Evaluating the extent of real exchange rate misalignment in China

  • Dan Zhou

    Student thesis: Doctoral ThesisDoctor of Philosophy


    The dissertation investigates the issues pertaining to China’s fixed exchange rate policy and attempts to appraise the case for greater exchange rate flexibility. The thesis addresses three objectives: First, a critical appraisal of China’s exchange rate policy in the light of theoretical and empirical literature supporting greater flexibility in exchange rate; second, it builds a monetary dual exchange rate model and analyses in a dynamic theoretical framework the impact of nominal demand and price shocks due to over and undervalued currency. Third, using Chinese macroeconomic data it empirically examines the factors determining China’s real exchange rate fluctuations.

    After presenting a brief history of China’s exchange rate policy in the post-war period, an assessment of China’s fixed exchange rate policy is made, including the costs of maintaining its current peg. It is argued that the literature on China’s exchange rate regime has not reached a consensus, and further theoretical arguments are appraised regarding the reluctance to move to a more flexible exchange rate regime. A theoretical dual exchange rate monetary model, in the spirit of Flood and Marion (1983), is then developed to analyse the dynamics in the responses to nominal and real shocks. This provides a theoretical basis for analysing the underlying working mechanism and policy implications under some degree of capital control, to resemble the Chinese exchange rate regime. In the light of the theoretical analysis, empirical research is conducted using a structural vector auto-regression (SVAR) model to examine the effects of real exchange rate fluctuations to nominal and real shocks (represented by inflation and real GDP), in order to determine the case for exchange rate flexibility. Both the theoretical and empirical analyses complement to inform the ongoing debate on whether the current exchange rate regime in China should be made more flexible, and whether a more flexible regime is appropriate in stabilising the effects of macroeconomic shocks.

    The empirical findings reveal that the responses of the real exchange rate to nominal IX demand and real supply shocks are consistent with a managed exchange rate system that currently operates in China. In particular, the results show that, as China has been under a fixed exchange rate arrangement for much of the estimation period, the real exchange rate appreciates immediately in response to a positive nominal shock. The use of quarterly Chinese data in this study, which no previous study on China has used, makes it possible to identify to a greater degree the initial appreciation impact of a positive nominal shock on the real exchange rate, although the results are generally consistent with the previous study by Wang (2004) using annual data. The study finds that supply shocks are dominant in the fluctuations of output growth, and while both nominal and real shocks are significant the nominal contributes more than real shocks in real exchange rate fluctuations. Overall, these findings are consistent with other studies for developing countries and support a case for greater exchange rate flexibility for China.
    Date of Award2009
    Original languageEnglish
    Awarding Institution
    • Coventry University
    SupervisorSailesh Tanna (Supervisor), Tim Rogers (Supervisor) & Tomroe Moore (Supervisor)

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