ASSESSING CHINA'S RENMINBI PEG TO THE U.S. DOLLAR: THE CASE FOR GREATER RMB EXCHANGE RATE FLEXIBILITY

This paper assesses China's Renminbi peg to the U.S. dollar using a structural VAR model. One unique contribution of the paper is that we model China as a large open economy in one structural VAR model with the U.S. by utilizing combinations of short- and long-run identification restrictions and relax the small open economy assumption usually imposed on China. Using monthly data for the period of 1990:4 to 2007:12, we find the following. First, U.S. shocks do not explain much of the output fluctuations in China, indicating that the two economies are subject to asymmetric shocks. Optimum currency area theory suggests that more flexibility of the RMB relative to the dollar may be desirable. Second, U.S. shocks explain little of the fluctuations in China's CPI, suggesting that the benefits of importing inflation from the U.S. by pegging to the dollar are minimal, thus more flexibility in the RMB relative to the dollar is feasible. Third, U.S. shocks do not influence China's international competitiveness (REER) to a noticeable extent, suggesting that moving toward more flexibility relative to the dollar may be in China's interest.