Week-10

Yuan’s Valuation under Managed Floating Exchange Rate Regime

Yongqing Wang

Department of Social Science and Business, College of General Studies, University of Wisconsin-Milwaukee at Waukesha, Waukesha, Wisconsin, USA

ABSTRACT To U.S. politicians, the undervaluation of the Chinese yuan is usually blamed for the tremendous trade deficit between the U.S. and China. This study examines the yuan’s valuation under the Managed Floating Exchange Rate regime through three methods. We compare the real effect- ive exchange rate for U.S. and China; actual and PPP estimated bilateral exchange rates; and actual and a multi-currency basket approach for esti- mated exchange rates. Although the results are not the same when differ- ent methods are used, our results suggest that, since the beginning of the Managed Floating Exchange Rate regime, the Chinese yuan has been undervalued only for a few years. After that, the yuan is either overvalued or fluctuates moderately between overvaluation and undervaluation, depending on which method is used. Therefore, there is no evidence that the yuan has been undervalued all the time. More importantly, it seems the price of the yuan has been relatively fair in the last couple of years no matter which valuation method is used.

KEYWORDS U.S.-China bilateral exchange rate; undervaluation; overvalu- ation; real effective exchange rate; Yuan/dollar

1. Introduction

Chinese exchange rate regime has been frequently criticized by U.S. politicians, particularly in the last couple of decades. U.S. politicians commonly believe the Chinese government intentionally devalues its currency, the Yuan, to promote its exports, which is the cause of an enormous U.S. bilateral trade deficit with China. Morrison and Labonte (2013), in a Congressional Research Service report for U.S. Congress, state: “President Obama stated in February 2010 that China’s undervalued currency puts U.S. firms at a ‘huge competitive disadvantage’, and he pledged to make addressing China’s currency policy a top priority. At a news conference in November 2011, President Obama stated that China needed to ‘go ahead and move toward a market-based system for their currency’ and that the United States and other countries felt that ‘enough is enough’.” The report also states: “Many U.S. policymakers and certain business and labor representatives have charged that the Chinese government ‘manipulates’ its currency in order to make it signifi- cantly undervalued vis-�a-vis the U.S. dollar, thus making Chinese exports to the United States less expensive, and U.S. exports to China more expensive, than they would be if exchange rates were determined by market forces.” On Aug 5, 2019, U.S. President Donald J. Trump tweeted: “China dropped the price of their currency to an almost a historic low. It’s called ‘currency manipulation’.” Based on an article from The Guardian (2015), the yuan was undervalued by 43%

CONTACT Yongqing Wang [email protected] Department of Social Science and Business, College of General Studies, University of Wisconsin-Milwaukee at Waukesha, 1500 North University Drive, Waukesha, WI 53188, USA. � 2020 Taylor & Francis Group, LLC

THE CHINESE ECONOMY 2020, VOL. 53, NO. 6, 455–464 https://doi.org/10.1080/10971475.2020.1792067

in July 2015 since the average price of a Big Mac in America was $4.79, while it only costed $2.74 in China at market exchange rates.

There are two main reasons why the Chinese exchange rate takes the blame for the huge U.S. trade deficit with China. First, the bilateral trade imbalances between U.S. and China have increased dramatically, especially since 2000. Theoretically, devaluation of a currency would make exports cheaper when measured in foreign currency, and it could promote an increased volume of exports. Consequently, the value of exports may increase as the effect of increase in volume outweighs the decrease in price. Second, despite China’s astonishing economic growth since the economic reform that began in 1978, the Chinese exchange rate today is still not completely determined by the market force. From 1994 to June 2005, the Chinese exchange rate was pegged at about 8.3 U.S. Dollars. Starting from July 2005, China aborted the “Fixed Exchange Rate” and moved to the “Managed Floating Exchange Rate” regime. Under the Managed Floating Exchange Rate, the exchange rate is determined by a basket of currency, and it also allows the yuan to appreciate by 2.1% against the dollar. However, the practical rationalization for how it is deter- mined remains unclear to the public.

For this research study, we plotted the monthly data of nominal bilateral exchange rate defined as number of Chinese Yuan per U.S. Dollar under the Managed Floating Exchange Rate regime into Figure 1. The data is obtained from the Federal Reserve Bank of St. Louis (Federal Reserve Economic Data). The bilateral exchange rate from July 2005 to December 2019 is observed on the first day of each month and is not seasonally adjusted. July 2005 is the first month that China adopted the Managed Floating Exchange Rate regime, and December 2019 is the last month that the data is available. If there is a decrease in the bilateral exchange rate of yuan per dollar, it indicates depreciation of the dollar and appreciation of the yuan.

Roughly speaking, the Chinese exchange rate has experienced four phases under the Managed Floating Exchange Rate regime based the plotted data in Figure 1. The first phase occurred from July 2005 to about January 2014. During the first phase, the yuan gradually appreciated from 8.2 yuan per dollar in July 2005 to 6.8 yuan per dollar in June 2008, stayed at about 6.8 yuan per dollar from July 2008 to June 2010, and further appreciated to about 6.1yuan per dollar in January 2014. The second phase happened from February 2014 to December 2016, where the yuan’s valuation gradually depreciated to 6.9 yuan per dollar in December 2016. In the third phase, the yuan slowly appreciated again, from 6.9 yuan per dollar in January 2017 to 6.3 yuan per dollar in April 2018. The fourth phase is from May 2018, where the yuan gradually depreci- ated to about 7 yuan per dollar in December 2019, although its value fluctuated. There are

Figure 1. Actual yuan/dollar exchange rate (E) from July 2005 to December 2019.

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arguments that China manipulated its exchange rate because the U.S. started the trade war with China in 2018.

But has the Chinese yuan actually been undervalued? If so, by how much? Most previous liter- atures investigating the yuan’s valuation by examining different data through either equilibrium exchange rate models or methods based on the Purchasing Power Parity (PPP) theory. However, the results are mixed. After examining different equilibrium exchange rates from1990s to early 2000s, Garton and Chang (2005) suggested that there has been significant undervaluation of Chinese currency by analyzing internal and external balances. Based on data from 1980 to 2006, Tatom (2007) discussed PPP theory and real exchange rate stationarity, concluding that “yuan may be close to correctly value.” Peng et al. (2008) applied Behavioral Equilibrium Exchange Rate (BEER) and Permanent Equilibrium Exchange Rate (PEER) models and showed that the Chinese yuan was undervalued by approximately 15% from the second quarter of 2002 to 2003, but it was overvalued from the last quarter of 1997 to the second quarter of 2002. Chen et al. (2008) estimated a BEER for the data from 1997 to the third quarter of 2007. They found that the Chinese currency “has been fluctuating moderately around its long run equilibrium value with undervaluation up to 4% and overvaluation up to 6% at various points in time since 1997.” Jo et al. (2010) chose a multi-currency basket that includes the euro, the British pound, the U.S. dollar, and the Australia dollar to determine the value of the yuan. Jo et al. (2010) were able to show that the yuan was undervalued during January of 1999 to October of 2009. Gao et al. (2019) developed a new estimation method by combining a panel of data and PPP theory. Gao et al. (2019) suggested that the yuan was undervalued by 2.62% in 1994, 36.6% in 2001, 0.76% in 2005, and 20.43% in 2008, while being undervalued by 14.40% in 2010.

To determine if the Chinese exchange rate is fair, one needs to compare its actual value to its benchmark value or correct value. The problem lies in the fact that no one knows the accurate benchmark value of a currency. Economists only can estimate the benchmark value of a currency, which obviously would vary when different methods and time periods are used. Therefore, it is not surprising to see the mixed results in the previous literature.

Whether the yuan is undervalued may depend on the time period that we examine since the Chinese exchange rate varies as time changes, especially under the Managed Floating Exchange Rate regime. The purpose of this study is to investigate if the yuan is undervalued under the Managed Floating Exchange Rate regime. On one hand, the results from previous literature are mixed, with no clear consensus. On the other hand, there is no previous literature that examines the yuan’s valuation strictly under the Managed Floating Exchange Rate regime. The data in most previous literature was under both the Fixed Exchange Rate and Managed Floating Exchange Rate regimes. Although some economists believe the Chinese government still controls its exchange rate under the Managed Floating Exchange Rate regime, exchange rates under the Fixed Exchange Rate and Managed Floating Exchange Rate regimes obviously are not the same. Since the yuan’s valuation may be distinct according to different methods, we selected three different methods to investigate whether the yuan is fairly priced. To this end, Section 2 investigates the yuan’s valuation by comparing real effective exchange rate (REER) for both the U.S. and China, by examining actual and PPP bilateral exchange rates, and by assessing actual and a multi- currency basket approach estimated exchange rates. Section 3 concludes with a summary of these results and how they answer the research question.

2. Method and results

In this section, we adopt different methods to determine the yuan’s valuation. We discuss the yuan’s valuation based on REER for the U.S. and China in 2.1, the actual and PPP bilateral exchange rates in 2.2, and the actual and benchmark values of bilateral exchange rate calculated

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from a multi-currency basket approach in 2.3. In 2.4, we compare the results and make the remarks about their significance.

2.1. Yuan’s valuation based on real effective exchange rate for the U.S. and China

A country’s real effective exchange rate (REER) is usually created as an index that measures the value of a specific currency in relation to a basket of other major currencies, which can be com- puted using the weighted average of the bilateral exchange rates between the currency itself and its major trading partners. The weights depend on a country’s trade balance with its major trad- ing partners. Some economists consider the REER as a measure of the equilibrium value of a cur- rency. Therefore, we compared the real effective exchange rate data for the U.S. and China to see if the Chinese yuan is undervalued with respect to the U.S. dollar.

We plotted monthly data of real effective exchange rate index from January of 2000 to December of 2019 in Figure 2. The data is from Federal Reserve Economic Data (FRED) by Federal Reserve Bank of St. Louis, where the index in 2010 was 100 for both the U.S. and China.

From Figure 2, China’s REER was less than the U.S. REER from 2000 to 2007, indicating that Chinese currency is undervalued regarding to the U.S. dollar. If we consider U.S. REER to be the benchmark value, the Chinese yuan was undervalued at the beginning of the Managed Floating Exchange Rate regime. But as the yuan appreciates, the REERs of the U.S. and China are quite similar from 2008 to September 2010, and Chinese REER has been higher than U.S. REER since October 2010. This signals that Chinese currency has been overvalued with respect to the U.S. dollar since October 2010.

2.2. Yuan’s valuation based on actual and PPP bilateral exchange rate

Based on the PPP theory, an accurate exchange rate should equal the base year exchange rate times the relative prices. We consider the average monthly bilateral exchange rate between the U.S. and China to be defined as yuan per dollar from July 2005 to 2019 to be the base year exchange rate. Relative price in a specific month equals Chinese price level divided by U.S. price level in that month. We utilized the consumer price index (CPI) to measure price levels for both countries. Both the monthly bilateral exchange rate between the U.S. and China and the monthly consumer price indices are from Federal Reserve Economic Data (FRED) by Federal Reserve Bank of St. Louis, where the indices in 2015 ¼ 100. However, CPI data is only available up to

Figure 2. The U.S. and China real effective exchange rate from January 2000 to December 2019.

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October of 2019 for China. Consequently, we only calculated the PPP estimated exchange rate from January 2000 to October 2019.

We denote E2015 to be the calculated PPP bilateral exchange rate where the consumer price indices for both the U.S. and China were 100 in 2015. To see whether using a different CPI base year will affect the results, we chose 2010 to be another base year and carried out the same calcu- lation. We denote E2010 to be the calculated PPP bilateral exchange rate where the consumer price indices in both the U.S. and China were 100 in 2010. E is the actual exchange rate that is defined as yuan per dollar. Hence, if actual exchange rate E is greater than the calculated PPP bilateral exchange rate, it indicates the dollar is overvalued or the yuan is undervalued. We plot- ted the monthly data of E, E2015, and E2010 from January 2000 to October 2019 in Figure 3.

From Figure 3, E2010 and E2015 run in a similar pattern, although E2015 is less than E2010 for the same time point. When we contrast E2010 to the actual bilateral exchange rate E, the results are quite consistent with the results from comparing REERs for the U.S. and China. From 2000 to 2007, the actual exchange rate E is obviously higher than the calculated PPP bilateral exchange rate, which supports overvaluation of the dollar and undervaluation of the yuan. But as the yuan appreciates, the calculated PPP bilateral exchange rate is quite close to the real exchange rate from 2008 to July 2010. As the yuan further appreciates, the real exchange rate has been less than the calculated bilateral exchange rate since 2011, indicating undervaluation of the dollar and overvaluation of the yuan. For 2019, the actual bilateral exchange rate is quite similar to E2010.

If we compare E2015 to the actual bilateral exchange rate E, the yuan was undervalued until 2011, and it was overvalued for most of the time thereafter. But in the last couple of years, the actual bilateral exchange rate and E2015 were about the same.

2.3. Yuan’s valuation based on a multi-currency basket approach

In this part, we applied a multi-currency basket approach to calculate the benchmark value of bilateral exchange rate and then compared it to the actual exchange rate to study the yuan’s valu- ation. Following Jo et al. (2010), we assumed the yuan per dollar exchange rate is a function of a basket of currencies. However, instead of using the Australian dollar for comparison, like the study by Jo et al. (2010), we included the Japanese yen in addition to the euro, the U.S. dollar, and the British pound. This decision was made because European countries, Japan, the U.S., and the U.K. are China’s four major trading partners, so comparing their exchange rates would give a more accurate sense of correct valuation.

Figure 3. Actual and PPP bilateral exchange rates (Yuan/$).

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The annual yuan per dollar exchange rate and real effective exchange rate for the U.S. dollar, the euro, the British pound, and the Japanese yen are reported in Table 1. The real effective exchange rate for 2010 is 100. The data comes from Federal Reserve Economic Data (FRED) by Federal Reserve Bank of St. Louis.

We consider the yuan per dollar exchange rate to be the dependent variable, while the real effective exchange rates of the dollar, euro, pound and yen are the independent variables. In other words, the correct value for the Chinese exchange rate can be obtained from the regression of yuan per dollar exchange rate as a function of Dollar, Euro, Pound, and Yen. Monthly data from July 2005 to December 2019 are used to carry out the regression. All data are from Federal Reserve Economic Data (FRED) by Federal Reserve Bank of St. Louis. Following Pesaran et al. (2001) and Wang (2020), we employed the Autoregressive Distributed Lags model (ARDL) to run the regression. ARDL checks cointegration among the variables by carrying out an F-test and does not require the usual pre-unit root testing. In order to check the cointegration, Pesaran et al. (2001) calculated two sets of critical values: the upper bound and the lower bound of critical values, assuming all variables were integrated of order one and zero, respectively. If and only if the result of the F-test is higher than the upper bound of critical values, it supports cointegration among the variables.

After checking cointegration, we imposed a maximum of eight lags on each first differenced variable and carried out both long-run and short-run estimations. The optimal lags on each vari- able were selected by Akaike Information Criterion (AIC). The results might be sensitive to the maximum lags imposed on each first difference variable. To test how the results would change with different lags imposed, we also imposed a maximum of 6 lags on each first difference vari- able and employed the same procedure to conduct estimation. The results when 6 lags were imposed are extremely similar to the results when 8 lags were imposed. To be concise, we only report the results when 8 lags were imposed; however, the results when 6 lags were imposed are available upon request. The results of F-tests and some other statistics when 8 lags were imposed are reported in Table 2.

From Table 2, the calculated F-test is significant with probability 0.000, and the F-test at opti- mal lags (4.2302) is greater than the 95% upper bound (4.0898). Both support cointegration between the dependent variable and its regressors. Further, the error correction term obtained from the short-run estimates, Ecm(-1), is negative and significant, which is another evidence that cointegration exists among the variables in the function according to Wang (2020).

The results of long-run estimation when 8 lags are imposed are also reported in Table 2. From Table 2, the coefficients for the dollar, the pound, and the yen are all significant at a level of 0.1%, while the coefficient of the euro is significant at a 1% level.

Table 1. Annual yuan/dollar exchange rate and real effective exchange rate for dollar, euro, pound, and yen.

Yuan/Dollar Dollar REER Euro REER Pound REER Yen REER

2005 8.19 111.18 104.67 124.83 99.63 2006 7.97 110.22 103.90 125.14 90.10 2007 7.61 105.03 106.16 127.04 82.41 2008 6.95 100.38 108.00 110.24 88.55 2009 6.83 104.70 108.97 99.52 99.45 2010 6.77 100.00 100.00 100.00 100.00 2011 6.46 95.06 99.35 100.47 101.30 2012 6.31 97.29 94.48 104.51 100.00 2013 6.15 97.58 97.74 103.09 79.69 2014 6.16 99.84 98.27 110.25 75.10 2015 6.28 110.70 89.65 115.12 70.03 2016 6.64 115.28 91.59 103.24 79.39 2017 6.76 114.91 92.88 98.05 75.55 2018 6.61 113.71 95.99 99.79 74.80 2019 6.91 117.04 93.49 99.52 77.00

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We denote E8lags to be the estimated bilateral exchange rate based on a basket of currencies when 8 lags are imposed. From the regression results, E8lags at any month can be calculated from the following equation:

E8lags ¼ �8:7247 þ 0:0734 x Dollar þ 0:0288�Euro þ 0:0219 � Pound þ 0:0287 � Yen Based on this equation, we calculated monthly E8lags from July 2005 to December 2019.

Then, we plotted the actual and estimated bilateral exchange rates of E8lags into Figure 4. Both actual and estimated exchange rates are defined as yuan per dollar. Hence, if the actual exchange rate is higher than the estimated exchange rate, it implies the dollar is overvalued and the yuan is undervalued.

From Figure 4, the actual exchange rate fluctuates moderately around the estimated bilateral exchange rate based on a basket of currencies. From July 2005 to September 2008, the actual exchange rate is above the estimated exchange rate, supporting the yuan’s undervaluation. For the remaining time, the yuan’s price varies between overvaluation and undervaluation. But the amount of overvaluation and undervaluation is usually within 10% of E8lags. Since 2017, the actual exchange rate has been very similar to the estimated exchange rate from the multi-currency basket approach, revealing the exchange rate is fair priced.

2.4. Remarks

To better understand our results based on different methods, we calculate the amount of overvaluation or undervaluation. When comparing REER in the U.S. and China, we calculate percentage of valuation of the yuan, which denotes it as V1.

V1 ¼ Chinese REER – U:S: REERð Þ=U:S: REER � 100 When comparing actual exchange rate to PPP estimated exchange rate, we first calculate

valuation of Yuan in terms of percentage.

Valuation of Yuan ¼ actual –PPP estimated exchange rateð Þ= PPP estimated exchange rateð Þ � 100

Note that the yuan is in fact undervalued when actual exchange rate is greater than PPP esti- mated exchange rate. So, we define that V2010 equals to negative valuation of the yuan when CPI in both countries was 100 in year 2010, while V2015 equals to negative valuation of the yuan when CPI in both countries was 100 in year 2015. Under this definition, that yuan is overvalued when either V2010 or V2015 is greater than zero and it is undervalued when either V2010 or V2015 is a negative number.

Similarly, when comparing actual exchange rate to multi-currency basket estimated exchange rate, we first calculate the valuation of the yuan in terms of percentage.

Table 2. Results of long-run estimation for bilateral exchange rate (Yuan/$).

Dependent variable, bilateral exchange rate Yuan/$ Based on 166 observations Calculated F-test 4.8030�� Prob. 0.000 N.A. F-test at Optimal lags 4.2302 95% lower bound 2.9692 95% upper bound 4.0898 Ecm(-1) �0.0617�� T-ratio 4.1289 Prob. of T-ratio 0.000 R-Squared 0.6331 N.A. N.A. R-Bar-Squared 0.5676 N.A. N.A. Regressors coefficient t-statistics p-value Dollar 0.0734�� 7.9862 0.000 Euro 0.0288� 2.6948 0.008 Pound 0.0219�� 3.9940 0.000 Yen 0.0287�� 4.6552 0.000 Intercept �8.7247�� 5.7157 0.000 Note: � indicates significance at 1%; while ��indicates significance at 0.1%.

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Valuation of Yuan ¼ actual –basket estimated exchange rateð Þ= basket estimated exchange rateð Þ�100

We then define V3 equal to negative valuation of the yuan that compares the actual and multi-currency basket estimated exchange rate for the same reason that we define V2010 and V2015.

Under our definitions, V1, V2010, V2015, and V3 are all in percentage terms. Also, the yuan is undervalued when the number is negative and overvalued when the number is positive, no matter which valuation we examine. Thus, the yuan is overvalued by 5 percent if evaluation result is 5 and it is undervalued by 10 percent if evaluation result is �10. We then plot the data of V1, V2010, V2015, and V3 from July 2005 (the beginning of the managed floating exchange rate sys- tem) to October 2019 (the last month that data is available for V2010 and V2015) into Figure 5.

Clearly, when we use different methods to investigate the valuation of the yuan, the results are not exactly the same. However, there are some consistencies. At the beginning of the Managed Floating Exchange regime, the yuan was undervalued. Afterwards, the yuan was overvalued since around 2010 based on V1, V2010, and V2015, while the yuan has fluctuated between undervalu- ation and overvaluation since about 2009 based on V3. Therefore, there is no data to support the idea that the yuan has been undervalued all the time. If the Chinese yuan has not been underval- ued all the time, the argument that depreciation of the yuan causes the U.S. trade deficit with China is not valid. In the last couple of years, it seems that the yuan’s valuation is close to zero no matter which method we used, indicating it is fair priced.

To further investigate the yuan’s valuation, we calculate annual average valuation based on the available monthly valuation from one year. The results are reported in Table 3. AvgV1 is the average valuation of the yuan based on V1. Similarly, Avg2010, Avg2015, and AvgV3 are the average valuation of the yuan based on V2010, V2015, and V3, respectively. The results are reported in Table 3.

According to the data in Table 3, the yuan was undervalued by 23.4% in 2005 to 3.72% in 2009, but overvalued thereafter such as 0.04% in 2010, 17.02% in 2015, and 5.58% in 2019 based on average V1. From average of V2010, the yuan was undervalued from 25.35% in 2005 to 2.13% in 2010, but overvalued afterwards at 20.03% in 2015 and 6.52% in 2019. From average of V2015, the yuan is undervalued from 32.55% in 2005 to 6.63% in 2010, while it subsequently overvalued at 9.33% at 2015 and 1.14% in 2019. In accordance with average of V3, the yuan was undervalued from 2005 to 2008, ranging from 2.23% to 8.41%. Following that, the yuan is either overvalued or

Figure 4. Actual and estimated bilateral exchange rate based on a basket of currency (Yuan/$).

462 Y. WANG

undervalued moderately. For example, the yuan was undervalued by 1.18% in 2015 and overval- ued by 1.01% in 2019.

3. Conclusion

The Chinese exchange rate is usually blamed for the gigantic U.S. deficit with China. It is com- monly believed by U.S. politicians and the American public that China manipulates its exchange rate to take unfair advantage of devaluation in order to stimulate its exports. The current study would like to examine if the yuan is undervalued under the Managed Floating Exchange Rate regime.

We compare REER for the U.S. and China, the actual and PPP estimated exchange rates, and actual exchange rate and a multi-currency basket approach estimated exchange rate to examine valuation of the Chinese yuan under Managed Floating Exchange Rate regime. Our results sug- gest that the Chinese yuan was undervalued from the beginning of the Managed Floating Exchange Rate regime (July 2005) until about 2009 or 2010, depending on which method is used. After that, the yuan is overvalued based on either REER for the U.S. and China or on the actual and PPP estimated exchange rates; it fluctuates moderately between overvaluation and

Figure 5. Valuation of Yuan using different methods.

Table 3. Annual valuations of the yuan.

AvgV1 AvgV2010 AvgV2015 AvgV3

2005 �23.40 �25.35 �32.55 �2.23 2006 �22.18 �21.68 �29.37 �4.91 2007 �15.36 �18.51 �24.76 �3.67 2008 �3.95 �7.59 �12.94 �8.41 2009 �3.72 �2.35 �5.5 7.28 2010 0.04 �2.13 �6.63 �2.56 2011 7.90 6.07 0.2 �6.23 2012 11.76 12.89 5.82 0.81 2013 18.59 16.56 7.56 �6.75 2014 18.62 22.74 10.93 �2.85 2015 17.02 20.03 9.33 �1.18 2016 8.16 10.75 4.62 6.89 2017 6.12 3.4 0.12 0.2 2018 7.91 12.02 6.26 �0.75 2019 5.58 6.52 1.14 1.01

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undervaluation according to actual and a multi-currency basket approach estimated exchange rate. Our results indicate that the yuan has not been undervalued all the time. More importantly, it seems that the yuan’s valuation has been close to zero for the last couple of years no matter which method we used, indicating it has recently been fairly priced.

From our results, the argument that depreciation of the yuan is the main cause of the U.S. trade deficit with China is not valid as the yuan has not been undervalued consistently since July 2005. Therefore, forcing China to appreciate its exchange rate will not significantly reduce the U.S. trade deficit with China. U.S. policy makers may want to investigate the actual causes of its bilateral trade deficit with China in order to effectively reduce it. Since the current exchange rate is probably quite close to its correct value, policy makers in China may consider moving to a more flexible and transparent exchange rate regime, which may be helpful to control inflation in China and to take advantage of the benefits of market forces. Further, a more flexible and trans- parent exchange rate regime may reduce some tensions between the U.S. and China.

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