China must push ahead with exchange rate reforms

For years China has been labelled a ‘currency manipulator’. Its critics claim that China intentionally suppresses the value of the renminbi through massive market intervention to raise the competitiveness of its exports

The international currency market, however, has a different perception. The renminbi has appreciated by 30 per cent since the exchange rate reforms of 2005, and the market for non-deliverable forwards has started to move in both directions, indicating that the value of the currency has started to level off. And after reaching record levels of around 10 per cent of GDP in 2007, China’s current account surplus dropped to 2.6 per cent of GDP in 2012.

The People’s Bank of China (PBC) has adapted its exchange rate policy, silently changing course over the past few years. Before the global financial crisis, the PBC used to purchase large amounts of US dollars to stabilise the renminbi exchange rate. From early 2005 to the third quarter in 2011, about US$100 billion in assets were added to the PBC’s balance sheet every quarter. But from the fourth quarter of 2011 to the same time a year later, an average of only US$2.4 billion in assets showed up every quarter. This is a clear signal that the PBC has abandoned its direct — and clumsy — intervention in the market. The way the PBC manages the market now is to set the mid-price daily, which the market takes as its starting point for that day’s trading.

This is good news. The PBC’s new strategy helps to free up the bank and increase the autonomy of China’s monetary policy. But is the current policy sustainable? Probably not.

First, with the current under-limit and lower-limit control, the rise or fall of the renminbi against the US dollar cannot exceed 1 per cent of the middle rate. When supply exceeds demand on the foreign exchange market, as it did in the fourth quarter of 2012, and the PBC does not soak up the supply of US dollars, the renminbi to US dollar exchange rate hits an upper limit and trading on the market freezes as a result. This has begun to happen more often, and if it becomes the new normal, it will dampen the development of China’s foreign exchange market.

Second, taking into consideration the fact that there is still room for the renminbi to appreciate in future, it makes sense for the private sector to prefer RMB-denominated assets rather than assets denominated in US dollars. How can the PBC encourage the private sector to hold more US dollar assets? One way to do this is through stricter administrative measures; for example, the regulatory agency can urge companies to pay back their foreign debts, so that companies have to obtain more US dollars from the market. But this means the private sector has to bear a greater burden.

Yet China’s exchange rate reforms needn’t be so complicated: China can keep the 1 per cent daily band if it must, but it needs to make a clear announcement that unless the renminbi exchange rate (with the US dollar and/or with a currency basket) moves up or down more than 7.5 per cent annually, the PBC will not intervene in the market. This means the PBC will only respond to emergencies — for which there are two main examples.

First, if the renminbi exchange rate goes up dramatically, by more than 7.5 per cent, the PBC should step in — and for good reason. If the renminbi appreciates too fast, the Chinese government will face the potential bankruptcy of export factories and rampant unemployment among migrant workers from those factories. This is not only an economic threat, but a threat to social stability.

Second, if the renminbi exchange rate goes down dramatically, by more than 7.5 per cent, the PBC will also need to act. If this scenario occurs, it means the renminbi is overpriced, and China will go back to a de facto position of being pegged to the US dollar. In this case, intervention by the PBC is much better than a plummeting renminbi and the subsequent capital flight and financial crises.
Why the range of 7.5 per cent? The point is that whatever number you choose, it should be large enough to convince the investors, but not too large to scare the market.

Under this new regime, the renminbi may appreciate further, and there is likely to be more fluctuation of the exchange rate. Will this hurt China’s exports, employment and macroeconomic stability? China has a diversified group of trade partners. What really matters is not the bilateral exchange rate, nor the nominal exchange rate. The impact of a country’s exchange rate on trade performance is most clearly seen in the real effective exchange rate (REER). This is the weighted average of a country’s currency relative to a basket of currencies of its major trade partners, and adjusted for the effects of inflation. For example, data on the REER movement of several international currencies for the period 1994–2012 — when China moved from a fixed exchange rate regime to the new managed floating regime — shows the Singaporean dollar, which is under a kind of ‘basket, band and crawl’ regime, was the most stable currency. The implication is that constant market intervention does not guarantee exchange rate stability.

It is also unlikely that an appreciation of the renminbi can help the United States to reduce its current account deficit by any significant amount. The income elasticity of China’s exports is much larger than the price elasticity, meaning that China’s exports depend more on the depth of American pockets rather than the low price of Chinese goods. But exchange rate reform should still be one of the major components of any policy package to balance the Chinese economy. 

China’s exchange rate not only reflects the relative price of two currencies, but also the relative price of tradable and non-tradable products. China’s manufacturing sector is very competitive, even by international standards. But its services sector — mainly the non-tradable sector — is lagging behind. Getting the price right must therefore precede resource reallocation, which, in turn, will help to facilitate China’s long-awaited structural reforms.

China has enormous foreign exchange reserves, its economic growth is still robust, and there is room to manoeuvre its fiscal and monetary policies. It’s the right time to speed up exchange rate policy reform. This could pave the way for other reforms like the internationalisation of the renminbi and capital account liberalisation. But sequence matters. Some argue for a more rapid currency internationalisation and capital account liberalisation, and the PBC has started working out a timetable. This needn’t happen in such a rush. Internationalising the renminbi will have a profound impact on the global financial system, and capital account liberalisation is a prerequisite for currency internationalisation. But these are long-term goals. It’s a long march for China’s financial reform, and first things must come first. China needs to push forward with its exchange rate and interest rate reforms before moving into other areas.

He Fan is Deputy Director at the Institute of World Economics and Politics, Chinese Academy of Social Sciences. He is also Deputy Director at the Research Center for International Finance, Chinese Academy of Social Sciences.