With the Senate about to take up legislation to penalize China for “manipulating” its currency and keeping it artificially undervalued, we asked Peterson Institute of International Economics economist Arvind Subramanian to explain how calculations of under- and overvaluation are made. Mr. Subramanian is the author of a new book on China’s economic future, “Eclipse: Living in the Shadow of China’s Economic Dominance.” In recent Congressional testimony, he said China’s currency was about 15% undervalued, citing work by two colleagues at PIIE.
Broadly, there are two approaches to assessing whether a currency is over or under-valued: macroeconomic and development. Both these define or provide a sense of an “equilibrium” exchange rate, that is, what the level of the exchange rate ought to be at a point in time. Comparing this with the prevailing exchange rate gives a sense of over- or under- valuation. The assessment cannot be precise because an equilibrium exchange rate depends on many factors, changes over time, and the underlying determinants cannot be measured accurately.
From a macroeconomic perspective, an equilibrium exchange rate is one that will keep a country’s external position in balance. Balance here means avoiding two extremes. On the one hand, if the exchange rate leads a country to run large current account deficits (more imports than exports) it will become reliant on capital flows to finance those deficits and at some point those flows will not be forthcoming. In this case, the exchange rate is overvalued. In order to restore the current account to a level that can be financed by capital flows, the exchange rate has to depreciate because that will increase exports and reduce imports and hence improve the external balance. The financial crises in Mexico in 1994 and in a number of Asian countries in 1997 had their origins in currencies becoming overvalued, which led to large and unsustainable current account deficits. The crises then took the form of large declines, even collapses, in the exchange rate.