Critical Questions: The China Currency Conundrum
November 26, 2007
Many observers have been convinced for several years that China’s currency, the renminbi (RMB), is undervalued. Given the relative strength of the Chinese economy, the extent to which Beijing has to intervene in financial markets to maintain the value of the RMB at current levels, and other factors, this conclusion is now widely accepted, including by many at the highest echelons of the Chinese government. What is not widely accepted or understood is the impact of China’s currency value either on China or on other markets, including the United States.
Q1: Why does China peg its currency to the U.S. dollar?
A1: For most of the nearly 60-year history of the People’s Republic, China tightly controlled the RMB (of which the principal unit is the yuan), reflecting China’s underlying command economy in which wages and prices were fixed. In 1994, as the economy began to open up and market forces were introduced, the authorities in Beijing formally pegged the RMB to the U.S. dollar. During the Asian financial crisis in the late 1990s, Beijing held firm to the dollar peg, earning kudos for forestalling a successive wave of devaluations by other Asian currencies. By the early part of this century, however, after China’s World Trade Organization entry and a booming economy, a rigidly pegged RMB began to less clearly reflect the values of the Chinese economy than it did in China’s previous, less market-oriented incarnation. This particularly showed as China began to run overall global current account surpluses at record levels without any subsequent appreciation in the RMB.