China’s Currency Conundrum

In late February, the gradual appreciation of the renminbi was interrupted by a 1% depreciation. The resulting international outcry obscured a troubling feature of China’s exchange-rate policy: the tendency for sporadic renminbi appreciation (even small movements) to trigger speculative inflows of “hot” money.

PALO ALTO – The People’s Bank of China (PBOC), it seems, cannot win. In late February, the gradual appreciation of the renminbi was interrupted by a 1% depreciation (to $1:¥6.12). Though insignificant in overall trade terms, especially when compared with the volatility of floating exchange-rate regimes, the renminbi’s unexpected weakening sparked a global furor.

The uproar was not surprising. After all, China has been under constant pressure from foreign governments to revalue, in the mistaken belief that a stronger currency would reduce China’s large trade surplus. And, since July 2008, when the exchange rate was $1:¥8.28 (and had been held constant for ten years), the PBOC has more or less complied, with appreciations approximating 3% per year through 2012.

However, the international outcry obscured an unintended but perhaps more troubling feature of China’s exchange-rate policy: the tendency for sporadic renminbi appreciation (even small movements) to trigger speculative inflows of “hot” money. With short-term interest rates in the United States near zero, and the “natural” interbank interest rate in faster-growing China at near 4%, an expected 3% appreciation, for example, translates into an “effective” interest-rate differential of 7%. This is an enticing spread for currency speculators who borrow in dollars and circumvent China’s capital controls to buy renminbi assets.

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