Yang Yao, Dean and Professor, National School of Development(NSD), Peking University
In a surprising move, the People’s Bank of China, China’s central bank, allowed the renminbi to devalue by 1,136 base points on August 11 2015, following its announcement that the currency’s daily reference price would be changed from the official “fix” to the ending price of the previous trading session. In the subsequent two days, the renminbi continued to lose 1684 base points to reach 6.40 yuan to one dollar. According to PBoC, its move was a step toward “allowing market demand and supply to play a more decisive role in the formation mechanism of the exchange rate”. So, is China moving away from its peg to the US dollar?
China started to peg the renminbi to the American dollar in 1994. For practitioners and politicians, It fixed its currency to seek economic gains by promoting exports. Yet for most economists, this idea was not well founded. In economic theory, what matters is the real exchange rate, composed by the nominal exchange rate and the domestic aggregate price level, that determines the flow of goods across borders. Real appreciation — that is, either the appreciation of the nominal exchange rate or higher domestic prices — hurts a country’s exports. Conversely, real depreciation promotes a country’s exports. Fixing the nominal exchange rate will not fix the real exchange rate; domestic prices will still go up when a country exports more. So a fixed exchange rate should not help a country for long.
This apparent discrepancy between academic ideas and popular beliefs needs to be reconciled. Politicians often adopt an economic policy for political reasons, but in many cases they also make economically sound policies, particularly when those policies help their political survival. In China, economic growth has been in the centre of politics for a long time, so there is reason to believe that the country’s officials adopted the fixed exchange rate to promote growth. Probably they saw some economic fundamental that economists have not noticed.
That economic fundamental is fast industrialisation. Domestic prices may not adjust as quickly as economists have assumed — besides, the central bank can intervene to stabilise the aggregate price level. As a result, fixing the nominal exchange rate can suppress or at least delay the appreciation of the real exchange rate. This creates favourable terms of trade for exports, helping the industrial sector that produces those exports. Thus, the fixed exchange rate may have had a positive effect on China’s growth by accelerating its industrialisation process. Between 2001 and 2008, China’s export volume was increased fivefold, and export growth probably accounted for one-third of the country’s overall growth.
So the popular view is half right; China has benefited from its fixed exchange rate. However, it also comes with heavy costs. Fixing the exchange rate has forced China to accumulate a large amount of official foreign reserves. Standing at $3.7tn, the official foreign reserves are larger than the gross domestic product of Germany, the world’s fourth-largest economy. But while the rate of return to capital in China is more than 10 per cent, its official foreign reserves can only earn about 3 per cent, mainly because they have been invested in safe assets such as American Treasury bonds. That 7 per cent gap in the rate of return implies that each year since 2001 China has on average lost 2.5 per cent of its GDP.
The fixed exchange rate, therefore, has been a mixed blessing. Many countries do not adopt it, either because they do not have the economic fundamentals that China has had, or because the financial costs are too high to bear. On balance, China benefited from its fixed exchange rate between 2001 and 2010, mostly because its industry expanded with an extraordinary speed in this period.
Today, the country is on its way to rebalancing. Export growth has dropped dramatically. In the first half of 2015, export barely grew. After 15 years of expansion, the industrial sector has slowed down and its shares in the national GDP and employment have begun to decline. That is, China is losing its economic fundamentals that support the success of the fixed exchange rate.
It is thus no longer a wise strategy for China to pursue. In fact, the PBOC’s devaluation on August 11 was seen by some as a move to correct the renminbi’s misalignment with the US dollar, which has dragged down China’s exports. The peg has forced the renminbi to appreciate together with the dollar against most other currencies. Another consideration is probably the renminbi’s bid to join the International Monetary Fund’s Special Drawing Rights basket of elite currencies in this round of the IMF’s five-year review. A more flexible exchange rate regime will definitely help that bid. There is no better moment than now for China to delink the renminbi from the dollar.