The Chinese Currency: Valuation and Convertibility

Research and Event Summaries

Event Summary

Professor Jiawen Yang of the Department of International Business presented his findings on the valuation of the Chinese currency at a recent brown bag lunch. The presentation, entitled "The Chinese Currency: Valuation and Convertibility," presented findings made by Professors Yang and Bajeaux-Besnainou.

The objective of the presentation was to answer two research questions—is the Chinese currency undervalued at its current rate (8.28 yuan/dollar) and should China float its currency more?

Yang first looked at the indicator used by other economists and journalists to prove the overvaluation of the Chinese currency. By convention, quantifiers of the Chinese economy use the price of a McDonalds Big Mac sandwich as the measure purchasing power parity in an economy.

Yang, however, found that this standard is, at best, a "medium rare" indicator of the overvaluation of currencies. The main reason given for the unreliability of the Big Mac standard is that labor costs are lower in China than in the United States. Following from this, Yang writes that "purchasing power parity implied in the value of a dollar is less than the exchange rate determined by the traded goods market." Yang continued, that the purchasing power parity implied in the value of the RMB (Chinese currency) is higher than the value of the RMB determined in the traded good market. Yang concluded that when considering the exchange rate values of low income countries, purchasing power parity standards tend to overestimate their currency value.

Yang also cited research done by economists Paul Krugman and Maurice Obstfeld, in which the two economists concluded price levels are based on the country's per capita income and that international price variations between nontradable goods, like services, contribute to price level discrepancies between rich and poor countries.

China's accumulation of foreign exchange reserves has been driven by China's economic reforms, investment policy, and some non-market factors, but not by currency overvaluation, Yang found.

What are Yang's final recommendations for financial stability? Trade and investment adjustments should be made, including a reduction in the value-added tax rebate. China should also improve its export structure and start treating domestic and foreign investment equally. A decrease in U.S. Treasury holdings by the Chinese government should also take place, Yang concludes.

In the area of the exchange rate regime, Yang recommends widening the band of fluctuations. Control over capital account transactions should also be loosened and hot money should be monitored, Yang continues.

Full convertibility of the RMB will only happen when there is sustainable foreign exchange earning capability, Yang concludes. A financial market deep enough to absorb shocks will be needed to achieve full RMB convertibility.

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