China's inflation, which reached 5.4 percent on a year-over-year basis in March, is largely a product of that country's desire to closely manage the renminbi-dollar exchange rate. Over the past decade and a half, China has alternated between exchange-rate pegs or controlled renminbi appreciations, and foreign-exchange reserves have poured into the country. Despite allowing the renminbi to appreciate 23 percent on balance since 2005, the flood of reserves has only accelerated, which suggests that the renminbi remains substantially undervalued. While the exact currency composition of these reserves is unknown, economists guess that China holds roughly 65 percent in dollar-denominated assets.
This inflow of reserves connects China's exchange-rate policies with its inflation problem. When companies in China acquire dollars through their exports or through inward investments, they exchange them with commercial banks in China for renminbi. The People's Bank of China (PBoC), in turn, requires the banks to cash in the lion's share of these dollars with the PBoC. In payment, the PBoC credits the banks with newly created renminbi reserves. The monetary base—the tinder from which inflation ignites—expands.
Between 2003 and 2009, the PBoC neutralized nearly 40 percent of the impact of these reserve inflows on the monetary base by selling so-called "sterilization bonds" to banks. The monetary base, nevertheless, expanded sharply over these years. In the absence of this monetary offset, the situation would probably have been worse. The monetary base would have grown more closely in step with the foreign-exchange reserves on the PBoC's books.
Last year the situation was a little different, but still disconcerting. The PBoC's accumulation of foreign-exchange reserves was again enormous, but it only accounted for 73 percent of the expansion in the monetary base, according to IMF data (International Financial Statistics April 2011, lines 11 through 17r). The bank's acquisition of domestic assets accounted for a small part (4 percent) of the base expansion, and a reduction in other central-bank liabilities—including outstanding central-bank bonds—accounted for the rest.
To damp inflationary pressures, the monetary authorities have raised reserve requirements and mandated bank interest rates, and they have encouraged banks to limit their lending. These actions do not affect the monetary base directly, but they limit the extent to which the monetary base can support a bigger money stock—the stuff people in China actually spend. Still, with the base growing sharply, this seems a little like blowing on a house fire.
China and many other countries that closely manage their exchange rates blame commodity prices—typically expressed in dollars—and an easy U.S. monetary policy for fanning global inflation. A renminbi appreciation, as economist Dave Altig recently reminded us, would lower the renminbi prices of dollar-denominated imports to China. Even better, a renminbi float would allow China to adopt a monetary policy focused on domestic price stability. Europe implemented floating dollar exchange rates in early 1973 specifically for that purpose. That's what floating exchange rates do.