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A Triangular Analysis of Exchange Rate Determination and Adjustments - The case of RMB, the US dollar and the euro

Listed author(s):
  • Peijie Wang


    (IESEG School of Management)

Exchange rate determination is of phenomenal importance in international economic relations and should be scrutinized with diverse perspectives and from various points of view. While RMB is pegged to the US dollar, the exchange rate between RMB and the euro is not fixed, due to that the exchange rate between the euro and the US dollar is not fixed. Since RMB is not a small currency, its pegging to the US dollar would have a profound effect on the floating exchange rate between the US dollar and the euro, forcing the exchange rate between the US dollar and the euro to depart from a “fair” market determined rate if the exchange rate between the US dollar and RMB is not set right. The above scenario provides us with a means to assess the fairness of exchanges rates resulting from pegs. Our analysis suggests that when RMB is overvalued relative to the US dollar, the euro would tend to be overvalued relative to the US dollar too, and vice versa. This in turn leads to a channel for examining whether RMB is undervalued or overvalued against the US dollar, an argument all stemming from the effective peg of RMB to the US dollar. It is to scrutinize the exchange rate of the US dollar vis-à-vis the euro to establish ultimately whether RMB is undervalued or overvalued vis-à-vis the US dollar. That is, an overvalued euro currency vis-à-vis the US dollar would imply a kind of overvaluation of RMB vis-à-vis the US dollar; or put it another way, an undervalued euro currency vis-à-vis the US dollar would justify that RMB is undervalued vis-à-vis the US dollar. As a corollary derived from the above analysis, if the objective of the monetary authorities is to float RMB at the right exchange rate and at the right time, a triangular rotation approach to anchoring currencies can be appropriate. A peg of RMB to a basket of currencies is unfeasible, inconvenient and moreover, unable to avoid being criticized for pegging at an artificially low value as its peg to the US dollar. While it has been increasingly acknowledged that competitive advantages in international trade in the long run can rarely benefit from distorted exchange rates, a notion of currency undervaluation remains cumbersome.

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Paper provided by IESEG School of Management in its series Working Papers with number 2010-FIN-01.

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Length: 22 pages
Date of creation: Jul 2010
Handle: RePEc:ies:wpaper:f201001
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