Chinese Inflation and the Renminbi
China is increasingly worried about its inflation rate, which topped 6.5 percent on a year-over-year basis in December. One thing that the People’s Bank of China might do to garner more control over inflation is to allow its exchange rate more flexibility.
Over the last decade, China has managed the renminbi-dollar exchange rate closely. Between 1998 and July 2005, the People’s Bank pegged the renminbi at 8.28 per U.S. dollar. In mid 2005, the People’s Bank loosened its reigns on the exchange rate and has since allowed the renminbi to appreciate 12½ percent relative to the dollar. Given China’s trade surplus with the United States, many observers think that a larger renminbi appreciation is in order.
Many believe that China manages the renminbi–dollar exchange rate to encourage a large trade surplus with the United States and to attract strong inward direct foreign investments. There is, however, another element to the story. China limits the ability of its residents to reinvest the dollars that they acquire through trade and inward investments outside of the country. Instead, they must exchange the lion’s share of these dollars—and other foreign currencies—for renminbi with the People’s Bank. This strategy has contributed to China’s acquisition of a huge portfolio of foreign exchange. Economists guess that nearly 70 percent of this portfolio is held in liquid U.S. dollar assets, like U.S. Treasury securities.
When Chinese residents fork over the funds to the People’s Bank, they receive renminbi in exchange, and the renminbi monetary base—a narrow measure of money—expands. For many years, this was not a problem. China’s economy grew quickly, and the expanding monetary base accommodated that growth. If anything, money growth often seemed too slow. Between 1998 and 2003, prices in China frequently fell, suggesting that money growth was not keeping pace with the economic expansion. By 2003, however, China’s reserve accumulation started to accelerate, and inflation began warming up.
In 2003, the People’s Bank started to offset—or sterilize—the expansionary effects of its official reserve accumulation on its monetary base by selling renminbi bonds to the banking system. The bond sales drained away part of the renminbis created when the People’s Bank bought dollars. Since then, the People’s Bank has sterilized nearly one-half of the effects of its reserve accumulation on the monetary base. This suggests that the banking system is holding a lot of low-yielding sterilization bonds, which, in such a vibrant growing economy, must have a significant opportunity cost.
But the People’s Bank has probably made money from the deal over the past few years, since the yield on U.S. Treasury securities has exceeded the interest rate on short-term Chinese securities. Since last summer, however, those profits may have disappeared, as inflation in China has pushed rates on the Bank’s short-term instruments up and turmoil in financial markets has pushed yields on U.S. Treasury securities lower.
The People’s Bank has taken other measures to reduce inflationary pressures in China. Since the beginning of 2007, it has raised reserve requirement 11 times, reaching a new high. In addition, the central bank has hiked official (and administered) lending and deposit rates. Observers widely anticipate further moves to tighten monetary policy and lower the inflation rate.
Ironically, China’s tight management of the renminbi–dollar exchange rate seems to be eroding its competitive position, albeit ever so slightly thus far. Exchange rates are not the only thing that matters for a country’s competitive position. Inflation in China relative to inflation in the United States also affects the relative price of goods. Over the past year, the rate of inflation in China has exceeded the rate of inflation in the United States. The real renminbi–dollar exchange rate combines all three of these variables—the conventional exchange rate, inflation in China, and inflation in the United States—into a convenient metric. Since its peak in August 2006, the dollar has depreciated 9 percent against the renminbi in real terms, compared to 7½ percent in conventional exchange-rate terms. To be sure, this differential is not a big deal, but it does bolster our point. China might get better control over inflation by adopting more exchange-rate flexibility.