Handbook of Exchange Rates

27.1 Introduction

Exchange rates are a key macroeconomic price in international economics. And, exchange rate misalignment is perceived to be the culprit of both domestic and global economic ills, including inflationary pressures, trade imbalances, and misallocation of resources within an economy and across trading partners (Hinkle and Montiel, 1999). Since the 1970s, the debate on currency valuation and misalignment has recurred several times and has involved different currencies. The recent contentious debate on the Chinese currency valuation vividly exemplifies the complexity of assessing the extent of misalignment.

During the 2000s, the meteoric rise in China's trade surpluses has put its foreign exchange policy under close scrutiny. One common view is that China has intentionally depressed the value of its currency, the renminbi (RMB), to gain unfair advantages in the global market. As a result, China has built up huge trade surpluses in the 2000s. In addition to global imbalances, the RMB misalignment induces chronic inflationary pressure on the Chinese economy. There are repeated calls from the international community urging China to ease global imbalances by revaluing its currency.

In the subsequent sections, the recent debate about the RMB valuation is used to illustrate the difficulty of determining the degree of misalignment. The theme is not to argue whether the RMB is overvalued or undervalued. Instead, the theme is to highlight a few selected factors that could make ...