The Short-Run Relationship Between Real Effective Exchange Rate and Balance of Trade in China

Abstract

This paper analyzes the short-run relationship between the real effective exchange rate of Chinese Yuan and the balance of trade. We examined the causality between effective exchange rate and balance of trade using Granger-Causality Test. The findings are striking. The test suggests that in the short run balance of trade causes a change in effective exchange rate but not vice versa. The uni-directional relationship between exchange rate and balance of trade compels the use of transfer function methodology. Transfer Function estimation shows that the balance of trade has a 3-4 month delayed effect on effective exchange rate in China. Moreover, the coefficients are positive suggesting that a positive trade performance shock leads to a favorable change in exchange rate in China.