Real exchange rate and economic growth in China: A cointegrated VAR approach

Abstract

This study investigates the relationship between the real exchange rate (RER) and economic growth in China applying a cointegrated VAR (CVAR) model. However, in contrast to the assumptions of trade partners, this paper finds that the Chinese economy has not benefited from the lower exchange rate of the RMB, and no direct linkages exist between the RER and growth in the long run. Interestingly, it appears that the Chinese economy is stimulated by the expansion of exports and inflow of foreign capital according to the empirical evidence, which also suggests that the long run equilibrium RER is jointly determined by the foreign trade, foreign reserves and the foreign direct investment. In addition, the 2005 RMB policy reform did not show any significant impact on the RER, but instead contributed to the steady economic growth. It is clear that, after the 2008 world crisis, the RMB exchange rates were largely dependent on the enhancing of the national strength and inflow of foreign capital, rather than the slow increase in foreign trade. As for policy implications, China may insist on the managed floating exchange rate policy making limited adjustments to the currency's daily floating range in response to the pressures from trade partners.