In search of an optimal strategy for yuan’s real revaluation

Abstract

International commentators seem to have a consensus view that the Chinese yuan is substantially undervalued and the Chinese monetary authority must take speedy actions to redress the currency misalignment by rapid nominal revaluation. This paper argues for a gradualist but comprehensive strategy for adjusting the renminbi’s exchange rate. Taking into consideration the facts that the yuan’s undervaluation is caused by an array of domestic and international factors and that the Chinese central bank cannot effectively invest its growing holdings of foreign reserves, we develop a framework to provide a theoretical underpinning for the optimal strategy for the renminbi’s gradual revaluation. With this strategy, the renminbi undervaluation problem is gradually redressed through a combination of nominal appreciation and higher inflation plus some other structural and macroeconomic policies. This strategy can also allow absorption of external imbalances, hence strengthening the foundation of China’s long-term growth.

Keywords:

• real revaluation
• yuan
• renminbi (RMB)
• foreign reserves
• external imbalances
• macroeconomic adjustment

JEL Classifications:

• E52
• E61
• F31
• F41

Acknowledgement

The author is grateful to an anonymous reviewer for very helpful comments and suggestions.

Notes

1. For an overview of the literature on the quantitative assessment of the yuan’s undervaluation, see Das (2009). For related studies see Peng, Lee, and Gan (2008) and Wang (2010).

2. The exchange rate was 2.9366 and 6.8310 for 1985 and 2009, respectively. See Ceglowski and Golub (2012) for international comparison of labour costs in manufacturing.

3. For a review of Chinese exchange rate policy, see Xu (2000), Lin and Schramm (2003), Huang and Wang (2004), Corden (2009) and Sun (2010).

4. A technical appendix is available upon request.

5. A number of these measures have already been advocated to deal with the yuan’s undervaluation issue (Liu 2004 Dai 2006; Woo 2006; Eichengreen and Hatase 2007; Hong, Vos, and Yao 2008; N’Diaye 2010).

6. See the speech of President Jingtao Hu at the 17th Congress of the Chinese Communist party, the 24th, October 2007, Beijing, China.