With the visit of President Hu to the United States, Chinese currency misalignment is at the top of the agenda. What is “misalignment”?
This question is not rhetorical. In a paper written with Yin-Wong Cheung and Eiji Fujii, presented at a Sept. 2005 SF Fed conference on Pacific Basin imbalances, we exploited the well known cross country relationship between the real exchange rate and relative per capita income (expressed in PPP terms).
Figure 1: Scatterplot of Relative Price Level against Relative Per Capita Income (in PPP terms), Conditional Mean, and Serial Correlation Adjusted Prediction Intervals. Source: Cheung, Chinn and Fujii (2005).
As can be seen,the Renminbi (Rmb) appears to be substantially undervalued, even after taking into account the fact that absolute PPP doesn’t hold. The regression line is for a pooled sample encompassing over a 174 countries over the 1975-2003 period, with plus/minus 1, and plus/minus 2 standard error bands (adjusted for serial correlation). The point estimate indicates that each one percent increase in relative (to US) per capita income induces a 0.25 percent real appreciation (these real exchange rates are the Penn World Tables “price level”).
One key result is the confirmation that according to this criterion, the Rmb is indeed undervalued, and undervalued by a very large amount (in log terms, over 70%; in level terms about 50%). A second, equally important result, is that the 2003 estimate is within one standard error of the conditional mean. Hence, the corresponding p-value for the hypothesis that the Rmb is undervalued is larger than conventional significance levels. In other words, by conventional levels of statistical significance, the Rmb is not undervalued.
Speaking for myself, I do not take this as proof positive that the Rmb is not undervalued. After all, failing to reject the null hypothesis is not the same as accepting the null hypothesis. Rather, I would say it tells us something about the difficulties of defining exchange rate misalignment. One notices that the degree of measured undervaluation was not that much smaller in 1997-98, when the Rmb was widely acknowledged as overvalued, or not misaligned.
Brad Setser would likely argue that the Chinese trade surplus (which has ballooned since 2003, and is now running around $100 billion a year) is clear indication that the Rmb is undervalued. I would tend to agree, although I (like Brad) would take to heart Jeff Frankel’s key observation that it is not really interesting to discuss misalignment without discussing both internal and external equilibrium. That nuance is often missed in the discussion of Rmb misalignment.
Now, most of us now agree that, under conditions of a capital control-ridden economy laden with many distortions (a legacy of central planning), the Rmb is undervalued according to both the price criterion (discussed above) and the internal-external equilibrium criterion. The question I have is what is the equilibrium value if the capital controls were not in place. This might seem to a hypothetical question, but I suspect that the initiative to acclimate the markets to a more flexible Rmb might presage greater capital account openness. Then, we may discover the equilibrium Rmb rate is much weaker than what we currently see.
The second part of the title asks whether Rmb undervaluation matters. Of course, yes. But partly no. Even if the Chinese Rmb is allowed to appreciate substantially, and the other East Asian currencies follow, the new set of imbalances is with the oil exporting countries (see the IMF WEO Chapter on oil prices and global imbalances.)
Figure 2: Current Account Balances. Source: UN ESCAP, Key Economic Developments and Prospects in the Asia-Pacific Region 2006 (Dec. 2005)
Chinese revaluation will do little to affect these balances — much of which is run with the U.S. For real change, I reiterate, the central responsibility lies with American policymakers: cut the budget deficit and decrease oil imports. (For everything you wanted to know about evaluating the Rmb, see this website).