Commentary Type

China's Exchange Rate

Attachment to "The US Trade Deficit and China," testimony by C. Fred Bergsten before the Hearing on US-China Economic Relations Revisited, Committee on Finance, United States Senate

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Background

The Chinese renminbi is undervalued by 20 to 40 percent on average and by even more against the dollar. This distortion adds substantially to the competitiveness of Chinese products in international trade.

Other Asian countries are reluctant to let their exchange rates rise against China's because of the adverse effects on their own competitiveness. Renminbi undervaluation thus promotes undervaluation of other important currencies against the dollar. A substantial renminbi revaluation is essential to moderate the huge global trade imbalances, centered on the US current account deficit that reached an annual rate of $900 billion in the last quarter of 2005.

Most countries let their currencies fluctuate largely in response to market forces. China, however, has pegged the renminbi to the dollar at a virtually fixed exchange rate since 1995. It has maintained that peg by buying $15billion to $20 billion per month in the exchange markets to resist market pressures for a stronger renminbi. Those pressures emanate from China's large and rapidly growing trade surpluses, substantial inflows of foreign direct investment and speculative capital inflows betting on eventual renminbi revaluation. By continuing to peg to the dollar since 2002, during a period when the dollar was declining against most other currencies, the renminbi has actually fallen in value against most currencies and enabled China to become even more competitive.

The Current Situation

Two issues arise: the level of the exchange rate of renminbi and the currency regime implemented by China. The US government, G-7, and IMF have tended to focus on the regime, arguing that China should let its currency fluctuate in response to market forces. The Chinese, while agreeing that a floating currency is desirable in the long run, have responded that such a change now could produce a large movement of money out of the country that would further weaken their banking system and jeopardize their economy. Hence China has been unwilling to initiate any sizable response to the external urgings and an impasse has resulted.

The immediate need is for a substantial rise in the value of the renminbi rather than a change in China's currency regime. This can be achieved by a series of revaluations, within the existing fixed-rate system, or by a sequence of managed upward floats. China has taken several small steps in that direction, revaluing by 2.1 percent in July 2005 and letting the currency creep upward a bit further in early 2006. It has also announced that the renminbi would henceforth be managed against a basket of currencies rather than solely against the dollar. Through March 2006, however, China continued to intervene massively to keep the renminbi from rising substantially.

China resists currency appreciation for several reasons. It values the “stability” offered by its fixed peg to the dollar (although the wide fluctuations of the dollar against most other currencies instead produce a very unstable renminbi). It hesitates to inject a new uncertainty into its economic outlook. It worries that any reduction in its trade competitiveness would add to its transitional unemployment. It also apparently doubts that the United States or the relevant international organizations (IMF, WTO) will force it to move, essentially viewing currency undervaluation as on off-budget job and export subsidy that avoids effective international reaction.

What Should Be Done?

China will have to phase in a faster expansion of domestic consumption and government spending to offset the dampening of its economic growth from the decline in its trade surplus that is the intended result of currency appreciation. Fortunately, sharp increases in government spending on health care, education and pensions are needed in any event because such benefits, which were previously provided by state-owned enterprises, are now grossly inadequate and social unrest has resulted from their elimination.

An early and sizeable revaluation of the renminbi, however, is essential for three reasons. It would moderate China's own surplus against the United States and the rest of the world. It would enable other Asian surplus countries to let their currencies rise against the renminbi (and hence against the dollar), and thereby participate constructively in the global adjustment process. It would head off protectionist pressures against China in both the United States and Europe, which is likely to erupt in the near future in the absence of substantial revaluation.

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