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.
Historical USD to RMB Exchange Rate
China’s exchange rate policies, however, have been heavily criticized abroad. In the past, the United States and European Union (each facing rising trade deficits with China) have claimed that China artificially deflated the value of the RMB in order to boost exports. This heated political rhetoric was based on a fundamental failure to distinguish between nominal and real exchange rates. China has bolstered the value of its currency as part of its transition to a more consumption-based economy. The following discussion examines the debate over RMB valuation, discusses 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 US and other foreign securities as part of its strategy to manage the RMB’s value. The European Union’s trade deficit with China more than doubled in real terms between 2002 and 2006, and peaked at €180 billion in 2015, 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 US exports to China and aid American companies that directly compete with Chinese firms.
While China’s alleged currency manipulation has been a source of political clamoring for decades, countries have typically shied away from outright labeling 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 2017, US President Donald Trump turned away from earlier claims that China was the “grand champion” of currency manipulation, but kept China on a currency monitoring list created under the Obama Administration in 2016.
Nevertheless, China has long resisted calls from the United States, EU, and international economic forums to alter the RMB’s exchange rate regime. China’s leaders have claimed such pressure to be a violation of Chinese economic sovereignty, claiming that China’s currency policy is a domestic concern. In March 2017, Chinese Vice Foreign Minister Zheng Zeguang noted that “China does not deliberately seek a trade surplus. We also have no intention of carrying out competitive currency devaluation to stimulate exports. This is not our policy.”
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
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. 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, such as managing price stability and addressing employment levels.
In contrast, a currency’s real exchange rate is determined by the market, and determines the actual purchasing power of a currency. Real exchange rates reflect the amount of goods and services in a domestic economy that can be exchanged for goods and services in foreign economies, and ultimately have a greater impact on global trade. While China fixes its nominal exchange rate, other countries like the United States also intervene in their domestic markets by setting their interest rates.
Policies that adjust nominal exchange rates have a limited effect on overall levels of trade. 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. Although Germany has very limited influence on the Euro’s nominal exchange rate, the country has maintained a soaring trade surplus that reached $287 billion in 2017.
Instead, trade flows are primarily influenced by the market-determined real effective exchange rate, which 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 choose between three exchange-rate regimes that determine how to maintain its nominal exchange rate in foreign exchange (forex) markets. A floating exchange rate allows the forex market to freely dictate the value of a currency relative to other currencies. Fixed exchange rates tie the value of one currency to another country’s currency. Lastly, a pegged float ties the currency to another foreign currency, but allows deviations within a specified band.
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.
|Key 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|
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. China has opted to maintain a fixed exchange rate and independent monetary policy, while keeping capital flows closed. China has worked to open its capital account in order to increase global RMB use, but this requires transitioning toward a floating currency in the long run.
Over the past couple of decades, China has frequently modified the RMB’s exchange rate regime. Beginning in 1994, China placed a strict peg between the RMB and the US dollar, which promoted a more predictable trade and investment environment in China by preventing large swings in the currency’s value. In 2005, China placed the RMB on a managed peg system, tying the RMB to a basket of international currencies which allowed for small amounts of appreciation. As a result, 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 US dollar. China’s leaders cited the strengthening dollar as the key reason behind the move.
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?
Accurately determining the RMB’s valuation based on its nominal exchange rate is 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. China introduced the “counter-cyclical” factor into its fixing of the yuan in 2017, allowing China’s banking authorities more power to resist market influences. However, by early 2018, China’s central bank directed lenders to reduce the “counter-cyclical factor” to allow for more exchange rate flexibility.
What are the effects of China’s currency policy for China?
In China’s push to promote consumption-led growth, China has shifted its economic policy toward promoting a stronger RMB. China’s efforts to strengthen the RMB also demonstrate 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.
For China, RMB internationalization has started to deliver meaningful payoffs. In October 2016, the IMF entered the RMB into its basket of special drawing rights (SDR) currencies, which increases the acceptance of the RMB among official forex reserves. Inclusion into the SDR basket has made the RMB freely usable abroad, which has contributed to the currency’s growing importance in overseas reserves.
The RMB’s internationalization also brings the debate over the currency’s value into the global spotlight. Strong dollar growth in 2015 caused the pegged RMB to rise against its other trade partners’ currencies more quickly than intended. However, some analysis has suggested that the yuan’s current strength may be exaggerated due to an overall weaker US dollar.
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. The RMB was the fourth most-used currency internationally in 2015, a marked shift from being the thirteenth-most used in 2012. According to a survey by the Bank of China, confidence in the international importance of the RMB is increasing among overseas enterprises and financial institutions. In 2018, Germany’s central bank announced that it would include RMB into its currency reserves, a reflection of the currency’s growing global importance.
|SDR Composition, Before and After RMB Inclusion|
|Currency||Weight Before||Weight After|
To complement China’s RMB internationalization, China’s leaders have taken steps to strengthen it for the domestic market by opening the country’s capital account. By doing so, however, China has allowed capital outflows to 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. China imposed a number of new rules on overseas currency transfers in late 2016 and early 2017. China’s state media has emphasized that these rules should not be considered capital controls, but instead as measures that target illegal activities, such as money laundering and terrorism financing. Nonetheless, the improved capital flow regulations and the increasing international use of the RMB have ultimately strengthened the currency’s value.