VoxEU Column Exchange Rates

Reframing the debate about the Chinese Renminbi

US and EU pressure on China to revalue the renminbi create the mistaken impression that there is an unavoidable conflict of interests. A switch by China to a more flexible exchange rate regime, accompanied by a shift to a new nominal anchor, would serve China’s domestic interests and simultaneously defuse protectionist sentiments abroad. A politically savvy recasting of this issue as one of Chinese monetary-policy independence could help solve many problems.

As the US trade deficit continues to swell, the denizens of Capitol Hill are back on the warpath against their favourite bogeyman—the Chinese economy. The rising US bilateral trade deficit with China provides ammunition (made in China!) for those who want to argue that Chinese trade policies are at the root of the problem. The rising trade deficit of the European Union with China has led to similar sentiments among some European politicians.

The notion is that, by maintaining its exchange rate at a relatively fixed level against the US dollar, China is keeping its currency cheap and thereby gaining a competitive advantage in international markets, with adverse consequences for US and European manufacturers. China’s enormous trade surplus ($218 billion, or 8% of GDP, in 2006) and massive accumulation of foreign exchange reserves (now about $1.3 trillion) have led to even more dire accusations of currency manipulation.

Flaws in the arguments

Some facts are a little inconvenient for this line of argument. For instance, until recently, the rise in the US trade deficit with China was matched by the decline in the deficit with the rest of Asia, leaving the US deficit with all of Asia unchanged. China’s accession to the WTO in 2001 opened up US markets to Chinese imports and more Asian trade is now routed through China in order to take advantage of cheaper labour there to process and package goods in their final stages of production. So the bilateral US (or EU) trade deficit with China is not in itself very meaningful. Moreover, the renminbi has been maintained at a stable rate relative to the US dollar for over a decade now, even during the Asian crisis when the Chinese were under pressure to devalue the renminbi. So to argue that the fixed exchange rate reflects a new and deliberate policy of undervaluation is disingenuous.
Nevertheless, economic fundamentals — such as the rapid productivity growth in China — clearly point to strong pressures for the renminbi to appreciate in value. The Chinese authorities have resisted these pressures. They are reluctant to allow more than a modest appreciation for fear that it could hurt exports by making them more expensive for foreign importers, harm the agricultural sector by making food imports cheaper, and expose domestic banks to risks of currency volatility.

This policy of resisting renminbi appreciation has led to vociferous demands by some US congressmen and even a few academics for a large revaluation of the Chinese currency relative to the US dollar. The US Treasury has so far staved off calls to label China a currency manipulator and impose trade sanctions, but tempers are rising on Capitol Hill against the Treasury’s perceived softness. Legislation compelling the Treasury to take firmer action against China is rapidly moving through both the House and Senate.
More moderate voices have argued that a significant revaluation of the currency would be in China’s own interest as it would help “rebalance” growth towards domestic consumption, and tilt the economy away from investment- and export-led growth. Many observers also regard a revaluation as an essential element for resolving the broader problem of rising global current account imbalances. A move by China might embolden other Asian economies to allow their currencies to appreciate as well.

The key point missing from the debate

This debate has so far been framed in a way that largely misses the key point. What is essential for China is to have an independent monetary policy oriented to domestic objectives. China’s monetary policy has hitherto been hamstrung by the tightly managed exchange rate regime. This regime prevents the People’s Bank of China (PBC) from raising interest rates to manage domestic demand since such a move could spur further capital inflows and increase pressure on the exchange rate. Giving the PBC room to raise interest rates by freeing it from having to target a particular exchange rate would help rein in credit growth and deter reckless investment, reducing the risk of boom-bust cycles. A key point here is that an independent monetary policy requires a flexible exchange rate, not a one-off revaluation.

For an emerging market economy, however, a fixed exchange rate does provide a clear and transparent anchor for monetary policy, tying down inflation expectations and making the task of sustaining low inflation easier. So what could take the place of the exchange rate as a stable anchor for monetary policy? Indeed, many supporters of China’s present currency regime have argued, with good reason, that proponents of greater currency flexibility have not squarely addressed the question of what would serve as a suitable alternative anchor.

We have an answer. We recommend the adoption of an inflation objective—a long-run target range for low inflation—as a new anchor for monetary policy in China.1 Theoretical research and practical experiences of countries both show that a formal or informal inflation objective, coupled with exchange rate flexibility, may be best for managing domestic demand and retaining the flexibility needed to respond to internal and external macroeconomic shocks.2 Indeed, focusing on inflation stability is the best way for monetary policy to achieve broader objectives such as macroeconomic and financial stability, high employment growth etc.

The low inflation objective need not involve the formalities of a full-fledged inflation-targeting regime; Ben Bernanke has advocated a similar approach for the US.3 Moreover, framing the issue in terms of monetary policy independence would provide a broader context for exchange rate flexibility and a variety of other reforms.

Making it work in China’s case

How could such a framework ever work, let alone work effectively, in an economy in which the decrepit banking system has weakened the transmission mechanism for monetary policy? Full modernisation of the financial sector is of course a long way off, but a feasible set of minimal reforms would strengthen the banking system sufficiently to support a more flexible exchange rate anchored by an inflation objective. The key is to make banks’ balance sheets robust to interest rate fluctuations. The PBC has already made good progress on this front by clearing a large chunk of bad loans from the books of the key large banks and recapitalising them.

The oft-cited argument that the financial system needs to be fully fixed before allowing currency flexibility has it backwards. Indeed, durable banking reforms are likely to be stymied if the PBC is constrained in using market instruments such as the interest rate in guiding the growth of bank credit. The PBC then has to revert to its old practice of telling state banks how much to lend and to whom, which hardly gives banks the right incentives to assess and price risk carefully in their loan portfolios. Thus, in the absence of an independent monetary policy, financial reforms will be even more complicated than they already are. Price stability and the broader macroeconomic stability emanating from an independent and effective monetary policy framework are in fact essential to provide a good foundation for pushing forward with other financial sector reforms.

Operational independence for the PBC

Isn’t our notion of central bank independence a non-starter, especially in a command economy like China? And if the central bank is not independent, how can it guarantee low inflation? The concept that we have in mind is the narrower (but more important) one of operational independence—the ability to use monetary instruments such as policy interest rates to manage domestic demand and keep the economy oriented towards a low level of inflation. The PBC should be freed from the obligation to target a particular level of the exchange rate that could conflict with the inflation objective.

Full central bank independence would in fact be a bad idea for China. It is essential that the government endorse and actively support the central bank’s low inflation objective by making other policies, including fiscal policy, consistent with that objective. Only then would the inflation objective be fully credible.

We disagree with those who regard the discussion of an alternative monetary framework as premature.4 There are good reasons for China to begin right now to build the institutional foundation for the transition to an independent monetary policy. Indeed, the early adoption of an inflation objective would help secure the monetary and financial stability that China needs as it allows greater exchange rate flexibility.

The time is right

The time is propitious for making this switch—economic growth is strong and headline inflation is at a low level. At an operational level, the PBC could therefore largely continue its current approach to monetary policy, which includes setting targets for money and credit growth. The crucial difference would be in the strategic focus on the inflation objective rather than the level of the currency. Over time, this would almost automatically provide a basis for allowing more currency flexibility.

Rather than push for ad hoc measures such as a one-off currency revaluation, it would be far more productive to actively encourage China to undertake deep and enduring reforms, including to the monetary framework. Policies that promote sustained and stable growth in China, including financial sector reforms and the strengthening of the social safety net, would stoke domestic consumption and reduce the reliance on export-led growth. This is ultimately the best contribution that China could make to an orderly resolution of global imbalances.

China needs to put an independent monetary policy in place soon — with currency flexibility being a crucial element for this — to foster the macroeconomic stability that would serve as a foundation for the other reforms the economy sorely needs.




1 For more details of our analysis and recommendations for China, see Goodfriend and Prasad (2007).
2 See, e.g. Rose (2007) and the papers in Bernanke, Ben, and Michael Woodford, eds., 2005, The Inflation Targeting Debate (Chicago, IL: University of Chicago Press).
3 http://www.federalreserve.gov/boarddocs/testimony/2005/20051115/default.htm
4 Ronald McKinnon (2007) “Why China Should Keep Its Exchange Rate Pegged to the Dollar: A Historical Perspective from Japan” International Finance. Posted at http://www.stanford.edu/~mckinnon/papers.htm



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