Out of Whack—the Renminbi
China’s foreign exchange reserves, currently near $2.7 trillion and mostly in dollar-denominated assets, have increased fivefold since 2004. This rapid, persistent increase suggests that China’s exchange-rate arrangements have, quite simply, been out of whack.
Many in the United States, however, incorrectly complain that China obtains an unfair trade advantage and gains on foreign investments because the People’s Bank of China systematically undervalues the renminbi relative to the dollar. Yet, when all is said and done, the nominal exchange rate—the one people commonly quote—doesn’t matter much for international commerce. What matters instead is the real—or inflation adjusted—exchange rate, and its unresponsiveness to international economic pressures seems the true underlying problem. The real exchange rate should appreciate even if China keeps the nominal exchange rate artificially low.
The route from an undervalued exchange rate to inflation is pretty straightforward: If China keeps the renminbi artificially low relative to the dollar, demand for Chinese goods and investments will rise, and dollars in search of Chinese goods and assets will flow into that country. This inflow will create incipient pressures for the renminbi to appreciate against the dollar.
To neutralize these pressures and to maintain the peg at an artificially low level, the People’s Bank of China must buy dollars with renminbi. Chinese official dollar reserve holdings will skyrocket, as they have, but so then should the Chinese monetary base, the country’s overall money stock, and, eventually, its inflation rate. The inflation that follows should create a real appreciation of the renminbi that is substantially greater than any controlled nominal appreciation and should dull China’s competitive edge. Frustratingly, this has not happened. Since 2004, the real and nominal renminbi-dollar exchange rates have pretty much moved in unison. This is the real exchange-rate problem in China.
China avoids the inflation and real appreciation of the renminbi that should naturally accompany its massive accumulation of foreign-exchange reserves by continuously offsetting their impact on the monetary base. Since 2003, the People’s Bank of China has stopped nearly 40 percent of the reserve inflows from sloshing into the monetary base. It does this by foisting renminbi sterilization bonds on Chinese commercial banks, and if constraining monetary base growth is not sufficient to prevent inflation, by raising reserve requirements. Reserve requirements limit the amount of bank loans that a given change in the monetary base can support. These instruments represent a significant tax on commercial banks. Under a more market-driven environment, these instruments would eventually impair the banking system, but China, despite reforms, still closely controls its banking sector. Therein lies its exchange-rate advantage.