The Renminbi Goes Forth

BEIJING – In June, the Peoples’ Bank of China (PBC), China’s central bank, announced an end to the renminbi’s 23-month-old peg to the dollar and a return to the pre-crisis exchange-rate regime adopted in July 2005. So far, however, the RMB’s appreciation against the dollar has been slow. Will the pace of appreciation accelerate enough to satisfy American demands? If it does, will global imbalances disappear sooner?

It is hard to argue that the RMB is not undervalued, given China’s large and persistent current-account and capital-account surpluses. But, despite ending the dollar peg, faster appreciation of the RMB seems unlikely for the foreseeable future.

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China’s official position is that, to avoid the negative impact of a stronger RMB on China’s exports and hence employment, appreciation must proceed in an autonomous, gradual, and controllable manner. The current exchange-rate regime, which links the RMB to a basket of currencies, was designed to give the PBC leeway to control the pace of RMB appreciation, while creating two-way fluctuations in the exchange rate against the US dollar in order to discourage speculators from making one-way bets on the RMB.

RMB appreciation should have started earlier and at a faster pace, when China’s trade surplus was much smaller and its growth was much less dependent on exports. Delay has made current-account rebalancing via RMB appreciation costly. And now China faces a dilemma.

As a result of the global financial crisis, China’s export growth in 2009 dropped by 34% compared to 2008. In the first seven months of 2010, China’s trade surplus was $84 billion, down 21.2% from January-July 2009. This large, steady fall in the country’s trade surplus makes the Chinese government hesitant to allow the RMB to appreciate significantly, for fear of the lagged impact on the trade balance.

But the PBC is also reluctant to buy dollars constantly. The PBC knows that rapid deterioration in America’s fiscal position and continual worsening in its external balance may create an irresistible temptation for the US to inflate away its debt burden. The more the PBC intervenes, the larger the national welfare losses that China may suffer in the future.

The Chinese government must, therefore, strike a balance between protecting China’s export sector and preserving its national welfare. The dilemma that officials face is that the impact of a fall in exports as a result of RMB appreciation will be felt acutely and immediately, whereas the large welfare losses due to the evaporation of the value of China’s foreign-exchange reserves will be borne by society as a whole – but not immediately.

Moreover, the increase in China’s overall price level – and wage levels in particular – has caused the RMB to strengthen steadily in real terms, reducing (to a certain extent) the need for nominal RMB appreciation. True, commerce ministry officials recently declared their wish to see a further fall of China’s trade surplus in 2010. But RMB appreciation is not the preferred instrument for achieving this goal. Thus, nothing dramatic will happen to the RMB exchange rate in the near term – unless something dramatic happens.

At the same time, the effect of currency appreciation on the trade balance should not be exaggerated. The RMB appreciated by 18.6% in real effective terms, and by 16% in dollar terms, from June 2005 to August 2008. Yet, from 2006 to 2008, China’s annual exports grew 23.4%, outpacing import growth of 19.7%.

Exchange rates are just one of many factors that affect trade balances. For China’s, the income effect of global demand is significantly larger than the price effect of the exchange rate. The fall in China’s trade surplus since late 2008 is attributable mainly to the global slowdown and the stimulus package introduced by the Chinese government, rather than to changes in the RMB’s exchange rate.

But if the RMB is allowed to float, isn’t a balanced trade account likely? Probably not. With a fast-rising RMB, net capital outflows will increase, which is what Japan experienced after the Plaza Accord of 1985 pushed the yen upward. As a result, balance-of-payments equilibrium would be reached at a certain exchange-rate level, but a current-account surplus (albeit smaller) would still exist.

America should not pin too much hope on a weakening dollar to correct its trade imbalances. For the US, the fundamental cause of imbalances is not a strong dollar, but America’s over-consumption and over-borrowing. A strengthening dollar would worsen the US trade balance, but a weakening dollar could cause panic in capital markets, which might push up risk premia on dollar-denominated assets, including US government securities, in turn leading to an economic slowdown and a further weakening of the dollar.

Of course, RMB appreciation may displace Chinese goods sold in the US. But if the US fails to narrow its savings gap, its current-account deficit will not disappear, regardless of where the dollar goes. Whether America can achieve decent growth while keeping its current-account deficit in check depends on whether it can reinvigorate its ability to innovate and create, thereby restoring competitiveness and creating demand at the same time.

For both China and America, the RMB-dollar exchange rate is important for achieving growth and a more balanced current account. But that dual objective requires structural change in the Chinese and US economies.