Edited by P. J. Lloyd and Xiao-guang Zhang
Chapter 10: China's exchange rate mechanism and the real effective exchange rate
10. China’s exchange rate mechanism and the real effective exchange rate Lei Lei Song* INTRODUCTION From 1980 to 1994, China devalued its currency, the renminbi (RMB), substantially. The primary objective of devaluation was to promote exports and give exporters more incentives. The manipulation of the nominal exchange rate has long been part of reforms to foreign trade policy. A very early document issued by the State Council (State Council 1979) stated that the key measure to increase foreign exchange revenues substantially was to administer the ofﬁcial exchange rate, either directly by devaluation or indirectly by introducing parallel exchange rates. This clearly indicates that the exchange rate was thought of as an important economic instrument to ensure external balance in China. There has been very little research done on the determination of China’s exchange rate and exchange rate policy. Zhang (1998) ﬁnds strong evidence in the period 1991–96 suggesting that changes in the trade balance Grangercause changes in the nominal exchange rate, but provides no evidence of a causal link running from the exchange rate to the trade balance. He believes that causality from the trade balance to the exchange rate shows that the policy-makers try to achieve the external balance using exchange rate policy. Lardy (1992) argues that the Chinese have had to resort to a series of domestic deﬂationary packages and systematic devaluation of the currency in order to keep the balance of trade deﬁcits within bounds. The literature suggests that China’s exchange rate policy...
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