DOES CHINA NEED A MORE FLEXIBLE EXCHANGE RATE?
by

TengT. Xu
B.A., Acadia University, 2006

PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF
THE REQUIREMENTS FOR THE DEGREE OF
MASTER OF ARTS
IN
DEVELOPMENT ECONOMICS

UNIVERSITY OF NORTHERN BRITISH COLUMBIA
September 2011

© Teng T. Xu, 2011
UNIVERSITY of NORTHERN
BRITISH COLUMBIA
LIBRARY
Prince George, B.C.

EXECUTIVE SUMMARY

During the past few years, there has been heated debate-both domestically and
internationally-about China's exchange rate policy. At the heart of the debate are two
fundamental issues: First, is the renminbi undervalued? If so, by how much; and second, toward
what exchange rate regime should China move? This paper sheds light on the first issue by
examining the "equilibrium" value of the renminbi and its alleged undervaluation, but focuses on
the second issue- in particular, the risks to financial stability and the domestic costs of China's
current exchange rate regime. By reviewing a large number of Chinese and western literatures on
a series of specific issues pertaining to China's exchange rate policy such as: the revolution of
the renminbi exchange rate regime since the start of the economic reforms 30 plus years ago; the
"equilibrium" value of the renminbi and its alleged undervaluation; China's fast growing current
account surplus in recent years and its contributing factors; the risks to financial stability and
other domestic costs of China's current rigid exchange rate regime, this paper finds that the latest
debates on the renminbi exchange rate regime in China mirror those in the west. In other words,
there are same rival camps both inside and outside China. The synthesis of their findings is that
greater exchange rate flexibility can resolve many of the challenges and obstacles posed by
China's current tightly managed exchange rate regime.

ii

TABLE OF CONTENTS
Executive Summary ......................................................................................... ii
Table of Contents ............................................................................................ iii
List of Figures ................................................................................................ iv
Acknowledgement ........................................................................................... v
Chapter
1. Introduction and Preview ......................................................................... 1
2. China's Exchange Rate Regimes Since the Late 1970s ...................................... 7
2.1 Moving Toward A More Market-Based Exchange Rate Regime (1979-1994) ......... 7
2.2 De Facto Pegged Exchange Rate Regime (1994-2005) .................................. 10
2.3 New Managed Floating Exchange Rate Regime (Post 2005) ............................ 11
3. Renminhi's Equilibrium Exchange Rate and Its Alleged Undervaluation ............ 14

4. China's Extraordinarily Large Current Account Surplus and Its Determinants ... 21
4.1 The Upsurge in China's Current Account Surplus in Recent Years ..................... 21
4.2 Capital-Intensive, Industry-Led Growth with High Domestic Savings and
Investment ........................................................................................... 23
4.3 Total Factor Productivity Improvements .................................................... 26
4.4 Factor Market Distortions ..................................................................... 28
a) Distortions in the Labor Market ....................................................... 28
b) Distortions in the Market for Land, Energy, and Primary Commodities ....... 30
4.5 Exchange Rate Distortion and Policies Promoting Export Growths ..................... 33
5. Conundrums Facing the Chinese Authorities Under the Current Exchange Rate
Regime ............................................................................................... 38
5.1 Monetary Policy Independence ............................................................... 38
5.2 China's Large Hoarding of Foreign Exchange Reserves .................................. 41
5.3 Banking Sector Reforms ....................................................................... 43
5.4 Rebalancing ofthe Chinese Economy ....................................................... 44
6. Concluding Remarks ............................................................................. 46
References .................................................................................................... 52

iii

LIST OF FIGURES
FIGURE

PAGE

Figure 2.1: Dual (Nominal US Dollar) Exchange Rates of the Renminbi, 1981-1994 .. ..... .. 10
Figure 2.2: Nominal US Dollar Exchange Rate of the Renminbi, 1994-2005 ........ .... ....... 11
Figure 2.3: China Balance of Trade ............. ... ........ ..... ... .... ..... ....... ......... ........ .. 13
Figure 2.4: Nominal US Dollar Exchange Rate of the Renminbi, Post 2005 ........ ........... . 14
Figure 4.1: China' s Current Account Position(% GDP), 1985-2009 ....... .. ..... ......... .... . 21
Figure 4.2: China' s Real Effective Exchange Rate, 1994Q1-2008Q2 ...... ... .. ..... ... ........ 34

iv

ACHNOWLEDGEMENTS
I would like to acknowledge appreciation for the support of my graduate supervisor, Dr. Paul
Bowles. I would like to thank him sincerely for his insightful advice and guidance, and for his
boundless generosity and patience toward me.
I would also like to thank my friends and family, in particular my mother for supporting and
inspiring me to stick to my dreams.

v

CHAPTER 1- INTRODUCTION AND PREVIEW
Since its opening up to the outside world and the series of economic reforms it
started to adopt in the late 1970s, China's economic performance has been one of the
strongest in history with annual gross domestic product (GOP) growth averaging nearly 10
percent over the 1980-2010 period, compared to 4.5 percent for all emerging and
developing economies over the same period (IMF, 2011).1 Although the country's per
capita income is still modest at USD$3,678 in 2009 (World Bank, 2011), with almost one
fifth of the world's population, China surpassed Japan as the world's second-largest
economy after the United States by both nominal GOP and by purchasing power parity
(PPP) in the second quarter of 2010, according to a well-known economist with the
Chinese Academy of Social Sciences (CASS) named Ming Zhang (2010a). Following three
decades of rapid economic expansion, China has also become the second largest trading
nation in the world and the largest exporter and second largest importer of goods. The
package of macroeconomic and structural policy reforms that has generated this growth
has clearly worked well for China. Nevertheless, the Chinese authorities need to deal with a
much more complicated economic situation than ever before as the country is facing
macroeconomic, social and environmental challenges that have their origin in its pattern of
growth.
Together with other structural reforms that have opened up the Chinese economy to
foreign investment and trade, a tightly managed exchange rate regime has been one
important part of a development strategy that promotes export-led economic growth in
China over the past three decades or so. Since the late 1970s and prior to 2005, as China's

1 Source: IMF World Economic Outlook database for April 2011 and author's own calculations.

1

economic reforms and liberalization process moved forward, its exchange rate regime had
gradually evolved from a "centrally planned administrative mechanism to a dual-rate
system, then to a managed float with a narrow band, and finally to a managed float with a
very narrow band-a de facto peg to the [U.S.] dollar" (Huang & Wang, 2004, p.337).
According to Zhichao Zhang (2000), with the deepening of market-oriented reforms in the
mid-1980s, the exchange rate was for the first time recognized by the Chinese authorities
as an "economic lever" that should be applied to promote exports. That is also when
exchange rate reform was first launched in China. In July 2005, the renminbi's decade long
peg to the U.S. dollar was formally changed when China launched a much-heralded
currency reform. However, despite pledges by the Chinese authorities in recent years to
increase the role of market forces in the determination of the renminbi exchange rate, and
to manage a floating exchange rate against a basket of currencies rather than the U.S. dollar
alone, in practice, the renminbi still appears to be pegged to the dollar, with little flexibility.
During the past few years, there has been heated debate-both domestically and
internationally-about China's exchange rate policy. At the heart of the debate are two
fundamental issues: First, is the renminbi undervalued? If so, by how much; and second,
toward what exchange rate regime should China move? This paper sheds light on the first
issue by examining the "equilibrium" value of the renminbi and its alleged undervaluation,
but focuses on the second issue-in particular, the risks to financial stability and the
domestic costs of China's current exchange rate regime. By reviewing a large number of
articles on a series of specific issues pertaining to China's exchange rate policy such as: the
revolution of the renminbi exchange rate regime since the start of the economic reforms 30
plus years ago; the "equilibrium" value of the renminbi and its alleged undervaluation;
2

China's fast growing current account surplus in recent years and its contributing factors;
the risks to financial stability and other domestic costs of China's current rigid exchange
rate regime, this paper aims to synthesize findings by analysts and policymakers from both
inside and outside China (some written in Chinese) and act as the culmination of a study of
the latest debate on China's exchange rate policy.
At the current stage of development, China needs to employ monetary policy to
accommodate some broad objectives such as price stability, balanced balance-of-payments
(BOP) account, and sustainable economic growth. Since the effective management of the
renminbi exchange rate system could help China's economy achieve all these
macroeconomic objectives and have an impact on the country's competitiveness, trade
relations and resources allocation, the question of an equilibrium exchange rate has been a
major source of concern among analysts and policymakers during the current debate on
China's exchange rate policy. The mismanagement of the renminbi exchange rate regime
along with a misaligned renminbi, on the other hand, could negatively influence the
stability of China's financial system, possibly resulting in regional and even global financial
crises.
However, according to Morris Goldstein and Nicholas Lardy (2008, p.3), "[a]ny
methodology that defines the equilibrium exchange rate for the renminbi as the real
effective exchange rate 2 (REER) that would produce 'balance' in China's global current
account position, or in its basic balance, or in its overall [BOP] position, yields the
2 An "effective" exchange rate index is a weighted average of the country's exchange rate against its major

trading partners, where the weights on individual currencies are typically related to the importance of that
country in the home country's trade. A "real" exchange rate index adjusts movements in the nominal
exchange rate for differences in inflation rates between the home and foreign country, since higher inflation
represents a decline in price competitiveness just like an appreciation of the home currency. A "real effective"
exchange rate index combines these two features (Goldstein, 2007).

3

qualitative conclusion that the renminbi is significantly undervalued and probably by an
increasing margin over time." In an effort to keep the renminbi from appreciating, the
Chinese authorities have been engaging in large-scale, one-way intervention in the foreign
exchange market for many years. The excessive expansion of China's current account
surplus that has accompanied, among other factors, the increasingly undervalued renminbi
exchange rate, along with the continuous blocking of a renminbi appreciation large enough
to substantially reduce China's current account surplus, not only imposes a constraint on
the country's monetary policy, with increasing risk to the banking and the financial system,
but also makes it much harder for China to move to a more balanced and sustainable
growth path.
First, a rigid exchange rate regime compounded by a large current account surplus
substantially reduces the independence of monetary policy. In recent years, the growth in
China's current account surplus-which is a by-product of the distinct features of China's
pattern of growth and a variety of policies that are behind it, including, perhaps crucially,
exchange rate policy-has reached unprecedented levels. Normally, a large expansion of
current account surplus would lead to appreciation pressures on the domestic currency,
which in turn would lead to deterioration in the country's competitive position in
international trade. However, resisting pressures for renminbi appreciation, the People's
Bank of China (PBOC), China's central bank, purchases a large amount of foreign exchange.
Such rigid exchange rate arrangement fuels a surge in the supply of base money and
generates a "liquidity overhang" in the Chinese banking system. At the current juncture,
relatively high domestic interest rates would be needed to cool down the "overheated"
economy and to prevent risks of hyperinflation. However, the paradox is that higher
4

interest rates would trigger speculative capital inflows, which in turn would put more
upward pressures on the renminbi exchange rate. Moreover, China's massive intervention
in the foreign exchange market has resulted in the accumulation of a large hoarding of
foreign exchange reserves reaching USD$3.04 trillion in March 2011, according to figures
released by the central bank 3 (PBOC, 2011), mainly in the forms of U.S. dollars and U.S.
dollar-denominated assets give a number here for the reserve holdings that puts the
country at risk for potential capital losses in the event of U.S. dollar depreciation.
Next, China's current exchange rate arrangement given its extraordinarily large
foreign exchange reserves has negative implications for the profitability and efficiency of
the domestic banking system, which in turn may hamper banking sector reforms. In order
to prevent any large movement of the renminbi exchange rate, the PBOC intervenes
massively in the foreign exchange market. This in turn increases the supply of monetary
aggregates and thus generates excessive liquidity in the Chinese banking system. The PBOC
is then forced to engage in large-scale, open-market sterilization operations to keep
domestic inflation at bay. Such sterilization operations are normally carried out through
non-market oriented tools including low-yielding sterilization bonds issued by the PBOC,
administrative controls on bank lending and credit expansion, as well as moral suasion.
However, the accumulating large stocks of low-yielding, non-performing liquid instruments
on the balance sheets of commercial banks raise concerns over bank profitability as "the
true cost of sterilization is partly transferred off the balance sheet of the central bank and
onto the balance sheet of the banking system" (Cappiello & Ferrucci, 2008, p.8). In addition,
3 According to Cappiello and Ferrucci (2008, p.16), "China's stock of foreign exchange reserves has grown

around eightfold since the beginning of 2000, to USD$1,202 billion in March-the largest stock in the world,
equivalent to around 46 percent of GDP." At the end of that year, the country's total foreign exchange reserves
reached USD$1,530 billion, close to 50 percent of GDP (PBOC, 2008).

5

according to David Dollar and Shang-Jin Wei (2007), as commercial banks are constrained
by the monetary authority to provide cheap credit to inefficient state enterprises,
especially in the export sector, large distortion and efficiency costs have been incurred as a
result.
Lastly, a rigid exchange rate regime vitiates China's efforts to rebalance the sources
of its economic growth and make it more sustainable in the long run. Over the past decade
or so, China's exceptionally rapid economic growth has relied heavily on manufacturing,
external demand, and investment. While the reliance on manufacturing exports in urban
China has become a growing burden on the environment, overinvestment and the resultant
accumulation of capital in urban industry has led to widening productivity differences, and
therefore income inequality, between urban and rural areas (Hofman & Kuijs, 2007). On
the one hand, these imbalances all appear linked, inter alios, to China's tightly managed
exchange rate regime. On the other hand, a more flexible renminbi exchange rate that is
increasingly driven by market forces can contribute to the country's desired transition to a
more equitable and environmentally sustainable growth path by reducing the profitability
and competitiveness of Chinese exports, and by allowing monetary authorities to raise
domestic interest rates to moderate investment booms in the urban manufacturing export
industry-both of which would translate into reduced export growth in China.
As a result, this paper advocates greater flexibility in the renminbi exchange rate
regime and thus faster revaluation of the renminbi for the sake of China's own interests.
The rest of the paper is organized as follows. Chapter 2 explores the evolution of China's de
facto exchange rate regime since the late 1970s in the context of its development strategy.
Chapter 3 examines the renminbi's alleged undervaluation by providing an overview of the
6

different estimates of its equilibrium REER. Chapter 4 analyses China's current account
surplus and its determinants. Chapter 5 discusses the key challenges facing the Chinese
authorities under the existing currency regime, and makes the case for greater flexibility in
the renminbi exchange rate. Chapter 6 offers some concluding remarks on what can and
should be done to accelerate China's exchange rate reform.
CHAPTER 2- CHINA'S EXCHANGE RATE REGIMES SINCE THE LATE 1970S
2.1 Moving Toward A More Market-Based Exchange Rate Regime (1979-1994)
In the late 1970s, China contemplated its exchange rate reform for the first time
when general economic reforms and liberalization process focused on increasing foreign
trade and investment were adopted by the ruling Communist Party of China. Since a
country's choice of an appropriate exchange rate regime-be it fixed, floating, or
intermediate-can affect its macroeconomic performance such as inflation, cross-border
trade and capital flows, etc., exchange rate policy in China has since been regarded as a
matter of exceptional importance. This, however, was not true before 1978 when China
first launched its economic reforms and open-door policy. According to Zhang (2000),
throughout its system of economic planning from the late 1940s to the late 1970s, market
forces had virtually no role in China's administrative exchange rate arrangements. "It was a
mere accounting device linking foreign trade and the domestic economy" (Zhang, 2000,
p.1076). Moreover, changes in the exchange rate could not affect directly China's overall
balance of payments as the volumes of trade and financial flows were fixed by the central
government as part of the country's import-substitution industrialization strategy.
"The transformation of the role, adjustment rules, and the institutional arrangement
of the renminbi exchange rate since the late 1970s has been successful in bringing
7

'economic realism' to China's official exchange rate which was previously considered
economically meaningless" (Wu & Chen, 1992, p.37). According to Dilip Das (2008), taking
lessons from its dynamic Asian neighbors, the Chinese authorities soon decided to abandon
its strategy of keeping the currency overvalued for the simple reason that a competitively
priced renminbi was imperative for adopting an export-led growth strategy like that in
Japan and other high-performing Asian economies. This in fact explains why in the post
1978 period the renminbi exchange rate, which had long been fixed at overvalued levels,
was devalued repeatedly over a long period of time as economic policies became
increasingly pro-trade (Das, 2008).
In early 1981, in an effort to improve the profitability of exporters and the
competitiveness of Chinese exports in the global market place, the PBOC conducted a major
exchange rate reform exercise in which a dual exchange rate system was introduced-that
is, the official exchange rate coexisted with a market-determined, trade-related internal
settlement rate. According to Goldstein and Lardy (2009), at that point the official rate was
RMB1.5 to the dollar, so the internal settlement rate of RMB2.8 was a devaluation of almost
100 percent. Whereas the official rate was adjusted periodically in response to changes in
the value of a basket of currencies and was used mainly to cover non-trade, service-related
transactions such as overseas Chinese remittances, tourism, etc., the internal settlement
rate was pegged exclusively do the U.S. dollar and was applied to all current account
transactions (Goldstein & Lardy, 2009).
Over the next few years, the official exchange rate was further devalued. It
eventually unified with the internal settlement rate on January 1, 1985 when the PBOC
formally abandoned the latter (Goldstein & Lardy, 2009). In 1986, however, a dual
8

exchange rate system re-emerged in China with the establishment of Foreign Exchange
Adjustment Centers or "swap centers" (Das, 2008). As Das (2008) expounds, under this
new dual-track system, the official exchange rate coexisted with a market-driven, swap
center rate that was "depreciating over time in response to economic fundamentals."
Foreign investors along with domestic enterprises in the four Special Economic Zones
namely Shantou, Shenzhen, Xiamen and Zhuhai, were permitted to trade foreign exchange
on the basis of negotiations between sellers and buyers at over 100 swap centers nationwide. And by 1988, all Chinese enterprises with foreign exchange earnings were allowed to
make use of the swap center rates (Das, 2008).
As economic liberalization and the opening-up process accelerated in the late 1980s,

the PBOC progressively devalued the official rate in an effort to close the gap between it
and the market rates. According to Lardy (2002), in a single step on July 5, 1986, the official
rate depreciated by 15 percent to RMB3. 7 per dollar from its mid-1986 rate of RMB3.2. A
further devaluation in December 1989 took the official rate to RMB4. 7 per dollar. In 1991,
the Chinese authorities summarized the objectives of the renminbi exchange rate reform
as: (1) rationalizing the level of the exchange rate and (2) making full play of the exchange
rate as an economic lever that should be applied to promote exports (Yin et al., 1991). Over
the next four years, the PBOC continued to devalue the official renminbi exchange rate until
it reached RMB5.8 per dollar at year-end 1993 (Lardy, 2002). Figure 2.1 plots the nominal
US dollar exchange rate of the renminbi for the period 1981 to 1994.

9

Figure 2 .1
Dual (Nom inal US dollar) Exchang e Rates of the
Renm inb i. 1981- 199 4
:

~

- - - OltQOI A ale

o----- Secondary Rate

I

71

'
[

6~
5·

1980

1990

1 99~

So u rce: Zhang (2000, pl071)

2.2 De Facto Pegged Exchange Rate Regime (1994-2005)
On January 1, 1994, a major revamp of China's exchange rate system was carried out
when the official exchange rate was devalued further to unify with the prevailing swap rate
of RM88. 7 per dollar4 (Das, 2006). In other words, the dual exchange rate system in China
was formally abandoned. At the same time, the Chinese monetary authorities introduced a
unified, managed floating exchange rate regime with a narrow band of ±0.3 percent around
the reference rate set by the PBOC for interbank transactions (Yi, 2008). Under the new
structure, the renminbi exchange rate was revalued until it reached RMB8.3 per dollar in
June 1995, and then slowly moved to RMB8.28 by October 1997 (Huang & Wang, 2004 ).
However, from that time up to the new renminbi exchange rate reform initiated on July 21,
2005, the nominal value of the renminbi vis-a-vis the U.S. dollar was actually allowed to
fluctuate within a margin of less than ±1 percent around the de facto fixed rate ofRM88.28,
as noted by Yi (2008). Thus, albeit China claimed to have a managed floating renminbi
exchange rate during that period, it "essentially operated its exchange rate system as a de
4 According to Das (2006), the official exchange rate jumped from RMBS.S to the dollar to RMB8. 7 which
amounted to a devaluation of 32.09 percent in nominal terms.

10

facto peg to the U.S. dollar" (Das, 2008, p.61). Figure 2.2 plots the nominal US dollar
exchange rate of the renminbi for the period 1994 to 2005.
Figure 2 .2
Nominal US Dollar Ex change Rate of the Renminbi , 1994- 2005

9 .0
8 .0

Ill

a
ul
:::S

~

I

.......

. . . . . . . . . ·--.......

7.0
6 .0
5 .0
4 .0
3 .0
2 .0
1 .0

Tim e Period

Source: Inte rnationa l Moneary Fund (2008) . IMF Onte rnat i ona l Financ ial Statistics, IF S

In fact, expounds Das (2008, p.59), the option for a de facto U.S. dollar peg during
the 1997-2005 period was regarded by the Chinese authorities as "an essential factor for
vitalizing the external sector." The overarching feature of China's exchange rate reform
thus far corroborated the fact that a relatively higher weight had been attributed to
external competitiveness in its objective function (Zhang, 2000). As the renminbi-U.S.
dollar bilateral exchange rate remained normally stable during that period despite rapid
real GDP growth, rising total factor productivity, robust export expansion and massive
foreign direct investment (FDI) inflows-all these factors would theoretically lead to
currency appreciation, China's exports were given a substantive competitive advantage in
relation to other exporting economies.
2.3 New Managed Floating Exchange Rate Regime (Post 2005)

11

The decade-long fixed nominal exchange rate of the renminbi vis-a-vis the U.S.
dollar had served the Chinese economy well-in particular the export sector. However, in
recent years, it has, along with other factors, contributed to huge internal and external
imbalances in the country. For example, according to Goldstein and Lardy (2009), in 2008
China's current account surplus stood at USD$426 billion or 9.8 percent of the preliminary
GDP announced by the government in January 2009 (see figure 4.1). The increase of
USD$54 billion compared with 2007 was primarily due to the increase in the trade surplus
(Goldstein & Lardy, 2009). Figure 2.3 displays China's balance oftrade from 2005 to 2008.
Faced with increasing pressures to move toward a more flexible exchange rate regime and
to let the renminbi appreciate monotonically in accordance with market forces, the PBOC
on July 21, 2005 introduced a new managed float exchange rate system with reference to a
basket of currencies rather than the U.S. dollar alone. Most importantly, the PBOC said that
the renminbi exchange rate was to become more flexible with its value based more on
market supply and demand (PBOC, 2005). According to Goldstein and Lardy (2008), under
the new renminbi exchange rate regime, the official renminbi-U.S. dollar nominal exchange
rate was immediately adjusted from RMB8.28 to RMB8.11 to the dollar, amounting to a 2.1
percent appreciation against the dollar. By the end of 2008, the nominal renminbi-U.S.
dollar exchange rate was RMB6.83, reflecting a cumulative appreciation of 21 percent
compared with that in July 2005 (Goldstein & Lardy, 2008).

12

Figure 2.3 CHINA BA LAN CE OF TRA DE
~

Jul / 05

Jan /0 6

:f

Jul/0 6

~

~

:- .. :;J

Jan /0 7

Jul / 07

Jan / 08

Source: TradingEconomics.com; General Admin istration of Custom

Turning from the size and variability of renminbi exchange rate changes to the
"basket" characteristics of China post-2005 currency regime, Frankel and Wei (2007) found
that the renminbi continued to trace the U.S. dollar. In other words, only a limited degree of
flexibility was introduced as a result of the exchange rate reforms of July 21, 2005. On
August 10, 2005, for example, the PBOC published the currencies which made up the
currency basket. It included the U.S. dollar, the euro, the Japanese yen and the Korean won
as the four first tier currencies that have the largest weights. Albeit the weight of each
individual currency, which reflected China's geographical distribution of trade, services,
and capital flows, has been kept confidential, it is not difficult to imagine that the U.S. dollar
heavily dominated the weights in the currency basket (Das, 2008).
Since the onset of the global financial crisis in late 2008, however, the PBOC
effectively re-pegged the renminbi near 6.83 per dollar to provide stability to its export
sector in light of weakened external demand. As the recovery and upturn of the Chinese
economy became more solid a couple of years later, the PBOC said on June 20, 2010-just
one week before the G-20 meeting in Toronto-that it would proceed further with its
currency reform by allowing more flexibility in the renminbi exchange rate, despite the fact
13

that no timeframe for the change was given. For example, in a Chinese articled published in
International Finance in August 2010, economist Sibo Wang (2010) points out that since
the PBOC announced the restart of the renminbi exchange rate regime reform a month ago,
the nominal RMB-USD bilateral exchange rate has experienced rapid appreciation only in
the initial stage and two-way fluctuations after that. Wang (2010)'s article examines from
two aspects the trend of the renminbi exchange rate during this period: the flexibility of the
renminbi exchange rate in relation to the currency basket and the speed of the renminbi
appreciation on the initiative, discovering that the renminbi has in fact not appreciated on
the initiative. In addition, the PBOC ruled out a one-time revaluation of the renminbi by
saying that there was no basis for a large-scale appreciation, and kept the renminbi's 0.5
percent daily trading band against the U.S. dollar unchanged. Figure 2.3 plots the nominal
US dollar exchange rate of the renminbi for the post 2005 period.
Figure 2.4
Nominal US Dollar Exchange Rate of the Renminbi. Post 2005
8 .2
8
7 .8
7 .6
7.4

7 .2
7
6 .8
6 .6
6.4
2005-07-21 2006-04-28 2007-02-08 2007-11-23 2008-09-02 2009-06-19 2010-03-31 2011-01-12

Source: People's Bank of China, 2011

CHAPTER 3- RENMINBI'S EQUILIBRIUM EXCHANGE RATE AND ITS ALLEGED
UNDERVALUATION

14

The historical account going back to the late 1970s summarized in the last chapter
give us insights into Chinese policymakers' mentality behind managing the country's rigid
exchange rate regime in the economic reform and opening-up era. The trends of the
nominal RMB-USD bilateral exchange rate since the start of the reform 30 plus years ago,
especially prior to the July 2005 exchange rate reform, indicate the nominal renminbi
exchange rate has been heavily-manipulated by the Chinese authorities to implement an
export-led growth strategy. Over the past few years, monetary authorities in China have
been set against any dramatic changes in their currency regime due in large part to
apprehension that a sharp renminbi appreciation would seriously destabilize the country's
current export-led growth trajectory. As a result, the renminbi has been kept from
appreciating by massive intervention in the international exchange market. Such
intervention in tandem with China's sustained high export growth and a burgeoning
current account surplus hitting a peak of 11 percent of GOP in 2007 (Batson, 2010),
indicates an undervalued renminbi and that "[the] appreciation of the renminbi that has
taken place to date against the U.S. dollar is completely inadequate to make a real dent in
China's huge current account surplus" (Goldstein, 2007, p.2).
Using different measurement approaches such as the Purchasing Power Parity
(PPP), Behavioral Equilibrium Exchange Rate (BEER), and the Fundamental Equilibrium
Exchange Rate (FEER), a good number of empirical studies have been undertaken to
examine whether accusations of an undervalued renminbi can hold. However, by how
much the renminbi is undervalued was, and continues to be, an area of complete
disagreement in international monetary economics. This, according to Das (2009, p.574) is
partly due to the fact that "which [methodology] is appropriate for the purpose of sizing up

15

the undervaluation of the [renminbi] has remained an unresolved issue until the present
time."
The first approach to identify the renminbi's equilibrium exchange rate is, according
to William Cline and John Williamson (2007, p.3), "to find the exchange rate that would
lead to purchasing power parity (PPP)." The PPP approach is perhaps one of the earliest
approaches to determining the equilibrium exchange rates. It provides the long-run
framework for the monetary and portfolio approaches to exchange rate determination.
However, economists such as Cline and Williamson (2007) are skeptical of the PPP
approach in general and its application to China in particular. "One major limitation of the
approach," according to Cline and Williamson (2007, p.4), "is that by definition it means the
United States can never be over- or undervalued: the United States is the numeraire for PPP
exchange rate equal to market rate. This is a gaping hole for an analytical approach,
considering that the US current account deficit currently absorbs the vast bulk of combined
surpluses of the rest of the world." According to the Big Max index of The Economist, which
falls squarely into the PPP category, the value of the renminbi to the dollar was 58 percent
undervalued in 2007 (The Economist, 2007a). However, according to another analogous
index called the "Starbucks talllatte index", the renminbi was only 1 percent undervalued
in 2004 (Das, 2009).
The second approach is the BEER developed by Peter Clark and Ronald MacDonald
(1999). According to Cline and Williamson (2007, p.6), "A [BEER] aims to estimate the
index level to which the market exchange rate might be expected to revert in the medium
or long run, given an absence of shocks." Unlike PPP, which deals in direct price
comparisons for internationally comparable baskets of goods, and in a similar fashion than
16

the FEER (which will be discussed later), the BEER explains the real exchange rate behavior
in terms of economic fundamentals using reduced-form econometric equations. It focuses
on the real exchange rate and the medium-term equilibrium rates of the fundamental
determinants (i.e. internal and external balance proxies). In particular, the BEER approach
can capture the sources of changes in capital accounts as well as other factors affecting the
behavior of the REER. In fact, according to Clark and MacDonald (2000), exchange rate
misalignments resulting from the BEER approach at any point in time can be decomposed
into the effect of transitory factors, random disturbances and the extent to which the
economic fundamentals are away from their sustainable values.
BEER models in China have generally produced much lower estimates of the
renminbi. Studies such as Wang (2004) reported that the renminbi's value to the dollar was
only about 5 percent undervalued in 2003 according to the BEER approach, and Funke and
Rahn (2005) estimated that the renminbi was undervalued by about 3 percent at the end of
2002. A problem with some BEER estimates, according to Cline and Williamson (2007, p.6),
"is that they are calculated from a regression for a single country rather than from crosscountry experience. Such studies are surely incapable of examining whether a country's
policy intervention is or is not making the country over- or undervalued."
The third yet the most widely employed approach is the FEER, or the
macroeconomic balance concept of equilibrium (Das, 2009), introduced into academic
analysis by John Williamson in 1983. The FEER, which is expected to simultaneously
achieve internal and external balance-that is, output growth at its potential level and a
sustainable current account position, is the most important and relevant approach to date
for economists and policymakers to compute the degree of renminbi undervaluation given
17

China's extraordinarily large current account surplus in recent years. It, expounds Das
(2009), is a "rational approach" that tries to answer the question of what level of real
effective, and therefore trade-weighted, exchange rate would generate a current account
surplus or deficit equal to the underlying capital flows over the business cycle, assuming
that the economy is pursing internal balance, which implies full non-inflationary
employment.
Methodologically, the FEER is the most preferred approach by economists and
policymakers alike. This, according to Cline and Williamson (2007, p.4), is "because the
necessary assumption of average equilibrium over the estimation period makes even the
internationally-based BEER approach less reliable." Furthermore, because of its underlying
fragility and likely bias in Chinese price comparison estimates, the estimates arrived at by
the PPP approach are also considered to be unreliable (Cline & Williamson, 2007). We will
thus discuss the FEER approach in more detail. One of the studies in the FEER school is by
Vanessa Rossi (2005) who estimated that the exchange rate of the renminbi was close to
equilibrium in 2000-2001. Projecting from these results, Rossi (2005) predicted that in
2010 the undervaluation of the renminbi against the U.S. dollar would be in the range of
5.5-7 percent. Also using the FEER model, Cline (2007) estimated the needed remaining
appreciation of the renminbi to be in a range of 11 to 18 percent from its 2006 level in real
effective terms and 34 to 39 percent against the dollar.
Why are there large variations in estimates arrived at based on the FEER
methodology alone? According to Cline and Williamson (2007), the major source of
discrepancies among the FEER estimates is the studies' assumptions about how much of
China's current account surplus is strictly cyclical and transitory, thereby how large a
18

change in the current account of the balance of payments should be targeted. After that
come different assumptions about the price elasticities of demand, including assumptions
about the import content of exports, a step that turns out to be critical for calculating how
much the exchange rate would need to move to close the gap between the cyclically
adjusted actual and target current account balances.
On the former issue, the biggest surplus reduction target-which is rationalized by
China's high saving propensity-is one of Tao Wang (2004)'s estimates. Wang (2004)
argues that it is in China's national interest to save in excess of the level of investment that
is efficient at the world interest rate and export the resulting savings as a current account
surplus. In other words, China should aim for a larger current account surplus because it
has a high saving rate. However, as Cline and Williamson (2007) point out, in Wang
(2004)'s exercises phenomena such as China's high saving rate are not calculated to
maximize social welfare of the Chinese citizens, since there are still about a hundred
million social underclass in China who save a large portion of their incomes partly because
much of the saving is corporate and is not their decision at all, and partly because they are
afraid of the future due to the lack of a social safety net. If one holds such a view, then a
current account not enormously different from balance-similar to the objectives of most
of the FEER exercises-seems to be a more natural and reasonable target. Consequently,
Cline and Williamson (2007) consider the Wang (2004) calculations-which estimate
China's cyclically adjusted current account surplus to be around 2 percent of GOPseriously understated. Excluding these estimates, the average for the FEER estimates
summarized by Cline and Williamson (2007) is a needed renminbi appreciation of 27

19

percent in real effective terms and 36 percent in the renminbi-U.S. dollar bilateral exchange
rate.
On the latter issue, one study that investigates the impact of variations in trade
elasticities is that of Steven Dunaway, Lamin Leigh, and Xiangming Li (2006). Their
estimates of the impact of increased export and import elasticities from 1 to 1.5 are
interdependent with those of the current account adjustment to be accomplished: If this is
only 1 percent of GDP, lower elasticities would increase the alleged renminbi
undervaluation by about 4 percent, whereas with a gap of 3 percent of GDP, the impact on
the undervaluation would be about 13 percent (Cline & Williamson, 2007). The difference
is substantial. However, as Cline and Williamson (2007) point out, even after accounting for
the relatively large share of imported intermediates used to produce exports, China's
current account balance should be expected to show relatively high response to the
renminbi's REER in light of its large share of trade in GDP.
So far we have seen that, despite enormous efforts, different econometric exercises
based on different measures have come up with extensively varying estimates of the extent
of undervaluation of the renminbi- ranging from 0 to close to 50 percent. Nevertheless,
the average estimates of 18 studies summarized by Cline and Williamson (2007) indicate
substantial undervaluation of the renminbi. "The simple average of the 14 estimates of the
correction needed in the real effective exchange rate [of the renminbi] is a 19 percent
appreciation; the corresponding simple average of the 16 estimates of the bilateral rate
against the U.S. dollar is an appreciation of 40 percentS" (Cline & Williamson, 2007, p.131-

s "The extreme Big Mac estimate of 138 percent needed appreciation is omitted from this average because the
'simple' PPP approach is widely regarded as inappropriate" (Cline & Williamson, 2007, p.132).

20

132). The 2006 Article IV consultation report of the International Monetary Fund (IMF)
(IMF, 2006) also took this position. For example, Dominique Strauss-Kahn, the managing
director of the IMF, took a swipe at the renminbi in early 2009 and declared it "significantly
undervalued," emphasizing the official position of the IMF (Das, 2008).
CHAPTER 4- CHINA'S EXTRAORDINARILY LARGE CURRENT ACCOUNT SURPLUS AND ITS
DETERMINANTS
4.1 The Upsurge in China's Current Account Surplus in Recent Years
Politicians in the United States and Western Europe often criticize China's rigid
exchange rate regime. Their real concern, however, is probably not China's exchange rate
policy per se, but its large and growing current account surplus-the broadest measure of
net export. It was argued that, by artificially depressing the value of the renminbi, China
took jobs away from its trading partners. It was also argued that the resulting global
imbalances were a cause of the recent global financial crisis. Despite the fact that China's
current account surplus moderated slightly in 2008 and 2009 following the global financial
crisis 6 -as its external demand was seriously dampened, the country continues to display
the world's largest current account surplus in absolute dollar terms (Krugman, 2010).
According to Yiping Huang and Kunyu Tao (2010), the rapid expansion of China's current
account surplus is, in fact, a relatively recent phenomenon with the sharpest rise occurring
after 2004. Within three years, the surplus jumped from USD$68.7 billion (3.6 percent of
GDP) in 2004 to its recent peak ofUSD$371.8 billion (10.8 percent ofGDP) in 2007. Bottom
line is that a surplus of this magnitude relative to GOP is "unprecedented for a country of

6 According to China's State Administration of Foreign Exchange, the country's current account surplus
accounted for 9.9 percent ofGDP in 2008, compared with 5.8 percent in 2009.

21

China's size and stage of development" (McGregor, 2007, p.1). Figure 4.1 plots China's
current account position as percent of GOP for the period 1982 to 2008.
Figure 4.1 Ch ina "s Current Account Posit ion (% GDP), 1985 - 2009

12

10
8
6
4

:
2

-4

••... ••• _.........1. '
~

-6

85

87

89

91

93

95

97

99

01

03

OS

07

09

Sou rce : CEI C Da ra Compan y .

How does one account for an almost tripling of the current account surplus as a
share of the Chinese GOP, from 3.6 percent in 2004 to close to 11 percent in 2007? What is
the root cause of the problem? According to Huang and Tao (2010), there is a long list of
competing explanations that may be helpful for understanding China's growing external
imbalance problem. These explanations may be broadly grouped into four categories: (1)
capital-intensive, industry-led growth with high domestic savings and investment; (2) total
factor productivity improvements; (3) factor market distortions; and (4) exchange rate
distortion and policies supporting export growth. It should be noted that these
explanations are not necessarily mutually exclusive. For instance, the perceived exchange
rate distortion might be applied as a part of the general policies supporting export growth
(Corden, 2009). The upshot is that China's growing current account surplus is a by-product
of the distinct features of China's pattern of growth over the past decades and a variety of
22

policies that are behind it, including, of course-perhaps crucially-its exchange rate
policy.
4.2 Capital-Intensive, Industry-Led Growth with High Domestic Savings and Investment?
We will now analysing each explanation in turn. First, since the current account
surplus is, by definition, the surplus of savings over investment, some economists 8 sought
to explain China's large current account surplus by examining the structural factors behind
its saving and investment behavior. They argue that China's traditionally high household
saving rates have risen further in recent years due to the increasing need to provide for
healthcare, basic education, employment insurance and pension, given the lack of sufficient
public provision of these services for the bulk of the population resulting from the
restructuring of state-owned enterprises starting in the mid-1990s. In addition, investment
rose with savings, but less rapidly. For example, from 2000 to 2006, saving outpaced
investment even as the investment to GOP ratio increased by 10 percentage points during
that period (He & Kuijs, 2007). Due in part to the widening of the domestic savingsinvestment gap during this period, China's external imbalance has thus boomed-as
reflected in the sharp rise of current account surplus from 1. 7 percent of GOP in 2000 to an
estimated 9 percent of GOP in 2006 (He & Kuijs, 2007). It is further argued that the
increasing share of household savings in GOP has been matched by a rapid decrease in that
of consumption. Although domestic consumption has grown rapidly in China for many
years, it has lagged behind the overall growth rate of the economy.

7 According to Jianwu He and Louis Kuijs (2007), FDI has played an important role in China's development, in

particular in transferring foreign technology. However, at 3-4 percent of GOP, FDI has not been a key source
of financing. Indeed, as in most countries, domestic saving has been the key source of financing.
8 For example, Feenstra, Hai, Woo and Yao (1999)

23

However, contrary to popular thinking, household savings has not been the main
driving force behind the impressive increase in China's domestic savings in recent years.
According to Huang and Tao (2010), Chinese household savings as a share of GDP have, in
fact, been very stable over the past decade, fluctuating slightly around 20 percent. This rate
is certainly high compared to those in the OECD countries, but no higher than that of other
rapidly growing East Asian ones (Huang & Tao, 2010). In fact, owing partially to low
wages 9 and absence of payments of taxes or dividends to the government, much of China's
high savings is done by corporations whose profits and thus savings have been
experiencing a persistent increase in recent years (Carden, 2009). Corporate savings in
China, according to the Bank of China governor Zhou Xiaochuan, were about 22.9 percent of
GDP in 2007, roughly doubling their share in 1992 (Zhou, 2009). Thus, rising corporate
savings has probably been the key factor of China's large and growing current account
surplus in recent years. Zhou (2009) also suggested that, given its unique income
distribution pattern, China should increase the investment rate, in addition to lowering the
saving rate, in order to reduce its current account surplus. The only problem, however, is
that China's investment has already risen very rapidly in recent years, both in terms of level
and as a share of GDP. 1o According to Huang and Tao (2010), investment has in fact become
the single most important driver of China's overall growth, accounting for almost 50
percent of real GDP growth in 2010. Consequently, China probably has limited room now to
further raise the investment rate.

9 Notwithstanding reported increases in average urban wages, unskilled worker wages have not increased

much because of continuous massive labor inflows from the rural economy to urban centers (Corden, 2009).
1°From around 35 percent in 1995 to 44 percent in 2006-a record high by regional standards and a level
comparable to that in several other East Asian economies prior to the 1997-98 crisis (Cappiello & Ferrucci,
2008).
24

As Cappiello and Ferrucci (2008) point out, high investment shares of GOP are not
uncommon for catching-up economies like China that need comparatively faster capital
accumulation to keep the capital stock constant as a share of GOP. In principle, rapid
investment growth may result from a rational response by the corporate sector to
expectations of future demand growth in sectors that are doing well at present. By the
same token, since industry is more capital intensive than other sectors, it requires a lot of
investment both to offset depreciation and to expand capacity (He & Kuijs, 2007). As
corporate profitability has remained broadly sound in China over the past few years, much
of the country's industrial investment can be financed through retained earnings of
profitable firms (which are counted as corporate savings). Another part of the correlation
between investment and industry runs via government investment. According to Jianwu He
and Louis Kuijs (2007, p.7), "In fast industrializing countries like China, heavy investment
in infrastructure supports industrialization ... The infrastructure pays off in terms of more
growth and, indirectly, more government revenues." That is why the high government
investment in infrastructure will continue to be part of the pattern of growth in China.
Furthermore, according to Prasad (2007), growth accounting analyses suggest that
investment in physical capital has been a major contributor to China's growth during the
past decade, in some recent years accounting for nearly two-thirds of nominal GOP growth.
Gross fixed capital formation in factories, buildings, infrastructure, etc. has, in fact, always
been high in China, but it increased even further from 35 percent of GOP in 2000 to an
estimated 45 percent of GOP in 2006 (Prasad, 2007). This was combined with a rise in
gross domestic savings from 37 percent of GOP in 2000 to an estimated 51 percent in
2006-one of the highest shares among economies of comparable size and level of

25

development, according to He and Kuijs (2007). Private consumption, by contrast, has
made a much smaller contribution to China's growth during the same period. Thus, one
distinct feature of China's growth pattern is that it is increasingly capital-intensive and
industry-led, with high and increasing domestic savings and investment. Such growth
pattern has certainly served the Chinese economy well in many respects. But, as Prasad
(2007) points out, one consequence of this investment-heavy expansion has been relatively
slow employment growth. 11 Moreover, "[w]hile factor accumulation is a time-honored path
to higher growth for many developing countries, whether such a high level of savings
intermediated mainly through an inefficient banking system can produce long-lasting
welfare gains is dubious" (Prasad & Rajan, 2006, p.6).
4.3 Total Factor Productivity Improvements
Another important explanation for the sharp rise in the current account surplus in
recent years is that the Chinese economy underwent a strong, positive productivity shock
which made Chinese exports far more competitive in international markets than they have
ever been. According to Bert Hofman and Louis Kuijs (2007), an important feature of
China's growth is that much of the GOP growth has come from rapid growth of industrial
production 12 -much of it in the form of higher labor productivity. To a large extent, this is
due to an earlier investment boom in physical capital and hence, increased capital-labor
ratio. For example, "[i]n recent years the contribution of capital accumulation to labor
productivity growth increased from 3.3 out of 7 percent per year in 1978-1993 to 5.3 out of
8.4 percent in 1993-2005, a very high figure compared with other countries" (He & Kuijs,
11 For example, from 2000 to 2005, growth of total non-agricultural employment averaged only 3 percent per
annum compared with average non-agricultural GOP growth of about 9.5 percent (Prasad, 2008).
12 "In 2003-06, industry contributed 60 percent of total GOP growth in China, compared with 6 percent by
agriculture and 34 percent by the services sector" (Hofman & Kuijs, 2007).

26

2007, p.3). Thus, contrary to popular thinking, total factor productivity has not been low in
China, and high capital accumulation explains the bulk of the difference in labor
productivity growth between China and other countries or regions.
As Goldstein and Lardy (2008, p.12) points out, "Despite a 9 percent appreciation of
the renminbi vis-a-vis the US dollar between June 2005 and August 2007, the price of
Chinese goods imported into the United States was basically unchanged." 13 Since profit
margins in China's export industry have increased (World Bank, 2007) rather than
decreased, "[the] most likely explanation is that productivity growth in those industries
exporting to the United States was sufficiently large that firms could more than absorb the
adverse effect of the rising value of the renminbi on their earnings" (Goldstein & Lardy,
2008, p.23). Goldstein and Lardy (2008) continue to argue that the combination of a
nominal appreciation of the renminbi vis-a-vis the U.S. dollar of about 9 percent and
unchanged price of Chinese imports in the United States suggest that total factor
productivity growth in China's export industries was about 9 percent between June 2005
and August 2007. Gang Fan, another economist with CASS, is one of many China experts
who express support for Goldstein and Lardy's "hidden productivity thesis." Specifically,
Fan (2007) points out that rapid productivity growth helps explain why profitability in
Chinese corporations has recently been high, and why import substitution has been a
prominent feature of China's recent net export surge. Thus, total factor productivity
improvements in China's export industry are a convincing explanation for China's rising
current account surplus in recent years.

According to Goldstein and Lardy (2008, p.l2), "Prices of Chinese imports in August 2007 were 0.2 percent
less than in June 2005. These estimates are not based on unit values of imports but take into account the
changing composition and quality of imported goods."
13

27

4.4 Factor Market Distortions
Yet another explanation about China's growing current account surplus is factor
market distortions-which are also considered to be part of the Chinese government's
broad policy measures to support its export-led growth model. The hypothesis is that during
China's economic reform period, while the government focused on reform of the product
markets, including abandoning policy interventions in domestic markets and liberalizing
trade, it has, in contrast, adopted measures distorting prices of almost all factors including
labor, land, energy and the natural environment in order to achieve rapid export growth.
These factor market distortions have indeed exerted more upward pressures on China's
already large current account surplus by lifting producers' profitability, investors' returns,
and hence the international competitiveness of Chinese exports to even higher levels.
According to Huang and Tao (2010), estimated factor market distortions, in fact, provide
"good fits" of China's external sector surplus which rose after 2004 but peaked in 2006 at
12.2 percent ofGDP.
a) Distortions in the Labor Market
China's labor market has become highly distorted over the past decade or so. China
is well-known for its abundant and cheap labor. This was a key factor behind China's
success in labor-intensive manufacturing exports. According to Huang and Tao (2010),
labor costs in China may be distorted for two interrelated reasons: segmentation of rural
and urban labor markets and under development of social welfare systems. Labor market
segmentation in China was largely a result of the household registration system (HRS)
introduced in the pre-reform era. Although the HRS has not prevented much migration in
China recently, evidenced by the largest migration in human history with nearly 150
28

million people on the move by early 2011 (National Bureau of Statistics, 2011), it
conditions the terms on which migrant workers from rural areas have been able to obtain
work and basic social services in urban areas, and thus erects important barriers for labor
mobility in China.
According to James Lee (2009, p.1), more than half of China's population lives in
rural areas, and "as a legacy of past economic and pension policies, there is great disparity
in both economic development and pension coverage between the urban and rural
populations." While the urban population is generally better covered, the rural populations
sit outside the scope of any pension coverage. Indeed the pension system and reform
process in China have thus far largely ignored the rural sector. According to the World
Bank (2009), China's pension system covered just 15 percent of the population as of March
2008. Moreover, "alongside the transition from collectivized agriculture, households in
rural China also faced increasing integration with the broader Chinese economy, as well as
international markets" (Benjamin et al., 2005, p.9). The HRS which limited the movement of
people out of agriculture and the rural areas where productivity and income are much
lower 14 has also generated changing terms of trade between agricultural and nonagricultural products over the period of the reform, especially in the latter half of the
1990s. As a result, agricultural prices in China declined in relation to non-agricultural
prices (He & Kuijs, 2007). This not only reduces production costs in urban manufacturing
industries by lowering both input and labor costs-which further improves exporters'
profitability and accentuates China's already large external surplus, it is also an important

14 According to He and Kuijs (2007), productivity in agriculture is about 1/61h of that in the rest of the Chinese
economy, compared to a global average ratio of 1/3.

29

reason behind the increase in rural-urban income inequality as measured by the Gini
coefficient.
Furthermore, during the last decade and a half, pushed by insufficient employment
opportunities in rural areas and their abundant labor resources, and pulled by the fastgrowing manufacturing industries and the relatively high standard of living in urban areas,
China has witnessed a domestic migration of workers from rural to urban areas on an
unprecedented scale. This has resulted in the emergence of a large urban "underclass" who,
lacking local or urban household registration, cannot access any of the basic social welfare
benefits urban residents are entitled to, such as medical insurance, pension coverage,
unemployment support and compulsory 9-year basic education, even if they have been
working in cities for years. On the one hand, the large increase in the number of noncontract based, migrant workers in China's urban labor market has undoubtedly facilitated
the efficient allocation of labor in accordance with market demand and supply; on the other
hand, it poses a serious challenge for the development and enforcement of regulations that
can offer adequate protection to those workers who now face new forms of social
insecurity. According to Huang and Tao (2010, p.15), "Should urban employers make social
welfare contributions for their migrant workers, their payrolls could rise by about 35 to 50
percent, which includes contribution to pension (20 percent of payroll), medical insurance
(6 percent), unemployment benefit (2 percent), working injury insurance (1 percent),
maternity benefits (0.8 percent) and housing entitlement (5 -10 percent)." Thus, social
welfare contribution is the most important area of distortion or underpay in China's labor
market.
b) Distortions in the Markets for Land, Energy, and Primary Commodities
30

Over the past decade or so, also due in part to the Chinese government's deliberate
policy measures to support export-led growth, the markets for land, energy, and primary
commodities have also become highly distorted. These distortions which have put
increasing strains on the environment, generally push factor prices and, therefore,
production costs below levels otherwise would be in market environment.
First, according to Huang and Tao (2010, p.16), "land [in China] is owned by the
state in the cities and by the collectives in the countryside." However, since the start of the
economic reform, especially over the past 20 years or so, local governments have been
selling user rights of land to private investors and property developers on an
unprecedented scale. According to official (National Bureau of Statistics of China) Chinese
data, investment by the private sector in fixed assets such as factory buildings and
machinery grew nearly threefold between 2000 and 2005. In addition, the private share of
total fixed-assets investment which includes investments by collective enterprises (many
of which are private) has risen from 42 percent to 60 percent during the same period (The
Economist, 2007b ). However, since for a long time there had not been any market

mechanism for determining land prices for industrial use in China, they were often set by
the local governments at artificially low levels through under-the -table negotiations in
order to attract investment and promote growth. Local governments sometimes even
compete with each other in offering preferential policies to attract investment. For
example, "[i]n recent years, the average fees collected from negotiated granting of land use
rights were only about 16 percent of those collected through auctions" (Huang and Tao,
2010, p.16). Furthermore, according to The Economist (2007b), since most of the land
appropriated for housing and factory construction has been farmland in rural areas, it has

31

rendered millions of farmers landless. In fact, many of the land owners in China have been
given little or no compensation for their land loss. This probably explains why property
and land disputes have become a leading cause of social unrest in China in recent years
(The Economist, 2007b).
Next, because China's export-led growth has been particularly intensive in energy,

primary commodities, and other natural resources, its overall reliance on these inputs is
high. For example, according to He and Kuijs (2007), in 2007 China used 4.5 times as much
energy per US dollar of output as the United States (at market exchange rates), and 7.5
times as much as in Japan. Also in 2007, China consumed more than 30 percent of the
world total consumption of coal, steel, tin and cement (Streifel, 2007). However, as Huang
and Tao (2010) expound, when international prices of key energy products such as oil, gas,
and coal moved violently upward, the Chinese government were reluctant to follow for fear
of disrupting economic growth. For instance, when international crude oil prices reached
their recent peak, at close to $150 per barrel in 2008, the equivalent domestic prices were
only around $80 per barrel in China (Huang & Tao, 2010). With the acceleration of industry
growth and as the markets for land, energy, and primary commodities become increasingly
distorted, emission and pollution are another problem facing China today.
According to He and Kuijs (2007), after a long period of declining nitrous oxide
(NOx) and sulphur dioxide (S02) emission, they rose again since 2003. "With 16 of the 20
cities with the worst air pollution in the world are in China, the country has become the
largest source of S02 emission in the world and may soon become the largest emitter of
carbon dioxide (C02); some say the country already is" (He & Kuijs, 2007, p.10). Today,
poor air quality is still a very visible issue in China, and costly, especially in large cities. A
32

recent study done by the World Bank (2007) estimates that the health costs of air pollution
amounted to about 3.8 percent of the Chinese GOP in 2007. In addition, according to
Hofman and Kuijs (2007), one-third of China's landmass regularly experiences acid rain,
causing an estimated environmental damage of some $13 billion U.S. dollar, or 1 percent of
China's (2003) GOP per year. "Since producers do not always fully compensate their
damages to the environment, it reduces the short-term production costs, at the expense of
long-term development of the whole economy and society" (Huang & Tao, 2010, p.17).
Thus, despite China's remarkable economic progress, it still has a long way to go to make
its growth more environmentally sustainable.
4.5 Exchange Rate Distortion and Policies Promoting Export Growths
Finally, we move to the central question and the most reasonable explanation for
the surge in China's current account surplus in recent years, at least on the surface. In the
view that exchange rate distortion and policies supporting export have played a crucial role
in boosting China's current account surplus, an increasingly undervalued renminbi under
China's current rigid exchange rate regime raises the country's export and depresses its
imports, and thus inflates its current account surplus. The common argument, which has
been most frequently referenced in public debate about China's external imbalances, is that
if the renminbi were allowed to float, it would appreciate substantially more, and this
would reduce China's high current account surplus.
According to Goldstein (2007), despite an appreciation of the renminbi against the
U.S. dollar since June 2005, the REER of the renminbi-widely regarded as a more
comprehensive and superior measure of the overall competitiveness of Chinese exportshad actually depreciated since the dollar peak in February 2002. The depreciation ranges
33

from 2 to 11 percent, depending on the measure chosen (Goldstein, 2007). Figure 4.2
displays China's REER from 1994Q1 to 2008Q2. According to Lardy (2007), usually,
external payment adjustments call for appreciation of the REERs of the domestic
currencies, that is, for declines in external competitiveness in countries with large current
account or trade surpluses. In the case of China, however, the REER of the renminbi has
moved in a direction opposite to what is needed. Lardy (2007) continues to argue that even
indicators of the REER understate the improvement in China's competitive position in
global trade because "the price indices used to construct them include some non-tradable
goods and hence do not give adequate weight to rapid productivity growth in China's
export industries.
Figure 4.2 China 's Real Effective Exchange Rate, 1994Ql-2008Q2
110

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~~

Time Period

So urce: Internation al Monetary Fund (2008), IM F (Internat ional Fi nanc ial Stat isti cs, IFS)

Goldstein and Lardy (2006) applied the "underlying balance" approach to evaluate
the misalignment of the renminbi. As discussed in Chapter 3, the essence of their approach
was to calculate the needed adjustments in the renminbi's REER in order to retain a

34

"normal" current account balance. They concluded that resisting underlying pressures for
REER appreciation-coming partially from China's high productivity growth in its traded
goods sector relative to that of its trading partners-had contributed to growing trade
surplus and, at least in some years, had fed very large portfolio capital inflows, which
appeared motivated by an expectation of renminbi appreciation. Furthermore, applying
data for the period of 1994 to 2003, Xiangqian Lu and Guoqiang Dai (2005) examined the
long-run relationship between China's international trade and the renminbi's REER.
Results of their co-integrated vector auto regression (VAR) model suggested that the
renminbi's REER had significant impacts on China's exports and imports. These results
confirm the fact that the renminbi's REER has indeed been an important determinant of
China's anomalous current account imbalance in recent years (Huang & Tao, 2010).
Nevertheless, it is important to point out that the maintenance of a rigid exchange rate
regime since at least the mid-1990s is only part of China's export-led growth strategy, and
that by the same token, the country's large external surplus is a by-product of policies
supporting export growth.
Yu Yongding, another prominent economist with CASS, identified China's exportpromotion policy, which includes the so-called "self-balancing" regulation, exchange rate
policy and tax rebate, as another contributing factor to China's current account surplus in
recent years. According to Yu (2007), the Chinese authorities demanded foreign investors
to guarantee the "self-balancing" of foreign exchange for important investment projects. In
other words, FDI in China must be export-oriented. This is evidenced by the fact that all the
multinational corporations are now in China, and all of them aim to export to the
international market. In 2009, for example, 60 percent of China's export is actually from
35

multinational corporations, either joint ventures or foreign investment companies (Corden,
2009). This, as concurred by Corden (2009), is another fundamental reason for China's
growing current account surplus in recent years.
Yet there have also been other factors. As is pointed out by Prema-chandra
Athukorala (2009), China's accession into the World Trade Organization (WTO) in 2001
significantly improved the attractiveness of its domestic investment climate for exportoriented production. Consequently, the process of relocation to China, from Japan, Taiwai
and Korea especially, of final assembly activities of information and communication
technology products accelerated. In addition, according to Corden (2009), WTO accession
contributed significantly to improve investor confidence in the Chinese economy, and this
might also be regarded as a productivity improvement in the export sector. Although this
showed up in China's current account balance with a time lag (Corden, 2009), the overall
picture is that China's export growth intensified following its WTO accession.
The Chinese authorities' policy bias in favor of strong, export-led growth is well
known. In fact, a significant part of China's growth stems from increasing production of
manufactured goods. According to Hofman and Kuijs (2007), while aggregate demand and
supply in China's economy are growing broadly in line with each other, a large share of the
demand is coming from abroad, instead of Chinese households and businesses. Under the
investment-heavy, export-oriented pattern of growth, and with surplus labor in agriculture
keeping wage growth below productivity gains, production in China increasingly outstrips
domestic demand (Hofman & Kuijs, 2007). Thus, from an external perspective, accelerating
manufacturing production means continued strong export expansion.

36

Also according to Huang and Tao (2010), over the past few years China has chosen
to boost manufacturing production at whatever costs. One prosaic explanation is that China
still has huge surplus labor in the countryside, and at the same time does not have welldeveloped social welfare system. Thus, a key challenge facing the government is job
creation. The widely accepted 8 percent growth target, for instance, was formulated based
on employment pressure (Huang & Tao, 2010). Another policy orientation, according to
Huang and Tao (2010), is to maintain stability on the domestic and external fronts while
opening up to trade and financial flows, especially after the Asian financial crisis in 199798. In this context, the buildup of foreign exchange reserves resulting from these policies
may serve as a form of self-insurance against vulnerabilities arising from the country's
weak baking system. However, as Eswar Prasad and Raghuram Rajan (2006, p.S) point out,
there comes a point when the policy distortions-especially exchange rate distortionneeded to maintain this approach "could generate imbalances, impose potentially large
welfare costs, and themselves become a source of instability."
In fact, at least since 2006 China's foreign exchange reserves have been well above
the level that seemed to be required (Carden, 2009). Consequently, the Chinese authorities
have made improving quality of growth a top policy priority (see, for example, Wen 2006).
Albeit exchange rate policy-as reflected in the reluctance to let the renminbi appreciate in
line with China's development progress-has just been one part of the story, it can and
does affect the country's external surplus. Does it really matter anyway? As Jonathan
Anderson (2008, p.66) points out, "Whatever the driving force, the fact that China has seen
a high and sharply rising current account surplus over the past few years clearly means
that the renminbi is undervalued in a near-term, workaday sense." Consequently, if the
37

Chinese authorities were really hoping to reduce the country's external surplus, a more
flexible exchange rate regime that would bring about significant real appreciation of the
renminbi could definitely be part of the policy prescription.
CHAPTER 5- CONUNDRUMS FACING THE CHINESE AUTHORITIES UNDER THE CURRENT
EXCHANGE RATE REGIME
5.1 Monetary Policy Independence
As China undergoes market reforms and integrates into the world economy,
monetary policy is a crucial means through which the Chinese authorities manage the
country's complex and rapidly changing economic situation. Because monetary policy
carries with it system-wide implications for the Chinese economy, even at the
microeconomic level, the flexibility and effectiveness of monetary policy are of particular
importance under China's unique circumstances. More specifically, according to the Deputy
Governor of the PBOC Hu Xiaolian, "[m]onetary policy in China helps achieve various
objectives, including managing inflation, supporting growth, promoting a balanced BOP
account, boosting employment and facilitating financial reform" (Hu, 2010, p.1). However,
over the last decade or so, China's rigid exchange rate regime has imposed a substantial
constraint on the conduct of its monetary policy and the impact is likely to continue
(Goldstein & Lardy, 2006; Lardy, 2006; Prasad et al., 2005).
According to Hu (2010), prior to 1993, China ran surpluses in the current account
and in the capital account-the two principal divisions of the balance of payments (BOP)on an alternate basis. The situation changed in 1994 when China began to run "twin
surpluses" of its BOP (a large and growing current account surplus compounded by a
surplus in the capital account), and intensified following China's accession to the WTO in
2001. For example, China recorded a current account surplus of USD$250 billion in 2006
38

(9.3 percent of GOP), on top of which net financial inflows 15 contributed to increase further
the country's overall BOP surplus (Cappiello & Ferrucci, 2008).
Normally, a large expansion of BOP surplus would lead to appreciation pressures on
the domestic currency, which in turn would lead to deterioration in the country's
competitive position in international trade. This can happen even with little flexibility in its
exchange rate regime. However, resisting pressures for renminbi appreciation, the PBOC
intervenes massively in the foreign exchange market by purchasing a large amount of
foreign exchange-to the tune of about US0$20 billion a month in 2006 and US0$45 billion
a month in the first quarter of 2007 (Goldstein, 2007). According to Goldstein (2007, p.7),
in each of the past three years from 2007, "China's exchange market intervention has
amounted to roughly 10 percent of its GOP-a truly extraordinary amount." The renminbi
equivalent of foreign exchange purchases has in turn fueled a surge in the supply of base
money, and generates a "liquidity overhang" in the banking and financial system. Such
liquidity overhang has in turn led to inflation in the Chinese economy. For example, the
inflation rate in China was last reported at 5.3 percent in April 2011, compared to an
average of 4.25 percent over the 1994-2010 period (PBOC, 2011). 16 Moreover, in a recent
Chinese article, CASS economist Qiyuan Xu (2010) points out that the official CPI data has
been "systematically under-reported by the government" since his research found that over
7 percent of price increases in the Chinese economy could not be explained by the
subcategories and their assigned weight for the past 5 years or so.

15 According to Cappiello and Ferrucci (2008), net FDI inflows in China averaged nearly 5 percent of GOP
annually in the five years prior to the Asian financial crisis. They have fallen since then, but were still US0$61
billion in 2006 (2.3 percent of GOP). Other capital flows-probably mostly speculative in nature-grew
significantly in 2004 (to US0$91 billion) but were negative in the following two years.
16 Source: PBOC Statistics for 2011 and author's own calculations.

39

Under the current situation, relatively high domestic interest rates would be needed
to cool down China's "overheated" economy and to rein in inflation. However, the paradox
is that higher domestic interest rates in relation to foreign rates would attract higher levels
of speculative capital inflows, which would put even higher upward pressures on the
renminbi exchange rate. Furthermore, as Goldstein and Lardy (2009) point out, "[c]apital
controls, in theory, could prevent large inflows [of international capital] when domestic
interest rates are higher than foreign rates, but in practice it is difficult to maintain
effective controls over time, particularly in an economy [like China] that is very open to
trade."
In fact, as Robert Mundell (2004) points out, the serious challenges faced by China's
monetary policies are those implied by the "impossible trinity" hypothesis which
postulates that in an integrated world economy, it is impossible for a country to achieve
simultaneously exchange rate stability, monetary independence, and free international
movement of capital. So far, however, it appears that it has been possible for the Chinese
authorities to keep the renminbi exchange rate relatively stable without overriding
domestic monetary policy.
This, according to Cappiello and Ferrucci (2008), is achieved by "imposing tight
controls on the capital account and by maintaining close restrictions on the cross-border
movement of capital... [which] has allowed a certain degree of monetary autonomy to be
retained through the use of administrative measure, such as increase in the reserve
requirement ratio on bank deposits and the so-called 'window guidance' policy, which aims
to control the growth of domestic credit to certain sectors" (Cappiello & Ferrucci, 2008,
p.15). For example, the compulsory reserve requirement ratio on bank deposits increased
40

from 7.5 percent in July 2005 to 19.5 percent in May 2011 (PBOC, 2011). Nevertheless, as
Hu (2010) points out, the root cause of China's liquidity problem, i.e., the rapid expansion
of renminbi supply as a result of foreign exchange purchases has not been solved. Thus, if
China wants to ensure price stability and, by doing so, to promote higher-quality economic
growth, it must face a trade-off between exchange rate stability and interest rate
liberalization, which is a key condition for the development of an independent and effective
monetary policy.
5.2 China's Large Hoarding of Foreign Exchange Reserves
Also as a net result of China's current account surplus, its massive open-market
foreign exchange interventions, as well as capital inflows responding to the incentives
created by its rigid exchange rate policy, the PBOC has accumulated an extraordinarily
large hoarding of foreign exchange reserve (now passed USD$3 trillion) with U.S. dollars
making up a large part of the total. Given that China trades mostly with the United States,
the choice of the U.S. dollar as the primary reserve currency is not surprising. However, the
resultant rapid accumulation of U.S. dollar-denominated foreign assets-predominately in
the form of the U.S. Treasury bills (T -bills )-entail some large risks and costs, and therefore
has not been in the long-term interest of China. As Carden (2007) explains, China's
ownership of vast amounts of U.S. T-bills-which are regarded as the least risky
investment available on the planet-tends to yield a very low rate of return and is very
likely to lose real value relative to the prices of non-dollar goods in the face of U.S. dollar
depreciation.
The Chinese authorities seem to be well aware of this problem, but the low yield
does not seem to bother them much. They are, apparently, worried more about the fact that

41

around 70 percent of their foreign assets are dollar-denominated, so any sharp decline in
the value of the U.S. dollar would mean huge capital losses on the balance sheet of the
Chinese monetary authority (Krugman, 2009). "Suppose that the eventual dollar decline
andre-equilibration of the renminbi result in a 20 percent capital loss for China. This
would amount to USD$400 billion or roughly 10 percent of the Chinese GOP," according to
economist Arvind Subramanian (2009). In fact, the threat of dollar deprecation has become
more immediate due to the continuous deterioration in the fiscal balance of the U.S.
economy.
Certainly, China would like to tear itself away from the U.S. Treasury market, but as
one might expect, "[a] precipitous action by China to shift aggressively out of U.S. dollardenominated instruments, or even an announcement of such an intention, could act as a
trigger that nervous market sentiments coalesce around, leading to a sharp fall in bond
prices and the value of the U.S. dollar" (Prasad, 2010). As a result, the Chinese authorities
have shown few signs of attempting to weaken the dollar. The reason for this seems
straightforward: such a move would not be without cost for China. After all, China is the
world's largest dollar investor, and no one else would have less interest in seeing the value
of the U.S. currency plummet than China would. In a recent New York Times column, Paul
Krugman (2009) argues that China has in fact "driven itself into a 'dollar trap', and that it
can neither get itself out nor change the policies that put it in that trap in the first place."17

17 Recently, some Chinese policymakers argue that renminbi appreciation would have the same effect on the
value of China's foreign exchange reserves. For example, in an article published on Caixin's Century Weekly
on May 2, Anyuan Zhang, head of the fiscal and financial policy research division of the National Development
and Reform Commission (NDRC)'s Institute of Economic Research, predicted that China will lose USD$578.6
billion in its foreign exchange reserves if the nominal RMB-USD bilateral exchange rate drops to 6. However,
an unnamed official with China's State Administration of Foreign Exchange (SAFE) said in a statement May 6
that renminbi appreciation will not directly reduce the value of China's foreign exchange reserves. According
to the statement, the real purchasing power of China's foreign exchange reserves would remain unchanged

42

5.3 Banking Sector Reforms
In order to prevent the risks of hyperinflation in the domestic economy, China's
central bank must conduct large-scale, open-market sterilization operations. However,
such sterilization may not only run into limits quickly, it entails some costs on the domestic
banking system. These costs, which are likely to increase more than proportionally as the
stock of China's foreign exchange reserves rises (Cappiello & Ferrucci, 2008), may in turn
hamper banking sector reforms in China. According to Cappiello and Ferrucci (2008),
China's open-market sterilization operations are normally carried out through sterilization
bills issued by the central bank. As a rough estimate, the PBOC currently sterilizes around
half of the increase in its foreign exchange reserves, and in March 2007, the outstanding
stock of sterilization debt was around 40 percent of official reserves (Cappiello & Ferrucci,
2008). However, as the total stock of sterilization bonds increases, the PBOC have to offer
increasingly higher interest rates or yields to convince domestic economic agents to hold
them. As Goldstein and Lardy (2009, p.28) point out, "Eventually, the interest the central
bank pays on these bonds could exceed it earnings from its holdings of interest-bearing
foreign currency-denominated financial assets, imposing a substantial financial constraint
on sterilization operations."
Equally important, such sterilization operations have also perpetuated large
efficiency costs due to the provision of large amounts of low-yielding central bank bills
mainly to inefficient state-owned enterprises (Dollar & Wei, 2007). According to some
estimates, loans extended since 2002 represent around 57 percent of the total loan book of

despite fluctuations in the renminbi exchange rate. Substantive changes would occur only when huge
amounts of reserves are repatriated and converted to the renminbi, a scenario that is unlikely to happen
because China faces no such pressure.

43

Chinese commercial banks (Setser, 2005). Thus, as Cappiello and Ferrucci (2008) expound,
the health of China's banking system depends increasingly on the quality of the central
bank loans extended during the current lending boom. If a fraction of these loans becomes
non-performing, commercial banks in China could face huge capital losses.
Furthermore, in order to control credit growth given the inability of the PBOC to use
interest rates as a primary tool of monetary policy, the Chinese authorities have to resort to
credit quotas such as required reserve ratios for individual banks as well as various types
of "window guidance" on bank lending as mentioned earlier. This, however, "vitiates the
process of banking reform by keeping banks' lending growth under the administrative
guidance of the [PBOC] rather than letting it be guided by market signals" (Prasad, 2007,
p.8). In the first quarter of 2011 alone, as inflationary pressures remain in the spotlight, the
PBOC raised the ratio three times to a record high of 20 percent, based on its public
statements (Back & Orlik, 2011). The upshot, according to Goldstein and Lardy (2009,
p.30), is that the PBOC's need both to place large amounts of low-yielding sterilization bills
with commercial banks and to repeatedly raise their requirement reserves (which likewise
pay low interests) has an adverse impact on the profitability of these banks, and thus
"hindering their transition to operation on a fully commercial basis."
5.4 Rebalancing of the Chinese Economy
Lastly, a few statistics quickly illustrate how skewed or unbalanced China's
economic structure has become in recent years. According to Simon Tilford (2009, p.1),
"While the household savings rate is running at over 20 percent of income, household
consumption represented just 35 percent of GOP in 2008-an exceptionally low share by
any standards." This is probably a product of social and culture forces, which still

44

emphasize savings. Nevertheless, China has been able to produce much more than it
consumes by exporting the difference. The surge of cheap Chinese products has definitely
benefited consumers in the advanced economies-notably the United States-by boosting
their disposable incomes, but, at the same time, distorted China's economic structure.
For their part, the Americans have been able to live beyond their means because of
the readiness of the Chinese authorities to purchase huge quantities of U.S. government
debts in the form of U.S. Treasury bonds and bills. This, according to Tilford (2009), is a
reversal of the norm. "Developing countries usually import capital because their domestic
savings are inadequate to meet their high investment needs ... For a developing country to
be lending capital to the most important developed economy in order for it to buy the
developing country's goods is not something that has happened before" (Tilford, 2009, p.2).
However, Tilford (2009) continues to point out that if something cannot go on forever, it
will not. Countries cannot run huge deficits indefinitely-not even the U.S. The recent
global financial crisis has indeed demonstrated this. In fact, the current account deficits of
big consumer countries like the U.S. are narrowing, and this trend will likely to continue.
U.S. households, for example, are likely to save more in the years ahead, and hence
consume less. The Obama administration has recently made plain that the world can no
longer rely on the U.S. acting as the "consumer of last resort." It is against this backdrop
that many Chinese policymakers have started to fear that Chinese exports will never again
play the same role in driving growth in the Chinese economy.
Indeed, China's leadership is aware that there needs to be a rebalancing of its
economy if the country is to maintain its rapid economic growth. For example, in a recent
government work report to the annual parliamentary session, Chinese premier Wen Jiabao
45

said: "We should focus on restructuring the economy, and make greater effort to enhance
the role of domestic demand, especially consumption, in spurring growth." The Chinese
government knows that sustainable growth requires a very big shift from external to
domestic demand. This, however, requires the Chinese people to produce less and to
consume more of what they produce. Thus, in order to put the Chinese economy on a sound
footing, China must shift towards a more consumption-based economy.
A more flexible exchange rate regime while not the only answer to the imbalance

problem of the Chinese economy, it is an essential part of the issue. With it, China can
transition to a consumption-driven growth path at a much faster pace since a renminbi
appreciation would reduce the growth of exports and increase the growth of imports, and
thereby promoting a more efficient allocation of domestic resources between the tradable
and non-tradable sectors. Without it, the problem cannot be resolved. As Prasad (2007,
p.10) points out, "The case for a flexible exchange rate rests on a deeper set of policy
priorities, with the ultimate objective being balanced and sustainable growth in the longer
term." This, in fact, is very much in the interest of China's vast population.
CHAPTER 6 - CONCLUDING REMARKS
By reviewing the Chinese and western literature, this paper finds that the latest
debates on the renminbi exchange rate regime in China mirror those in the west.
Specifically, there are same rival camps both inside and outside China surrounding two key
issues - first, whether the renminbi is significantly undervalued, and second, whether
China would benefit from adopting a more flexible exchange rate regime.
With respect to the first issue, one camp, i.e., CASS economists Ming Zhang (2010c,
2011) and Yongding Yu (2010) along with some western economists [e.g., Rossi (2005),
46

Cline and Williamson (2007), Goldstein and Lardy (2008)] support the IMF (2006)'s
position that the renminbi is substantially undervalued. However, in response to
accusations ofrenminbi undervaluation, the other camp which includes high-level officials
in China (e.g., Wen (2006)] and some Chinese academics such as professors Yu Zhang,
Haiping Qiu, and Wei ping Huang at Renmin University and professor Jiandong Ju at
Tsinghua University 1B disagree with the argument that China's large and growing current
account surplus proves that the renminbi is significantly undervalued. They argue that a
structural reduction in the balance of payments surplus was already unfolding in China
thanks to steps taken to boost domestic consumption. They also retorted that greater
pressure from abroad for more rapid exchange rate reform would only slow the process
down since there had not been any consensus on the degree of renminbi undervaluation
(e.g., People's Daily, 13/05/2005).
However, does it matter how much the renminbi is undervalued? Is the degree of
undervaluation the primary focus of the current renminbi debate? The answers are no. As
discussed earlier, an independent monetary policy, which is a crucial tool for improving
domestic macroeconomic management and promoting stable economic growth and low
inflation, "requires a flexible exchange rate, not a one-off revaluation or a sequence of
revaluations" (Prasad, 2007, p.13). As Prasad (2007, p.13) explains, "A flexible exchange
rate buffers some of the effects of interest rate changes, especially in offsetting the
temptation for capital to flow in or out in response to such changes. A one-off revaluation
can solve this problem temporarily but could create even more problems subsequently if
interest rate actions in a different direction become necessary, or if investor sentiment and

18

Meetings with these Chinese Economics professors were undertaken in Beijing in November 2010.

47

the pressures for capital inflows or outflows shift." Hence, the increase of the flexibility of
the renminbi exchange rate regime is more important than a mere appreciation of the
renminbi, concurs CASS economists Zhang (2010b) and Yu (2010).
With respect to the second issue, the commonality the two camps share is the
viewpoint that a more flexible renminbi exchange rate is in China's own best interests as it
can resolve many of the challenges and obstacles posed by its current tightly managed
exchange rate regime that have been highlighted in the previous chapter. It would not only
allow the PBOC to gain more control over China's domestic monetary conditions given its
excessive accumulation of foreign exchange reserves that has accompanied the increasingly
undervalued renminbi and other factors, it would also prevent further buildup of liquidity
in the domestic financial system, thereby promoting banking sector reforms in China. In
addition, a more flexible exchange rate regime can support China's transition to a more
balanced and sustained growth path by reducing the reliance of exports and promoting
domestic consumption. Hence, "[a] strong argument can be made for an early move
towards greater exchange rate flexibility, irrespective of whether or not the renminbi is
substantially undervalued" (Cappiello & Ferrucci, 2008, p.8).
Albeit there is no real dispute between the two camps both inside and outside China
that the renminbi exchange rate has to become more flexible, what can we say about the
speed of the adjustment? The Chinese authorities representing one camp have repeatedly
stated their resolve to move toward increased exchange rate flexibility. However, as
Cappiello and Ferrucci (2008) point out, they have also expressed concerns that some
conditions have to be in place to ensure a smooth transition to a more flexible renminbi
exchange rate system. "In particular, a number of institutional reforms have to be
48

implemented in order to prepare the economic system to manage exchange rate risk. These
include developing a proper foreign exchange market, where the central bank shifts from
acting as a rate-setter to a supervisory role, and introducing more sophisticated hedging
instruments. The financial and non-financial corporate sectors will also have to learn to
adapt to increased foreign exchange risk" (Cappiello & Ferrucci, 2008, p.29). Thus, they
argue that a sudden move toward a fully floating renminbi exchange rate regime is not
advisable, and therefore should not be envisaged, in the short to medium term.
The other camp [e.g., Prasad (2007), Goldstein and Lardy (2008), Yu (2010), and
Zhang (2011)] disagrees, arguing that an independent monetary policy that is able to guide
credit expansion through domestic interest rate adjustments is essential to encourage
commercial banks to become more robust financial institutions. Consequently, it is also a
key input into durable banking sector reforms in China. Nevertheless, the Chinese
authorities often express concern that, given the fragility and underdevelopment of the
country's financial and banking system, more exchange rate flexibility-which is the key
ingredient for an independent monetary policy-could be disastrous in the event of a sharp
increase in the value of the renminbi as it could destroy bank balance sheets (Prasad,
2007). However, according to Prasad (2007, p.14), "there is little evidence that Chinese
banks have large exposures to foreign currency assets or external liabilities denominated
in renminbi that would hurt their balance sheets greatly if the renminbi were to appreciate
in the short run."
In addition, according to Zhang (2010c), over the past few years, especially since the
onset of the recent global financial crisis in 2008, the world's advanced economies such as
the US, the EU and Japan have been experiencing relatively slow economic growth, whereas
49

newly industrialized countries (NIC) including China have been experiencing higher
growth. For the advanced economies, their primary goal after the crisis is to stimulate
domestic economic growth. However, due to their worsening fiscal deficit and government
debt problems, there is not much leeway for further fiscal stimulus. Also against the
backdrop of high unemployment, these countries have put promoting export growth at top
of their priority lists. Thus, driving down the values of their currencies and pressuring the
NICs to appreciate their ones have become their main strategy. As advanced economies
notably the United States resort to quantitative easing policies to depreciate their
currencies in an effort to promote export growth, and as NICs like China continue to
interfere in the foreign exchange market to prevent their currencies from appreciating, a
global currency war has thus begun (Zhang, 2010c). What are the implications of such a
global currency war for China? As Zhang (2010c) expounds, the rejection by the Chinese
authorities of any call for the increase in the flexibility of the renminbi exchange rate
regime and thus a renminbi appreciation large enough to make a real dent in China's
current account surplus may exacerbate the problem and create a lose-lose situation for
China and the rest of the world-notably the advanced economies.
So how then can we explain the glacial pace of exchange rate reform in China? Why
are the Chinese authorities reluctant to let its exchange rate regime become much more
flexible? They are, in fact, more concerned about the potential economic costs associated
with greater exchange rate flexibility. Their primary concern, according to Cappiello and
Ferrucci (2008), is that a much more flexible exchange rate regime under which a
significant appreciation of the renminbi is likely to occur may hurt China's external
competitiveness, thereby reducing export growth and weakening FDI inflows. Since export

so

growth has been an important engine of China's spectacular economic performance in the
past decades, it is feared that a weakened export capacity may jeopardize overall growth
prospects and be disastrous for employment and hence, social stability. This may be an
important reason why exchange rate reform is a highly politically sensitive issue in China.
A related concern is that higher renminbi exchange rate under a flexible exchange

rate regime could adversely affect rural incomes in the country (Cappiello & Ferrucci,
2008). As Cappiello and Ferrucci (2008) expound, the Chinese rural sector is widely
believed to be internationally uncompetitive due to the large amount of surplus labor
combined with low productivity growth. Consequently, the Chinese policymakers fear that
a fall in domestic prices of food imports resulting from a renminbi appreciation may have
significant adverse consequences for farmers. The upshot is that although a more flexible
exchange rate regime which would bring about a significant appreciation of the renminbi
would be beneficial for the Chinese economy as a whole, the benefits would not be shared
equally among different sectors of the economy.

51

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Batson, A. (2010). China's Current-Account Surplus Fell in 2009. The Wall Street journal,
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Clark, P., & MacDonald, R. (2000). Filtering the BEER: A permanent and transitory
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