Up Front

China’s Currency Policy Explained

Arthur R. Kroeber

Arthur Kroeber expands upon a recent paper, answering questions about China’s monetary policy on the valuation of the renminbi and the political issues this raises.

1. The Chinese currency, or renminbi (RMB) has been a contentious issue for the past several years. What is the root of the conflict for the United States and other countries?

The root of the conflict for the United States—and other countries—is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Although the U.S. Treasury has repeatedly stopped short of labeling China a “currency manipulator” in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace, and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund, the World Bank and many economists have also argued for faster appreciation and a more flexible exchange rate policy. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25% against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the U.S. and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.

2. What impact does exchange rate control have on the economy?

According to foreign observers, consistent intervention by China to keep its exchange rate substantially below the level the market would set is a price distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy, by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus, it is in the interest both of China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly. However, Chinese policy makers do not agree with this view, and believe the managed exchange rate is broadly beneficial for economic development.

3. What is the Chinese view of their policies toward exchange rate control?

Chinese officials see the exchange rate—and prices and market mechanisms in general—as tools in a broader development strategy. The goal of this development strategy is not to create a market economy but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus, they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy in order to meet development objectives such as the creation of basic industries and infrastructure.

Since they perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are “in China’s interest.” And because China is an independent geopolitical power, it is fully able to resist international pressure to change its exchange rate policy.

4. What are some misconceptions about China’s large-scale reserve holdings and investments in U.S. Treasury Bonds, specifically the idea that China is “America’s banker?”

Because China’s central bank is the single biggest foreign holder of U.S. government debt, it is often said that China is “America’s banker,” and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. China is not in any practical sense “America’s banker.” China holds just 8% of outstanding US Treasury debt; American individuals and institutions hold 69%. China holds just 1% of all US financial assets (including corporate bonds and equities); US investors hold 87%. Chinese commercial banks lend almost nothing to American firms and consumers – the large majority of that finance comes from American banks. America’s banker is America, not China.
It is more apt to think of China as a depositor at the “Bank of the United States:” its treasury bond holdings are super-safe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States, since it has little ability to move those deposits elsewhere (no other bank in the world is big enough).

5. What are the implications for U.S. policy and how should policymakers react?

China’s exchange-rate policy is deeply linked to long-term development goals and there is very little that the United States, or any other outside actor, can do to influence this policy. Also, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy generating large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency.

In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, since the United States possesses no leverage which can be plausibly brought to bear. U.S. policy should therefore de-emphasize the exchange rate, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market, which in principle is provided for under the terms of China’s accession to the World Trade Organization.