The RMB Debate: Empirical Analysis on the Effects of Exchange Rate Shocks in China and Japan

• Published date: 01 October 2016
• Date: 01 October 2016
• DOI: http://doi.org/10.1111/twec.12417

The RMB Debate: Empirical Analysis on

the Effects of Exchange Rate Shocks in

China and Japan

Soyoung Kim

1

and Yoonbai Kim

2

1

Department of Economics, Seoul National University, Seoul, Korea and

2

University of Kentucky,

Lexington, KY, USA

1. INTRODUCTION

THE exchange value of China’s currency, the renminbi (RMB), has become a contentious

issue. Many economists argue that the currency is undervalued; thus, it has become the

main source of the country’s large current account surpluses especially in relation to the Uni-

ted States. There has been mounting external pressure on China to allow the RMB to appreci-

ate against the US dollar. Many economists also argue that the exchange rate regime in China

should change to market-based floating from heavy intervention in the foreign exchange

market (see, inter alia, Frankel, 2006; Goldstein, 2006: Roubini (2007)).

Thus far, China has been resisting the pressure, permitting only gradual and small changes

in its exchange rate policy. Apparently, its main concern seems to be that currency apprecia-

tion would cause detrimental effects on its crucial export sector and create a host of economic

problems that may worsen the unemployment problem in the rural sector and reduce econ-

omic growth. The Japanese experience of undergoing a decades-long recession after huge

appreciation has frequently been invoked as a reason for the resistance. In addition, some

studies argue that exchange rate adjustments cannot restore the balance because the imbal-

ances originate from structural problems, such as high consumption (and low savings) of the

United States (See Xu, 2000; Bosworth, 2004; Mundell, 2004; McKinnon, 2007; Tatom,

2007). The heated contention between the two largest economies in the world has pushed the

world economy into a situation of competitive devaluations or ‘currency wars’ among many

developed and emerging market economies.

In this paper, we briefly review two of the most contentious issues regarding the RMB.

One is whether China should move to a float or at least an exchange rate regime with greater

flexibility; the other is whether and how much the RMB is undervalued. We find irreconcil-

able differences around the two issues of the RMB debate. Important questions underlying the

contentions are about (i) whether RMB appreciation can reduce trade imbalances in China

and the United States and (ii) whether the appreciation can induce recessionary impacts on

the Chinese economy. Admittedly, both are empirical issues. However, to our surprise, very

few studies provide comprehensive empirical evidence on the issue.

The purpose of this paper is to examine empirically the effects of exchange rate changes

on various macro variables of the Chinese economy, especially output and the current

We wish to thank David Cook, He Dong, Wei Liao and seminar participants at the AEA meetings,

HKIMR, HKUST and Beijing Forum for the various suggestions and comments they have given. This

research was conducted while Soyoung Kim was visiting the Hong Kong Institute for Monetary Research

whose hospitality is gratefully acknowledged. This work was supported by the National Research

Foundation of Korea Grant funded by the Korean Government (NRF-2013S1A5A2A03044693).

©2016 John Wiley & Sons Ltd 1539

The World Economy (2016)

doi: 10.1111/twec.12417

The World Economy

account/trade balance and their components. The studies of Ahmed (2009), Thorbecke and

Smith (2010) empirically examine the effects of (real) exchange rate changes on Chinese

exports. Garcia-Herrero and Koivu (2007), Kwack et al. (2007), Marquez and Schindler

(2007) and Cheung et al. (2010) estimate price elasticity of Chinese trade, exports and/or

imports. Liao et al. (2010) analyse the effects of exchange rate shocks from East Asian coun-

tries on Chinese exports using the calibrated dynamic stochastic general equilibrium (DSGE)

model. Shi (2006) examines the effects of real exchange rate changes on output in China

using VAR model. Compared with these previous studies that frequently focus on a specific

aspect of Chinese trade or output relation, the current study offers a comprehensive analysis

of the RMB/dollar exchange rate changes on the Chinese economy. In addition, while most of

the above-mentioned studies analyse the relation with the real exchange rate, we examine the

effects of nominal exchange rate changes because the effect of nominal exchange rate changes

is more directly related to the current policy debate. Also, we examine the effects of the bilat-

eral exchange rate against the US dollar considering the recent policy debate between the

United States and China. Then, as the Japanese experience is frequently invoked as supporting

evidence, we apply a similar model to Japan and compare the results with those of China.

Analysis based on simple correlation among the current account, output and the exchange

rate can be misleading because many different structural shocks can affect these variables

simultaneously. More importantly, the exchange rate, as an endogenous variable, not only

affects but is also affected by output and the current account. In this paper, we employ a vec-

tor auto-regression (VAR) model to take care of the third-factor effects and the reverse

causality problem and to isolate the exogenous part of exchange rate changes.

The rest of this paper is organised as follows. Section 2 briefly reviews the literature on

the two main issues involving the RMB exchange rate and summarises various channels on

the effects of exchange rate changes on current account and output. Section 3 presents the

empirical model to investigate the effects of exchange rate changes on current account and

output in a unified manner. Section 4 documents empirical results. Section 5 explores further

extensions of empirical analysis built on the baseline model. Section 6 concludes with

summary and implications.

2. LITERATURE REVIEW

Regarding the exchange rate of the RMB, two questions surface most frequently. One is

whether or not China would be better off with a floating exchange rate. The other is whether

it is undervalued and to what extent. We review the two issues first. Then, we briefly review

various theories on the effects of exchange rate changes on current account and output to

provide some theoretical background on our empirical analysis.

a. Should China Float the RMB?

Many economists argue that China should allow its currency to appreciate significantly and

move to a regime of more flexible exchange rate. According to Roubini (2007), for instance,

the RMB is grossly undervalued and it is in China’s interest to move to a more flexible

exchange rate regime. A failure to allow a nominal appreciation poses significant risks and

potential costs, such as protectionist backlashes from the United States and Europe and

increasingly costly forex intervention. He further offers several reasons for doing so including

the following: (i) protectionist backlashes from the United States and Europe such as branding

©2016 John Wiley & Sons Ltd

1540 S. KIM AND Y. KIM