Research "internal Devaluation And External Appreciation," The Causes And Mechanism Of RMB

Since the reform of the RMB exchange rate regime was implemented in July,2005, the value of the RMB has depreciated internally and appreciated externally.Externally, the appreciation was dramatic, both in terms of the appreciaton of theRMB against the U.S. dollar, and against a basket of currencies. Internally, thedepreciation of the RMB means the inflation in China. The RMB internaldepreciation and external appreciation and the imbalanced economy brought a seriesof shocks and challenges to the performance of China’s economy and the policysetting, such as the deterioration of the operation environment for firms, the financingdifficulty for small-medium enterprises, the decline of resource allocation efficiency,the difficulty of monetary policy implementation, the mounting risk for themanagement of foreign exchange reserve, the impairment of banking profit, thedifficulty for financial regulation and the rise of financial risk. The thesiscomprehensively analyzes the reason and mechanism of the RMB internaldepreciation and external appreciation from the perspectives of puchasing powerparity (PPP), interest rate parity (IRP), balance of payment (BOP), and globalperspective. Furthermore, the thesis discusses the logical relationships between thefour pespectives, and provides policy recommendations.According to the research, there are five reasons for the RMB internaldepreciation and external appreciation. Firstly, in terms of relative PPP, the RMBinternal appreciation and external depreciation between1998and2004caused theRMB real exchange rate deviation. The RMB internal depreciation and externalappreciation after2005was the result of mean reversion of the RMB exchange rate.Secondly, according to Balassa-Samuelson (B-S) Effect, in the catching up stagefor China economy, that the productivity of tradable sector was much higher than thatof untradable sector, as were as the turning point of labor supply, led to the rapid riseof the price of untradable sector, the structural inflation in China and the appreciationof the RMB real exchange rate. From the perpective of absolute PPP, the RMBapproaches parity gradually via real exchange rate appreciation, as the rise of China’sper capita income.Thirdly, the “carry trade cycle” accelerated the RMB internal depreciation and external appreciation. The RMB appreciation expectation, which was caused byexogenous variable, triggered the carry trade, and brought about the large-scale inflowof international capital from various channels. Additonally, this led to the loosemonetary and credit environment in China, the internal depreciation of the RMB, andthereby the tightening of monetary policy and the raise of interest rate by PBC, thecentral bank of China. Finally, the appreciation expectation of the RMB exchangerate and carry trade was strengthened. The “carry trade cycle”, an endogenousmechanism, caused the RMB internal depreciation and external appreciation in aself-fulfilment approach.The fourth, the high saving rate in China resulted from the factors such aseconomic development stage, income devision, demographic structure, housing boom,and hot money inflow. In addition, the rising saving rate led to the current accountsurplus as percent of GDP in China increased from1.7%in2000to10.1%in2007.The tremendous current account surplus brought about the rise of the RMB exchangerate appreciation pressure.“High saving rates cycle” was another endogenousmechanism that strengthened the RMB internal depreciation and external appreciation.The exogenous variable, such as economic development stage, increased China’ssaving rate, gave rise to huge current account surplus and the external appreciation ofthe RMB, and caused the hot money inflow and loose monetary and creditenvironment. Furthermore, it led to the internal dereciaion of the RMB and thehousing boom. Finally, the housing boom and hot money inflow further increasedthe saving rate.The fifthe, global imbanlances and two-speed world economy brought about theinternal depreciation and external appreciation of emerging markets currencies.Since2000, the appreciation of emerging markets currencies against the U.S. dollarhave been caused by the dramatic increase of the saving rate and the current accountsurplus of emerging markets, and the current account deficit of the United States.Under the background of the international monetary system, characteristized by thedollar standard and global imbalances, the long term weak dollar and the low interestrate of the dollar aggravated the carry trade, and led to the internal depreciation andexternal appreciation of emerging markets currencies, including the RMB.Furthermore, the thesis corrects the misuse of absolute PPP and B-S theory injudging the undervaluation or overvaluation of the RMB. It was belived that, as longas the RMB exchange rate against the U.S. dollar was higher than the absolute PPP, the RMB exchange rate was undervalued, for example, the big MAC index compiledby The Econmist. From the perspective of B-S theory, at the current developmentstage for China, when China’s per capita income is merely1/8of the United States,that RMB exchange rate is higher than absolute PPP conforms to the law ofdevelopment.The thesis reveals that, the world economy has experienced profound changessince international financial crisis broke out in2008. Especially since the recent oneor two year, the internal depreciation and external appreciation of the RMB, and otheremerging markets currencies, have temporarily eased, even might reverse in the nearterm. There are four reasons for the reversion. Firstly, due to the fast real exchangerate appreciation for the RMB, from the relative PPP perspective or the B-S theoryperspective, the RMB exchange rate have reached reasonable level in the short term,or even overvalued to some extent. Secondly, exogenous variable shocks such as the“4-Trillion stimulus plan” decreased China’s saving-investment gap, improved thebalance of payments imbalances, and broke the endogenous mechanisms such as“high saving rates cycle” and “carry trade cycle”. The third, international financialcrisis and European sovereign debt crisis forced the United States and Europeancountries to adjust their economic structure, which restored the banalce of paymentfor developed countries. The fourth, the quantitative easing (QE) tapering of the Fedled to the backflow of carry trade fund, which caused the turmoil of emerging marketsfinancial markets and the depreciation of emerging markets currencies.Of course, in the long term, as long as China’s economy keeps growing in arelatively high rate, the two-speed world economy persists, and the gaps of per capitaincome and tradable sector productivity between China and the United States keepdeclining, the RMB real exchange rate will maintain the trend of appreciation.To sum up, the RMB internal depreciation and external appreciation results fromboth exogenous variables and indogenous mechanisms. Furthmore, internaldepreciation and external appreciation is not the unique phenomenon of the RMB, butwidely shared by emerging markets. Emerging markes are in a dilemma, eithersuffering carry trade, internal depreciation and external appreciation, impairedmonetary policy autonomy, or sacrifying economic and financial stablilty. Animportant approach to solve the dilemma is to promote the RMB internationalization,the reform of international monetary system, and form a trio-currency (the U.S. dollr,the Euro and the RMB) international monetary system. In order to solve the problems broght about by the RMB internal depreciation and external appreciation,China has to promote the economic structural adjustment and reform of the RMBexchange rate regime on the one hand, and promote the capital account liberalization,the RMB internationalization, and the reform of international monetary system on theother.