Test On The Factors Affecting The RMB Real Exchange Misalignment

The real effective exchange rate misalignment is the difference between the real effective exchange rate and the long-term equilibrium exchange rate. And the long-term equilibrium exchange rate is considered the exchange rate at which the economy can achieve internal and external equilibrium. Economists and policy makers have been paying close attention to the level of misalignment and the factors affecting the level of misalignment. In particular, in the background that China's economy are growing rapidly recently and the trade surplus and foreign exchange reserve are also expanding rapidly, the level of RMB misalignment and the factors affecting the level of the misalignment have been drawn widespread attention to. The voice in the international community calling for the appreciation of the RMB is more and more constant. And some countries even threatened China with sanctions for the radical reform of the exchange rate.In this paper, the basic assumption is that there is the basic economic variables steady equilibrium. And when a series of economic variables are in their steady equilibrium the economy was in a steady equilibrium. This steady equilibrium is commonly known as the ideal state that the steady balance of internal and external economy (non-tradable goods market clearing, sustainable capital flows of capital account maintaining) has reached. Basic economic variables fluctuate around the steady equilibrium. The equilibrium exchange rate is an endogenous variable in the economic steady equilibrium. The real exchange rate is an endogenous variable in the current economic state. The real exchange rate misalignment is affected by the current value of the misalignment of the basic economic variables.In Chapter 1 three concepts of the real exchange rate are introduced. Since the real effective exchange rate (REER) is a multilateral exchange rate and synthesizes a country's foreign trade situation, it is the best indicator of a country's real exchange rate changes. Therefore, the real exchange rate will be adopted in this paper. Then several theories on the equilibrium exchange rate calculations are introduced. They are the fundamental equilibrium exchange rate theory (FEER), the behavioral equilibrium exchange rate theory (BEER), the natural exchange rate theory (NATREX) and the equilibrium real exchange rate theory (ERER). ERER theory which considers the actual situation of the developing countries is simple and operational like BEER model. Finally the literatures on the RMB exchange rate and the RMB real effective exchange rate misalignment are introduced. We find the BEER and ERER theory have been drawn more attention in the relevant literatures and after the real exchange rate misalignment has achieved, in the overwhelming majority of the literatures the authors adopted the qualitative analysis rather than continued to use quantitative analysis to analyze the influence of the basic economic variables misalignment on the level of the real exchange rate misalignment.In Chapter 2 the time series analysis methods which are used later are described. They include the unit root test, the selection method, the cointegration test, HP filtering and VAR model application.In Chapter 3 Elbadawi's ERER model is used to estimate the RMB equilibrium exchange rate. In the analysis the quarterly data from 1994 to 2006 is used. Not only the time of data selection is close to now, so the conclusion has more guidance, but also the selection of the quarterly data makes this result more convincing. Firstly, through the unit root test and the selection method based AIC criteria we get the basic economic variables involved in the analysis, and they are the rate of technological progress, openness, monetary policy and government expenditure. Then, Johansen cointegration test is used to work out the relationship between the real effective exchange rate and the economic fundamentals. Cointegration relationship shows that expansionary monetary policy, reducing the degree of openness, technological advances and increased government spending have resulted in the appreciation of the real effective exchange rate. The first three have the same direction with the traditional theory. The result shows that between the two impacts of government spending that it can lead to an increase in the demand for foreign goods and it also can support the domestic industry directly and in directly the latter is relative larger. Finally, the basic economic variables in the cointegration relationship are replaced by their equilibrium value to calculate the Chinese equilibrium exchange rate. And by that the real effective exchange rate minus the equilibrium exchange rate we can get China's real effective exchange rate misalignment from 94 to 06. We can see that the misalignment in China's real effective exchange rate is a constant situation, and the real effective exchange rate can be the positive or negative deviation from the equilibrium value for a longer period. From the fourth quarter of 1998 to the third quarter of 2006, except a few quarters China's real effective exchange rate was underestimated. This accorded with the continued expansion of the trade balance surplus in this period. However, in the fourth quarter of 2006, China's real effective exchange rate had returned to the situation near the equilibrium value, and slightly over-estimated. This didn't accord with the phenomenon observed in this period, because in the same time China's trade surplus and foreign exchange reserves reached a higher level. One possible reason is the impact of short-term capital flows.In Chapter 4 VAR model was used to study the channel and the dynamic characteristics of the basic economic variable misalignments affecting the RMB real effective exchange rate misalignment. Unit root test shows the real effective exchange rate misalignment is I (1). Further this shows that the real effective exchange rate misalignment can be sustained a positive or negative deviation from equilibrium for a long period. We also turned to the study of the interaction between the first order differential of the real effective exchange rate misalignment (ΔMISREER) and the fundamental economic variables misalignment. In the process of building a VAR model, we found a serious multi-colinearity. Since the result of autoregression distributed lag model shows that monetary policy misalignment need to be excluded from the VAR model. Therefore in this paper we use several other variables to build a VAR (3) model. Next, the Granger causality test shows the misalignments of openness, the rate of technological progress and government spending are the Granger reasons ofΔMISREER. This is the certification of the impact of the three variables to the real effective exchange rate misalignment, and shows that misalignments of the three variables influence the real effective exchange rate dynamic changes through a direct impact on theΔMISREER. In the impulse response analysis, we can see that three basic economic variables misalignment have a positive overall impact on theΔMISREER. But apart from the impact of the openness misalignment which is relatively stable, the impacts of the other two variables are very unstable in different periods. In the paper the unstable impact of the government spending seems to be disproportionately affected the two impacts with the different directions of the government spending and the instability in the impact of the productivity misalignment reflected the over-rebound of the economic fundamentals in the process of returning to the equilibrium situation resulted from that the economy lacks the necessary flexibility. The results of the variance decomposition further illustrate the significant impacts of the misalignment of the three basic economic variables onΔMISREER. It also shows the impacts of the different economic fundamentals misalignment have their own independent features, and the impact of openness is of relative stability.In Chapter 5 the results of the quantitive analysis were summarized and the involved policy recommendations were put forward. This article thinks that the results revealed the channel and the dynamic features of the misalignment of economic fundamentals affecting the real effective exchange rate misalignment. Apparently, there exists a theoretic likelihood that the fixed exchange rate system or the system that changing slow can be sustained and at the same time other economic policies can be used to balance the economic viability. However, because the dynamic responses of the basic economic variables on the real effective exchange rate at different periods are difficult to be grasped, the government has multi-target and so on, a more flexible exchange rate system is a wise choice. Only a more flexible nominal exchange rate system can change the current viscosity of the real effective exchange rate, make the economy suffering from the economic impact return to equilibrium faster to reduce the loss that resulted from the misalignment. In addition, in the formulation of the government policy, the impact on the real effective exchange rate misalignment should be considered.