An Extended FABEER Model for the Equilibrium Chinese Yuan/US Dollar Nominal Exchange Rate

This paper applies for the first time an extended FABEER model to China, in order to investigate the determinants of the equilibrium nominal CNY/USD exchange rate and the misalignments of the Renminbi for both pre- and post-reform periods. We extend the FABEER model to include eleven of China’s main trade partners which account for 82% of its foreign trade. Second, we model and estimate the sustainable current account and the trade equations by employing a unique data set of consistent time series for economic fundamentals, trade-related variables and Euro variables since 1960. The results show that the sustainable and trend current accounts for China have been positive and rising during the post-reform period, accelerating particularly since the middle of 1990s. The nominal RMB was overvalued against the US dollar throughout the pre-reform period, but was undervalued and less volatile during the post-reform period. The undervaluation became more persistent and rising since 2000, but the misalignment rates are considerably smaller than those suggested by previous studies. Our empirical findings imply that a gradual increase in the flexibility of the exchange rate system rather than a sudden switch to a floating system would be more feasible for China over the near future