China Research

Recent informal talks with business managers from both the industry and the financial sector in a number of developed countries have led me to the conclusion that general knowledge about the Chinese currency (renminbi = RMB or yuan = CNY, official) still is very limited. This is the case despite China’s great – and still growing – importance to the global economy and many globalized companies.

There are different reasons for this shortcoming. Many executive practitioners in the corporate world are not really interested in details of exchange rate policy. Furthermore – which may be an even more important reason for the lagging interest – the Chinese exchange rate policy is still extremely opaque for outsiders, i.e. for everybody outside the Chinese Communist Party leadership.

Some knowledge about Chinese exchange rate policy, however, exists. We know that China had an 8.3 RMB fixed link to the American dollar (USD) until 22 July, 2005. On this day, this fixed exchange rate regime (more or less) was abandoned and replaced by a limited floating policy which allowed for a sizeable appreciation until today all the same – the Chinese answer after many years of American complaints about an undervalued Chinese currency when considering China’s dynamically rising surpluses in foreign trade.

We also know that China is linking the RMB to a kind of currency basket that consists of about 20 different currencies. But what we do not know are the weights of these 20 different currencies in the Chinese basket despite the obvious dominance of the USD in this basket. In an interesting empirical study (“Re-pegging the renminbi to a basket: issues and implications”, Crawford School of Economics and Government, 2012, Asian Pacific Economic Literature), Heikki Oksanen from Helsinki University found that the RMB may be linked by up to 90 per cent to the USD. The consequence of this is that not very much influence is left to the other currencies – not even to the Euro – which means that predictability of the CNY vis-à-vis other currencies tends to be even more difficult.

Having said that the Chinese exchange rate policy is closely linked to the USD does not, however, rule out that China’s political leaders in recent years having been going for a cautious, but visible appreciation policy with slightly varying speed of this policy in relation to the USD (around 25 percent since July 25, 2005). Sometimes, we also have seen intermissions in this appreciation process – obviously in times when Chinese exports have been/are suffering from difficulties because of dampened global demand. This could be observed during the American subprime crisis in the latter part of the past decade and in 2012 when the European crisis was the seen as the main obstacle for Chinese exports.

Despite the fact that two thirds of the huge Chinese currency reserves are invested in USD, it would be beneficial to China to gradually decrease the weight of the USD in its currency basket which I have been pointing at before in different articles. The predominance of the USD is too strong in this respect, also from a (Chinese) risk perspective. The current Chinese foreign investment strategy makes China too dependent on financial markets’ confidence in the dollar. The U.S. economy will have major challenges in the forthcoming decade, too, and nobody can rule out that the USD may suffer from sizeable downward pressure at some point in the future.

Altogether, the composition of the Chinese currency basket should have much more hedging elements. This is another reason why China really dislikes the ongoing European crisis since only the Euro has the theoretical and practical capacity to become a real alternative to the USD for Chinese currency investors. Therefore, China is definitely not interested in a weak Euro.

However, there is only way for the Chinese exchange rate policy to get closer to the Euro, i.e. the very gradual one. Really fast moves in such a direction would cause turmoil on global currency markets at the expense of the dollar – but also when it comes to the development of the real economy of China, the U.S. and many other countries (exports, imports, GDP). China most certainly wants the survival of the Euro.

If we assume a positive outcome of the current Euro/European crisis, the Euro will gain a lot of importance in the longer run, maybe 10 years ahead or even more. This would “automatically” incline a weakening status of the USD as a reserve currency with unpredictable consequences for both the U.S. and the whole global economy. We really should hope that the U.S. will be successful in restoring fiscal stability and sustainability during this probable process.

Otherwise, the global economy will become even more unstable. China will – without doubt -have an increasing impact on this development, also by its exchange rate policy. However, the “global house” cannot be put in order during the next decade or so without major positive contributions from both Europe and the U.S. – also for the avoidance of (temporarily) chaotic conditions on global currency markets.

In the meanwhile, there should be room enough for China to make its exchange rate much more transparent and also for substantial changes in exchange rate policy. Such a change could mean a more trade-related basket in line with the Swedish model from the 1980s (which failed because of major macroeconomic imbalances in Sweden, not because of its composition of currencies) or – according to Oksanen’s second suggestion – a linkage to Special Drawing Rights (SDR, which contains USD, Euro, yen and the British Pound Sterling – a composition that has to be checked up/revised by the IMF every fifth year).

But even if these technical changes in Chinese exchange rate policy will occur in the forthcoming years, the road to a fully convertible currency will be very, very bumpy for the renminbi. It may take 10 years or even much longer to get there.

Hubert Fromlet
Professor of International Economics
Editorial board

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