A New Way to Deal with the Renminbi

Op-ed in the Financial Times

January 20, 2006

Last July, China announced a 2.1 percent appreciation of the renminbi against the dollar and a move to a managed float "with reference to a basket of currencies." So far, these reforms have had little effect: The renminbi-dollar rate has appreciated only a further 0.5 percent, there is little evidence of pegging to a basket rather than to the dollar alone, and China is not following through on its July pledge to give "market supply and demand" a greater role in exchange rate determination. China's average monthly intervention in the foreign exchange market between August and December remained huge, almost equal to the first half of 2005. In short, China's exchange rate system remains a heavily managed peg to the dollar and at a little-changed dollar rate.

Moreover, there is no indication of an end to the renminbi's substantial undervaluation. On the contrary, 2005 was the third consecutive year in which China's reserve accumulation amounted to an extraordinary 10 percent of gross domestic product or more. China's global current account surplus nearly doubled last year to reach 7 percent of its recently revised GDP, while the real trade-weighted renminbi still shows a cumulative depreciation since the dollar peak of February 2002. China's exchange-rate policies have created problems domestically and abroad. Exchange-rate inflexibility limits the independence of China's monetary policy and thus hampers macroeconomic stability. Renminbi undervaluation has contributed to growing trade surpluses and, in some years, to huge portfolio capital inflows. The country's central bank sterilized much of the resulting reserve accumulation but also resorted to administrative controls to limit bank credit creation. But when the central bank specifies lending ceilings and sectoral lending priorities, it slows development of a bank credit culture, setting back another top policy objective.

China's foreign exchange reserves at the end of 2005 were about 35 percent of GDP. A 20 percent revaluation of the renminbi against the major reserve currencies would thus impose a capital loss equivalent to 7 percent of GDP. Finally, China's prolonged, large-scale intervention in foreign exchange markets has fuelled US protectionist pressure.

China's inflexible, undervalued currency also drags on the adjustment of global imbalances and increases the risk of a hard landing for the dollar and the US economy, with adverse global spillover effects. The US current account deficit is at an all-time high; its inevitable correction will necessarily involve further depreciation of the dollar and US domestic demand growing more slowly than domestic output (and the reverse in the rest of the world). A more ambitious program of fiscal consolidation and prudent management of US monetary conditions are essential-along with policies that stimulate domestic demand growth among big US trading partners.

The real, trade-weighted dollar must fall by another 15 to 25 percent to support external adjustment. China remains a prime candidate for leading wider Asian currency appreciation because of its large external imbalance, robust domestic growth and the benchmark it increasingly sets for competitiveness within and outside the region.

China's ability to reform its exchange rate regime is constrained by its fragile banking system, which requires maintaining existing capital controls. Also, the degree of renminbi undervaluation is now so large and Beijing's commitment to an incremental approach so entrenched that eliminating the undervaluation in one hit no longer seems feasible.

Thus, we propose the following compromise. First, China should implement in the next few months a 10 to 15 percent appreciation of the renminbi relative to the current value of the basket. This could be done either by a revaluation or by allowing market forces to push up the currency's value. Such a "downpayment" would help to persuade external critics that China is serious about controlling its growing external imbalance. Second, China should widen substantially either the band around the central rate or the daily fluctuation limit. That would provide increased independence for monetary policy, allow scope for further renminbi appreciation and give China experience in managing increased flexibility. Third, to offset some of the contractionary effect of the renminbi appreciation, China should simultaneously implement fiscal expansion. Fourth, China should maintain most capital controls until its banks are further strengthened.

This would still require sizeable real appreciation of the renminbi later, with all the problems that such a phased adjustment entails. If speculative inflows resurge, the authorities would need to choose between an acceleration of renminbi appreciation and a temporary recourse to tighter controls on capital inflows. In the final stage of currency reform-when China's banking system is more stable-China would float the currency and remove the remaining capital controls. Admittedly, this is not an elegant plan. But if it would break the existing logjam in addressing global payments imbalances, it merits consideration.