Renminbi-Dollar Peg Once Again
China gains a competitive advantage not from its peg with the dollar, but from its ability to offset the impact of foreign financial inflows on its price level. Appreciating this distinction is crucial for understanding Chinese exchange-rate policies.
China is once again tightly managing the renminbi-dollar exchange rate. Between mid-1995 and July 2005, the People’s Bank of China pegged the renminbi at approximately 8.3 per U.S. dollar. In July 2005, following years of complaints about China’s exchange-rate policy, the People’s Bank loosened its grip and allowed the renminbi to appreciate 18 percent against the dollar over the next three years. With the emergence of the global economic crisis, however, China has once again tightened up on its renminbi reins. Since July 2008, the People’s Bank has effectively pegged the renminbi to the dollar, constricting movements even more since the beginning of this year.
Pegs with the dollar, in and of themselves, do not confer trade advantages on China. China’s trade competitiveness also depends on price trends in China as compared with the rest of the world. Real exchange rates, which incorporate Chinese and foreign inflation patterns along with conventional exchange rates, offer clearer pictures of China’s competitive position. During much of the 1990s, for example, the renminbi appreciated against the dollar in real terms, clipping China’s competitive position relative to the United States even though the country maintained a peg.
Recently, however, with inflation in China closely paralleling inflation in the United States, China’s real renminbi-dollar rate has not changed much. So China is not gaining a competitive advantage relative to the United States. The dollar, however, is depreciating on a broad basis, and the renminbi is going along for the ride. On a real trade-weighted basis, China’s renminbi depreciated 9 percent between March and October, implying a competitive gain against other countries, notably China’s Asian competitors.
The real trick to China’s competitive gains is its ability to offset inflows of foreign exchange. China maintains a substantial current-account surplus, the counterpart of which is a large financial inflow and an official accumulation of foreign-exchange reserves. All else constant, this reserve accumulation should expand the monetary base in China, raise the inflation rate, cause the renminbi to appreciate on a real basis, and negate any trade advantage China acquires from its peg. Yet this has not happened.
Since 2003, the People’s Bank of China has offset—sterilized, in econspeak—the expansionary effects of its official reserve accumulation on its monetary base by selling renminbi bonds to the banking system. The bond sales drain away part of the renminbi created when foreign exchange flows into the official coffers. Over the past seven years, the People’s Bank has offset nearly one-half of the effect of these flows on the Chinese monetary base. Over the four quarters ending in the second quarter of this year, the People’s Bank offset roughly 60 percent of the foreign-exchange inflow. This offset limits the inflation in China that otherwise would result, and it is tantamount to limiting the renminbi’s real appreciation.