Soaring Reserves Put Renminbi Back in the Spotlight

Editor’s Note: The following commentary originally appeared on the Financial Times website, and is based on data by the authors presented in the Financial Times’ China Currency Tracker interactive feature. 

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With China’s foreign exchange reserves soaring, the renminbi is back in the spotlight. Rising capital inflows have led to a surge in accumulation of reserves as China’s central bank tries to fend off pressures for the renminbi to appreciate. Further liberalization of capital outflows could help ease the pressure on the currency. Greater exchange rate flexibility remains in China’s interest and would also help pave the way for eventual convertibility of the renminbi.

Last year was a calm one for the renminbi. China’s trade and current account surpluses fell below 3 percent of GDP in 2012, suggesting that the economy was on its way to resolving its protracted external imbalances. Capital inflows eased off and capital outflows rose as the government liberalized controls on outflows. Net accumulation of foreign exchange reserves was just over $130 billion, compared to $330 billion in 2011 and an average of nearly $450 billion per year in the four years preceding that.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar.

Pressures on the renminbi appeared to have become more balanced. In fact, for most of the year, the offshore non-deliverable forwards (NDF) market indicated expectations of mild renminbi depreciation relative to the U.S. dollar. In April 2012, the government increased the flexibility of the exchange rate, allowing the renminbi to rise or fall by 1 percent each day relative to the midpoint of the trading range determined by the People’s Bank of China (PBC). Soon after that, the renminbi briefly retreated in value against the dollar before returning to a slow pace of appreciation.

2013 could prove to be a more interesting year on the currency front. Capital inflows into China seem to have picked up due to a mix of pull and push factors. The economy’s short-term growth prospects seem solid, although Chinese equity markets have not performed well. The major advanced economies are likely to maintain protracted low interest rate and easy money policies, pushing capital out to China and other emerging markets.

The economy seems to have settled down to a pace of 7-8 percent GDP growth. Inflation appears under control, leaving room for a strong policy response to counter any slowdown in growth. There are many risks to this relatively benign scenario, including concerns about local government debt, the housing market, and financial system weaknesses.

Still, capital flows to China are likely to increase, particularly since the government has been easing restrictions on inflows. This will maintain appreciation pressures on the currency barring any major global financial turmoil—for instance from a flare-up of the euro zone debt crisis—that could pull capital back from emerging markets to the traditional safe haven currencies.

On a trade-weighted basis, the renminbi’s nominal effective exchange rate relative to its major trading partners has appreciated by 3 percent over the past twelve months. The inflation-adjusted real effective exchange rate has appreciated by 5 percent over this period–although China has maintained moderate inflation, many of its advanced economy trading partners have even lower inflation rates.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries.

Over the past twelve months (March 2012 to March 2013), the renminbi has appreciated relative to the currencies of virtually all of its major trading partners. In inflation-adjusted terms, the renminbi’s value has risen sharply against the yen–by nearly 18 percent. By this measure, the renminbi has also appreciated by 5.9 percent relative to the euro and 1.5 percent relative to the U.S. dollar. Measured relative to its recent low against the dollar in August 2012, the renminbi is now up by about 3 percent against the dollar.

The renminbi’s modest appreciation relative to the dollar suggests that the exchange rate is still being tightly managed by the PBC through its intervention in foreign exchange markets. Indeed, in the first quarter of 2013, China added $128 billion to its stockpile of reserves, pushing them to a level of $3.44 trillion.

With the U.S. bilateral trade deficit with China hitting a new high of $314 billion in 2012 and U.S. job growth still at dismal levels, China’s currency policy could once again become a source of tension between the two countries. This would not bode well for the bilateral economic relationship and could also raise global trade tensions, particularly as China and other emerging markets continue to feel victimized by aggressive monetary easing in the major advanced economies.

Continued liberalization of capital outflows will help take some of the pressure off from any increase in inflows. Still, there is a strong case for allowing more flexibility in China’s exchange rate. This would have many other domestic benefits as well. As China continues to open up its capital account, greater exchange rate flexibility will be important to make the process smoother and to facilitate the move towards free convertibility of the renminbi. It will also boost monetary and financial sector reforms.