The Equilibrium Real Effective Exchange Rate of China: A NATREX Approach

In this paper we examine the determinants of China’s equilibrium real effective exchange rate and investigate the misalignments in the Renminbi. This paper makes a number of theoretical and empirical contributions. At the theoretical level, we extend the NATREX model to incorporate a large number of economic fundamentals that capture the unique features of the Chinese economy. At the empirical level, this is the first application of the extended NATREX model to China. Another contribution is that we estimate the extended NATREX model for both the pre- and post- reform periods. We have constructed a unique data set of consistent time series for the effective exchange rate and a large number of economic fundamentals for China since the 1950s. A further contribution is the use of total and net factor productivity obtained from an estimated production function. We find strong evidence of persistent undervaluation of the RMB during 1994-2005, accelerating in particularly after 2000. However the misalignment rates are much lower than those reported by previous studies. We also find weak evidence of overvaluation for most of the pre-reform period. For the rest of the sample period, there was no persistent misalignment