China Economic Review 23 (2012) 1146–1163
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China Economic Review
Structural breaks and the equilibrium real effective exchange rate of China: A NATREX approach Kefei YOU a,⁎, Nicholas SARANTIS b
Centre for International Capital Markets, London Metropolitan University, UK Cass Business School, City University London, UK
a r t i c l e
i n f o
a b s t r a c t
This paper investigates the equilibrium real effective exchange rate for the Chinese RMB during the post-reform period, 1982–2010. We extend the NATREX model in several important perspectives and apply it for the first time to China. A wide range of economic fundamentals that are unique to the Chinese economy is introduced into the model. We construct a unique set of quarterly data and employ unit root and cointegration tests that can account for multiple endogenous structural breaks. In addition, to capture the evolution of China's foreign trade pattern, we employ time-varying (i.e. 3-year average) trade weights to construct the real effective exchange rate. We find two structural breaks in the cointegration relationship (in 1988 and 1992). Effective terms of trade, demographic factors, liquidity constraints and government investment are significant determinants of the equilibrium real effective exchange rate. The RMB was overvalued against a basket of 14 currencies until mid-1980s. During 1986–2010, it was undervalued in most years except after the Asian financial crisis in 1997. We have found persistent undervaluation from 2004 onwards. However, the misalignment rates are much lower than those reported by previous studies and the undervaluation rate actually declined sharply in 2008. The undervaluation rate rose modestly in 2009 and sharply in 2010, though it is still lower than what has been suggested by other studies. © 2012 Elsevier Inc. All rights reserved.
Article history: Received 16 January 2011 Received in revised form 1 June 2012 Accepted 16 August 2012 Available online 25 August 2012 JEL classification: F31 F32 F41 C51 C52 O53 Keywords: NATREX Equilibrium real effective exchange rate Structural breaks Chinese Renminbi Misalignments
1. Introduction China's mounting trade surplus and its huge foreign exchange reserves have caused considerable debate among politicians and academics about the value of its currency, Renminbi (RMB). A number of studies have investigated the equilibrium real effective exchange rate for China, with the majority showing substantial undervaluation since the middle of the 1990s. 1 Most previous studies use either the PPP (Purchasing Power Parity) (e.g. Dunaway, Leign, & Li, 2006; Shi, 2006; Wang, 2004, 2005), the BEER (Behavioral Equilibrium Exchange Rate) (e.g. Bénassy-Quéré, Duron-Vigneron, Lahrèche-Révil, & Mignon, 2004; Chen, 2009; Funke & Rahn, 2005; Wang, Hui, & Soofi, 2007; Zhang, 2002) or the FEER (Fundamental Equilibrium Exchange Rate) (e.g. Coudert & Couharde, 2007; Jeong & Mazier, 2003; Wang, 2004) model. In this paper we develop and apply an extended NATREX model that has not been previously applied to China. In contrast to PPP, BEER and FEER, the NATREX model considers the structure of the whole economy and provides more information about the determination of the equilibrium exchange rate. In addition, the Chinese economy has a growth path that distinguishes it from other economies. This study reviews a wide range of studies on various aspects of the Chinese economy and, within the ⁎ Corresponding author at: London Metropolitan Business School, London Metropolitan University, 84 Moorgate, London EC2M 6SQ, UK. Tel.: +44 20 7320 1520; fax: +44 20 7320 1585. E-mail address: email@example.com (K. You). 1 For a recent review of the empirical literature on China's equilibrium exchange rate using alternative models, see Cline and Williamson (2008). 1043-951X/$ – see front matter © 2012 Elsevier Inc. All rights reserved....
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