The Empirical Test of Consumption-Real Exchange Rate Anomaly in China

Abstract

Consumption-Real Exchange Rate Anomaly is one of the well known puzzles in international finance. Most international business cycle models predict that, under the assumption of perfect financial markets along with supply disturbances, consumption should be higher in the country where its price, converted into a common currency, is lower. But empirical studies show that the consumption differentials across countries do not correspond in any systematic pattern with its relative price (i.e. the real exchange rate). Furthermore, consumption in countries with lower real exchange rate does not go up. Quite often than not it goes down. With regard to the current situation in China, on the one hand, there is the criticism from western countries that RMBexchange rate is undervalued; on the other, the final consumption rate has been very low with a continued downward trend. It has dropped to 52.1% in 2005 from 66.36% in 1985.  Especially, there has been a drastic decrease in resident consumption rate, from 48.8% in 1991 to 38.2% in 2005. However, according to statistics of the World Bank, the average consumption of the world stays between 77% and 79%. For example, the average consumption rate of the world in 2002 was 81%, and the figure for low income countries was 80.7%, middle income countries, 73.2%, high income countries, 81%. But the rate in China was only 58.2%.Is there a significant relationship between resident consumption rate and RMB real exchange rate? Does the persistent decreasing resident consumption affect the real exchange rate in China? These are undoubtedly subjects worth studying thoroughly.