Real equilibrium exchange rate in China is the renminbi undervalued?

We give some insights about the possible undervaluation of the Chinese currency. On the one hand, we address the issue of the "Balassa effect'', by comparing China with other emerging countries. We try to measure the gap between the evolution of the real exchange rate in China and what would have resulted from a "normal'' Balassa effect. For doing this, we use two methods regression on real exchange rate (RER) in level and panel cointegration on RER evolutions. We evidence a lack of Balassa effect in China, consistent with the fact that the real exchange rate did not appreciate despite the rapid catching-up. On the other hand, we use a FEER (Fundamental Equilibrium Exchange Rate) method to calculate the real effective exchange rate consistent with sustainable current accounts. Our results show that China's RER was undervalued between 2002 and 2005 in effective terms and even more against the USD. However, we also show that a revaluation of the renminbi would only have a small effect on the US external deficit. (C) 2007 Elsevier Inc. All rights reserved.