Op-ed in the Financial Times
January 20, 2006
© Financial Times
Last July, China announced a 2.1 percent appreciation of the renminbi against the dollar and a move to a managed float “with reference to a basket of currencies.” So far, these reforms have had little effect: The renminbi-dollar rate has appreciated only a further 0.5 percent, there is little evidence of pegging to a basket rather than to the dollar alone, and China is not following through on its July pledge to give “market supply and demand” a greater role in exchange rate determination. China’s average monthly intervention in the foreign exchange market between August and December remained huge, almost equal to the first half of 2005. In short, China’s exchange rate system remains a heavily managed peg to the dollar and at a little-changed dollar rate.
Moreover, there is no indication of an end to the renminbi’s substantial undervaluation. On the contrary, 2005 was the third consecutive year in which China’s reserve accumulation amounted to an extraordinary 10 percent of gross domestic product or more. China’s global current account surplus nearly doubled last year to reach 7 percent of its recently revised GDP, while the real trade-weighted renminbi still shows a cumulative depreciation since the dollar peak of February 2002. China’s exchange-rate policies have created problems domestically and abroad. Exchange-rate inflexibility limits the independence of China’s monetary policy and thus hampers macroeconomic stability. Renminbi undervaluation has contributed to growing trade surpluses and, in some years, to huge portfolio capital inflows. The country’s central bank sterilized much of the resulting reserve accumulation but also resorted to administrative controls to limit bank credit creation. But when the central bank specifies lending ceilings and sectoral lending priorities, it slows development of a bank credit culture, setting back another top policy objective.
China’s foreign exchange reserves at the end of 2005 were about 35 percent of GDP. A 20 percent revaluation of the renminbi against the major reserve currencies would thus impose a capital loss equivalent to 7 percent of GDP. Finally, China’s prolonged, large-scale intervention in foreign exchange markets has fuelled US protectionist pressure.
China’s inflexible, undervalued currency also drags on the adjustment of global imbalances and increases the risk of a hard landing for the dollar and the US economy, with adverse global spillover effects. The US current account deficit is at an all-time high; its inevitable correction will necessarily involve further depreciation of the dollar and US domestic demand growing more slowly than domestic output (and the reverse in the rest of the world). A more ambitious program of fiscal consolidation and prudent management of US monetary conditions are essential—along with policies that stimulate domestic demand growth among big US trading partners.
The real, trade-weighted dollar must fall by another 15 to 25 percent to support external adjustment. China remains a prime candidate for leading wider Asian currency appreciation because of its large external imbalance, robust domestic growth and the benchmark it increasingly sets for competitiveness within and outside the region.
China’s ability to reform its exchange rate regime is constrained by its fragile banking system, which requires maintaining existing capital controls. Also, the degree of renminbi undervaluation is now so large and Beijing’s commitment to an incremental approach so entrenched that eliminating the undervaluation in one hit no longer seems feasible.
Thus, we propose the following compromise. First, China should implement in the next few months a 10 to 15 percent appreciation of the renminbi relative to the current value of the basket. This could be done either by a revaluation or by allowing market forces to push up the currency’s value. Such a “downpayment” would help to persuade external critics that China is serious about controlling its growing external imbalance. Second, China should widen substantially either the band around the central rate or the daily fluctuation limit. That would provide increased independence for monetary policy, allow scope for further renminbi appreciation and give China experience in managing increased flexibility. Third, to offset some of the contractionary effect of the renminbi appreciation, China should simultaneously implement fiscal expansion. Fourth, China should maintain most capital controls until its banks are further strengthened.
This would still require sizeable real appreciation of the renminbi later, with all the problems that such a phased adjustment entails. If speculative inflows resurge, the authorities would need to choose between an acceleration of renminbi appreciation and a temporary recourse to tighter controls on capital inflows. In the final stage of currency reform—when China’s banking system is more stable—China would float the currency and remove the remaining capital controls. Admittedly, this is not an elegant plan. But if it would break the existing logjam in addressing global payments imbalances, it merits consideration.
Working Paper 12-19: The Renminbi Bloc Is Here: Asia Down, Rest of the World to Go? October 2012
Policy Brief 12-7: Projecting China's Current Account Surplus April 2012
Book: Sustaining China's Economic Growth after the Global Financial Crisis January 2012
Book: Eclipse: Living in the Shadow of China's Economic Dominance September 2011
Op-ed: For a Serious Impact, Tax Chinese Assets in the United States October 13, 2011
Op-ed: Taxing China's Assets: How to Increase US Employment Without Launching a Trade War April 25, 2011
Op-ed: Why the World Needs Three Global Currencies February 15, 2011
Policy Brief 10-26: Currency Wars? November 2010
Op-ed: Obama Has to Tell Beijing Some Hard Truths November 29, 2010
Congressional Testimony: Correcting the Chinese Exchange Rate September 15, 2010
Policy Brief 10-20: Renminbi Undervaluation, China’s Surplus, and the US Trade Deficit August 2010
Op-ed: Chinomics: Yes, China Does Need that Infrastructure June 23, 2010
Policy Brief 10-16: Deepening China-Taiwan Relations through the Economic Cooperation Framework Agreement June 2010
Congressional Testimony: China's Exchange Rate Policy and Trade Imbalances April 22, 2010
Op-ed: New Imbalances Will Threaten Global Recovery June 10, 2010
Policy Brief 10-7: The Sustainability of China's Recovery from the Global Recession March 2010
Congressional Testimony: Correcting the Chinese Exchange Rate: An Action Plan March 24, 2010
Paper: Submission to the USTR in Support of a Trans-Pacific Partnership Agreement January 25, 2010
Peterson Perspective: A Growing US-China Rift January 6, 2010
Book: China's Rise: Challenges and Opportunities (hardcover) September 2008
Paper: China Energy: A Guide for the Perplexed May 2007
Speech: Is China a Currency “Manipulator”? January 28, 2009
Congressional Testimony: China's Role in the Origins of and Response to the Global Recession February 17, 2009
Book: US-China Trade Disputes: Rising Tide, Rising Stakes August 2006
Book: Debating China's Exchange Rate Policy April 2008
Congressional Testimony: A Muscular Multilateralism to Engage China on Trade September 21, 2011
Peterson Perspective: Legislation to Sanction China: Will It Work? October 7, 2011
Book: The Future of China's Exchange Rate Policy July 2009
Working Paper 11-14: Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition September 2011