China’s exchange rate: too hot, too cold or just right?

Research story 5th Aug 2016

Was China’s exchange rate undervalued in the first part of the 21st century? In research published in the European Economic Review, Dr Qingyuan Du contends that the apparent undervaluation of China’s exchange rate could have been a consequence of the nation’s imbalanced sex ratio.

In the first decade of the 21st century, the value of China’s exchange rate was a key source of tension within the international community, no more so than between the world’s strengthening powerhouse and its incumbent superpower, the United States of America. While China asserted that its exchange rate reflected its own economic conditions, many in the U.S., which was facing a growing trade deficit with China, accused it of undervaluing its currency to keep its products cheap and its export market strong.

Traditional economic theory supported the U.S.’ position, suggesting that China’s real exchange rate was undervalued by at least 40% relative to purchasing power parity (PPP) as a result of government interventions in the currency market. However, to the extent that this analysis did not take into account all the important structural determinants of the real exchange rate, it remains contestable.

Dr Qingyuan Du and his co-author, Mr Shang-Jin Wei, Chief Economist of the Asian Development Bank, suggest that a critical but often neglected determinant of China’s exchange rate is its imbalanced sex ratio (i.e. its unnaturally high ratio of boys to girls at birth). Around 2003, marriage partner competition in China intensified as the first cohort born with an excess number of males began looking to settle down.  It was also at this time that China’s exchange rate policy started becoming a matter of international controversy. Dr Du and Mr Wei suggest this wasn’t a coincidence.

Drawing on within-China and cross-country empirical evidence, they show that a rise in the sex ratio in the pre-marital age group can lead to the appearance of an undervalued exchange rate. As competition for brides intensifies, young men and their parents seek to increase their marriage market attractiveness (i.e. their wealth) by saving and working more. The consequence of a rise in both the economy-wide savings rate and the economy-wide effective labor supply can be a decline in the real exchange rate, which would cause the rate to look undervalued even in the absence of currency manipulations.

Even more notably, Dr Du and Mr Wei find that virtually all of the departure of China’s real exchange rate from PPP can be accounted for by the sex ratio effect and other structural factors, offering important insights into the ongoing debate over the value of China’s currency.

To find out more

Read the paper: A Darwinian perspective on "exchange rate undervaluation".

Brief extract: "Standard models used to assess equilibrium exchange rates do not take into account the sex ratio imbalance. We show that a dramatic rise in the sex ratio for the pre-marital age cohort in China since 2003 could logically generate a decline in the equilibrium value of the real exchange rate. If other factors have also contributed to a rise in the Chinese household savings rate, such as a reduction in the dependency ratio, or a rise in the corporate and government savings rates, they can complement the sex ratio effect and reinforce an appearance of an undervalued currency even when there is no manipulation."