For any state, the ability to influence the actions of other actors is an essential component of exercising power. In terms of monetary policy, states can leverage their economic strength to enhance their currency’s role within financial markets, international trade, and central-bank reserves. The greater role a country’s currency plays in these international arenas, the greater its autonomy and influence. By maintaining autonomy over the Renminbi (RMB), China can directly manage key economic variables, including its currency’s nominal exchange rate.
China’s exchange rate policies, however, have been heavily criticized abroad. For years, the United States and European Union (each facing rising trade deficits with China) have claimed that China artificially deflated the value of the RMB as a means to boost exports. While this debate invoked heated political rhetoric, it was based on a fundamental failure to distinguish between the nominal exchange rate and the real exchange rate. While countries can influence their nominal exchange rate, the real exchange rate is determined by market conditions, and is ultimately more significant for trade. Furthermore, China has recently attempted to bolster the value of its currency as part of a transition to a more consumption-based economy. The following discussion examines the debate over RMB valuation, how countries determine currency exchange rates, and analyzes the domestic effects of China’s currency policies.
Why do countries consider the value of China’s currency a political issue?
China’s rapid economic rise has left its economic welfare increasingly intertwined with that of other countries. China has boasted a trade surplus with the United States since 1985, which has contributed to the United States’ current account deficit. Additionally, China holds large amounts of U.S. and other foreign securities as part of its strategy to manage the RMB’s value. Europe’s trade deficit with China more than doubled in real terms between 2002 and 2006, sparking concern over China’s exchange-rate policy across the continent.
As a result of these economic linkages, the RMB’s value relative to the dollar and the euro has been the subject of extensive political debate in the United States and the European Union. Critics have accused China of intervening in its currency markets to put itself at a competitive advantage. For years, the United States called for an appreciation of the RMB’s value against the dollar on the presumption that this would boost U.S. exports to China and aid American companies that directly compete with Chinese firms.
If China wants to have a dynamic domestic financial system it has to move forward toward having a more market-oriented exchange rate regime as well.
Daniel H. Rosen
While China’s alleged currency manipulation has been a source of political clamoring for decades, no country has outright labeled China as a currency manipulator. In 2009, former European Commission President Jose Manuel Barroso urged China to revalue the RMB, stating, “major imbalances because of trade or because of currencies can create problems in the future if they are not fully addressed.” In 2011, U.S. President Barack Obama criticized China’s currency policy, claiming that the Chinese were “gaming the trading system to its advantage and to the disadvantage of other countries, particularly the United States.” Nevertheless, China has long resisted calls from both the United States and the EU to alter the RMB’s exchange rate regime, and China’s leaders have claimed such calls to be a violation of Chinese economic sovereignty. Chinese leaders have also rebuffed attempts to address RMB valuation at international economic forums, claiming instead that China’s currency policy is a domestic concern. As a Chinese official stated in 2010, “The Chinese government will judge, research and make decisions on currency policy based on the situation of domestic and international factors.”
Top 10 Currencies By Exchange Rate Regime
|Economy||Currency||Exchange Rate Regime|
|European Union||Euro||Free Floating|
|United States||US Dollar||Free Floating|
|United Kingdom||Pound Sterling||Free Floating|
|Canada||Canadian Dollar||Free Floating|
|Australia||Australian Dollar||Free Floating|
* Russia is moving toward a free-floating currency. In 2014-2015, the currency floated freely for seven months, before a return to a peg with the US dollar. For more information, see: http://www.bloomberg.com/news/articles/2015-06-28/russia-free-float-skeptics-gather-as-ruble-seen-on-shorter-leash
Criticisms levied against China are often rooted in misinterpretations of international economics. All governments that print their own currency can set their currency’s nominal exchange rate. However, it is the market that ultimately determines a currency’s real exchange rate. Since real exchange rates reflect the amount of goods and services in a domestic economy that can be exchanged for goods and services in foreign economy, real exchange rates ultimately have a greater impact on global trade. Nominal exchange rates represent the relative value of a home country’s currency compared to foreign currencies, and can be adjusted by a country in pursuit of specific policy goals. Depending on a country’s economic situation, it can adjust its nominal rate to manage price stability and address employment levels. While China fixes its nominal exchange rate, countries like the United States similarly choose to intervene in their domestic market by setting their interest rates. Furthermore, when countries make short-term economic adjustments to manage exchange rates, these policies often have limited long-term effects on the country’s current account balance.
Policies that adjust nominal exchange rates have a limited effect on overall levels of trade, as it is the real exchange rate that determines the actual purchasing power of a currency. For example, despite decades of dollar depreciation against the yen throughout the late twentieth century, the United States did not accumulate a trade surplus with Japan, and actually experienced a widening trade deficit. Switzerland has intervened to control its nominal exchange rate with the euro, but these policies have not attracted the same international criticisms as China. Due to falling oil prices, Canada’s dollar has significantly depreciated against the U.S. dollar, but this has not resulted in political friction between the two countries. Instead, trade flows are primarily influenced by the market-determined real effective exchange rate. The real exchange rate is adjusted for differing levels of prices across borders, and therefore reflects the market forces of comparative advantage. Real exchange rates are also more stable than nominal exchange rates in the long run. In short, real exchange rates are more important than nominal exchange rates for determining the relative values of currencies.
How do countries manage their nominal exchange rate?
Every country with its own currency can also choose between three exchange-rate regimes that determine how to maintain its nominal exchange rate in foreign exchange (forex) markets. A floating exchange rate (as typified by the U.S. dollar and the euro) allows the forex market to freely dictate the value of a currency relative to other currencies. Exchange rates can also be fixed, which ties the value of one currency to another country’s currency. Lastly, countries can maintain a pegged float, which ties the currency to another foreign currency, but allows deviations within a specified band. Of the top 10 economies by nominal GDP in 2014, only China and Russia do not allow their currencies to freely float.
Each exchange-rate regime has its benefits and drawbacks. Floating exchange rates allow countries to easily adjust to economic shocks, but are vulnerable to large value fluctuations that can harm investors. Fixed exchange rates generally promote lower levels of inflation and stable trade and investment, but can distort the true value of a currency and incentivize short-term speculation. As a rule of international economics, countries typically can only implement two of the following three policies: a fixed exchange rate, an open capital account, and an independent monetary policy. By and large, China has opted to maintain a fixed exchange rate and independent monetary policy, while keeping capital flows closed. Moving forward, China’s rebalance will open its capital account, which will require transitioning toward a floating currency.
An exchange rate is not in a vacuum between two economies; it’s a global number. If China were to permit the RMB to devalue significantly at this point . . . one, two or three dozen other peer competitors of China such as Indonesia, Brazil, and Mexico . . . could very well follow suit.
Daniel H. Rosen
Over the past couple of decades, China has frequently modified the RMB’s exchange-rate regime. From 1994 to 2005, China maintained a strict peg between the RMB and the U.S. dollar. The peg was utilized to promote a stable trade and investment environment, as the peg prevented large swings in the currency’s value. In 2005, China placed the RMB on a managed peg system, which tied the RMB to a basket of international currencies and allowed small amounts of appreciation. As a result of this system, from 2005 through mid-2013 the RMB appreciated 34 percent on a nominal basis with the dollar. In August 2015, however, the People’s Bank of China (PBOC) allowed the RMB to depreciate 2 percent with the U.S. dollar. China’s leaders cited the strengthening dollar as the key reason behind the move. Currently, China remains flexible with its exchange rate policy, switching between a managed peg with the U.S. dollar and with a basket of currencies. Accurately determining the RMB’s valuation based on its nominal exchange rate is further complicated by the fact that China makes many short-run changes to its nominal exchange rate, all of which have a limited long-run impact on trade.
What are the effects of China’s currency policy for China?
While for years China sought to keep the value of the RMB low in order to promote export-led growth, China now seeks a strong RMB as it rebalances to a more consumption-led economic growth model. China’s economic policy shift requires the country to undergo a difficult transitional phase where its economic status depends as much on market expectations and global economic conditions as it does on the PBOC’s determined course of action. Managing China’s economic rebalancing will entail significant growing pains for the PBOC, as its efforts to strengthen the RMB have already led to significant economic problems for China’s leaders.
Prior to China’s economic rebalancing, low RMB values improved the price competitiveness of Chinese exports and attracted export-oriented foreign direct investment, particularly in light manufacturing sectors. Low currency values also helped China compete against regional economic actors that sold similar goods. As part of this strategy, China frequently sold its own currency and bought foreign currencies. From 2004 to 2013, China accumulated trillions of dollars in foreign exchange reserves in order to limit the RMB’s appreciation. In order to keep assets in RMB, China enforced strict quotas on its capital account, preventing its citizens from moving more than $50,000 of assets out of China in a year.
A Conversation with Daniel H. Rosen
0:07 - Why is it so difficult to judge whether the RMB is valued appropriately, undervalued or overvalued?
2:41 - Why has China resisted allowing its currency to float freely? Under what conditions would China likely change this policy?
5:02 - How much does the value of the RMB matter for China’s competitiveness?
8:19 - How does the RMB fit into China’s overall plan to rebalance the economy?
10:13 - What have been the consequences of China’s currency management policy for China and for the rest of the world?
However, as China aims to rebalance its economy into a more consumption-oriented model, a devalued currency is no longer in China’s interest. Since the start of President Xi Jinping’s administration, economic policy has shifted toward promoting a strong RMB, which will decrease the cost of imports and encourage domestic consumption. China’s efforts to strengthen the RMB also reflect a desire to improve the currency’s international usage. Japan employed a similar strategy of yen internationalization following the Asian financial crisis of 1997–1998, which was designed to promote regional economic stability. RMB internationalization has started to deliver meaningful payoffs for China, as a growing number of East and South Asian nations have started to peg their currencies closer to the RMB than the U.S. dollar. Further recognition of the RMB’s international standing came in November 2015 when the International Monetary Fund (IMF) entered the RMB into its basket of special drawing rights (SDR) currencies.
The RMB’s internationalization has once again brought the debate over the currency’s value into the global spotlight. When China announced in August 2015 that it had allowed the RMB to depreciate 2 percent relative to the U.S. dollar, many outside observers believed that China sought to again prop up its exports. Conversely, this one-time devaluation was part of a long-term strategy to allow the RMB to gradually rise relative to other currencies. Strong dollar growth in 2015 caused the RMB (on a managed peg with the dollar) to rise against its other trade partners’ currencies more quickly than intended.
Should the RMB continue to internationalize, the currency could act as a complement to the dollar in the global financial system and boost China’s prestige in the process. Nevertheless, the inclusion in the IMF’s SDR basket, while symbolically important for China, does not guarantee that investors will shift to holding RMB assets and securities. According to Daniel Rosen, “The yuan’s contribution to international economic stability—whether to enhance it or to undermine it—will depend on China’s economic stability at home.”
Composition of SDR Basket Currency Weight, Before and After RMB Inclusion
After RMB Inclusion
Before RMB Inclusion
While the internationalization of the RMB might be a long-term economic goal for China’s leaders, short-term to medium-term efforts to strengthen the RMB face considerable challenges. In order to strengthen the RMB for China’s domestic market, Chinese leaders have taken steps to open the country’s capital account. By doing so, however, China has put downward pressure on the RMB’s value as Chinese individuals and companies seize the opportunity to move more assets abroad (and thus into foreign currencies). This presents the PBOC with a significant management challenge. When the RMB is seen as weak, international traders tend to predict greater devaluation, further fueling capital outflows. With assets moving abroad, the PBOC has intervened by purchasing large amounts of RMB in order to support its value. In 2015 alone, China spent over $500 billion of its foreign reserves to protect the RMB from getting shorted by traders. If China decides it can no longer accept this rapid foreign-reserve decrease, it might be forced to reimpose capital restrictions or allow the RMB to depreciate. As a result, the PBOC might need to impose short-run measures that temporarily stray from its long-run objectives.