China Revalues its Currency

For over a decade, the Chinese currency, the renminbi, has been pegged to the US dollar at a rate of 8.28 to the Yankee unit. After two years of complaining from outsiders, China finally decided to move that closer to where a free market might take the currency. Strengthening the renminbi by 2.2%, China revalued its currency in a fashion that should make American policy makers tone down their cheering and think again.

In theory, a dollar peg gives stability to a developing country’s currency allowing it to develop without the excessive distortions that unfettered capital flows into and out of its economy would create. In practice, it distorts trade patterns by making it either too easy or too hard to export (depending on whether the peg is too low or too high). After a decade of its dollar peg, China now has $711 billion in foreign exchange, most of it dollar-denominated US Treasury bonds. At these levels, such quantities become difficult to invest, recycle or even burn. It also represents huge amounts of deferred consumption, funds that could be used to make life more comfortable in China today. Moreover by revaluing now rahter than letting the market do it over the last decade, the government has wiped out as much as $12 billion of its own reserves when measured in local currency.

In officially strengthening the renminbi, the People’s Bank of China may have hushed Congress up a little. Such a small changes is in keeping with the slow approach China takes toward such matters. As Senator Chuck Schumer (D-NY) noted, “It is smaller than we had hoped but to paraphrase the Chinese philosophers, a trip of a thousand miles can begin with the first baby step.” The question is whether the first baby step was taken in the wrong direction. The statement by the People's Bank said

The daily trading price of the US dollar against the RMB [renminbi] in the inter-bank foreign exchange market will continue to be allowed to float within a band of [plus or minus] 0.3 percent around the central parity published by the People’s Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People’s Bank of China.

The People’s Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies. The People’s Bank of China is responsible for maintaining the RMB exchange rate basically stable at an adaptive and equilibrium level, so as to promote the basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability.