The Changing Sources of Real Exchange Rate Fluctuations in China, 1995–2017: Twinning the Western Industrial Economies?

Relative real demand shocks are the most important source of real exchange rate fluctuations for most countries, including China, but prior to 2005 supply shocks were also large and highly significant. Whereas China’s pegged exchange rate policy rendered nominal (monetary) shocks unimportant, the shift to a more flexible exchange rate policy made nominal shocks a more important source of real exchange rate variability. Using a structural VAR model and quarterly data on China from 1995 to 2017, impulse response and variance decomposition analysis suggest that, although real relative demand shocks remain the main source of real exchange rate fluctuations, nominal shocks have become much more important in both absolute terms and relative to supply shocks. This suggests that, since adopting a managed floating exchange rate regime, the sources of China’s real exchange rate fluctuations have become similar to those of developed industrial countries. This stands in contrast to the fact that, despite being the world’s largest manufacturing economy, China is still classified as a developing country.