Re-testing Chinese RMB s Currency Basket:

Transcription

1 Re-testing Chinese RMB s Currency Basket: US dollar pegging vs. currency basket pegging Yuming Cui Abstracts --This paper examines China s current RMB exchange rate policy by using latest data. The results illustrate that RMB did not perfectly peg to a basket of currencies during the period of January to November US dollar still was the most important candidate currency to peg. But its weight in RMB s currency basket declined. Lastly, this paper provides some exchange rate policy implication and recommendations based on empirical findings. 1. Introduction Exchange rate policy has been becoming one of key global economic issues when cooperation on protesting trade protectionism and stabilizing global economy among countries had weakened since Financial Crisis of Recently, some emerging countries struggled to keep their currencies unappreciated, if not depreciated, in order to keep export competitiveness advantage. Since late of 2008, the U.S. Federal Reserve pumped liquidity into market which were known as QE1 and QE2 to stimulate economic growth. US dollar considerably depreciated against most emerging economies currencies. International community concerned the Currency War 1 when some governments attempted to use exchange rate policies as a tool to solve their domestic increasing inflation and keep export competitiveness advantage. Among many arguments on exchange rate policies, Chinese currency--renminbi (also called yuan, henceforth RMB,) and China s exchange rate policy are on the central stage. RMB suffered increasing pressure economically and politically from international community, especially from Unite States 2. Since China announced to adopt new exchange rate regime which shifted from pegging to US dollar into pegging to a basket of currencies in 2005, it seems that rest of world doubted if China has truly implemented this new regime and to what extent that China implemented it. Considering China s rapid growth in the last three decades and its increasing current account surplus and foreign 1 On October 2010, Brazilin Financial Minster initially said: "we re in the midst of an international currency war", and this threatens us because it takes away our competitiveness." 2 U.S. Congress started the legislative process for the RMB exchange rate on October 2010 and attempted to take legislation to force RMB appreciation. reserve, combining the huge trade deficits in the U.S., it is very significant to analyze China s exchange rate regime by applying the latest data. From a historical view, RMB exchange rate policy seems to own its unique characteristics and evolution path. It will be helpful for economists and policy makers to evaluate an economic issue once they truly understand its evolution history. It is applicable for RMB exchange rate, particularly bearing in mind that China just shifted from command economy to market economy for three decades when exchange rate policy was one of the most powerful tools to keep its economic growing rapidly. In this study, firstly, we reviewed previous studies on RMB exchange rate policy and compared results. We then move forward to analyze the contents of RMB currency basket and estimate the weights of the each candidate currencies. Frankel and Wei (1994 and 2007) developed a well known model to analyze a basket of currencies. We will apply this model to analyze RMB s currency basket by using the latest data. Lastly, we attempt to make some recommendation on RMB exchange rate policies based on the review on RMB exchange rate regime and empirical results. 2. Literature review There are some papers to research RMB s currency basket since the new exchange rate regime was announced by Chinese central bank in TAC s research team (2005) 3 finds that Chinese authorities took one day to adjust RMB exchange rate to respond the fluctuations of these currencies in its currency basket. Moreover, they find that the main four currencies which are US dollar, Euro, Japanese yen and Korean won explained more than 90% of the daily variation of RMB exchange rate and rest currencies explained about 10%. On comparison, Jen (2005) estimates the weight of the US dollar to be 85 percent and Eichengreen (2006) finds the weight of US dollar to be 90 percent by employing the daily data over the period from July 2005 to March Yamazaki (2006) finds the evidence that Euro, Japanese yen and Korean won s weights in RMB s currency basket increased gradually. In addition, Frankel and Wei (2007) conclude that RMB was 3 TAC (Thierry Apoteker Consultant) provides applied economic and financial research to financial institutions, international companies and multilateral organizations. DOI: _ _ GSTF

2 characterized by more flexibility and its behavior has changed from weighting on US dollar remaining close to one to weighting on some non-dollar currencies since 2006, but still not dramatically. More recently, Moosa (2008) argues that RMB actually crawling pegged to US dollar rather than a currency basket as Chinese central bank announced during August 2005 May In contrast, Frankel (2009) concludes that RMB s currency basket switched a substantial part of US dollar s weight onto Euro. Moreover According to the empirical result by using TV-AR-GARCH models from Funke and Cronwald (2008), evolution of the RMB exchange rate regimes was smooth nonlinearity rather than linearity used in most of previous studies. 3. RMB s currency basket analysis 3.1 RMB s currency basket Since People s Bank of China (thereafter PBoC) officially announced to employ managed floating exchange rate regime by pegging to currency basket rather than de facto pegging US dollar, it has released very limited information on the currencies components and respective weights in the basket. 4 But details on this new regime and the contents of the RMB s currency basket have not been officially released by the PBoC, the weight of each currency in this basket remains unclear. importance of the current account transactions. The first tier and second tier currencies unveiled by PBoC are shown in Table Data and methodology Data Because some similar studies have been done before, we selected the latest data to test currencies weight in this study. Setting the date of June 19th, 2010 as the middle point, we chose the same days in two periods which are before and after this date (from February 19, 2010 to June 19, 2010 and from June 19, 2010 to November 19, 2010, see Graph 1). One of advantage of employing above data is that we could compare the result of before and after announcement of new RMB exchange rate policy. In addition, RMB exchange rate dramatically appreciated since October 2010 when it was under increasing pressure. Moreover, this dataset has never been covered by previous studies. Graph 1 RMB nominal exchange rate from January 2010 to October 2010 Table 1 Candidate currencies in RMB currency basket Currencies Name Symbol Main Currencies U.S. Dollar Euro USD EUR (first tier) Second Currencies (second tier) Japanese Yen Korean Won Singapore Dollar British Pound Malaysian Ringgit Australian Dollar Canadian Dollar Russian Rouble Thai Baht JPY KRW SGD GBP MYR AUD CAD RUB THB Source: according to PBoC governor s public speech on August 9, 2005 According to the information released by China s PBoC, anchor currencies selection criterion is the 4 On July 21, 2005, PBoC officially announced to move into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Source: PBoC s data and statistical data As Frankel and Wei (2007), we used SDR (Special Drawing Right) 5 as numeraire to define the real value of each currency. 6 Compared to other potential numeraire, like gold and Swiss franc, SDR is more appropriate partly because it is calculated based on a weighted currency basket of the major currencies in the world Methodology We employ the model developed by Frankel (1993c) and Frankel and Wei (1994, 1995 and 2007) to examine the RMB s currency basket. This is a well known model which was applied by Shah et al. (2005), Eichengreen (2006), Yamazaki (2006), Frankel and Wei (2006, 2007) to analyze RMB s 5 Currency value of the SDR is determined by summing the values in U.S. dollars, based on market exchange rates, of a basket of major currencies (the U.S. dollar, Euro, Japanese yen, and pound sterling). Based on their roles in international trade and finance, On November 15 th, 2010, IMF adjusted the weight of each currency: USD 41.9%, EUR 37.4%, GBP 11.3% and Yen 9.4%. 6 Frankel and Wei (2007) explained in details why used SDR as a numeraire rather than others, like Swiss franc GSTF

3 currency basket. Frankel (2009) continued to use the upgraded model which added new variable, so called Exchange Market Pressure variable, which is defined as the percentage increase in the value of the currency plus the increase in reserves, to re-study RMB currency basket. This upgraded model helped to capture the extent of flexibility of RMB exchange rate. Higher coefficient of this variable should lead higher floating degree because there is less external intervention on foreign exchange market. Zero means RMB exchange rate is purely fixed while one indicates purely floating. According to his result, there was upward trend on this coefficient although not very significant. It increased from in December 2008 in to in May It showed us that RMB exchange rate gradually pegged currency basket in larger extent rather than only US dollar. Moreover, Euro and Japanese yen s weights grew during the period from July 2006 to May Graph 2 plots the percentage changes of RMB exchange rate over the period. Compared to previous finding, RMB exchange rate s daily fluctuation is larger than before. Its daily movement reached 0.2% frequently before June 19 th, While more than 4% of daily change on November 10 th, 2010 reflected the largest daily change since July 2005 when PBoC declared new exchange rate regime. Evidence from Graph 2 indicated the larger daily movement, especially after June Graph 2 Changing in RMB exchange rate over period from 19/01/2010 to 19/11/2010 Source: author s calculation Note: RMB exchange rate valued in SDR Based on Frankel (2009) s finding, in this paper, we will not add this new variable (Exchange Market Pressure variable) into Frankel and Wei (2007) s model. We assume that RMB pegged to currency basket more heavily than before, especially considering that PBoC officially announced to proceed to reform the RMB exchange rate regime and enhance the RMB exchange rate flexibility. The latest data will be employed to capture the latest features of RMB currency basket. The weight-inference model which regress the changes in log value of RMB exchange rate against the changes in log value of eleven candidate currencies in the basket is simple and neat. The reason of choosing the change rather than level is non-stationary concerns. Exchange rate data is very typical time series data. It was proved that some time series data is non-stationary. So we cannot simply regress two or more time series data without testing cointegration (Engel and Granger, 1987). This model avoids the econometrics problem by taking first difference. Graph 3 supports above argument that first deference of RMB exchange rate seems look stationary. Moreover, we would like analyze the weight of each candidate currencies rather than to what extent of candidate currencies exchange rate changes will influence RMB exchange rate. Thus this model does make clear sense in economics view. Because we cannot ensure that RMB was fully pegged currency basket, constant c is included to allow the possibility of RMB not perfectly pegging currency basket and measure the trend. log RMB( t + s) log RMB( t) = c + w( j) [ log X ( j, t + s) log X ( j, t) ] where X indicates the currencies which are the eleven currencies declared by PBoC in RMB currency basket. w denotes weight of each currency, j represents each of currency and c is constant. The results of this test are shown in Table 2. We can see that only the weight of US dollar is significant both in the period before and after June 19 th, It means that RMB still pegged USD rather than rest currencies in its basket. But on the other hand, the weight of US dollar decreased from to which can be interpreted that the importance of US dollar in currency basket is weakening. It seems that above two finding are contradictory. Assuming RMB is purely pegging on a basket of currencies, when one currencies weigh (US dollar in this case) declined, weight of rest currencies should correspondingly increase. But the result we found did not showed it. We may conclude that RMB was not perfectly pegging currency basket during the period of RMB did not strictly peg to US dollar. But US dollar still is the most important candidate currency to peg for RMB, even its weight is decreasing. We also found that R square value of sample data in two periods dropped from to which supports our conclusion that RMB exchange rate regime did not, at least not perfectly, peg to the basket of currencies in most time of 2010, especially in second half of year because higher R square value indicates tighter pegging to the basket. Furthermore, if RMB exchange rate is truly a basket pegging, the sum of the weight of each currency (eleven currencies in this case) should be one. But our GSTF

4 findings convinced us that RMB exchange rate did not act as PBoC announced during period we covered. Table 2 Estimating eleven currencies weights in the RMB s currency basket (January 19 th, 2010 November 19 th, 2010) (Numeraire currency = SDR) Currencies Before 19 / 06 / 10 After 19 / 06 / 10 Change considerable inflationary pressure 7. Exchange rate policy is becoming one of the most popular and sensitive issues, particularly RMB exchange rate policy. RMB appreciated about 2.8 percent against US dollar from June to November Graph 3 illustrates that RMB exchange rate fluctuated more dramatically since September To some extent, the degree of RMB appreciation is more linked with external political pressure and internal inflation pressure rather than pegging to a basket of currencies. US dollar Euro Japanese yen Korean won Singapore dollar 0.794***(0.082) 0.719***(0.143) (0.047) (0.087) (0.023) (0.044) (0.017) (0.032) (0.075) (0.146) Table 3 Comparing eleven currencies weights in the RMB s currency basket in different period (Numeraire currency = SDR) Currencies (1) (2) (3) (4) British pound (0.026) (0.055) US dollar 0.904**( **( **( **(0.14 Malaysia ringgit (0.048) (0.091) Euro Australian dollar (0.021) (0.045) Japanese yen Canadian dollar (0.019) (0.033) Korean won Russsia rouble (0.025) (0.056) Singapore dollar * Thai baht (0.061) (0.085) British pound Constant E-5 (0.000) E-5 (0.000) - Malaysia ringgit 0.053**( Observations Australian dollar Adjusted R-squared Canadian dollar *** significant at 5% Data source: IMF data and statistics Before 19/06/10: January 19 th, June 19 th, 2010 After 19/06/10: June 19 th, 2010 November 19 th, 2010 Russsia rouble Thai baht Constant **( * - - Graph 3 RMB nominal exchange rate against US dollar from July to November 2010 Source: IMF and PBoC s data and statistics Our finding reflects current situation of RMB which is on the crossroad. Since Financial Crisis 2007, many countries implemented economy stimulus plan, including Unite States and China. It caused excessive liquidity in most emerging economies and some developing countries. Since October 2010, many emerging countries suffered Observations Adjusted * Significant at 10%; ** significant at 5%. Data source: Frankel and Wei (2007) finding and author s calculation (1)Sub-period (whole sample period in Frankel and Wei (2007)): July 22 nd, 2005 January 8 th, 2007 (2)Sub-period (sub-period in Frankel and Wei (2007)): October 1 st, 2006 January 8 th, 2007 (3)Sub-period (sub-period covered in this study): January 19 th, June 19 th, 2010 (4)Sub-period (sub-period covered in this study): June 19 th, 2010 November 19 th, 2010 We also compared our finding with the results of previous study (Frankel 2007) which are presented in Table 3. Not surprisingly, US dollar remained to be the largest weigh in RMB currency basket since July But its importance is fading. Compared to more than 0.9 during period July 2005 to January 2007, US dollar s weight in the basket of currencies 7 China s CPI reached 4.4% in October 2010, which is the highest in recent two years. On comparison, CPI was 8.6% in India, 7.5% in Russia and 5.2% in Brazil in October GSTF

5 was a little more than 0.7 in second half of year Meanwhile, sample data s R square in early data is much higher than latest data which is It implies that RMB exchange rate regime moved away from pegging to currency basket during period January to November Policy suggestion and implications 4.1 Improving market mechanism function in RMB exchange rate regime Since PBoC announced to adopt a managed floating exchange rate regime in 1994, RMB had been consistently pegged to US dollar at the rate of 8.28 RMB per US dollar until 2004 for about nine years. This exchange rate regime played an important and positive role for Chinese economy growth in that specific period. But such pure US dollar pegging regime distorted RMB nominal exchange rate form its real exchange rate and accumulated huge surplus in current account. RMB exchange rate should be determined by its market supply and demand as PBoC s announcement on July 21, Along with rapid economy growth, China government is committed in RMB s internationalization 8. Undoubtedly, enhancing market mechanism function in RMB exchange rate regime is one of most important steps in the process of RMB internationalism. 4.2 Continuing to shift to basket of currencies pegging from US dollar pegging From our finding and previous studies on RMB exchange rate regime, some evidences showed that US dollar s weight is decreasing and the weights of some currencies in the basket are increasing gradually, but not very significantly. In this study, we found no evidence of pegging to a basket of currencies. We think it is because that recent non-pegging adjustment on RMB exchange rate appeared more frequently, especially in late of this year. Taking a long view, PBoC should continue to shift RMB exchange rate from US dollar pegging to basket of currencies pegging because firstly, pegging to basket of currencies rather a single currency can reduce impact of external economy turbulence on China economy 9. Secondly, EU has replaced US to become China s the largest trade partner since Euro should be as important candidate currency like US dollar and yen in RMB basket. Thirdly, truly pegging to basket of currencies rather than US dollar may assist China to fight back someone who labeled China as currency manipulator. 8 On July 2 nd, 2010, PBoC and other five national department, including Ministry of Finance, Ministry of Commerce, State Administration of Taxation, General Administration of Custom and China Banking Regulatory Commission jointly launched RMB Settlement for Transnational Trade which was looked as an attempt to push RMB into the international settlement system. 9 China need learn lessons from Financial Crisis China owned a large number of US bond. US dollar s volatility during the Financial Crisis 2007 and post crisis put those Chinese assets priced in US dollar in the risk of devaluation. 4.3 Allowing RMB appreciation gradually but at appropriate pace From July 2005 to October 2010, RMB has appreciated against US dollar by more than 23%. More recently, RMB s exchange rate increased 3.6 percent against US dollar in No evidence showed that RMB appreciation deferred China s economy growth. RMB appreciation gradually can not only help China stimulate domestic demand 10 and optimize resource allocation, but also relieve domestic increasing inflationary pressure and bubbles in property market. It seems that China authority and PBoC agree to appreciate RMB further. But difference between China and U.S. government is the pace of appreciation. PBoC announced that China would proceed to reform the RMB exchange rate regime and enhance the RMB exchange rate flexibility on June 19 th, But Someone (Pan and He 2010) argued that China should learn lessons from the experience of Japanese yen s Plaza Accord in Obstfeld (2007) came up with the proposal of RMB exit strategy from current relatively US dollar pegging regime by taking a few steps (stages) approach. Due to relatively immature financial market, absence of regulations and very limited capability of risk management, gradual appreciation at an appropriate pace is the optimal option for China. 5. Conclusion In this study, we reviewed RMB evolution history and analyzed RMB s basket of currencies by employing lasted data. The findings show us that RMB was not perfectly pegging to the basket of currencies during the period of January to November US dollar still is the most important candidate currency to peg for RMB, even its weight is decreasing. Based on our empirical findings and RMB evolution history, we suggest that PBoC should enhance market mechanism function in RMB exchange rate revaluation. Taking a long view, PBoC should continue to shift RMB exchange rate regime to currency basket pegging from purely US dollar pegging. In addition, RMB appreciation at appropriate pace is in China s own interest in a long term. References 10 Chinese government intended to shift economy development model from export and investment driven to domestic consumption driven (Wen and Hu, 1996 and 2010). It is because firstly, increasing surplus in current account caused much criticism on Chinese trade policies and exchange rate policies. Secondly, Chinese government realized that export driven model is fragile and unsustainable, especially after Financial Crisis Pan and He (2010) think Japanese yen s one-step appreciation caused Japan economy into serious recession in Lost Decade. On the other hand, Kuroda (2004) argues that Japan s recession was due to Japanese government s following monetary policies rather than yen appreciation. Furthermore, current economic situation in China is different from Japan s situation in 80s GSTF

6 [1] Cheung, Yin-Wong, Ma, Guonan and McCauley, Robert N, 2010, Renminbising China s Foreign Assets, Hong Kong Institute for Monetary Research s working paper, No. 16/2010. [2] Frankel, Jeffrey, and Shang-Jin Wei, 2007, Assessing China s Exchange Rate Regime, Economic Policy no. 51, July, pp [3] Frankel, Jeffrey, and Shang-Jin, Wei, 2008, Estimation of De Facto Exchange Regimes: Synthesis of the Techniques for Inferring Flexibility and Basket Weights, IMF Staff Papers, September [4] Frankel, Jeffrey, 2009, New Estimation of China s Exchange Rate Regime, Pacific [5] Economic Review (Wiley), special issue. [6] Funke, Michael and Gronwald, Marc, 2008, The Undisclosed Renminbi Basket: Are the Markets Telling Us Something about Where the Renminbi- US Dollar Exchange Rate Is Going, The World economy (2008), doi: /j x. [7] Hu, Xiaolian, 2010, A managed floating exchange rate regime is an established policy, People s Bank of China and Bank for International Settlements (BIS). [8] Ito, Takatoshi, 2007, The Influence of the RMB on Exchange Rate Policy in Other Economies, Peterson Institute for International Economies Conference: China s Exchange Rate Policy. [9] Jen, S. (2005, Chinese RMB Basket Still a Mystery, Global Economics Forum, Morgan Stanley, 19 August, 5/ Fri.html#anchor1 [10] Kuroda, 2004, Lessons from Two Seemingly Failed Cases of Japan s Exchange Rate Policy, China & World Economy, 3-10, Vol. 12, No. 1, [11] Liu, Xiaohui and Fan, Conglai, 2010, The Model and Empirical Estimation of the Optimal Flexibility of RMB Exchange-Rate Regime: A Study Based on the Price-Stabilization, Frontiers of Economics in China, 2010 Springer. [12] Ma, Guonan and McCauley, Robert N, 2008, The evolving East Asian Exchange Rate System, seminars of the Hong Kong General Chamber of Commerce, etc. [13] Moosa, Imad A, 2008, Exchange Rate Regime Verification: Has China Actually Moved from a Dollar Peg to a Basket Peg, Economia Internazionale. [14] Moosa, Imad A, 2008, Forecasting the Chinese Yuan-US Dollar Exchange Rate under the New Chinese Exchange Rate Regime, International Journal of Business and Economics, 2008, Vol. 7, No. 1, [15] Obstfeld, Maurice, 2007, The Renminbi s Dollar Peg at the Crossroads, Monetary and Economic Studies (Special Edition), December 2007 [16] Ogawa, Eiji, and Shimizu, Junko, 2006, Progress toward Common Currency Basket System, the 5 th Asia Pacific Economics Forum. [17] Pan and He, 2011, The implication of comparison of Japanese yen and West German mark s internationalization on Chinese RMB s internationalization, Jianghuai Forum, X(2011) [18] Qin, Fengming, 2009, The Evolution of Renminbi Exchange Rate Regime and Its Policy Implication, China Review. [19] Shah, Ajay and Zeileis, Achim and Patnail, IIa, 2005, What is the New Chinese Currency Regime? epubwu Institutional Repository s working paper. [20] Thierry Apoteker Consultant (TAC) s research, 2005, Assessing the Composition of the Chinese Currency Basket, pdf Yuming Cui is PhD candidate in the Graduate School of Asia-Pacific studies, Waseda University, Tokyo, Japan. Mr. Cui is Research Associate in Asian Development Bank Institute (ADBI) since January This paper is a part of author s PhD thesis RMB Exchange Rate Misalignment, Adjustment and Potential Impacts on China s Economy and World Economic Balance (tentative). It was presented at the World Conference on Financial Crisis and Impact, Ankara, Turkey on September cuiyuming88@googl .com GSTF