s exchange rate system. If the flexibility of renminbi’s exchange rate could be increased, the misalignment of renminbi could be improved automatically. In addition, the effectiveness of monetary policies will also be increased and improved, so that China’s government could deal with different economic situations better.

If China always remains the fixed exchange rate regime, the reform of China’s financial and banking systems could be obstructed

Some signs of excess liquidity in 2009 imply that the further reform of China’s exchange rate system is still necessary and could be inevitable

Thanks for your attention