China’s Equilibrium Real Exchange Rate: A Counterfactual Analysis*

China’s maintenance of a de facto peg against the US dollar during the Asian crisis caused a realignment of exchange rates in the Asian region. This paper explores the “equilibrium” level of China’s real effective rate in the lead-up and during that crisis. A derivative of the Devarajan-Lewis-Robinson three-good general equilibrium model is employed to estimate time paths of the equilibrium real effective exchange rate under a variety of assumptions about the balance of trade. Key requirements of the model are indices of import and export prices in time series. Since these are unavailable from secondary sources they are here constructed from trade data. The results suggest that China’s real effective exchange rate was on the low side in the four years prior to the crisis, due in part to an extraordinary rate of accumulation of foreign reserves. If, instead, no more than 10 per cent of annual export revenue had been set aside as reserves in this period, it is estimated that China’s real effective exchange rate would have been higher by between five and 12 per cent.