Rattling the Renminbi

BEIJING – From July 2005 until this past December, China’s renminbi (RMB) appreciated steadily. But then the RMB fell unexpectedly, hitting the bottom of the daily trading band set by the Peoples’ Bank of China (PBoC) for 11 sessions in a row. Though the RMB has since returned to its previous trajectory of slow appreciation, the episode may have signaled a permanent change in the pattern of the exchange rate’s movement.

As long as China was running a trade surplus and receiving net inflows of foreign direct investment, the RMB remained under upward pressure. Short-term capital flows had little impact on the direction of the RMB’s exchange rate.

There were two reasons for this. First, thanks to an effective – albeit porous – capital-control regime in China, short-term “hot money” (capital coming into China aimed at arbitrage, rent-seeking, and speculation) could not enter (and then leave) freely and swiftly. Second, short-term capital flows usually would strengthen rather than weaken upward pressure on the RMB’s exchange rate, because speculators, persuaded by China’s gradual approach to revaluation, bet on appreciation.

So why, if China was still running a decent current-account surplus and a long-term capital surplus, did the RMB suddenly depreciate, forcing the PBoC to intervene (though not very vigorously) to prevent it from falling further?