China’s Exchange Rate Policy in the Post-Crisis Era
By Charles W. Freeman III and Wen Jin Yuan / From the Center for Strategic and International Studies, Freeman Chair in China Studies, March/April 2010
On March 17, five U.S. senators introduced a new bipartisan bill, making it easier for the United States to declare a country as a currency manipulator. Even if the bill is not passed, the Obama Administration is expected to put additional pressure on China to raise the value of its currency, the Renminbi (RMB), against the U.S. dollar.
China has pegged the RMB to the U.S. dollar since 1994 and, until 2005, the value of the RMB was virtually unchanged in U.S. dollar terms. However, after 2002, the year following China’s accession to the World Trade Organization, the U.S. bilateral trade deficit with China skyrocketed, and the RMB’s value became a significant trade issue between China and the United States. Many U.S. legislators attributed the huge U.S. trade deficit to China’s supposed manipulation of the RMB to gain an unfair advantage in trade. In response, a number of bills were introduced in Congress seeking to put pressure on the Chinese government to appreciate the RMB.
In June 2009, Senators Charles Schumer and Lindsey Graham introduced a bill designed to squarely address the RMB issue as a U.S. domestic legislative priority. At the time, Senate Finance Committee Chairman Max Baucus and Ranking Republican Chuck Grassley did not take up debate of the bill, indicating that addressing the RMB’s alleged undervaluation was not a high priority for Congress in 2009. By stark contrast, in 2010, due to the high U.S. unemployment rate, legislators have focused on the trade deficit as a supposed source of joblessness, and China’s supposed manipulation of its currency is front and center on Congressional minds.
It is highly unlikely that marginally increasing the value of the RMB vis-à-vis the dollar would reduce the trade imbalance between the two countries, since the margin between the average cost of consumer goods in China and the equivalent wholesale costs of manufacturing goods here in the United States is so high. Further, if Chinese exports to the U.S. were to become more expensive due to the RMB revaluation, the United States would shift its demand to other third party developing countries, such as Mexico, rather than moving the manufacturing facilities back to the United States. Therefore, there is little if any compelling correlation between joblessness and the trade deficit, as well as the trade deficit and the undervalued RMB.
The real danger of China pegging the RMB to the U.S. dollar is that China boosts the asset bubble in the United States. With China’s speedy productivity growth, the rate of capital return in China is higher than that in the United States. A large amount of capital denominated in U.S. dollar therefore flows into China seeking investment opportunities. In order to maintain the peg between the RMB and the U.S. dollar, therefore, China’s central bank has to buy all the extra U.S. dollars at the fixed rate, resulting in a rapid increase in the amount of its foreign reserve. By 2008, Beijing had accumulated around 1.4 trillion in U.S. dollar reserves and used them to purchase U.S. Treasury Bonds. All things being equal, it would in turn augment the price of US Treasury Bonds and cause the nominal interest rate in the U.S. to decline accordingly, pushing up prices in the U.S. asset market. Therefore, in order to maintain the stability of the US asset market and to reduce financial risks, it is in the U.S. interest – working with like-minded economies and the International Monetary Fund (IMF), to move China into a market-oriented floating exchange rate regime.
However, the Beijing leadership circle has been cautious on the reform of its exchange rate regime. In 2005, Chinese Premier Wen Jiabao announced the first step in China’s currency reform – moving towards a managed float regime and allowing the RMB to float against a basket of currencies within a certain range. Since then, the RMB has gradually appreciated against the U.S. dollar for three years. However, amid the financial crisis, The Chinese Central Bank resumed its peg to the U.S. dollar, and the RMB has been pegged at about 6.83 Yuan per dollar since July 2008.
On March 6, 2010, Zhou Xiaochuan, Governor of the People’s Bank of China, depicted the current “soft peg” of the RMB to the dollar as a temporary response to the global financial crisis, which is regarded as the strongest signal yet that China would resume its appreciation process in short order. However, Zhou offered no detailed timetable for the policy change. Moreover, Zhou and Yi Gang, Vice governor of the People’s Bank of China, both emphasized on “maintaining the stability of the RMB exchange rate at an equilibrium level”. Meanwhile, on March 14, 2010, when answering questions during a press conference after the closing meeting of the Third Session of the 11th National People’sCongress (NPC), Premier Wen said that “China is opposed to some countries taking strong measures to force other countries to appreciate their currencies”, further asserting that the RMB is not undervalued.
According to voices from the China Intellectual circle, the reason why the Beijing leadership circle is so cautious on the currency reform is that Chinese leaders, including Wen Jiabao and Vice Premier Wang Qishan, who oversees China’s financial affairs, all believe that an abrupt revaluation would wreck China’s exports and result in speculative inflows just as Japan experienced at the beginning of the 1990s after the Plaza Accord, when the Japanese Yen was forced to appreciate against the U.S. dollar.
It is also important to note that the discussion on the currency reform is not confined to the leadership circle. According to a survey conducted by Sina Finance, a popular Chinese website in 2005, among 88,334 respondents 71.5percent bolstered the view that RMB exchange rate should be “relatively stable” but “float within a certain range”. 20.6percent supported the view that China should move into a market-oriented floating exchange rate regime, and only 7.6percent supported pegging the RMB to the dollar. However, amid the post-crisis era, the Chinese public is growingly dissatisfied with Obama administration’s pressure on China to appreciate its currency, opining that Chinese small and medium sized companies (SMEs) that provide the bulk of China’s would be negatively affected if RMB appreciates at this juncture. So U.S. aggression on the subject has a direct impact on popular Chinese opinions, which in turn restricts leadership’s willingness to move on the issue.
In this environment, the most appropriate strategy for the United States may be to maintain a composed and rational stance, giving China a little more time to resume its appreciation process, rather than initiating the retaliation process immediately. After all, Chinese authorities would always want to launch policy changes themselves without looking like they are caving in to the pressure from the United States.
Charles W. Freeman III holds the CSIS Freeman Chair in China Studies. Wen Jin Yuan is a research intern with the Freeman Chair in China Studies.