China manages the renminbi-dollar exchange rate closely. Between mid-1995 and July 2005, the People’s Bank of China pegged the renminbi at approximately 8.3 per U.S. dollar. Since then, the People’s Bank has loosened its reigns, allowing the renminbi to appreciate to 6.8 per dollar. Many people claim, however, that China still manipulates the rate in an unfair bid to encourage large trade surpluses with the United States and to attract hefty inflows of investment funds. Such claims are not strictly correct. Nevertheless, China has never given the exchange-rate-adjustment mechanism free reign.
The above-mentioned exchange rates—called nominal in econ speak—have little to do with trade. What matters more than the nominal renminbi-dollar rate for China’s long-term competitive advantage vis-a-vis the United States is the real renminbi-dollar rate. Basically, a real renminbi-dollar exchange rate incorporates the inflation rates of both China and the United States in its calculation. Between 1995 and 1998, the renminbi appreciated on a real basis against the dollar, despite a fixed nominal peg, because China’s inflation rate exceeded the U.S. inflation rate. Between 1998 and 2004, however, the situation reversed. The renminbi depreciated against the dollar on a real basis, as inflation in China fell below inflation in the United States. Since 2004, and especially since China eliminated the peg, the renminbi has again appreciated against the dollar on a real basis.
While countries can control a nominal exchange rate fairly easily, managing a real exchange rate is a whole other—and difficult—ballgame. If, as the claim against China asserts, a country sets the nominal rate to gain a trade and investment advantage, inflation should eventually result and offset any temporary gain that the nominal exchange rate provided.
This process has unfolded to some degree in China. China limits the ability of its residents to reinvest the dollars that they acquire through trade and investment. Instead of being permitted to invest as many of these dollars as they choose outside of the country, they must exchange most of them with the People’s Bank for renminbi. The strategy has contributed to China’s acquisition of a huge official portfolio of dollar assets.
When Chinese residents exchange dollars for renminbi, 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 seemed too slow between 1998 and 2003 when prices in China frequently fell. 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 effect of its reserve accumulation on the monetary base. Undertaking sterilization to limit the inflation caused by an accumulation of dollar reserves, however, is tantamount to limiting the real appreciation of the renminbi against the dollar.
Complaining about China’s nominal exchange-rate choice seems unfair; it is not important for trade. Criticizing China’s controls on financial flows and its persistent sterilization is another matter. These actions can affect the country’s trading position.