Why China Should Abandon Its Dollar Peg*

China should allow its currency to appreciate significantly, and should move to a regime of more flexible exchange rates. China has pegged the renminbi (RMB) to the United States dollar since 1994, only recently allowing a very slow rate of upward crawl after a small revaluation in July 2005. It should phase out this peg, and allow a faster rate of currency appreciation. The significant market pressure for a currency appreciation is driven by the increasingly large Chinese trade and current account surpluses, with additional pressure resulting from the massive amounts of foreign direct investment (FDI) and hot money flowing into China. The Chinese authorities have been able to prevent a sharp exchange rate appreciation only by intervening very aggressively in the foreign exchange market. This accumulation of foreign exchange reserves ran at staggering annual rates of about $250 billion per year in 2005 and 2006. Numerous empirical studies have shown that the RMB is grossly undervalued, and that China's rapid and sustained economic growth implies that the equilibrium real exchange rate is appreciating over time. Thus, actual nominal appreciation is required to allow the real exchange rate to move toward its equilibrium value without causing higher inflation. A failure to allow a nominal appreciation poses significant risks and potential costs. First, if Chinese net exports continue to grow at their current rapid rates, protectionist policies will gain further legitimacy in the United States and Europe. Second, the policy of partially sterilized intervention is creating excessive liquidity credit and asset bubbles, which are fuelling the already overheated Chinese economy and exacerbating the risk of an eventual hard landing. Third, the imbalanced composition of aggregate demand has resulted in excessive reliance on net exports and real investment, and in a very low level of private consumption. Fourth, once the currency eventually appreciates – which it will, given that its fundamental value is appreciating over time – there will be capital losses on holdings of foreign reserves. Delaying the appreciation will create larger losses as the stock of reserves will be greater and therefore the required and actual appreciation will also be larger. And fifth, there is the risk of an eventual surge in inflation if the nominal exchange rate is not allowed to appreciate. However, some argue that an RMB appreciation would involve significant risks as well, such as an excessive slowdown of growth, deflationary pressures and increased poverty in the rural sector. But these risks are modest – the evidence for them is weak, and appropriate policies could reduce any potential costs. In contrast, given the risks associated with the status quo, even ignoring the unfair ‘China bashing’ and protectionist pressures emanating from the United States, it is in China's interest to move to a more flexible exchange rate regime. Delaying the necessary nominal and real appreciation of the RMB increases the real risk of a hard landing similar to what China experienced in 1994–98, when an investment bubble burst and led to a sharp slowdown in growth. The paper is structured as follows. Section II argues that the growing Chinese trade and current account surpluses and massive foreign reserve accumulation suggest that the RMB is very undervalued. Section III addresses the argument that the surpluses could be the result of Chinese domestic factors, such as the high savings rate, and international factors such as the United States fiscal and current account deficits. Section IV analyses the various real and financial risks faced by the Chinese economy if the current exchange rate regime is maintained. Section V considers the distortions and imbalances in the Chinese economy caused by the weak currency regime. Section VI discusses how the effectively pegged exchange rate has led to a risky loss of monetary and credit policy independence and why a more flexible exchange rate is necessary to restore such independence. Section VII presents counter-arguments to the view that exchange rate flexibility should be delayed until the financial system is sounder. Section VIII counters the arguments that currency appreciation risks causing a dangerous price deflation in China. Section IX concludes. China's increasing export growth and trade surpluses have been phenomenal recently. In 2002, Chinese exports of goods were about $325 billion. For 2006, such exports may be as high as $950 billion, nearly triple the level of four years ago. The current account surplus is expected to be $220 billion in 2006, up from $35 billion in 2002 and $160 billion in 2005. In 2005, China intervened in the foreign exchange market to accumulate reserves of $250 billion, preventing the currency from appreciating in the face of a massive current and capital account surplus. This reserve accumulation was driven by a current account surplus of close to $160 billion, an inflow of about $50 billion in FDI, and hot money inflows that were about $50 billion. Without aggressive intervention, the RMB would have sharply appreciated. In 2006, the trends of 2005 continued. Exports were still growing at a 30% annualized rate. The current account surplus further increased relative to 2005, while FDI and hot money inflows ran at rates only modestly lower than the previous year. Thus China accumulated about another $250 billion of reserves in 2006, while its total stock of foreign reserves officially reached the staggering figure of $1 trillion in late 2006. Once again, there is strong evidence that the RMB would have appreciated sharply if the Chinese authorities were not intervening. However, some disagree and argue that the demand and accumulation of foreign assets by Chinese authorities are not preventing an RMB appreciation. Instead, China's intervention is a for the domestic private demand for foreign assets caused by capital on private This argument is Chinese and foreign a sharp appreciation of the even a of the on would not to a significant in the demand for foreign assets by the Chinese private sector. hot money is flowing into China in of an RMB appreciation driven by massive trade surpluses and FDI This appreciation is not the result of the United States China into its currency the and growing Chinese current and capital account surpluses are market pressure for an appreciation. if capital were out capital inflows would still be larger than Chinese and would not accumulate large amounts of foreign assets the appreciation of the RMB would to large capital losses on foreign when the RMB appreciates sharply would private Chinese large amounts of foreign assets – as a of their – as expected capital losses from further appreciation would be more once the RMB Thus, China's foreign intervention as a for the private demand for foreign assets in the of capital is The evidence that the RMB would have sharply appreciated in the of intervention by the is evidence that the RMB is undervalued. But evidence on the RMB also from some empirical studies that at the equilibrium value of the even surpluses and capital has the to the the nominal exchange rates of are their exchange the to as per However, the China's exchange rate and its nominal exchange rate is large with In in China were of the level of be with the for at a similar of economic Chinese should have been about of China's rapid growth over the years – a over which the nominal exchange rate has – the China's actual and by is even larger have a similar by the a level and its real exchange rate. an in a per relative to the United States to an appreciation of its real exchange rate. In the of the real exchange rate has been while per has sharply on their the Chinese currency to appreciate by for its real exchange rate to be with the for at similar studies have also a of that the RMB is sharply undervalued, even if the on the of on the and of studies is an in economic on in current account on The to in the relative price of exports and caused by nominal and real exchange rate to lower demand for foreign goods and higher domestic of The implies that in trade and current account in relative to in savings relative to the current account is by the and the savings and real is a of argument that the growing Chinese trade surplus has to with the value of the even a large RMB appreciation would have on the Chinese surplus. This argument that imbalances are caused by the United States fiscal of as China's savings it is to factors and not to the weak exchange fiscal have been an of the growing current account from to that the United States fiscal from a large surplus to a large in of a sharp in the United States investment rate, the current account But in the United States current account also in of in the fiscal in this an of savings from China as as from nominal and real interest rates lower than would have been – what the market interest rates, in real investment, in with lower rates also led to higher and and to higher private and lower private for the high Chinese savings rate, factors Chinese for and to for the of these is also by the of a system and net in the of credit allow to to of to of implies very high high on the of a However, the exchange rate regime has also a in China's trade A weak RMB has and exports which has in relative and of The of China's trade with the very sharp of the RMB relative to the from 2002 to this In this from the appreciation in July 2005 and the very modest upward crawl the RMB the United States And it the United States dollar relative to the The of this sharp of the RMB relative to the have been Chinese exports and net exports to have at an even faster rate than their exports to the United States, which that exchange rates and relative for trade and trade The view that an RMB appreciation would have on China's trade surplus its surplus with the United States is It not with the evidence that export and price are significant in It also not with the Chinese that a strong RMB appreciation would and growth. there is that current account imbalances are growing and over policy to in surplus and to a Chinese currency and savings policies have – of the low level of and private savings – to China's policies have been to and economic for the weak RMB of of Chinese goods inflation and But will also eventually significant on the Chinese of imbalances will in to policies that and reduce the United relative to in relative currency The with imbalances in the with a in exchange rates have on net trade when by the appropriate increasing are risks for the Chinese economy from the of its regime of effectively exchange rates by a massive accumulation of foreign exchange reserves. The risk is growing protectionist pressures in the United States and Europe. China's net exports continue to and exports a 30% rate of growth, there will eventually be a in the United States and Europe. China could be a by the United States be as a currency the of the of the by and of protectionist are in the United States the of a on Chinese goods if China not allow its currency to appreciate A economic slowdown with growth potential – a hard landing – would these protectionist this is the of in the United States which is to to a The economy of trade policy is such that protectionist pressures will grow if Chinese net as a of without for the and China to to trade The risk for China from its current policy of partially sterilized China is to the on the monetary of its $250 billion a year the money growth and credit growth that is the investment bubble and the asset bubble – in real – and is the increasing the risk of an eventual hard landing. In 2006, excessive growth of the monetary a credit bubble that is are only the of capital is – investment in capital and is close to of economy have investment that it of its annual and it in A similar Chinese investment in the up in an investment and by it caused a hard with growth The investment is even than that of the and is the risk of a The risk is that the currency policy will eventually high inflation. China's rate is that of its its real exchange rate will have to appreciate over time – its fundamental real exchange rate is real appreciation in only a nominal appreciation an in inflation. the a nominal appreciation that inflation low is and than a real appreciation an eventual surge in the inflation rate. It is Chinese inflation has not in of its weak currency and the very growth rate that is causing an of the of goods and and of in a market with an of to inflation But will in the this has already to in the Thus, an overheated economy will eventually to higher inflation. The risk is that of a massive capital loss on the holdings of foreign reserves once the appreciation A appreciation of the RMB on a stock of $1 trillion of reserves amounts to a billion capital about of current – a very large the appreciation of the currency will only these capital losses for First, the of reserves on which losses will will be larger. the current rate of reserve China will trillion of foreign reserves four years from the Second, the up over the China the larger the required equilibrium nominal appreciation will to A 30% appreciation on trillion of reserves four years from would to a staggering capital loss of billion. China's economic growth has on FDI to a This to FDI, with a weak a foreign demand for Chinese goods and exports and an for foreign to in China. be foreign investment is small relative to total investment and But foreign investment has a larger in China's than in the of in and the sharply FDI, for a time China has and therefore massive amounts billion in 2005 argue that China is at the of a regime of exchange rates in The of this argue that the pegged currency and growth of China and is and will until the of of and Chinese rural are into the sector. But the of this growth is by Chinese and this growth is creating a of distortions and imbalances in the Chinese economy and 2005 for First, there are imbalances in the composition of aggregate a of is the savings rate is the investment rate is excessive and net exports are The rate of investment is high and the rate of low that China may already be a economy and therefore its relative to an level if were investment close to of and growth close to it of investment relative to to by In the to investment of the is very And this low on high investment and savings rates at the of a very low rate of private – about of that from an economic of investment by is not a of increased it is that increases and Thus, excessive investment reduce if very Second, there are investment to be toward goods for It also to on China's have to the not to China's foreign investment and rapid export growth to the economic the and The Chinese about as as growth, in it about the of are increasing and and economic The of to capital is increasing and real have to in to and are A that poverty and – relative and – have increased in rural of real of have in the are from For some from a large as a result of while are out of the market. that to to and The about the increasing and in the rural has officially its in its from growth to there are dangerous financial reserve accumulation rapid credit growth, asset price and in the real and export of which to The authorities have on and on than on price such as to interest rates, to The interest rate was increased by only in and 2006, a for an economy growing as as China. The to the interest rate as a of is in to the of the in interest rate risks further capital inflows from inflows that would to the liquidity in the system if are not Thus the current RMB is an Chinese China and and its economy is to the economy is by a the with trade and financial to the and the and and rural of the of the exchange rate regime is that it has led to a dangerous loss of of monetary and credit policy in China. The resulting of the economy and of financial may eventually result in a hard landing. China's current monetary and exchange rate policy implies a of policies by of the in that policy have monetary policy to the exchange rates to low inflation and monetary and an capital account to from international capital The that at once – to and up the a to a capital account and the economy with an monetary it have a exchange rate. if it to a capital account and have a exchange rate, it have an monetary And if a to monetary independence and a exchange rate it to capital and capital In some China has the by a while to the economy interest rate and credit But with large hot money inflows capital its of China's capital are a of hot money still the billion in 2005 and a than that in 2006. the to and monetary policy is caused by capital to excessive monetary growth and the of the a a surge of hot money even FDI and to a in of capital it could to prevent the appreciation of the currency foreign exchange In the of this is not such an intervention would domestic interest rates, exacerbating the already China is not able to its intervention it is by the of its domestic money and money are necessary to massive amounts of Thus, the rate has been only of the intervention sterilized intervention and the liquidity implies that China has been to reduce domestic interest rates rates to the for hot money capital But these low interest rates are at a time when economic higher interest rates and not lower interest rates and excessive liquidity and intervention is only partially sterilized and excessive liquidity and a credit China has on such as direct on credit to to slow the of the But such are and the investment and asset have In 2006, the excessive money led to a financial asset the stock market more than in a year to that are with economic Thus, with goods inflation still – if recently – to the factors the excessive liquidity has led to financial asset The that China is that it an monetary policy and higher interest rates to the But at the as are these higher interest rates would to further capital a the only to the is to up on the exchange rate In an overheated economy in which policies to a landing have and to a more flexible exchange rate regime is an toward monetary and credit argument exchange rate flexibility is that China a more flexible exchange rate regime until its and financial system is and – its are still weak, and with a move toward currency flexibility and that reduce will by allowing to more to and This will to a of aggregate demand from net exports and investment toward consumption. But in the the financial system is than the credit nominal growth is about the of capital – by the rate – is still This very low real of by the pegged exchange rate, is in the a more and is an for the financial The current exchange rate policy is to credit growth that could a surge in to as high as of This could once from the excessive growth of to the private – that have since 2002 – up on of the already massive stock of and to the current regime of rates and of foreign exchange intervention direct losses to the financial the massive intervention and its fiscal China has effectively financial over to of of of at very low and market interest rates on in sterilized intervention the financial system to effectively the losses for the financial The policy of increasing required reserve as a to credit growth, has also losses for Thus the current policy to an further of a financial system as a of the direct fiscal of a currency the arguments that the Chinese economy a more flexible exchange rate regime until the domestic and international capital are up and have very a financial system in which and in are still and and are still would be in and of a for will a time and should be Instead, in the the current exchange rate and credit regime is the and of distortions the financial of the arguments by of revaluation is that a currency move could a deflation in China similar to the that for of the and in the of this the appreciation of the in and in the late caused the asset price bubble and its with the goods price deflation that in the the argument about the of the appreciation of the and that China could the argues that In a in the United States the for the of in nominal and real exchange rates. view is in on argument that a regime of exchange rates is this currency are than In with growth will an appreciation of the equilibrium and actual real exchange But argues that this real appreciation – the in the relative price of domestic foreign goods – be domestic inflation than a nominal appreciation of the the at recently a similar This is not the time that has to a into by the of currency appreciation as the for a trade the when the was in the of its – a current account that at a of of – on to the the with was the of the trade The was if its would be for an the this and the rate from in to an of in the of was a its – the of asset in and that with a into a to that a years is the Chinese the that a of have in However, and the that the appreciation in the stock market and real bubble and its burst into deflation in the distortions in the of savings to capital the bubble of the and its deflationary in the the that exchange rate in the late in to an a fiscal a dollar led to a of the United States of the exchange rate have an in the required of the real exchange rate in its of high growth since the In the was at to the while it is to But a sharp nominal appreciation not high growth until the very in the years after the of the system in when the its and for after it Thus, it is to flexible exchange rates for economic of the China has already a of high growth with nominal exchange rates. its equilibrium real exchange rate has an of the actual real exchange rate toward the equilibrium a nominal exchange rate as the real appreciation will eventually a in inflation. China experienced high inflation in the to the real economy experienced a hard landing and sharply growth in the late the of higher inflation as a of real appreciation the risks of inflation in China. should also that the implies that Chinese inflation will, over the to be higher than the inflation rate of more as out by In if growth in that of the in nominal in the will the of and of goods faster than of and are in the that fiscal in an But their view that such not any exchange rate in China is at with over years of with flexible exchange rates. This that exchange rate flexibility has exchange rate that from time to time. relative nominal exchange rate is than to such relative price deflation inflation. the risks of a deflationary in China are on the are not as late on inflation The actual inflation rate is low various on the price of and by appreciating its currency China could pressures while an in of trade over foreign potential pressures from and pressures in the of China. the about the deflationary of a and appreciation be on its a failure to the Chinese and flexible may to deflation in the United States, and that the appreciation not a nominal and it not higher inflation in as slow growth of Chinese real may such inflation this is the the only in which a real appreciation could is a in the price of goods in the of the – that a in in the United States, and Thus, while about Chinese not the that the required real exchange rate could in a deflation in as the of in the such deflationary pressure would have on the of the Thus, a fiscal without a in relative that a nominal and real exchange rate will not of an to reduce the are necessary for a to in an A of the argument the of an RMB appreciation on the and of the Chinese sector. The argument is that the appreciation will the price of goods and will reduce the of the already very Chinese However, it would be and for any to its currency value on the of its such as on in the Chinese currency value should on that are and in which the has a In this would be the sector. the equilibrium value of the currency is the value that the to in there would be for any from trade and from the currency value in China on the of the is economic and an RMB appreciation were to the the policy for China would be to direct to the sector. given the of and in the rural of the Chinese authorities could the of such to the rural sector. policies over the and of in the rural This paper has that it is in China's economic interest to move to a more flexible exchange rate regime. The current to the United States dollar the of the monetary and credit policy that China to its overheated The policies of partially sterilized foreign exchange intervention and are in the credit The accumulation of foreign in of a staggering $1 will eventually to massive capital losses when the required currency Delaying this necessary currency will only such eventual capital losses as the stock of reserves will be higher and the required appreciation greater if such appreciation is further its high growth, the Chinese economy and grow in a more sustained and by its currency appreciate at a faster rate over time. The current economic and the real appreciation of the equilibrium exchange rate from high growth would eventually high inflation in the of a nominal exchange rate appreciation. Thus, such appreciation is required to prevent a in inflation. of current account imbalances in economic policies in and surplus And the exchange rate, with appropriate is an for an of excessive trade that the of in real exchange rates are necessary and in the demand for exports and and trade China has hard to for its economic policies over the some of the relative are still by the exchange rates, of the of a to excessive of to the export and to and consumption. The nominal and real of capital is also to credit and with low The of savings to investment is still by the in that are increasingly And the relative price of is by policies investment, to a bubble that could burst and real economic are by monetary policy over a of on domestic capital and capital to a more flexible exchange rate regime will be a of the of China toward a market economy in the It will and demand to the Chinese economy more more and to and the of the It will also allow China to of interest rate and credit the of the landing of an overheated