The value of the renminbi (RMB) against major currencies has become a contentious issue in political circles in recent months (see The RMB Controversy and Beyond). China's effective peg to the US dollar has led to a decline of the RMB exchange rate against other major currencies, particularly the euro and the yen. European, Japanese, and even US companies and their government representatives have accused China of purposefully undervaluing the RMB to make already competitively priced Chinese exports even cheaper in overseas markets. Many China-based businesspeople are familiar with this debate. The question is, are the critics right? And if so, what, if anything, are PRC officials likely to do?

China Facts:

• Exchange rate: ¥ 8.276-8.28 to $1
• Current account surplus, 2002: $35.4 billion
• Current account surplus, January-June 2003: $4.5 billion
• Foreign exchange reserves, 2002: $286.4 billion
• Foreign exchange reserves, January-June 2003: $346.5 billion
• Foreign direct investment (utilized), 2002: $50.7 billion
• Foreign direct investment (utilized), January-June 2003: $30.3 billion
• Foreign-invested enterprises' share of China's total exports in 2002: 52 percent

RMB basics

Large inflows of foreign funds and large export volumes are putting upward pressure on the value of the RMB. This seems hard to dispute. The reason for this pressure is that first, more foreigners want to buy goods and services valued in RMB, so they need to convert foreign currency to RMB to make their purchases. Second, more RMB holders are selling things for dollars and needing to convert the dollars back to RMB.

This demand for RMB drives up its value relative to other currencies — even the US dollar, to which it is tied. The PRC government is concerned about the value of the RMB against the dollar and other currencies for several reasons, though not the same ones that concern foreign firms or the politicians whose ears they bend.

One reason is that a higher RMB could hurt PRC-based exporters, at least in theory, by making their goods more expensive overseas relative to goods denominated in other currencies. Since exports are crucially important to China's economic growth, the government is loath to make life harder for exporters. (Of course, if the RMB were to rise against other currencies, imports used as inputs for finished exports would become cheaper, easing the pain to some extent—and also undermining the argument that a higher RMB would help foreign-made goods competing against Chinese-made goods.)

Another is that China is just emerging from years of deflation. Deflation, which is defined as a fall in the general price level, suppresses consumption and can cause an economy to stagnate. A higher RMB could push China back into deflation because less RMB would be needed to buy things in dollars—the price of the dollar (and dollar-denominated goods) would have fallen.

Thus, allowing the RMB to rise against the dollar would hurt important sectors of the PRC economy unless the PRC government somehow eases the upward pressure by printing more RMB, to satisfy the demand—and maintain its current exchange rate. The money supply has indeed grown by as much as 20 percent this year. Bank lending has also surged (thanks to low interest rates among other policies in place to cure deflation), fueling a worrisome rise in property investment. Another downside of this monetary expansion is that excessive growth in the money supply can turn a borderline deflationary environment into an inflationary one.

In fully flexible exchange rate regimes, the value of a currency against others adjusts until the supply-demand equilibrium is re-established. Calls are increasing for China to move to a more flexible exchange rate regime. According to Jun Ma of Deutsche Bank, PRC officials are aware of the advantages of a more flexible system, in the form of an easing of inflationary pressure and a possible fall in excessive bank lending—and of its disadvantages. Without a healthy financial system, moving from a fixed to a fully floating exchange rate system can be destabilizing because a floating currency is exposed to international currency fluctuations. China's banks are weak and the country's legal and regulatory systems are arguably too immature to police and defend the financial markets adequately.

China already allows free conversion for current account (trade) transactions. A fully floating exchange rate, analysts point out, can exist even if China maintains controls on the inflow and outflow of (non-trade, i.e. financial) capital. But the currency will still react to global supply and demand—and be a potential target of speculation.

Economists have studied the effectiveness of capital controls in countries like Chile that maintained both capital controls and a floating exchange rate during the Asian financial crisis and its aftermath. The jury is out on whether such controls are sustainable over the long term.

Misplaced blame

Meanwhile, it is hard to argue that the RMB's recent decline against other currencies is the primary reason that the world is buying Chinese-made goods, for several reasons:

• China's trade balance is moderating in 2003, even as the currency falls, which supports the possibility that the value of the RMB is neither the sole reason for China's trade surplus nor the sole reason for the US trade deficit with China.
  
  
• Companies are setting up factories in China because of the country's large and inexpensive labor pool, its continual improvements in infrastructure and support services for business, and its emerging consumer base.
  
  
• China's exports were strong even in the months after the Asian financial crisis in the late 1990s, when the RMB strengthened against many currencies that depreciated during the crisis.
  
  

China's middle road

There has been no indication that the Chinese government intends to move to a new, fully flexible exchange rate regime anytime soon. The Chinese learned the lesson of the Asian crisis—that flexible exchange rates in economies with weak financial sectors and inadequate legal regimes leave economies exposed to international financial meltdowns.

China may seek a middle road to soak up the excess RMB that is, as of August 2003, already flooding the economy and risking turning deflation into inflation. The alternatives facing China that are mentioned often in the press are to widen the band around which the RMB fluctuates and to let it settle within a slightly higher range, or to undertake a one-time revaluation and then proceed as before. The consensus among analysts seems to be that despite pro forma public statements by the PRC premier and the heads of the People's Bank of China and Ministry of Finance that the Chinese government has no intention of altering the exchange rate regime, these same PRC officials will allow the band around which the RMB fluctuates to widen.

Of course, PRC officials have been promising greater flexibility for years. What may be different this time is the realization that more flexibility might actually help the government manage monetary policy while answering overseas critics.

The government is also reportedly considering allowing PRC banks to issue bonds denominated in dollars and to permit PRC companies to hold and transact business in foreign currency. The government may also establish a qualified domestic institutional investor system to encourage investment in financial markets. If China decides to widen the RMB trading band, at least one estimate put the end rate at ¥ 8.15 to $1. As others have pointed out, such a cautious move to widen the band slightly—or undertake a one-time revaluation—may not be enough to head off the calls for protection in the United States and elsewhere from manufacturing firms facing the intractable structural problems that prevent them from competing against Chinese goods.

—Catherine Gelb