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UNIVERSITY OF MACAU FACULTY OF BUSINESS ADMINISTRATION An Empirical Exploration of the Real Exchange Rate of the RMB: A Wage Perspective LIU RUOCHUAN MA957171 Thesis presented to the Faculty of Business Administration University of Macau In partial fulfillment for granting the MBA Degree 2012 Content Abstract ....................................................................................................................... 1 1. Introduction ............................................................................................................. 2 1.1 Exchange Rate Selection ............................................................................... 2 1.2. China’s situation .......................................................................................... 4 1.3 Wage Factor .................................................................................................. 6 1.4 Hypothesis ..................................................................................................... 8 2. Literature Review .................................................................................................... 9 3. Methodology ......................................................................................................... 13 3.1 Empirical Approach .................................................................................... 13 3.2 Econometric Methods ................................................................................. 16 4. Results Interpretation ............................................................................................ 18 4.1 Stationary Analysis ..................................................................................... 19 4.2 Johansen cointegration analysis .................................................................. 21 4.3 Cointegration Result ................................................................................... 24 4.4 Short Run Relation ...................................................................................... 29 5. Summary and Concluding ..................................................................................... 35 6. References ............................................................................................................. 37 Abstract Exchange rate is at the heart of international finance, and also remains a central issue in many disputes of international trade. Mainstream theories study exchange rate based on the purchasing power parity and a common sense which assume wage level equals labor productivity. Unfortunately, this assumption may not be true in reality, and existing theories likely fail to account for trade imbalance especially between developed and developing countries. This paper does not take that assumption for granted, but will instead consider a more realistic situation: labor may get underpaid (relative to its productivity) in some countries or overpaid in others when these countries trade. Distorted wage level may have certain interactions with the exchange rates of various currencies. The wage factor is used in this paper to estimate the equilibrium real exchange rate of the RMB. We expect to see that the comparative advantage of China trade lies actually in its extremely low wage, not in the alleged currency misalignment, and RMB may not be undervalued after taking into account distorted factor prices. Moreover, if the RMB appreciation is forced to continue in a substantial manner, the degree of wage distortion will be increasing further with adverse impacts on both China and its trading partners. 1