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Applied Economics Letters

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The relationship between the real exchange rate and

balance of payments: empirical evidence for China
from cointegration and causality testing
a a
Paresh Kumar Narayan & Russell Smyth
a
Department of Accounting, Finance and Economics, Gold Coast Campus, Griffith
University, Gold Coast, QLD 9726, Australia
Version of record first published: 20 Aug 2006.

To cite this article: Paresh Kumar Narayan & Russell Smyth (2004): The relationship between the real exchange rate and
balance of payments: empirical evidence for China from cointegration and causality testing, Applied Economics Letters,
11:5, 287-291

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 Applied Economics Letters, 2004, 11, 287–291

The relationship between the real exchange

rate and balance of payments: empirical
evidence for China from cointegration and
causality testing
P A R ES H K U M A R N A R A Y A N * and R U S S E L L S M Y T H
Department of Accounting, Finance and Economics, Gold Coast Campus, Griffith
University, Gold Coast, QLD 9726, Australia
Downloaded by [University of Arizona] at 08:16 12 December 2012

This article examines the relationship between the renminbi real exchange rate and
China’s foreign exchange reserves using cointegration and Granger causality testing.
The main findings are that in the long run foreign exchange reserves Granger cause
the real exchange rate. Meanwhile, in the short run there is unidirectional Granger
causality running from foreign exchange reserves to the real exchange rate.

I. INTRODUCTION official exchange rate started to hurt the competitiveness of

The objective of this article is to examine the relationship
between the renminbi (RMB) real exchange rate and
China’s foreign exchange reserves within a cointegration
and causality framework using monthly data from 1980:1
to 2002:7. The real exchange rate is defined here as the
trade-weighted real effective exchange rate for the
Chinese RMB vis-à-vis China’s major trading partner cur-
rencies as composed by the International Monetary
Fund (IMF). It is defined as the ratio of the price of
non-tradable goods over the price of trade-weighted
goods. Therefore an upward movement of the real
exchange rate index represents a real appreciation. The
data on the exchange rate and foreign exchange reserves
were compiled by the IMF.
For most of the 1980s there was little change in China’s
foreign exchange reserves. However, this changed in the
1990s when foreign exchange reserves showed a significant
upward trend, which was fuelled by sizeable increases in
capital inflow. Prior to the introduction of market reforms
in China in the late 1970s the state monopolized foreign
trade and the official exchange rate was overvalued. After
1978, when foreign trade was decentralized, the overvalued
exporters. An internal settlement rate closer to the average
cost of earning a US dollar in exports (2.8 RMB per dollar)
was used for trade transactions in place of the official
exchange rate between 1979 and 1984.
The official rate depreciated towards the internal settle-
ment rate and the two merged in 1985. The problem,
however, was that foreign enterprises had to balance their
own foreign exchange requirements because of foreign
exchange controls. In response to this issue, in the
mid-1980s regionally based swap markets started to emerge
in which foreign enterprises could swap foreign exchange
among themselves. From 1988 local governments and
state-owned enterprises were also permitted to trade their
retained foreign exchange quotas at these swap markets.
In January 1994 the official exchange rate and swap market
rate were unified to form a national foreign exchange
market. Since 1994 the nominal exchange rate has been
officially a managed float although the float has been
within a very narrow band and the real effective exchange
rate has slightly appreciated. The RMB became fully
convertible for current account transactions at the end of
1996 (see Xu (2000) and (Zhang 2000, 2001a) for more
details).

* Corresponding author. E-mail: P.Narayan@griffith.edu.au

Applied Economics Letters ISSN 1350–4851 print/ISSN 1466–4291 online # 2004 Taylor & Francis Ltd 287
http://www.tandf.co.uk/journals
DOI: 10.1080/1350485042000221535
 288
Studies of the Chinese (RMB) have been relatively few
until recent years, particularly compared with the vast
literature on the currencies of developed countries.
However, interest in the RMB has been growing since
China first signalled its intention to seek membership of
the World Trade Organization (WTO). Recent studies
have considered the relationship between the RMB
exchange rate and China’s exports and/or imports (Chou,
2000; Zhang, 1998, 1999, 2001a), the relationship between
the RMB exchange rate and China’s inflation rate
(Phylaktis and Girardin, 2001; Lu and Zhang, 2003) and
real exchange rate misalignment of the RMB (Zhang,
2001b, 2002).
Recently, Montiel (1999) and others have proposed the-
ories suggesting that relevant real fundamentals determine
the equilibrium real exchange rate (see Jin (2003) for an
overview). In an attempt to tie the real exchange rate with
Downloaded by [University of Arizona] at 08:16 12 December 2012
its fundamental determinants, previous studies have treated
the cumulated current account as a determinant of the real
exchange rate (see e.g. Blundell-Wignall and Browne, 1991;
Edison and Pauls, 1993). We depart from these studies
and, instead, follow the approach in Jin (2003), who argues
that the current account variable may not be the most
appropriate proxy for exchange rate fundamentals.
Montiel (1999) shows that factors such as productivity
growth, government spending, changes in the international
environment and changes in commercial policies are
important determinants of the real exchange rate. Jin
(2003) argues that real foreign exchange reserves can
capture the impact of the variables identified by Montiel
(1999).
We proceed in three stages. The next section considers
the order of integration of the variables, which is essential
for implementing the Granger causality test. Section III
examines whether the variables are cointegrated using the
bounds test to cointegration, within an autoregressive
distributive lag (ARDL) framework, developed by
Pesaran and others (Pesaran and Shin, 1999; Pesaran
et al., 2001). The results from the Granger causality tests
are reported in Section IV. Conceptually causation could
run from foreign exchange reserves to the real exchange
rate or vice versa. On the one hand, a change in the real
exchange rate will generate a change in the level of net
exports, which can be expected to be reflected in a change
in the level of foreign exchange reserves. On the other
hand, the level of foreign exchange reserves is an indication
of export performance, which should be reflected in the real
exchange rate. Foreshadowing the main results, we find
that the real exchange rate and foreign exchange reserves
are cointegrated when foreign exchange reserves is treated
as the dependent variable. In the long run foreign exchange
reserves Granger cause the real exchange rate, while
in the short run there is unidirectional Granger causality
running from foreign exchange reserves to the real
exchange rate.
P. K. Narayan and R. Smyth
II. ORDER OF INTEGRATION
While the bounds test approach to cointegration can be
applied irrespective of the order of integration of the
variables, the Granger causality test requires that both
variables are integrated of order one or I ð1Þ. To ascertain
the order of integration of the variables we first applied the
augmented Dickey–Fuller (ADF) unit root test. The results
are not presented here to conserve space, but suggested that
both variables are I ð1Þ. However, as Perron (1989) notes, in
the presence of a structural break the power to reject a unit
root decreases if the stationary alternative is true and a
structural break is ignored. To address this, we applied
the sequential trend break model developed by Zivot and
Andrews (1992), which allows for a break in the intercept
of the trend
X
k

yt ¼
þ yt
1 þ t þ DUt þ dj
yt
j þ "t ð1Þ
j¼1
The null hypothesis in Equation 1 is that  ¼ 0, which
implies that there is a unit root in yt . The alternative
hypothesis is that  < 0, meaning that yt is break point
stationary; DUt is an indicator dummy variable for a
mean shift occurring at time TB:


1 if t > TB
DUt ¼
0 otherwise
To select the lag length (k) we use the ‘t-sig’ approach
proposed by Hall (1994). We set kmax ¼ 8 and we use the
approximate 10% asymptotic critical value of 1.60 to deter-
mine the significance of the t-statistic on the last lag. We do
not increase the upper bound when the procedure selects
k ¼ kmax : We follow Zivot and Andrews (1992) and treat
the structural break as endogenous. The break points are
selected by choosing the value of TB for which the ADF
t-statistic (the absolute value of the t-statistic for ) is
maximized. A ‘trimming region’ must be chosen such
that the end points of the sample are not included, for in
the presence of the end points the asymptotic distribution
of the statistics diverges to infinity. Consistent with
the suggestion in Zivot and Andrews (1992) we use the
‘trimming region’ (0.15T, 0.85T).
While Zivot and Andrews (1992) present asymptotic
critical values, the critical values for this test are sensitive
to sample size. Therefore, we calculate ‘exact’ critical
values, which are tailored to our sample size of 259
observations following Zivot and Andrews’s (1992) meth-
odology. This involves estimating an ARMA (p,q) model
for each
yit , with p and q selected according to the
Schwartz Bayesian criterion. The implied ARMA process
is then used as the data-generating process for generation
of 5000 259-observation series under the null hypothesis of
a unit root with no structural breaks. We then follow the
 Relationship between the real exchange rate and balance of payments 289
procedure in Zivot and Andrews (1992) for determination framework involves estimating the following error correc-
of k, and obtain a minimum ADF statistic for each of the tion models:
5000 series. The critical values are then constructed from
this empirical distribution. The results for Equation 1 X
n X
n

together with the exact critical values are reported in
ln ERt ¼ a0ER þ biER
ln ERt
i þ ciER
ln RESt
i
i¼1 i¼1
Table 1. We also report the Ljung–Box Q-statistics,
which find no evidence of residual correlation in the error þ 1ER ln ERt
1 þ 2ER ln RESt
i þ "1t ð2Þ
terms. For both the real exchange rate and real foreign
exchange reserves we are unable to reject the unit root
null hypothesis. The findings from the Zivot–Andrews X
n X
n

(1992) test confirm the results from the ADF test that
ln RESt ¼ a0RES þ biRES
ln RESt
i þ ciRES
lnERt
i
i¼1 i¼1
both variables are I ð1Þ.
þ $1RES ln RESt
1 þ $2RES ln ERt
i þ "1t ð3Þ

Here
is the difference operator, ERt is the log of the real

I I I. COI N T E G R A TI O N effective exchange rate, RESt is the log of China’s foreign
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exchange reserves and "1t and "2t are serially independent

To examine whether a long-run relationship exists between random errors with mean zero and finite covariance
the real exchange rate and real foreign exchange reserves matrix.
using the bounds test to cointegration within an ARDL The F-test is used for testing the existence of one or more
long-run relationships. When one or more long-run rela-
tionships exist, the F-test indicates which variable should
Table 1. Zivot and Andrews (1992) unit root test with one break in be normalized. The null hypothesis for no cointegration
the intercept
amongst the variables in Equation 2 is ðH0 :1ER ¼
Exchange rates Foreign reserves 2ER ¼ 0Þ against the alternative hypothesis ðH1 :1ER 6¼
2ER 6¼ 0Þ, denoted as FER ðERjRES Þ. In Equation 2,
TB 1984:5 1994:7

0.040 9
0.053 4 where real foreign exchange reserves is the dependent
(
3.430 1) (
4.097 2) variable, the null hypothesis for no cointegration is

0.037 8 0.042 9 ðH0 :$1RES ¼ $2RES ¼ 0Þ against the alternative hypothesis
(
3.750 8)* (2.653 6)* ðH1 ¼ $1RES 6¼ $2RES 6¼ 0Þ, denoted as FRES ðRESjERÞ.
 – –
k 0 5 The distribution of the F-test is non-standard, but the
Ljung–Box 17.478 6 7.167 1 critical values are available in Pesaran et al. (2001).
Q-statistic [0.291 1] [0.952 8] One of the benefits of the bounds testing approach to
Exact critical values for t cointegration is that where there is a single long-run rela-
1%
5.410 4
5.409 1 tionship we can identify which variable is the dependent
5%
5.132 0
4.878 4 variable. The bounds testing approach suggests here that
10%
4.590 4
4.589 9 ½ER, RES  are cointegrated when RES is the dependent
Notes: The Ljung–Box Q-statistic is for 15 lags. The figures in variable. The results of the cointegration tests are reported
parentheses are t-statistics. The figures in square brackets below in Table 2. The calculated F-statistic FRES ðRESjERÞ ¼
the Ljung–Box Q-statistics are probability values. The critical 19.4806 is greater than the upper bound of the critical
values for the structural break dummy variables follow the value of 9.786 at the 1% level of statistical significance
asymptotic standard normal distribution. The critical values for
t are calculated based on 5000 replications of a Monte Carlo while FER ðERjRES Þ ¼ 0.4885 which is lower than the
simulation as described in the text. * Statistical significance at lower bound critical value of 9.063 at the 1% level of
the 1% level. statistical significance.

Table 2. Bounds test for cointegration

95% Critical value bounds 99% Critical value bounds

F-statistics I ð0Þ I ð1Þ I ð0Þ I ð1Þ
FER ðERjRESÞ ¼ 0.4885 6.606 7.423 9.063 9.786
FRES ðRESjERÞ ¼ 19.4806

Note: Critical value bounds are from Pesaran et al. (2001).

 290
I V . GR A N G E R C A U S A L I T Y
On the basis of the bounds test for cointegration, the
Granger causality test requires a vector autoregressive
model when the real exchange rate is the dependent
variable and a vector error correction model (VECM)
when real foreign exchange reserves is the dependent vari-
able. This is because in the presence of cointegration
Granger causality requires the inclusion of an error
correction term in the stationary model in order to capture
the short-run deviations of series from their long-run
equilibrium path. The cointegrated error correction models
are as follows:
p q

lnERt ¼ 0 þ 11 ðLÞ
lnERt þ 12 ðLÞ
lnRESt
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lnRESt ¼ 1 þ p21 ðLÞ
lnRESt þ q
22 ðLÞ
lnERt
þ #ECTt
1 þ 2t
where
Pij
X Qij
X exchange reserves is the dependent variable. Consistent
p 1 q 1
ij ðLÞ ¼ ijn L ij ðLÞ ¼ ijn L
n¼1 n¼1
Here
is the difference operator and L represents the lag
operator, implying that ðLÞ
lnFRt ¼
lnFRt
1 . ECTt
1 is
the lagged error correction term, which is derived from the
long-run cointegrating relationship, while 1t and 2t are
serially independent random errors with mean zero and
finite covariance matrix.
The results from the Granger causality tests are reported
in Table 3. The F-statistics on the differenced explanatory
variable depict the short-term causal effects, whereas the
significance or otherwise of the lagged error correction
term, when real foreign exchange reserves is the dependent
variable, denotes whether there is a long-run relationship.
In the foreign exchange reserves VECM the coefficient on
the lagged error correction term is significant at the 1%
level with a negative sign, which confirms the findings
from the cointegration test that there is a long-run relation-
ship. This implies that changes in foreign exchange reserves
are a function of disequilibrium in the cointegrating
Table 3. Results of Granger causality
F-statistics [probability values]
Dependent variable
ERt
RESt

ERt – 3.4734*
[0.0001]

RESt 0.4905 –
0.0642*
[0.9191]
* Statistical significance at the 1% level.
P. K. Narayan and R. Smyth
relationship. Thus, in the long run the real exchange rate
Granger causes real foreign exchange reserves with causal-
ity running interactively through the error correction term.
The error correction coefficient is very small (
0.0642),
which suggests that once shocked convergence to the
long-run equilibrium is slow. In the short run there is
unidirectional Granger causality running from real foreign
exchange reserves to the real effective exchange rate.
V. CONCLUSION
There has been growing interest in the RMB since China’s
accession to the WTO. This article, for the first time, exam-
þ 1t
ines long-run and short-run Granger causality between the
ð4Þ RMB and China’s foreign exchange reserves. While our
finding that foreign exchange reserves and the real
exchange rate are cointegrated is consistent with theories
ð5Þ suggesting that there is a long-run relationship between the
real exchange rate and its fundamentals (Montiel, 1999),
we find that a long-run relationship exists when foreign
with this finding, the results from the VECM when foreign
exchange reserves is the dependent variable indicate that in
the long run foreign exchange reserves Granger cause the
real exchange rate. In the short run there is unidirectional
Granger causality running from foreign exchange reserves
to the real exchange rate.
ACKNOWLEDGEMENTS
The authors thank Zhongxia Jin for generously providing
them with the data and Brett Inder for assistance with the
GAUSS codes used to run the unit root tests with struc-
tural breaks.
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