In search of an optimal basket for the Renminbi

In July 2005, Mainland China announced that she would adopt a more flexible exchange rate regime, “making reference to a basket of currencies”, instead of the de-facto peg to US dollar. This raises questions of how the new system works and what the best weights and composition are in China’s circumstances. In review of the literature, this paper first reviews the internal and external forces for China to reform her regime in 2005 suggested by Chinese and foreign scholars. Afterwards several stages of exchange rate regime of China since 1970s are examined. Then it compares simulated exchange rate movements and volatilities of various baskets with different weighting methods─original trade weights and Hong Kong re-export adjusted trade weights, of both total trade and manufacture goods trade, and alternatively the real “world output” basket proposed by Ho(2000). Considered currency baskets include the single currency basket (US dollar), the three major currency basket (US dollar, Japan Yen and Euro), four, six and thirteen currency baskets, and the eleven currency basket revealed by China’s central bank. Afterwards it simulates the effects on China’s bilateral trade balances with her major trading partners under each basket by using Johansen cointegration test and vector error correction estimation. The result of the paper indicates that a country which has adopted a trade-weighted currency basket will generally enjoy more stable, less fluctuating bilateral nominal exchange rates, nominal effective exchange rate index and real effective exchange rate index with much lower volatilities than other regimes. In terms of exchange rates volatility, it shows that currency baskets are superior to the historical regime, a fixed peg and a WCU link. Moreover, scenarios adopted a currency basket will perform a relative more stable export growth and a more stable trade balance with a lower surplus. However, an increase in the number of currencies in a basket does not necessarily lead to a better result