Law of Yuan Price: Estimating Equilibrium of the Renminbi

This study seeks to estimate an equilibrium value for the Chinese currency, the Renminbi. While existing literature puts forth various measures of equilibrium value, there exists a gap in reconciling historical trends with current estimates, which vary from 60% undervaluation to 5% overvaluation. I perform several Purchasing Power Parity (PPP) studies of the Renminbi vis-à-vis the U.S. Dollar, the Euro, and the Yen. The tests presented represent an estimate of the market equilibrium value given the relevant macroeconomic data available. There are different methods to interpret the available data, which result in different estimations of equilibrium. In order to present a complete picture using all relevant data, I perform 14 empirical tests. They show the effect of changes in: base year (1978 through 2005), Absolute versus Relative PPP and the use of CPI versus PPI. I compare my findings to three macroeconomic estimates of equilibrium: Fundamental Equilibrium Exchange Rate (Williamson 1994), Behavior Equilibrium Exchange Rate and Permanent Equilibrium Exchange Rate (Funke and Rahn 2006). This comparison suggests the macroeconomic studies are generally in line with PPP comparisons from the early 1990s. The results also show a considerable effect on the exchange rate from the 1994 appreciation of the Renminbi by Chinese monetary authorities. The summation of evidence suggests an equilibrium exchange rate around 4.0 RMB/USD, which implies a 37.5% undervaluation. For all measures of undervaluation, I use the exchange rate from the time of publication (April 2011), 6.5 RMB/USD. Lastly, I examine how China has recently allowed Renminbi appreciation. Assuming similar actions going forward, I propose it could take at least five years of steady appreciation for the Renminbi to reach equilibrium.