This paper examines China’s foreign exchange policy, the implementation, the reason behind it, the global effect and the argument for and against it. We will then discuss and compare this thinking with the main stream economic thinking.
Table of Contents
China’s Yuan (¥) or Renminbi (RMB) was pegged to the U.S dollar from 1997 to July 2005. On July 21, 2005 when the peg was lifted, People Bank of China (PBC) allowed RMB to appreciate within a daily narrow band of 0.3% which later was changed to 0.5%. On July 2008, the peg was reinstituted with the financial crisis cited as the main reason. Under constant pressure from U.S and China’s other trading partners, RMB was allowed by PBC to appreciate again on June 21, 2010. Since then RMB has appreciated to its current rate (as of 19 September 2010) of 0.1492 (1.8% increase from 0.14645 on 19 June 2010). PBC statement was that they would “proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.”
19 June 1010
CNY per 1 USD 5 years.png
Figure 1 CNY per 1 USD 5-year rate ( source: www.xe.com)
19 June 1010
CNY per 1 USD 1 year.png
Figure 2 CNY per 1 USD 1-year rate (source: www.xe.com)
This paper will start with the explanation of the managed float policy used by China. Section 3 will discuss the argument for and against the policy seen from multiple angles such as sterilization cost, capital flow restriction, global trade imbalances and RMB as a global currency. Section 4 concludes.
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China’s Managed Float policy
In a “pure” fixed exchange rate, the currency’s value is fixed to a certain value. To hold the exchange rate when it is appreciating, a central bank will have to buy foreign assets and expand the home money supply. The extreme opposite of that policy is the floating exchange rate in which the currency’s value is allowed to float freely according to the foreign exchange market. This is preferable to some economist since floating exchange rates automatically adjusts itself. This enables the country to dampen the impact of shocks and foreign business cycles. It is also one of the corrective mechanisms to prevent balance of payment crisis.
Managed floating exchange rate, which is adopted by China, is a policy in which the central bank intervenes in the currency market to influence exchange rates. It is also known as “dirty float” (the opposite is “clean float” in which the governments make no direct attempt to influence the currency values). This system is a hybrid of “pure” fixed and floating rate system.
People Bank of China (PBC) intervenes almost daily by buying any excess foreign currency on the Shanghai foreign exchange market in order to hold down the value of RMB within a certain band. In making these purchases, PBC credits the reserve accounts of mainland banks with equivalent amount in RMB, which will increase the money supply.1
3. Argument for and against China’s Managed Float Policy
3.1 Sterilization Cost
PBC’s constant intervention results in an increase in domestic money supply. To nullify the impact of the foreign exchange operation on the money supply, the central bank will have to engage in sterilization process.
China’s sterilization process is primarily done by doing two things:
To raise reserve requirements against deposits of commercial banks (China’s current reserve requirement is 16.5% with a rumour of another increase coming in October)
To issue RMB-denominated bills and bonds (sterilization bills or bonds) to the banks and other financial institutions.
The sterilization process is not cost free and will create distortions on China’s economy. Firstly, sterilization tends to encourage over expansion of the export sector while delaying inflation. As a result, domestic sectors are neglected in favour of export oriented industry. Secondly, sterilization distorts the interest rates and the asset portfolio of Chinese Commercial banks. Instead of lending to normal customers such as firms and individuals, the banks are compelled to lend money bank to the central bank instead. 1
Sterilization suppresses the monetary expansion that would otherwise occur under conditions of an undervalued exchange rate; however it cannot prevent other needed economic adjustments. At the current rate, the economy is overheated with the risk of a “bubble-burst” in the future.
Sterilization can only continue as long as it is profitable to do so. This is determined by the spread between the cost of issuing sterilization bills and the returns on foreign assets. When the interest cost of the sterilization bills that it is issuing begin to exceed the yield it is earning on its U.S Treasuries and other foreign assets, the sterilization will end. The situation is similar to what happened to Malaysia in the 1990’s. During that period, Bank Negara Malaysia has conducted sterilization operation in a significant scale, resulting in an increase in Malaysian interest rates which exceeded U.S interest rates for an extended period. Therefore, Bank Negara suffered spread-losses and was eventually forced to cease their sterilization operation. This scenario has not happened so far in China, but as the interest rate is raised further to cool down the economy, it is bound to happen.
While sterilization process may stabilize the Chinese economy, it is no more than a temporary solution and exacerbates the problem cumulatively. Thus, this argument supports the view that China should let RMB appreciate.
3.2 Impossible Trinity and Capital Flow Control
At any time a country could only have a combination of any two of these three conditions
Free Capital Flow
Fixed Exchange Rate
Independent Monetary Policy
We will now relate China’s current situation with the trilemma of the impossible trinity which is derived from the Mundell-Fleming model
Figure 3 – Impossible Trinity
The Trilemma states that it is impossible for a country to have any 3 policies concurrently. In the case of China, they chose to have fixed exchange rate and independent monetary policy at the cost of restricted capital flow. Thus, since January 2010 China has restricted the capital flow in and out of China. The rule stated that Chinese and non-Chinese citizens have an annual quota to change a maximum of 50,000 USD. Exchange will only proceed if the applicant appears in person at the relevant bank and presents his passport or his Chinese ID; these deals are being centrally registered. The maximum withdrawal is 10,000 USD per day, the maximum purchase quota of USD is 500 per day. 2
If successful, capital controls would greatly reduce inflows of capital into China from foreign investors. As we have discussed, one of the effect of managed float policy would be an increase in the money supply which needs to be sterilized or countered by increasing the reserve requirement which in turn would increase the interest rate. This higher interest rate would induce the inflows of hot money from foreign investors which could appreciate RMB. By preventing capital flow, China could significantly reduce the demand for RMB and thus would stop the exchange rate of RMB from appreciating. A decline in the value of RMB would increase net export as it would make Chinese goods less expensive abroad. Ceteris Paribus, the improvement in the export sector of the economy would increase GNP and employment. However this would also increase the price the Chinese have to pay for imports which would trigger further increase in China’s inflation rate. Higher interest rates would also dampen the GNP growth by reducing private investment, offsetting the gain from the higher next exports, a phenomenon known as the “crowding-out effect”
Despite the negative effects of capital control described above and other effect such as delaying the rebalancing process of global imbalance which we will talk about in the next section, study has shown that Capital Control does work on avoiding the worst part of economic crisis such as seen in the case of Malaysia, where they used Capital Control during the Asia Financial Crisis to prevent outflow or Ringgit. Although, in the case of China, their goal of capital control is the other way around which is to prevent massive inflows of hot money that could uncontrollably appreciate the exchange rate and threaten macroeconomic stability.
Recently, IMF has also voiced their support for Capital Control as one of the useful tool in policy tool kit to fix the economy. The following is an excerpt from IMF publication titled Capital Inflows: The Role of Controls.
The discussion above suggests that certain types of capital flows-debt and certain forms of financial FDI-contribute to crisis vulnerability, partly (though not exclusively) by helping fuel domestic lending booms. But is there any indication that capital controls have helped limit financial fragility? Specifically, did countries that had controls on inflows in place during the years leading up to the crisis turn out to be less vulnerable in the global financial crisis? Although the results should not be taken as anything more than suggestive correlations, it does appear that such countries indeed fared better in the current crisis. This association shows up more clearly when considering crises-that is, large declines in output growth rates. Although causation is far from established, the empirical evidence suggests that the use of capital controls was associated with avoiding some of the worst growth outcomes associated with financial fragility. Moreover, consistent with the discussion above, it is controls on debt flows that are significantly associated with avoiding crises. 3
In summary, capital controls on certain types of inflows might be useful on limiting financial fragility and preventing macroeconomic stability. This is especially true for the case of China as Renminbi is considered the anchor for stability in Asia in the times of crisis which we will discuss further in section 4.
3.3 Global Trade imbalances
Currently U.S balance of trade stands at -42.8 billion dollars in total. With China, the trade deficit is at -145 billion dollar.
US balance of trade 5 years.png
Figure 4 – United States Balance of Trade (source: www.tradingeconomics.com)
Some U.S politicians and economist have argued that the main cause of the trade imbalance is the undervalued RMB. If the RMB appreciates and USD depreciates, there will be more export than import and thus the trade imbalances would be fixed, according to the theory. But is this really true? Or is it just a politically motivated “China Bashing”
The trade balance is defined by the equation
X – M = S – I = Trade (Saving) Surplus
S= gross national saving
I= gross domestic investment
Most of the popular economists have been focusing on the X-M part which supports the argument that an increase in RMB rate and a decrease in USD value will reduce China’s import and boosts US export. This is also known as the elasticity approach of the trade balance which put more focus on the microeconomic
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On the other hand, the right-hand side of the equation (S-I) puts more emphasis on the macroeconomic. According to this theory, the reason for the global trade imbalance is that China saves too much and US saves too little. The high rate of Chinese savings could be attributed to the poor structure of social safety net in China. Chinese need to save for education, health-care and retirement because of the lack of public provision for these from the government and also from the underdeveloped credit market.4
Both the microeconomic and macroeconomic factors have contributed to the global trade imbalances. There is some truth to the claim that undervalued RMB has indeed contributed to the trade imbalances between China and U.S. However, the huge difference in the savings rate between China and US has also played a part.
Drastic increase of the RMB exchange rate is not the quick and easy solution to this problem. Suppose the RMB appreciate drastically, Chinese export industry will fall followed by wave of job losses and business bankruptcies. Furthermore, potential foreign or domestic investor will suddenly find China as a more expensive place to invest and will invest somewhere else, causing a huge impact on the Chinese economy. USD depreciation in value is also not preferred by China because it will depreciate the value of most of China’s 2.4 trillion USD Foreign Reserve.
There is a lingering fear that China would suffer the same fate as Japan in the 1990’s when the Yen was free-floated which results in the deflationary period experienced by Japan. However this should not happen to China due to the following reasons:
Ever since the Yen started to appreciate, Japan still grew rapidly for two decades until the early 1990s
The risk of inflation is more prevalent in China rather than deflation as shown in the data on China from Economist Intelligent Unit (EIU) that shows that it will increase to 3.8% in 2010.
In the short term, considering the possible negative effect of a drastic appreciation of RMB, it is understandable that China would not want a sudden jump in RMB value. Therefore, US should not impose a trade sanctions on China as it could escalate into a trade war which could be costly for both countries.
In the long term, adjustment will need to be done gradually to the exchange rate, as what PBC has been doing since June 2010. Adjustment will also need to be done in US by cutting back on its huge fiscal deficits and constraining private consumption while China stimulates her private consumption. With enough time, the export industry in China adapted should be able to adapt to support domestic consumption in which time China would be ready to be a global consumer as well as producer.
In summary, both a better balance net saving in US and China and real exchange rate appreciation (to increase US export) will be necessary in the process of global rebalancing.
3.4 RMB as International Currency
RMB is considered the anchor of stability in Asia especially during the time of crisis and it is one of the main reason the crisis did not precipitate an even more devastating meltdown in the region. However, undervalued RMB also has adverse effect on Asian economy as it could precipitate competitive devaluation pressure on the rest of the region. The undervalued RMB would reduce the export of Asian countries especially on exports of textiles and apparels which is a big proportion of the trade in countries such as Indonesia, Philippine and Thailand, an effect known as “Beggar thy neighbour”. Thus, it is in Asia’s best interest that RMB is properly valued.6
One of PBC long term goal is to put RMB as an international currency. By definition, international currency has to satisfy the following criteria
Table 1: Roles of an International Currency Function of money
Store of value
Currency substitution (private dollarization)
Medium of exchange
Vehicle currency for foreign exchange intervention
Invoicing trade and financial transactions
Unit of account
Anchor for pegging local currency
Denominating trade and financial transaction
Figure 5 -Source: Chinn and Frankel (2005), originally from Kenen (1983)
Currently most of governments reserve is denominated in USD. China is trying to persuade world governments to use RMB as their reserve by announcing, on August 17 2010, that it will allow foreign financial institutions to participate in the interbank bond market on a trial basis as part of its RMB cross-border settlement programme. Since then, the Malaysian government has bought large amount of RMB denominated bond for its reserve, a move that is considered a major boost for China’s effort to promote RMB as a global currency. This is also considered good news for Washington as it would help appreciate the value of RMB. Naturally, for a government to hold their reserve in RMB they want the RMB to be properly valued, otherwise their foreign reserve may not reflect their true value.6
Furthermore, for RMB to be accepted as international medium of exchange, it has to be fully convertible. By definition, fully convertible means any holder is free to convert it at a market rate into one of the major international reserve currencies (Greene 1991). At the moment China is still limiting the convertibility of RMB and thus it is not yet fully convertible. If China wants RMB to become an international currency, it will have to remove the restriction that it has put since January 2010.
In summary, for RMB to be accepted as international currency it has to be properly valued and fully convertible. Since these two criteria are effectively linked, it is probable that China will allow RMB to appreciate to achieve their goal. A greater use of Renminbi internationally will be a balancing factor to global financial stability
Since China started the RMB reform in July 2005 and moved into a managed floating exchange rate regime, RMB has appreciated gradually and has played a positive and supportive role in supporting China’s economic growth. In 2008, when the global financial crisis hit, they narrowed the floating range of RMB exchange rate. This policy helped China and the rest of Asia mitigate the shock of the financial crisis and is the right thing to do for that time.
However, the time has come for China to realise that they could not keep the peg forever due to the reasons we have discussed such as sterilization cost, global trade imbalances and their drive to push RMB as a global currency. The longer China waits, the more harmful the effect would be later and she knows it.
Despite the urgency, the revaluation of RMB has to be done gradually so as to give time to the exporting industry to adjust and not to give shocks to the domestic economy and financial stability. The appreciation of RMB would turn the Chinese export industry to be high value-added product based. It will also be supportive to job creations especially in the service sector.
While mainstream economist such as Nobel Laureate Paul Krugman points their finger at China for the problem in US, they do not have China’s best interest in mind. Instead of blaming China for all problems US is having, US should control their fiscal spending. Imposing a trade sanctions on China would not solve the problem and would just lead to a costly trade war for both sides.