Is Chinese currency undervalued? : an empirical analysis

The Chinese currency, Renminbi (RMB), is widely believed to be undervalued since 1997 based on the fact that China has experienced a substantial balance of payment (BOP) surplus. China's accumulative BOP surplus was more than 10% of GDP from 1997 to 2002, compared with 6% of GDP from 1982 to 1997. However, in the first quarter of 2004, China recorded a trade deficit of $8.43 billion. The huge increase of BOP was result from China's exchange rate regime reform, which became effective in early 1980's with a dual exchange rate system, followed by unification in 1994 with a managed floating system, and adopted a de facto peg exchange rate regime since 1997 to current. Given the unique situation in China, where capital account is inconvertible and the economy is growing at annual average rate of 8% over the last two decades, it would be appropriate to apply econometric model to empirically analyse the exchange rate misalignment issue. In this research, as a bench mark of misalignment, we will follow the concept of Behavioural Equilibrium Exchange Rate (BEER), which differs from the macroeconomic balance approach model (Williamson, 1995). The BEER is determined by a set of fundamental economic variable instead of calculating the level of the real exchange rate that is consistent with internal and external balance. The real exchange rate is said to be in equilibrium when it reflects the changes of its relevant economic variables. By comparing the actual rate with the BEER, we examine the degree of its misalignment if the RMB has been undervalued. Time series econometric methodology will be employed for the quantitative analysis