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Contemporary Logistics 05 (2011) 1838-739X
Contents lists available at SEI
Contemporary Logistics
journal homepage:
Take RMB’s Exchange Rate System Vicissitude as a Clue to Quest
the Forming of Real-life Exchange Rate Misalignment
Chunping Wang*
Business School, Shandong University at Weihai, No.180, Wenhuaxi road, Weihai 264209, Shandong Province,
P.R. China
Exchange rate,
System vicissitude
After establishing the equilibrium of the real effective exchange rate model of RMB, this
paper analyzed the trends and the degree of misalignment of RMB realistic exchange rate
on the different stages of the exchange rate system. The result shows that the stronger the
market mechanism in the realistic exchange rate forms the function to be, the closer realistic
exchange rate's tends to the equilibrium exchange rate. Otherwise, the misalignment in the
trend of the realistic exchange rate is more obvious. To reduce the misalignment level of the
RMB exchange rate in reality and make the equilibrium exchange rate play an important
role in the economic balance, we should push forward the market-oriented reforms
unswervingly about RMB exchange rate formation mechanism and improve the managed
floating exchange rate system.
1 Instruction
Since July 2005, China began to carry out the managed floating exchange rate system. The RMB exchange rate generally has been
raised and foreign exchange reserves continue to increase. After the international financial crisis, expectations for RMB appreciation
continue to rise. Western countries on different occasions put forward the point that China had manipulated the exchange rate to
make RMB undervalued. Since the reform and opening-up was implemented, China's RMB management system has been changed
and adjusted several time. Whether the value of local currency was significantly undervalued during this period? How much should
the equilibrium and reasonable exchange rate be? If the misalignment of the RMB exists, what impact China's exchange rate system
confront on the disorders of exchange rate? The answers will be very essential to promote and improve the RMB exchange rate
The equilibrium exchange rate, usually refers to the exchange rate which is consistent with internal and external equilibrium in the
macro economy, which is a kind of exchange rate in theory. The exchange rate that can keep China’s international income and
payments basically balanced and make the national economy grow sustainable, stably and healthily is the RMB equilibrium exchange
rate, which needs to be calculated by the theoretical model.
Corresponding to the equilibrium exchange rate, I defined the objectively existing exchange rate in the real economy as the r ealistic
Corresponding author.
Email: chpwang616
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI: 10.5503/J.CL.2011.05.016
exchange rate in this paper. It is a completely different concept from the equilibrium exchange rate and it is a corresponding concept
with nominal exchange rate. Realistic exchange rate refers to exchange rate which exists in the real economy. It is a concept
corresponding with the equilibrium exchange rate. The misalignment of the realistic exchange rate means that the realistic exchange
rate deviates from the equilibrium exchange rate. In indirect quotation, if the realistic exchange rate below the equilibrium exchange
rate, then it is undervalued.
The usual estimate equilibrium exchange rate model used are Williamson’s (1983) fundamental elements equilibrium exchange rate
(FEER) model, Stein’s (1995) natural balanced the real exchange rate (NATREX), MacDonald’s (1998) behavior equilibrium
exchange rate model (BEER) and Edwards’s (1989) developing country equilibrium exchange rate model (ERER) and so on.
Zhongxia Jin (1995), Xiaopu Zhang (2000), Xiangsheng Dou and Yang Xin (2003), Weiguo Wang and Wanyang Huang (2005), Shi
Jianhuai and Yu Haifeng (2005) used the above models to estimate the RMB equilibrium exchange rate level and currency disorder
degree. MacDonald & Dias (2007) used BEER model and fund RMB’s misalignment of 8% to 30% with respect of effective
exchange rate. When previous studies estimated the equilibrium exchange rate, because of the equilibrium exchange rate model of its
own limitations, the selected independent variables are quantitative economic indicators and external shocks that cannot be quantified
are rarely considered. In the stage of reform and opening up, the RMB exchange rate system is constantly changing and improving.
The changes of the exchange rate regimeform an impact on the equilibrium exchange rate and real exchange rate misalignment to a
large extent. Weiguo Wang and Wanyang Huang (2005) have taken the external strike into consideration by setting dummy variable,
but have not considered the impact of changing in exchange rate system. Therefore, in the study of RMB exchange ratio of
misalignment, the relationship among RMB exchange rate system and the formation mechanism reform and realistic exchange rate
disorders lacks of deep analysis based on solid evidence and clear understanding.
This paper intends to calculate RMB realistic exchange rate maladjusted degree by establishing RMB equilibrium exchange rate
model based on the structure mutations. According to the calculated result, By taking the change of the RMB exchange rate system as
a clue, this paper investigates the influence that the change of the exchange rate system has on realistic exchange rate maladjustment
in different stages.
In the second part of this paper, the behavioral equilibrium exchange rate model was used to calculate the misalignment level of
RMB real exchange rate. In the third part, I take the changes of the RMB exchange rate system for clues, combining the calculated
result of the second part to analysis the affect that RMB exchange rate system change has on realistic exchange rate disorder. The
fourth part is the conclusion of the study.
2 Calculating the Misalignment Level of RMB Real Exchange Rate
2.1 Variable selections and data specification
This paper will select what may affect the RMB equilibrium exchange rate, like degree of openness, trade conditions, technical
progress and the level of investment etc as basic economic variables and screen through the statistic test. We use trade reliance to
signify the degree of openness (OPEN), tariff revenue in the proportion of import and export to signify trade protection degree (TAR),
investment in fixed assets in whole society (INV) to signify investment degree, the overall labour productivity expressed by per
capita GDP index (AGDP) to signify technology progress, fiscal expenditure (GOVE) to signify fiscal policy, nominal currency
balances (M1) to signify monetary policy and foreign debt balances (WZ) to the scale of foreign debt. As to trade conditions (TOT),
we use the overall terms of trade according to the exports and imports over the years to express it. Ratio increases explain trade
conditions improve. Each variable data sample is 1980 ~ 2008 annual data, from Zhong Jingwang database, China information lines
(college financial database) and over the “China statistical yearbook”. We use the RMB real effective exchange rate provided by IMF
to express RMB exchange rate. In the international financial statistics database (IFS) provided by the International Monetary Fund,
all the data have indexing processing by the initial value 100 of the 1980's data except for REER. What needs explanation is real
effective exchange rate provided by IFS in the indirect price law, so the smaller the REER numerical is, the lower the RMB is.
Namely when currency value in real effective exchange rate is lower than equilibrium exchange rate, we say currency equilibrium
exchange rate is undervalued, vice is overrated.
All the variables above to have been taken natural logarithm, "LREER" signifies the real effective exchange rate taken logarithm.
Other variables may be deduced by analogy. The econometric analysis in this paper is made by Eviews6.01 software.
2.2 The test of data sequence of unit root
Because the quantitative indicators of changes in exchange rate regime could not be presented in the model, the only way is to put the
influence of institutional change on the real effective exchange rate of RMB as an external strike. The result of the strike is structure
mutations in the process of LREER data generation. Therefore, it is necessary to conduct unit root test on real effective exchange rate
of RMB on the structural change. For other variables, ADF test is directly used. LREER curve taken logarithm in 1982 ~ 2005 is
shown in figure 1.
82 84 86 88 90 92 94 96 98 00 02 04
Figure 1 The RMB real effective exchange rate index (Natural logarithm value) curve
The real effective exchange rate changed many times during 1982 ~ 2005, and the RMB exchange rate system had a significant
change in 1993. 1993 was the mixture of the official exchange rate and regulate market exchange rate. Therefore, we suppose the
year of 1993 is points for structural change. This selection contains the intercept and slope term drift of the mutation model.
LREER  a0  a1DT  b0t  b1DT t  et
In this formula, t is the time variable, tT is the structural break points assumed, DT is the virtual variable (DT=0 if t≤tT; DT=1 if
t≥tT) , a0 is constant term, b0 is time factor, and a1, b1 are the time varying coefficient.
In order to show the change of time parameters in the model, make H1993=D1993×t. Test results are as follows after the regression:
LREER  5.62 - 1.27 D1993  0.13 H1993 - 0.12 t
R =0.92
et  0.49 et 1   t
( 2.61)
AIC=-2.05 SC=-2.00 ADF(0)=-2.61 DW=1.59
In the above assumption mutation equation, the ADF value is -2.61. The critical value of 1% is -4.91 in structural changes in the unit
root test of the progressive two-tailed critical value table provided by Perron. Because -2.61>-4.91, we accepted the original
hypothesis that LREER as a structural break unit root process and confirmed that the points of structural change are in the year of
1993. Taking the natural logarithm of real effective exchange rate index series is a process of structural break unit root.
After ADF test to other variables, we find other variables are all I (1) sequence and co-integration relationship model can be
established with LREER by that. These variables are: LM2, LTOT, LTAR, LTP, LOPEN and LWZ. This paper will adopt Granger
two-step inspection to establish a model. Firstly we use static least-squares regression and then test its residual stability.
2.3 Establishing equilibrium exchange rate model
Because the RMB real effective exchange rate index had structural changes in 1993, it is necessary to add virtual variable D1993 and
H1993 when conducting Static regression, make t=(1,2,...,27), so D1993=0 when t≤12, otherwise,D1993=1.
Take LREER for the dependent variable, then I conduct the OLS regression for the virtual variable sequence and economic factors
variables and time variable t, eliminating the variables such as LM1, LTP and tendency item which have no apparent connection to
LREER, the results are as follows:
LREER  3.7303 - 0.8929 D1993  0.0931H1993 - 0.0156 H1998 - 0.2055LOPEN  0.3272 LTAR
0.3631LTOT - 0.2824 LWZ  
Conduct ADF test on the regression residuals, ADF statistic is -4.33 (no constant term, no tendency term, Lag 4 period), Less than 2.65, the critical value of 1% significant level. DW value is 1.61, this indicates regression residuals is stationary sequence. The
inspection showed that there is a long-term equilibrium relationship between LREER, LOPEN, LTAR, LTOT and LWZ.
The left side of equation (4) is the RMB equilibrium exchange rate equation on the basis of fundamental economic factors. The basic
elements variables have the same influence on RMB equilibrium exchange rate as the theory, which means that, for one thing, as
trade protection degree is deeper and trade condition is improving, the export competition strengthens, as well as RMB equilibrium
exchange rate appreciate. For another, as standard of opening to the outside world goes up and scale of investment expands, it is
necessary to lower the equilibrium exchange rate to keep the external equilibrium. The scale of external debt rises, increasing the
International debt repayment pressure, it is necessary to devaluate the equilibrium exchange rate to keep the external equilibrium.
2.4 The measurement of RMB real effective exchange rate
We use the HP filter method to process LOPEN, LTAR, LTOT and LWZ. Results show we are getting the sustainable equilibrium
value of the above elements. After taking the variable value of every basic element which has been processed by HP filter method
into the equation (4), calculating the equilibrium real exchange rate of RMB (logarithmic form), and then take “e” power value, we
will get the equilibrium real effective exchange rate index.
82 84 86 88 90 92 94 96 98 00 02 04
82 84 86 88 90 92 94 96 98 00 02 04
Figure 3 Misalignment of RMBMISreal exchange rate (MIS)
Figure 2 RMB real exchange rate (REER)and equilibrium
exchange rate(ERER)
Take ERER as the equilibrium real effective exchange rate, and define MIS as the level of the exchange rate misalignment, then the
formula is:
When the MIS<0, it means that the exchange rate is below the equilibrium real exchange, namely, underestimated; when the MIS>0,
it will be overestimated. The equilibrium exchange rate, real exchange rate and the degree of exchange rate misalignment are showed
in the curving forms in Figure 2 and Figure 3.
3 The Influence of RMB Exchange Rate System on Misalignment of the Realistic Exchange
3.1 The forming process of RMB real exchange rate going out of balance from 1982 to 1993
During 1982 to 1993, China adopted a dual and two-tier exchange rate system. IMF weighed the official exchange rate and foreign
exchange market exchange rates when calculating the real exchange rate of RMB. As was estimated roughly by IMF, the swap price
weight number was 0.44 during Jan. 1 st 1987 to Dec.31st 1990. It rose to 0.8 in the period of Jan.1 st 1991 to Dec.31st 1993. In the
early years when policies of Reform and opening to the outside world were implemented, the market mechanism began to play a role
in the forming process of RMB exchange rate system and its effect became more and more important.
3.1.1 RMB exchange rate going out of balance under the control of dual exchange rate system
Since Jan.1st 1981, the internal settlement of RMB exchange rate against the U.S. dollar was applied to foreign exchange settlement
in export and import trades while the official exchange rate was applied to foreign exchange settlement in traveling, transportation,
insurance and overseas remittance.
The real effective RMB exchange rate was mainly calculated according to official exchange rate. The rate of exchange $1 to ¥2.8
didn’t change until Dec.31st, 1984 when the internal settlement exchange rate system has been in force for four years.
From Figure 2, we can see from the changing tendency that as the level of official exchange rate constantly approached that of the
internal settlement rate, the level of practical RMB exchange rate also approached that of the equilibrium exchange rate. The level of
exchange rate was less overestimated. This is because the internal settlement rate is applied to the foreign trade settlement and plays
an important role in maintaining the balance of external economy while the official exchange rate has a less important effect on the
balance of the international income and expense. As a result, the practical RMB exchange rate based on the official exchange rate
was seriously overestimated when deviating from internal settlement rate but less overestimated when approaching the level of
internal settlement rate.
In conclusion, there are two reasons for the misalignment of RMB rate. For one hand, under the premise of highly planed
international balance of payment, the dual exchange rate system was out of relationship with the official exchange rate, which made
the practical RMB exchange rate out of joint with the real economic world. For the other, incessant unfavorable balance of trade
deteriorated the terms of trade which in turn decreased the equilibrium exchange rate. In contrast, the real exchange rate was less
depreciated, leading to the overestimation of the practical RMB exchange rate.
3.1.2 RMB exchange rate going out of balance under the control of Two-tier exchange rate system
In 1985, simple rate was applied again to the RMB exchange rate. The existence of the foreign exchange regulatory markets rate
turned the RMB exchange rate into a Two-tier exchange rate system. From Figure 2, the level of practical RMB exchange rate further
approached that of the equilibrium exchange rate in 1985 and began to be underestimated in 1986. From 1986 to 1988, the level of
underestimation gradually went up and approached that of the equilibrium exchange rate in 1988. In the second half of 1989, the real
exchange rate exceeded the equilibrium exchange rate and was overestimated again until 1993. With the yearly increasing proportion
of swap market exchange rate, the level of real exchange rate became more and more close to that of the market exchange rate, which
in turn made the practical RMB exchange rate approach the equilibrium exchange rate. Thus, the exchange rate would less
The reason RMB real exchange misalignment from 1985 to 1993 can be summarized as follows: firstly, the gradual improved
proportion of foreign exchange which regulated the market exchange rate under the double track system of exchange rate had a
impact on the movement of realistic exchange rate, generally making the convergence of the misalignment of the exchange rate due
to the correction function played by the internal mechanism of foreign exchange regulatory markets. As a result, trade deficits make
the exchange rate went low, which was helpful to reduce the deficit. Secondly, the exchange rate may be overvalued under the
influence of inflation which may make the steady rise of real exchange rate expressed by the real effective exchange rate.
3.2 The factor analysis of the RMB real exchange misalignment from 1994 to 2005
3.2.1 The real exchange misalignment due to managed floating exchange rate
After 1994, RMB equilibrium exchange rate soared for the unification of exchange rates in January 1994 caused about 50% the direct
depreciation of the RMB nominal exchange-rate and changed the growth trend of the RMB equilibrium exchange rate with a sudden
increase of 0.0931 (see equation 4); the continuous fall of real exchange rate at the same time changed the trade conditions and the
export surplus emerged ,which attributed to the rise of the equilibrium exchange rate since 1994 while over the same period the RMB
exchange rate also increased under the effect of inflation though the ascent scope was not as wide as that of the equilibrium exchange
rate. The underestimating of the real exchange rate allowed the trade surplus to hit $16.7 billion in 1995.
3.2.2 The real exchange misalignment due to the dollar peg
As judged from the Figure 2, the Yuan currency still remained at a slight undervaluation, after the Asian financial crisis in 1997 and
the equilibrium exchange rate fell rapidly, putting the undervaluation of the real exchange rate to an end in 1998 while the year of
1999 witnessed the beginning of overvaluation across board. During the Asian financial crisis, China has committed to
non-devaluation of the RMB exchange rate in March 17, 1998 when equilibrium exchange rate dropped considerably and the
overvaluation of real exchange rate was ended. Therefore, to be accurate, the overvaluation trend of real exchange rate caused by the
Asian financial crisis and the dollar peg began in 1998. Because of the linkage to US dollar, the effective exchange rate fluctuations
were far less than the equilibrium exchange rate fluctuations. Thus it’s reasonable that real exchange rate had been overvalued under
the dramatic fall of the equilibrium exchange rate. The decline of real exchange rate beginning in 1999 was concerned with that of
Prices Level in China at that time and after 2000 the fluctuation of exchange rate is in the very great degree was directly related to the
change of dollar-value.
Figure 2 shows that the Chinese currency has not been underestimated after 2002, but the overvaluation has become smaller,
gradually closes to the equilibrium exchange rates. The Continuing low of exchange rate was concerned both with price level and
dollar peg .The dollar dropped, so did Yuan.
Over the same period, due to the recovery of the economies suffering the financial crisis China's export trade was increasing rapidly
with the steady rising of RMB equilibrium exchange rate. The real exchange rate and the equilibrium exchange rate tended to move
in the opposite direction and finally crossed the critical point with increasing undervaluation of the exchange rate year until 2005.
We may find that RMB real exchange rate was in line with the movement of the equilibrium exchange rate from 1994 to 1997 when
the floating rate was adopted. Under the fixed dollar peg system, the Asian financial crisis as an extrinsic factor made a great
difference to the misalignment. Besides this point, the dollar peg itself could also be a critical factor in the formation of misalignment
which had much to do with the nonconformity of the movement of two exchange rates after 20001 when the impact of financial crisis
faded away.
4 Conclusion
As stated above, from the period of economy conversion to the social market economy, RMB Real Exchange Rate Misalignment was
closely related to the Yuan exchange management. It can be seen that the stronger role the market mechanism played in the formation
of real exchange rate, the more inclined real exchange rate would become to the equilibrium exchange rate and alternatively, the
more obvious tendency the exchange rate misalignment would show. Thus to decrease the level of the exchange rate misalignment
and excise the role of equilibrium exchange rate in balancing the economy, the market reform of RMB exchange rate should be
practiced firmly and steadfastly with the perfection of managed floating rate system to realize the harmonious movement of RMB
exchange rate and the equilibrium exchange rate.
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