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CHINA'S CURRENT ACCOUNT AND EXCHANGE RATE Yin-Wong Cheung Menzie D. Chinn Eiji Fujii Working Paper 14673

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 January 2009

Paper prepared for NBER conference on "China's Growing Role in World Trade," organized by Rob Feenstra and Shang-Jin Wei, in CapeCod, MA, August 3-4, 2007. We thank the discussant Jeffrey Frankel, Shang-Jin Wei, Arthur Kroeber, Xiangming Li, Jaime Marquez and conference participants for comments and discussion, and Kenneth Chow, Guillaume Gaulier, Chang-Tai Hsieh and Hiro Ito for providing data. Cheung acknowledges the hospitality of the Hong Kong Institute for Monetary Research, where part of this research was conducted.Faculty research funds of the University of California, Santa Cruz, and the University of Wisconsin are gratefully acknowledged. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2009 by Yin-Wong Cheung, Menzie D. Chinn, and Eiji Fujii. All rights reserved. Short sections of text, not to exceed twoparagraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

China's Current Account and Exchange Rate Yin-Wong Cheung, Menzie D. Chinn, and Eiji Fujii NBER Working Paper No. 14673 January 2009 JEL No. F3 ABSTRACT We examine whether the Chinese exchange rate is misaligned and how Chinese trade flows respond to the exchange rate and toeconomic activity. We find, first, that the Chinese currency, the renminbi (RMB), is substantially below the value predicted by estimates based upon a cross-country sample, when using the 2006 vintage of the World Development Indicators. The economic magnitude of the mis-alignment is substantial -- on the order of 50 percent in log terms. However, the misalignment is typically not statisticallysignificant, in the sense of being more than two standard errors away from the conditional mean. However, this finding disappears completely when using the most recent 2008 vintage of data; then the estimated undervaluation is on the order of 10 percent. Second, we find that Chinese multilateral trade flows respond to relative prices -- as represented by a trade weighted exchange rate -- but therelationship is not always precisely estimated. In addition, the direction of the effects is sometimes different from what is expected a priori. For instance, Chinese ordinary imports actually rise in response to a RMB depreciation; however, Chinese exports appear to respond to RMB depreciation in the expected manner, as long as a supply variable is included. In that sense, Chinese trade is notexceptional. Furthermore, Chinese trade with the United States appears to behave in a standard manner -- especially after the expansion in the Chinese manufacturing capital stock is accounted for. Thus, the China-US trade balance should respond to real exchange rate and relative income movements in the anticipated manner. However, in neither the case of multilateral nor bilateral trade flows should oneexpect quantitatively large effects arising from exchange rate changes. And, of course, these results are not informative with regard to the question of how a change in the RMB/USD exchange rate would affect the overall US trade deficit. Finally, we stress the fact that considerable uncertainty surrounds both our estimates of RMB misalignment and the responsiveness of trade flows to movements inexchange rates and output levels. In particular, the results for trade elasticities are sensitive to econometric specification, accounting for supply effects, and for the inclusion of time trends.

Yin-Wong Cheung Department of Economics University of California Santa Cruz, CA 95064 Menzie D. Chinn Department of Economics University of Wisconsin 1180 Observatory Drive Madison, WI...
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