Research paper: "Assessing China's Exchange Rate Regime"

China's exchange rate is seldom out of the news and is a cornerstone of China-US relations. The US want a revaluation to help the record trade deficit between the two countries whilst China is keen to maintain the current rate (subject too a little upward movement every now and then to appease the Americans).

A new NBER paper by Frankel and Wei assess China's exchange rate regime.

Ponder this for a moment. Does a trade inbalance between any two countries really matter in the globalised world? Assume the World consists of 3 countries. China, US and the EU. Now, if the US has a deficit with China of 100 but the EU has a deficit with the US of 100 and also China has a deficit with the EU of 100 then world trade is balanced. The US-China deficit is largely IRRELEVANT. So why all the fuss?

"Assessing China's Exchange Rate Regime"
NBER Working Paper No. W13100

Contact: JEFFREY A. FRANKEL
Harvard University - John F. Kennedy School of
Government, National Bureau of Economic Research
(NBER)
Email: jeffrey_frankel@harvard.edu
Auth-Page: http://ssrn.com/author=20568

Co-Author: SHANG-JIN WEI
International Monetary Fund (IMF) - Research
Department, Centre for Economic Policy Research
(CEPR), National Bureau of Economic Research
(NBER), The Brookings Institution
Email: SWEI@IMF.ORG
Auth-Page: http://ssrn.com/author=54129

Full Text: http://ssrn.com/abstract=986950

ABSTRACT: This paper examines two related issues: (a) the implicit methodology used by the US Treasury in determining whether China and America's other trading partners manipulate their exchange rates, and (b) the nature of the Chinese exchange rate regime since July 2005. On the first issue, we investigate the roles of economic variables consistent with the IMF definition of manipulation - the partners' overall current account/GDP, its reserve changes, and the real overvaluation of its currency - but also some variables suggestive of American domestic political considerations - the bilateral trade balance, US unemployment, and an election year dummy. The econometric results suggest that the Treasury verdicts are driven heavily by the US bilateral deficit, though other variables also turn out to be quite important. On the issue of China's de facto exchange rate regime, we apply the technique introduced by Frankel and Wei (1994) to estimate implicit basket weights, adding several refinements. Within 2005, the de facto regime remained a peg to the dollar. However, there was a modest but steady increase in flexibility subsequently. We test whether US pressure has promoted RMB flexibility. We also test whether the recent appreciation against the dollar is due to a trend appreciation against the reference basket or a declining weight on the dollar in the reference basket, and suggest that they have different policy implications.