Real exchange rate and economic growth in China: A cointegrated VAR approach

•Exports and FDI drive the Chinese economy.•There is no direct relationship between the RER and economic growth.•The RER is jointly determined by the foreign trade, foreign reserves and FDI in the long run.•No structural changes exist after the 2005 RMB policy reform.•China may adjust the currency's daily floating range in response to the pressures from trade partners.

This study investigates the relationship between the real exchange rate (RER) and economic growth in China applying a cointegrated VAR (CVAR) model. However, in contrast to the assumptions of trade partners, this paper finds that the Chinese economy has not benefited from the lower exchange rate of the RMB, and no direct linkages exist between the RER and growth in the long run. Interestingly, it appears that the Chinese economy is stimulated by the expansion of exports and inflow of foreign capital according to the empirical evidence, which also suggests that the long run equilibrium RER is jointly determined by the foreign trade, foreign reserves and the foreign direct investment. In addition, the 2005 RMB policy reform did not show any significant impact on the RER, but instead contributed to the steady economic growth. It is clear that, after the 2008 world crisis, the RMB exchange rates were largely dependent on the enhancing of the national strength and inflow of foreign capital, rather than the slow increase in foreign trade. As for policy implications, China may insist on the managed floating exchange rate policy making limited adjustments to the currency's daily floating range in response to the pressures from trade partners.