In response to global pressures, China ended on June 19, 2010, the peg of its currency, the renminbi (yuan), to the US dollar, allowed a greater flexibility of its exchange rate and let it to rise gradually. The explicit dollar peg had actually been formally abandoned in July 2005 when China adopted the managed floating system.
In reality, however, the renminbi had remained linked mainly to the US dollar at about 6.83 since July 2008 during the height of the American financial crisis.
Now, the People’s Bank of China (PBOC), the country’s central bank, sets a daily reference rate for the renminbi and allows it to fluctuate within a band of 0.5 percent.
According to calculation made by economists at the Peterson Institute of International Economics in Washington, DC, the nominal
renminbi appreciated by about 21 percent against the dollar from 2005 to 2008. But this is not enough.. Many analysts calculate that the renminbi is now undervalued by about 30-40 percent.
In addition to soaring China’s current account surplus, the appreciation of the renminbi is also justified because of the rapid productivity growth in its export sector that has raised the competitiveness of its economy.
Currency undervaluation is a protectionist trade policy because it is a combination of an export subsidy and an import tariff. After joining the World Trade Organization (WTO) in 2001, China replaced
the previous explicit industrial protective policies with currency devaluation.
The previous policies included distorted and selective trade policy, high tariff barriers, investment incentives, export subsidies, and domestic content requirements on foreign manufacturing firms.
Implementation of the traditional industrial policy requires complicated administration and is also prone to corruption and rent seeking activities.
In addition to exchange rate undervaluation, the government of China also subsidizes the prices of some industrial input for production of tradable goods and hence exports. The subsidies include prices of fuel, wages, and land and interest rates on bank loans.
“The exchange rate policy should also be accompanied by other policies to reduce the gap between saving and investment.”
The undervaluation of the renminbi has been used to attain two policy objectives. First, to promote exports by subsidizing them or making their prices artificially low in terms of foreign currencies.
Second, to discourage imports by taxing them or making their prices artificially high measured in the renminbi.
The policy to make external value of the renminbi undervalued is effective in China because the country adopts a strict capital control.
To maintain the prevailing exchange rate the PBOC buys export proceeds and capital inflow. As China exports more than it imports, the country ran a big current account surplus to accumulate foreign exchange reserves.
At present, the external reserve of China is one of the highest, amounting to more than US$2 trillion.
Most of this is invested in the US government bonds to finance the large twin budget and balance of payments deficits of the US and allow its banking system to expand credit at a low interest rate.
Some other external reserves are invested in other foreign assets with a low rate of return.
Because of the artificial undervaluation of the renminbi, the managing director of the IMF recently labeled it as “substantially undervalued” and the US official characterized China as a currency manipulator.
Noted economists such as Fred Bergsten and Paul Krugman argue the renminbi undervaluation has caused global imbalance and unemployment in Chinese’s export markets, such as the US and the EU.
The renminbi peg to the dollar and its undervaluation also harms other emerging economies that directly compete with China but use flexible exchange rate systems. Those countries, such as Korea, Indonesia and India, adopt flexible exchange rate systems to allow their currencies appreciate to dampen overheating because of the surge of both exports and short-term capital inflow.
This is the main reason why recently our farmers, handicraft makers and industrialists have been complaining about the China-ASEAN PTA. According to Dani Rodrik of Harvard University, the renminbi undervaluation has increased Chinese long-run growth by more than 2 percentage points as it encouraged the shift of resources from the low productivity non-traded sector of the economy to the high-productivity traded sector.
There are two policy instruments being used by the PBOC to sterilize or mop up the export proceeds and speculative short-term capital inflows. First to frequently raise the level of the required reserves, which pay a negative real rate of interest.
The second policy instrument is to sell the government’s T-bills and the PBOC’s sterilization bonds, similar to SBI debt instruments of Bank Indonesia.
These reduce bank profitability even though some of the losses are offset by a large spread between lending and deposit interest rates in the repressed financial sector. Like in Indonesia, most deposits in China are owned by the public sector, either the government or state-owned enterprises.
The correction of reminbi undervaluation should, however, be made gradually, say in five years because a rapid appreciation of the renminbi could destabilize China as it potentially creates unemployment for its large pool of workers now employed in export-oriented manufacturing. A rapid deceleration of economic growth of China is also bad for global economic recovery.
The exchange rate policy should also be accompanied by other policies to reduce the gap between saving and investment.
The ancillary policies include elimination of subsidies on industrial input including interest rates and building up social safety nets in education, health and pensions to encourage domestic consumption.
The writer is a professor of economics at the University of Indonesia, former senior deputy governor of Bank Indonesia (Central Bank) and former chairman of the Supreme Audit Agency (BPK).
