How is the renminbi’s value determined?

In 1994, the value of the renminbi was pegged to the US dollar at a rate determined by the People’s Bank of China (PBoC), China’s central bank. Since 2000, it had been trading within the range of 8.276 to 8.28 to the dollar. The new exchange rate policy drops the dollar peg and links the value of the renminbi to a basket of currencies instead. The renminbi was also revalued by 2.1 per cent on July 21, 2005 11:00 GMT. The revised value — 8.11 against the dollar — was used as the median for trading on the following day. The renminbi can fluctuate from the daily median within a narrow band: 0.3 per cent against the dollar, and 1.5 per cent on other currencies. The median is based on the renminbi’s closing rates against various currencies and published on the State Administration of Foreign Exchange website (www.safe.gov.cn) daily.

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What is the nature of China’s new currency regime?

China calls its new system a “managed floating exchange rate regime”. It is a form of managed float. But some aspects of it, such as allowing the currency to move 0.3 per cent per day against the dollar, have some similarity to a crawling peg.

Some related currency regimes include:

• Crawling peg. Used to smooth the path of a currency rather than fixing it, it allows the exchange rate to move a certain amount each day, sometimes with a predetermined direction. Crawling pegs, like fixed pegs, can be vulnerable to speculative attacks.

• Fixed peg. It is the system adopted by China until July 21. It involves announcing a target against a foreign currency, usually the dollar. The target exchange rate is maintained through a combination of interest rate changes and direct intervention in the currency markets.

• Managed float. This is a vaguer catch-all term. A managed float is any kind of system where the authorities try to guide the exchange rate or prevent destabilising movements but generally without announcing a formal target.

Benefits of renminbi revaluation

• Revaluation should improve China’s relations with its main trading partners in the west. China’s basic balance of payment has a sizeable surplus, equivalent to 6 per cent of GDP, and has been consistently positive for the last six years, according to calculations by UBS.

This reflects the strength of China’s exports and its ability to attract foreign investment. A “cheap” renminbi boosts both. As a result, countries have claimed their trade deficits have been exacerbated by the low renminbi. The US, for example, says imports from China account for around 25 per cent of its trade deficit. It is argued that if the renminbi were to be floated, market forces would drive the currency upwards and lessen the trade gap. The value of the renminbi, before revaluation, was often compared with that of the Japanese yen in the early 1980s. Trade with Japan accounted for half of the US’s trade deficit during the ‘80s. The 1985 “Plaza Accord” forced the yen to rise against the dollar.

• Revaluation will help silent critics who say that China breaks the rules to keep its currency artificially low. Section 4 of the IMF articles of agreement states that countries should “avoid manipulating exchange rates ... in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.” China, through the PBoC’s daily market intervention, was accused of doing just that. The PBoC’s foreign reserves were not just for buffering risks, but embody the blatant manipulation of exchange rates, critics claimed. The renminbi’s value has been blamed for rising unemployment and rising trade deficits in other countries and for exporting deflation to the rest of the world.

• It has been difficult for China to maintain the dollar-based exchange rate. China must meet demand for the renminbi by purchasing large volumes of foreign money every day. Having $711bn worth of foreign reserves, as of June 2005, largely held in dollar-based assets, has not brought returns as high as those China could gain from alternative investments. Revaluation will help to slow down the amount of capital flowing into China, thereby reducing the risk of over-investment.

Arguments against a revaluation:

• Local companies and banks in China will suffer under a higher renminbi. Unemployment, already rising at a worrying pace, will worsen with cheaper imports. Banks are also likely to see their non-performing loans increase with a higher renminbi, especially among companies who rely on exports.

• Some economists argue that the trade imbalance between other countries and China has been exaggerated due to China’s processing trade, which refers to the trade in goods imported, processed and re-exported. According to UBS, China only accounts for 13 per cent of Asia’s current account surplus against the US.

• Most other Asian currencies are also considered undervalued. They will come under increasing international pressure to appreciate as well if China revalues the renminbi.

• While the size of China’s foreign currency reserves has been used as evidence to a larger-than-normal capital influx, much of that is believed to have come from speculators betting on a revaluation.

Reasons why the renminbi debate will continue:

? The revaluation is considered minor and unlikely to satisfy those countries which argue that the currency has been significantly undervalued.

? A higher renminbi cannot fix the problems of the rest of the world, particularly the current slow growth in developed economies in Europe, the US and Japan. China, where labour cost is on average 10 times cheaper than in the US, will remain an increasingly important production base even if the renminbi rises by the highest of estimated margins. Multinationals that set up shop in China are also attracted by its sizeable domestic market. In other words, the US trade deficit is not going to vanish with a higher renminbi, nor will it do much to solve America’s unemployment problem.

Other countries in Asia are claiming to be the victim of China’s currency-induced competitive edge as well. This does not necessarily mean that a stronger renminbi will favour their own exports, since a number of Asian currencies are also considered undervalued. In fact, the renminbi’s trading value has not depreciated against the currencies of some of its trading partners, including Japan and Malaysia, in recent years.