Five Major Problems with the Equilibrium Exchange Rate Model of Peterson Institute

[Abstract] Based on the SMIM model, the Peterson Institute for International Economics concluded that RMB is undervalued by 41%. This finding by Peterson has had significant impact on the current Sino-US debate about RMB exchange rate, providing additional ammunition to those who are pressuring China on the currency issue. However, the SMIM model has five major problems. First, it examines only current account balance. Second, it is unclear how each country sets it current account balance. Third, in the model export price elasticity takes into account only exchange rate and fails to consider such factors as domestic production cost and product competitiveness. Fourth, it is unreasonable to assume that changes in exchange rate affect only exports, but not imports. Fifth, export price elasticity is stylized and simplified such that it is only related to export ratio.  Therefore, we conclude that Peterson’s finding is flawed.

1. Overview of the Equilibrium Exchange Rate Model 

(1) Negative Impact of Peterson’s Finding

In recent years, the Peterson Institute for International Economics has used the SMIM model to compute the equilibrium exchange rates of major countries, and has released its finding in several research reports. A recent report claims that RMB exchange rate against US dollar, as computed by this model, is undervalued by 41%. This figure is widely quoted in the United States, and has become a major piece of evidence cited by members of Congress when they pressure China on the currency issue. Paul Krugman, a Nobel Laureate in Economics, also lent his support to this finding. This has caused major negative impact around the world, bring additional pressure to bear on RMB appreciation.  

(2) SMIM Model Used by Peterson

  The basic formula of this SMIM model is as follows: Changes in current-account balance (% GDP）= effective exchange rate changes (%）× export price elasticity. The only goal of the SMIM model is to make a country’s current account balance fluctuate between -3% and +3% of it GDP, through adjustments in effective exchange rate. This model has only one policy instrument--effective exchange rate, and only one policy goal--to keep fluctuations in current account balance within the range of -3% and +3% of GDP. Of course, in order to achieve global balance, some countries are allowed to slightly exceed this range. Export price elasticity is a constant term, which is determined by the ratio of exports to GDP.

2. Five Major Problems with Equilibrium Exchange Rate Model

Since many aspects of the model are debatable, it seems rash to adopt it in policy making. To make the matter worse, Peterson’s finding based on the model has been frequently used for the purpose of political propaganda.

Problem 1: Current account equilibrium is treated as the sole goal of exchange rate.

Firstly, setting current account equilibrium as the goal of equilibrium is contrary to economic equilibrium theory and world economic development trend. Economic equilibrium includes external equilibrium and internal equilibrium. External equilibrium refers to the net balance of a country’s international payments, that is, the difference between net exports and net capital outflow should be zero. Internal equilibrium is the equilibrium among the three major macro-economic objectives, namely, economic growth, full employment, and price stability. Like inflation, external equilibrium is an intermediate variable that is not important on its own. The SMIM model is biased in that it takes into account only current account equilibrium in external equilibrium, with other equilibriums being excluded. Due to differences among countries in terms of resources, talents, technologies, cultures, and capital, countries that have certain comparative advantages can certainly obtain current account surplus through such advantages. Examples include oil-rich Middle East countries and Russia, technology-savvy Japan and Germany, and China with its large-scale production capacity. Ignoring such inherent differences among countries and pursuing only trade balance undoubtedly go against the trend of globalization. United States, for example, has actually achieved external equilibrium by its advantages in capital.

Secondly, many factors can affect current accounts, and exchange rate is merely one of such factors. Thus using exchange rate as the only method to adjust current accounts is not practical. In theory, a country’s net current account is the difference between savings and investments; it actually illuminates the fact that, under international division of labor, the endogenous economic structure of a country directly determines trade balance. As a result, even if RMB appreciates, because most industrial products of the world are still produced in China, ordinary people’s demand for US products will hardly increase. In addition, even if China’s industries were to be relocated abroad due to cost considerations, most of them will not be relocated to the United States, but to other developing countries and regions instead. Moreover, RMB appreciation will not increase jobs for the US, because US re-industrialization is absolutely not a lower-level industrialization. Therefore, pinning the hope exclusively on exchange rate to improve current account is not viable.

Thirdly, exchange rate as a policy instrument affects a variety of macroeconomic indicators. When adjusting exchange rates, we should consider not only current accounts, but also the impact of exchange rate adjustments on domestic industries and domestic prices. In a word, exchange rate is constrained by many factors,  and it is undesirable to disregard these factors for the sake of balancing current accounts. 

Problem 2: Equilibrium current account balance lacks basis.

The equilibrium current account balance set by the SMIM model is rather random and lacks convincing basis.  In the world of equilibrium set by SMIM--except for Middle East oil-producing countries, for those countries whose current account balance accounts for more than 3% of GDP, their current account balance is contracted to 3%, while for those whose current account balance accounts for less than 3% of GDP, their balance is contracted to zero. The degree of contraction is set randomly, which leaves room for subjective bias regarding some countries. Meanwhile, the model does not verify the stability of such random setting. If the stable solution is not contracted, slight variable fluctuations will cause substantial deviation from equilibrium solution. Thus the credibility of equilibrium solution can hardly be guaranteed. In fact, such contraction balance has never appeared in history.

Problem 3：Export price elasticity considers only the factor of exchange rate, excluding such factors as domestic production cost and product competitiveness.

The SMIM model equates changes in exchange rate with changes in export price. In other words, if exchange rate changes by 1%, so will the export price. This assumption is unrealistic, particularly with regard to Chinese products. Recent research shows that if RMB appreciates by 1%, the corresponding export price hardly changes, because most of the cost resulting from RMB appreciation is actually absorbed domestically. The ability to adjust to exchange rate cost varies among different types of products. Many factors affect export price, including cost, competitiveness, and demand elasticity. 

Problem 4：It is unreasonable to assume that fluctuations in exchange rate affect only exports but not imports.

The SMIM model postulates that exchange rate affects only exports but not imports. The justification given by the developer of the model is that changes in exchange rate cause changes in import price, which in turn affect demand. As price increases, demand decreases, and vice versa. But in either case, the total volume of imports is expected to remain largely unchanged. This assumption sounds absurd, because one country’s imports are another country’s exports. If exchange rate does not affect imports, nor will it affect exports. 

Problem 5: Export price elasticity is stylized and simplified, determined only by export ratio.

The SMIM model assumes that if a country’s exports account for 10% of its GDP, then export price elasticity will be 1; if the exports of a country accounts for 100% of GDP, then export price elasticity will be 0.5. Thus, the export price elasticity of a country can be determined by the ratio of exports to GDP.

However, as mentioned above, export price elasticity is impacted by many factors, and the ratio of exports to GDP being merely one of them. There can be significant differences in export price elasticity among different countries and different products. If an empirical model is to be built, the export price elasticity of relevant products should be estimated using actual data and econometric model.

But in SMIM, export price elasticity does not take into account these factors, and there is no measurement and calculation of the export price of each country. Rather, it assumes that export price elasticity is related to the ratio of exports to GDP. Export price elasticity derived from such a simplified and stylized model will inevitable diverge greatly from reality.

3. Exchange Rate should Be an Comprehensive Indicator of a Country’s Development Level

Exchange rate is an indicator of a country’s developmental stage, development level, and competitiveness. Changes in exchange rate are closely related to such factors as economic strength, scientific and technological advances, and industrial structural adjustment. 

The market exchange rate of a country is closely related to the economic development stage of the country. As economy progresses from underdeveloped to developed, market exchange rate will deviate less from PPP. This is the natural law of exchange rate. 

The degree of deviation of China’s market exchange rate from PPP largely corresponds to China’s current economic development stage. If RMB exchange rate is excessively manipulated to such an extent that it is artificially close to PPP, China’s economic will face serious consequences.

If the exchange rate of a country stays at an artificially high level for a long time, domestic goods will not realize their values through international exchange, production capacity will not be fully utilized, and development will stagnate. At the present stage, China, as one of the engines of world economic growth, is playing an active and important role in economic recovery and world economic development. If this engine is switched off due to exchange rate appreciation, it will be a huge loss to any other country in the world. Therefore, China needs to maintain an exchange rate corresponding to its economic development stage, in order to ensure rapid growth in the next two decades and to make significant contributions to world economic development on a continued basis.  

(Research Department   Zhang Huanbo)