How effective is the Renminbi devaluation on China\u27s trade balance

The rapid rise of the Chinese economy is creating opportunities for many but also causing increasingly trade disputes with its major trading partners. During the recent years, the Renminbi (RMB) exchange rate issue has been at the centre of ongoing debate over the source of global current account imbalance, especially with the United States. The United States and other countries have expressed, with considerable concern, the view that China’s national currency was seriously undervalued. Critics say that, by undervaluing its currency, China gains unfair trade advantage and has seriously injured the manufacturing sector in the United States. Moreover, some even attribute the recent East Asian financial crisis to the 50% devaluation of the Chinese currency in 1994. By far not many OECD countries have recognized China’s market economy status after its 27-year market-oriented economic reforms. The objective of this study is to contribute to the current discussion on the Renminbi (RMB) exchange rate by providing new evidence on China’s exchange rate policy and the impacts of RMB devaluation/revaluation on China’s output and trade balance. For a rigorous empirical examination, this research constructs a vector autoregression (VAR) model and employs the most recent econometric techniques to identify if the Chinese economic system has become responsive to the changes in the exchange rate after about three decades reform. More specifically, we use a structural VAR technique to estimate impulse response functions and variance decompositions for China’s output and trade balance, and to determine how the fundamental macroeconomic shocks contribute to the fluctuations in the real exchange rate, and how output and trade account respond to the identified various shocks. The results from the VAR estimations indicate that the coefficients relating China’s trade balance to the once lagged changes in the real exchange rate are negative and not statistically significant in all cases, while these with two lags for the whole sample and prior-unification period show positive but insignificant. The response of China’s trade balance to the once lagged US and world output is positive, even though not statistically significant, and to the once lagged change in the trade balance is positive and also statistically significant, taking on values from 0.67 to 0.97. These results inspire one’s expectation that the dynamic effect of exchange rate on China’s trade balance is still very limited, and China’s balance of trade is mainly determined by the world demand and its trade performance, with the latter being a result of its successfully maintained comparative advantage. These are supported by the results from the impulse analysis, and the variance decomposition analysis. The movement of the US output is attributed largely to its own shocks during the entire sample period, while China’s trade balance and the exchange rate are found to be the predominant shocks accounting for the variability of the US output during the period 1994-2007. The movement of the world output is attributed largely to the world output shocks, but China’s exchange rate shock is found to be increasingly effective on the fluctuation of the world output. The findings seems to suggest that, after about three-decade reform, the Chinese economic system has been gradually transformed towards a market-originated system under which economic agents have become responsive to market signals to allow changes in exchange rates to influence the trade balance. However, the exchange rate effect on China’s balance of trade is still limited. This has important policy implications for the economies concerned