Chinese Puzzle

Prying not allowed

A gargantuan trade deficit between the US and China has American lawmakers and business people howling for China to revaluate its currency, the renminbi (which is known as the yuan. You could say “renminbi” is the name of the currency, but you count in “yuan”).

So, after much dithering, in 2005 the Chinese obliged and announced a currency basket to which they would peg the renminbi, allowing it to fluctuate within a narrow band around a central parity. But the Chinese are inscrutable, so they declined to disclose the weights attached to each currency in the basket. That has kept the rest of the world wondering in which direction, and how fast, the renminbi is going in relation to their own currencies.

To be fair, there are respectable countries using currency baskets, such as Singapore, that have not even disclosed the composition of their basket, not to mention the relative weights. But Singapore has open financial markets, with no capital controls and, therefore, no need to publish the official central parity. That is not the case with China. So, understandably, investors and China’s trading partners are a bit queasy about the course the yuan could take.

To cast a light on this, two researchers from the University of Hamburg, Michael Funke and Marc Gronwald, subjected the foreign exchange data available on the markets to fine-tuned statistical tortures and, bingo, they found a model that closely reflects the pattern that underlies the Chinese policy approach. From there, they could project where the USD/Renminbi exchange rate could be in the future.

Clearly, the Chinese are a wary bunch. They do not want to repeat what they consider the Japanese mistake, where a sharp appreciation of the yen starting in the mid 1980s led to economic stagnation there. In many ways, as the authors point out, China today looks a lot like Japan in the 1980s. Like Japan, China has high saving and investment shares, an export-led growth process, big current account surplus, and upward pressure upon its exchange rate.

So, the Chinese remained true to their habit of allowing change only in a series of small steps. This lent itself to subjecting the exchange rate data to a univariate time-varying smooth transition autoregression (TV-AR, and a variation called TV-AR-GARCH), good for capturing non-linearities such as in this case and determining the underlying pattern.

What they found is that the model used adequately characterises the gradual appreciation of the renminbi against the dollar, corresponding closely with the actual exchange rate dynamics. Assuming no further breaks in the renminbi/dollar exchange rate, the deterministic extrapolation indicates that this rate will appreciate smoothly from the 8.09 renminbi per dollar observed immediately after the appreciation of July 2005, to 7.10 in autumn 2009.

Michael Funke and Marc Gronwald: The Undisclosed Renminbi Basket: Are the Markets Telling us something about where the Renminbi – US Dollar Exchange Rate is Going?, CESifo Working Paper No. 2272

• Other CESifo Working Papers dealing with China
• Other CESifo Working Papers by Michael Funke
• CESifo Working Papers published in the past three months