• Exchange rates and currency

Exchange rates and currency

Over the past four years there has been debate about undervaluation of the RMB (the Chinese currency) by Chinese authorities which was pegged to the US$ at a rate of 8.28 since 1995. Strong pressure came mainly from the United States that the RMB revaluation creates some dangerous imbalances in the world’s saving-investment balance, leading to a China trade surplus with the US.

This paper clarifies certain issues raised by this debate on the RMB revaluation in the light of Japan's experience after the 1985 Plaza Agreement, which led to a quasi-doubling of the Yen exchange rate against the US$ over a period of two years.

A method to be used for assessing whether a particular country is benefiting from revaluation also matters. As to the first issue whether the RMB is undervalued, such an undervaluation has to be assessed on the basis of the real effective exchange rate (REER) and not only of the market forex rate against a falling US$. On a REER basis, the undervaluation of the RMB may be estimated in the range of 15-20%, which would mean about 10-15% against the US$ and 20-25% against the Euro.

Second issue, is whether China should let its currency appreciate gradually or proceed immediately to a massive RMB revaluation of 20-25%, as requested by the US and Europe. A steep revaluation of the RMB would probably have devastating effects on China's economic growth and stability, while it would not solve the problem of the growing trade deficits of the US and Europe. This is confirmed by the example of Japan during the '80s and '90s: the quasi-doubling of the Yen exchange rate against the US$ after the Plaza Agreement did not reduce the US trade deficit, but its negative effects have weighted on the Japanese economy and financial system throughout the '90s.

Based on analysis, the paper draws several lessons from the Japanese experience when debating about the RMB revaluation:

• an immediate and steep revaluation may be dangerous and risky. The revaluation process of the RMB should be gradual and spread out over time, thus giving time to the economy and the financial system to progressively adjust

• it would be preferable that the exchange controls on the capital account be maintained (and made more efficient regarding hot money) during this process of a gradual appreciation of the currency

• the liberalization of the financial system shall also be made step by step, after the completion of the reforms now under way. In particular regular cleaning of doubtful loans in balance sheets as well as training of staff in risk analysis and hedging instruments
  

The paper concludes some key points including:

• a steep revaluation of the RMB as requested by the US and Europe could be quite dangerous for China's economic stability in particular and the world economy in general

• it would not solve their problems of trade deficits and job destructions, whose solution is to be found in the case of Japan maintaining a balanced trade with China due to its technological brilliance

• to address risks, author agues that China does not dispute the need for an appreciation of its currency, but it considers that this appreciation should be gradual, so that its agricultural, industrial and financial sectors may progressively adjust to the new risks involved and to more severe conditions of international rivalry

• the policy of a very gradual RMB seemed justified in 2005-2006. However, the explosion of the current account over the past few years would now require that Chinese authorities make full use of the instruments given by the reforms of July 2005 and let the RMB move more freely upwards, not only against the US$ but also against the currencies of its other main trading partners

• Full text of document
• Publisher details
• Send to a friend