Conclusion

PRC's pegged exchange rate has caused problems in the PRC and the rest of the world. In the PRC it has interfered with the allocation of credit by forcing commercial banks to hold increasingly large quantities of central bank bills. In other Asian countries the PRC's peg has caused central banks to intervene in currency markets and accumulate reserves in order to maintain competitiveness against the PRC. Many have thus argued that the PRC should move to a more flexible exchange rate regime.

This paper has investigated how the resulting exchange rate changes would affect the PRC's trade surplus. Since 2008 this surplus has been concentrated in processing trade. Processed exports are final goods produced using parts and components coming primarily from other Asian countries.

The results indicate that an appreciation throughout Asia would reduce the PRC's surplus in processing trade. An appreciation of the yuan alone may not reduce the surplus.

One way for supply chain countries to have their currencies appreciate together would be for the PRC to adopt an exchange rate regime characterized by a multiple-currency, basket-based reference rate with a reasonably wide band. In this case, the huge surpluses generated within East Asian production networks would cause currencies in the region to appreciate together. Market forces could then allocate these appreciations across supply chain countries based on their value-added in processing trade.

However, the fact that the exchange rate elasticities reported in this paper are not large suggests that greater exchange rate flexibility needs to be accompanied by other policies in order to rebalance growth. These include enforcing environmental regulations and liberalizing the markets for land, labor, fuel, and capital. After the PRC began liberalizing its product markets in the late 1970s, growth exploded in a quantitative sense. Liberalizing factor markets and fighting environmental degradation could similarly spark an explosion of growth in a qualitative sense.

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