China’s Exchange-Rate Puzzle

China’s abrupt decision to raise the value of the renminbi (yuan) by 2.1% and to end its peg to the dollar comes after months of pressure from the US. But the revaluation is likely to be a one-time affair and the free floating of the renminbi is probably not real because a stable currency is very much in China’s interest.

Indeed, the economist Robert Mundell, whose work on optimal monetary zones is credited with laying the theoretical groundwork for the euro, insists that China should maintain its fixed exchange rate as a necessary part of its current phase of economic development. But, owing to China’s skewed economic structure, its exchange-rate regime presents much more challenging problems than those encountered by Japan and other East Asian economies.

Pegged exchange rates clearly have been essential to East Asia’s economic takeoff, for they work well with the region’s export-oriented development model. But the effectiveness of a fixed exchange rate is determined by how developments in the export sector influence domestic industries and the national economy as a whole. If growth in the trade sector boosts that of domestic non-trade sectors, then a fixed exchange rate will not put pressure on the external balance of payments as demand for imports rises.

Under these circumstances, revaluation of the exchange rate will not have a severe impact on an economy’s development. For example, Japanese economists argue that the  Plaza Agreement, which called for “orderly appreciation” of non-dollar currencies against the dollar, was a natural outgrowth of high national income. This was one of the major reasons for Japan’s acceptance of the change.