China’s Currency Conundrum

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.

The hot-money problem is only made worse by the ongoing international pressure for further renminbi revaluation, usually from Western economists and politicians who blame the exchange rate for China’s current-account surplus with the US and other developed economies. In reality, the trade imbalance reflects the difference between China’s large savings surplus and the even bigger US saving deficiency (largely explained by the US fiscal deficit). Indeed, the wholesale price index – the best measure of tradable-goods prices in China – has been falling by about 1.5% annually, which suggests that the renminbi may even be slightly overvalued.