China’s central banker, Zhou Xiaochuan of the People’s Bank of China (PBOC), and other top Chinese officials recently launched a communications offensive to persuade markets and foreign policymakers that no significant devaluation of the Chinese currency is planned.
The attention of global markets was focused on China’s exchange rate last August when the PBOC announced a 1.9 percent devaluation of the renminbi against the dollar, together with some changes in how the exchange rate would be set in the future. Global markets reacted poorly. Evidently, many market participants—already jittery because of the large swings in the Chinese stock market—saw the devaluation as a signal that the Chinese economy was slowing by much more than they had previously thought, and that China’s leaders had decided that a cheaper currency would boost the country’s exports. Since then, the RMB has been allowed to decline another 3.6 percent against the dollar. Markets, though, seem to have come around to accepting the PBOC’s insistence that it is not pursuing a strategy of systematically devaluing the RMB. So did many of the foreign finance ministers and central bankers gathered in Shanghai for the recent meeting of the Group of 20. But, as I’ll discuss in the post, China’s ability to avoid a significant devaluation in the medium term will depend on a number of factors, including the country’s other policy choices.
China faces the classic policy trilemma of international economics, that a country cannot simultaneously have more than two of the following three: (1) a fixed exchange rate; (2) independent monetary policy; and (3) free international capital flows. Accordingly, China’s ability to manage its exchange rate may depend, among other factors, on its willingness and ability to adjust on other policy margins.
Start with four premises about the country’s current situation and its leadership’s objectives:
- China is undergoing a difficult but necessary transition from a growth model that emphasizes heavy industry, construction, and exports, to one that focuses on the development of services and greater domestic consumer demand. Observers have long understood that this shift would likely be accompanied by a slowdown in Chinese GDP growth (because the economy is more mature) and would be less predictable (because markets and entrepreneurs, rather than directions from the center, are expected to play a larger role.)
- However, China’s growth appears to have slowed recently by more than the leadership expected or wanted. This is worrisome to China’s leaders for the standard reason— the legitimacy of the government is closely tied to continued expansion of jobs and incomes—but also because the difficult process of transferring resources from shrinking sectors (manufacturing) to growing sectors (services) would be less daunting if overall growth were strong.
- To support economic growth during its difficult transition, China has eased monetary policy in various ways, recently reducing reserve requirement for banks, which allows them to lend more.
- At the same time, China has continued a process of reforming and opening up its capital markets. Notably, private Chinese citizens are allowed to invest some of their savings abroad, to a limit of $50,000 per person.
Points #3 and #4 are the sources of China’s trilemma. An economy that is growing more slowly, and in which monetary easing is the principal macroeconomic response, is not an economy that offers high returns to domestic savers. Consequently, Chinese households and firms who are able to do so are spurning yuan-denominated investments and looking abroad for higher returns. However, increased private capital outflows also constitute a flight from the yuan toward the dollar and other currencies; that, in turn, puts downward pressure on China’s exchange rate.
 China has indicated that they intend to guide the value of the currency with reference to a basket of foreign currencies, rather than tying the yuan only to the U.S. dollar as in the past. In this post, “significant devaluation” means a sharp reduction of the value of the yuan against both the dollar and other major currencies.
 For a fuller account, see page 29 of Eswar Prasad’s recent report, “China’s Efforts to Expand the International Use of the Renminbi.”
 Historically, financial repression in China, such as ceilings on deposit rates, has limited investment opportunities for domestic savers, though some of these limits have been removed recently. See “China’s Central Bank Lifts Ceiling on Long-Term Deposit Rates.” The government’s anti-corruption campaign has also motivated some Chinese to move funds abroad.
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Ben S. Bernanke
Distinguished Senior Fellow - Economic Studies - The Brookings Institution
Ben S. Bernanke is a Distinguished Fellow in Residence with the Economic Studies Program at the Brookings Institution. From February 2006 through January 2014, he was Chairman of the Board of Governors of the Federal Reserve System. Dr. Bernanke also served as Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.
The Hutchins Center on Fiscal and Monetary Policy provides independent, non-partisan analysis of fiscal and monetary policy issues in order to improve the quality and effectiveness of those policies and public understanding of them.
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