Transcript China’s Exchange Rate Regime Getting it right

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
2
tril.dollar
1.9
1.8
1.7
1.6
1.5
1.4
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Month
Foreign Exchange Reserves
Sep
Oct
Nov
Dec
China’s Real Effective Exchange Rate
Real Effective Exchange Rate
150
01
/0
1
07
/0
1
01
/0
2
07
/0
2
01
/0
3
07
/0
3
01
/0
4
07
/0
4
01
/0
5
07
/0
5
01
/0
6
07
/0
6
01
/0
7
07
/0
7
01
/0
8
07
/0
8
75
0
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:
 Pi 
 GDPi 
Log US    0  1 Log
  ui
US
P 
 GDP 
-1
-.5
0
.5
Relative price levels and GDP per capita compared to the Untied States
in year 2006 (all countries)/ Basic Model
-2
-1.5
China
-6
-4
-2
0
2
relative 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.
.5
0
-.5
-1
-1
-.5
0
.5
Relative price levels and GDP per capita compared to the Untied States
in year 2006 (using different samples)/ Basic Model
China
-1.5
-2
-2
-1.5
China
-6
-4
-2
0
2
-4
-3
-2
-1
relative PPP GDP per capita
relative Price Level
0
1
relative PPP GDP per capita
Fitted values
relative Price Level
-.5
-1
-1
-.5
0
Sub 1
0
All countries
Fitted values
China
-1.5
-2
-2
-1.5
China
-6
-4
-2
0
-4
-3
-2
relative PPP GDP per capita
relative Price Level
Sub 2
Fitted values
-1
0
relative PPP GDP per capita
relative Price Level
Sub 3
Fitted values
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:

 P 
 GDPi 
 GDPi
Log USi    0  1 Log


Log


2
US
US
P
GDP




 GDP

2

  u i

-1
-.5
0
.5
Relative price levels and GDP per capita compared to the Untied States
in year 2006 (all countries)/ Revised Model
-2
-1.5
China
-6
-4
-2
0
2
relative 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
-1
-1
-.5
-.5
0
0
.5
.5
Relative price levels and GDP per capita compared to the Untied States
in year 2006 (using different samples)/ Revised Model
China
-2
-2
-1.5
-1.5
China
-6
-4
-2
0
-4
2
-3
-2
-1
0
1
relative PPP GDP per capita
relative PPP GDP per capita
relative Price Level
relative Price Level
Fitted values
Fitted values
Sub 1
0
-.5
-1
-1
-.5
0
All countries
China
-1.5
-2
-2
-1.5
China
-6
-4
-2
0
-4
-3
-2
-1
relative PPP GDP per capita
relative Price Level
Sub 2
Fitted values
0
relative PPP GDP per capita
relative Price Level
Fitted values
Sub 3
Estimate for year 2006 (Revised model)
Renminbi’s misalignment from year 2005 to 2008
Basic Model
2005
2006
2007
2008
Misalignment
0%
-5%
-10%
-15%
-20%
-25%
-30%
Year
all countries
sub-sample 1
sub-sample 2
sub-sample 3
Revised Model
2005
2006
2007
2008
Misalignment
4%
2%
0%
-2%
-4%
-6%
-8%
Year
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
2006
2007
2008
10%
2005
Misalignment
Misalignment
2005
Sub-sample 1
0%
-10%
-20%
-30%
2006
0%
-10%
-15%
Year
Revised Model
Basic Model
Sub-sample 2
2006
2007
5%
0%
-5%
-10%
-15%
-20%
-25%
Year
Basic Model
Revised Model
Sub-sample 3
2008
2005
Misalignment
Misalignment
2005
2008
-5%
Year
Basic Model
2007
5%
2006
2007
0%
-5%
-10%
-15%
Year
Revised Model
Basic Model
Source: IMF World Economic Outlook Database, author’s calculation with MS-Excel.
Revised Model
2008
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
excess 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