appreciation since the end of the dollar peg was 12.8 percent at the end of June.

Since the end of June and in the context of slowing external growth and receding concerns about

inflation, renminbi appreciation has stalled against the dollar. The renminbi was virtually

unchanged (rising 0.2 percent) against the dollar from June 30, 2008, to end-October. However,

given the dollar’s rebound in this time period, the renminbi’s trade-weighted appreciation

accelerated. Between June and October, the renminbi gained 10.8 percent on a real effective

basis.

Despite the accelerated appreciation of the renminbi in the first half of 2008, the negative

impacts of China’s gradualist approach to exchange rate reform became more apparent as nontrade,

non-FDI capital inflows ballooned and the PBOC’s foreign currency intervention activities

reached an unprecedented scale. The undervalued renminbi, combined with positive interest rate

differentials, prompted investors to find ways to circumvent China’s capital controls to move

money into China. These net portfolio inflows, combined with persistent surpluses in trade and

direct investment, required large-scale intervention by the PBOC to manage the renminbi’s

value. China’s foreign reserves rose by $280.6 billion in the first half of 2008, up 18 percent

from the end of 2007.10 However, this increase presents an incomplete picture of the extent of

foreign exchange market intervention, as several important policy actions shifted accumulated

foreign exchange out of the PBOC’s official reserves. Accounting for these policy measures, the

PBOC took in an estimated $760 billion in foreign exchange in the 12 months up to June 2008,

equal to 20.4 percent of current GDP, or on average $3 billion per trading day.11 This is almost

double the increase in reserves in the twelve months leading up to June 2007.

When the PBOC intervenes, it buys foreign currency with renminbi, adding to the domestic

money supply. In order to counter the inflationary effects of such large foreign exchange

purchases from the corresponding creation of domestic liquidity, the PBOC “sterilizes” its

foreign exchange purchases by taking counteracting measures to recapture the money it has

created. One liquidity absorption measure is the issuance of central bank bonds. The PBOC

issued RMB 2.94 trillion ($417 billion) in the first half of 2008, and by the end of June 2008, had

a total of RMB 4.24 trillion ($657.3 billion or 37 percent of base money) in sterilization bills

outstanding. The central bank also uses repurchase agreements and increases in banks’ required

reserve ratio (RRR) to manage liquidity. As of end-June the PBOC had RMB 175.6 billion

($20.6 billion) of repurchase agreements outstanding. The PBOC raised the RRR by 3

percentage points to 17.5 percent in the first half of the year, but reduced the ratio by 50 basis

points in October as economic growth slowed.

Faced with continued large capital inflows, the authorities chose to strengthen supervision of

foreign exchange trading to try to limit unauthorized transactions. In August 2008, China

announced revisions to foreign exchange control regulations for the first time since 1997. The

foreign exchange market intervention, as several important policy actions shifted accumulated

foreign exchange out of the PBOC’s official reserves. Accounting for these policy measures, the

PBOC took in an estimated $760 billion in foreign exchange in the 12 months up to June 2008,

equal to 20.4 percent of current GDP, or on average $3 billion per trading day.11 This is almost

double the increase in reserves in the twelve months leading up to June 2007.

When the PBOC intervenes, it buys foreign currency with renminbi, adding to the domestic

money supply. In order to counter the inflationary effects of such large foreign exchange

purchases from the corresponding creation of domestic liquidity, the PBOC “sterilizes” its

foreign exchange purchases by taking counteracting measures to recapture the money it has

created. One liquidity absorption measure is the issuance of central bank bonds. The PBOC

issued RMB 2.94 trillion ($417 billion) in the first half of 2008, and by the end of June 2008, had

a total of RMB 4.24 trillion ($657.3 billion or 37 percent of base money) in sterilization bills

outstanding. The central bank also uses repurchase agreements and increases in banks’ required

reserve ratio (RRR) to manage liquidity. As of end-June the PBOC had RMB 175.6 billion

($20.6 billion) of repurchase agreements outstanding. The PBOC raised the RRR by 3

percentage points to 17.5 percent in the first half of the year, but reduced the ratio by 50 basis

points in October as economic growth slowed.

Faced with continued large capital inflows, the authorities chose to strengthen supervision of

foreign exchange trading to try to limit unauthorized transactions. In August 2008, China

announced revisions to foreign exchange control regulations for the first time since 1997. The

double the increase in reserves in the twelve months leading up to June 2007.

When the PBOC intervenes, it buys foreign currency with renminbi, adding to the domestic

money supply. In order to counter the inflationary effects of such large foreign exchange

purchases from the corresponding creation of domestic liquidity, the PBOC “sterilizes” its

foreign exchange purchases by taking counteracting measures to recapture the money it has

created. One liquidity absorption measure is the issuance of central bank bonds. The PBOC

issued RMB 2.94 trillion ($417 billion) in the first half of 2008, and by the end of June 2008, had

a total of RMB 4.24 trillion ($657.3 billion or 37 percent of base money) in sterilization bills

outstanding. The central bank also uses repurchase agreements and increases in banks’ required

reserve ratio (RRR) to manage liquidity. As of end-June the PBOC had RMB 175.6 billion

($20.6 billion) of repurchase agreements outstanding. The PBOC raised the RRR by 3

percentage points to 17.5 percent in the first half of the year, but reduced the ratio by 50 basis

points in October as economic growth slowed.

Faced with continued large capital inflows, the authorities chose to strengthen supervision of

foreign exchange trading to try to limit unauthorized transactions. In August 2008, China

announced revisions to foreign exchange control regulations for the first time since 1997. The

18

updated foreign exchange measures largely focus on heightened scrutiny and verification of

foreign exchange transactions. These potentially burdensome administrative measures point to

the complications caused by excessively slow exchange rate reform of a currency whose value is

out of line with market supply and demand.

The gap between the real exchange rate and its equilibrium level remains wide and the renminbi

remains substantially undervalued, according to a number of estimates. Despite a cyclical

slowdown in China’s major trading partners, China’s large external surpluses continue to

grow. In the first ten months of 2008, China’s global trade balance grew to a record high of

$216 billion, with exports growing by 22 percent over the same period in 2007. Imports grew by

30.7 percent in the first half of 2008 from the first half of 2007, in part due to rising import

prices, but import growth in the second half of 2008 has decelerated on a monthly basis, down to

a sixteen-month low of 15.6 percent in October versus October 2007. China’s global trade

surplus in the first three quarters of 2008 declined slightly to $181 billion (6.6 percent of GDP)

from $186.1 billion (9 percent of GDP) in the first three quarters of 2007. However, it remains

large compared to global trade surpluses of $109.7 billion in the first three quarters of 2006 and

$68.5 billion in the first three quarters of 2005.

Progress is slow on the structural reform agenda to rebalance growth away from investment and

net exports and towards domestic consumption. The share of consumption in China’s real GDP

growth declined from a recent peak of 62.3 percent in 2000 to 49.0 percent in 2007. In the first

half of 2008, growth in urban retail sales, a major component of household consumption,

remained flat in real terms, up 12.9 percent year-over-year versus 12.7 percent year-over-year in

the first half of 2007. Rising government consumption and declining corporate profit growth

may lead to a smaller surplus of national saving over investment in 2008, and thus a smaller

current account surplus, though data are not yet available. However, in the absence of further

liberalization of both the exchange rate and domestic interest rates, the saving and investment

gap, and therefore the external surplus, will expand again when global growth picks up.

China’s real GDP expanded by 10.4 percent year-over-year in the first half of 2008, down from

11.9 percent year-over-year in 2007. Inflation was policymakers’ primary concern, as CPI

growth climbed to 8.5 percent year-over-year in April. By the fall, as food price increases

slowed and other commodity prices declined inflationary pressures were rapidly fading. CPI

inflation subsided to 4.0 percent year-over-year in October. Producer price inflation (PPI) rose

from 6.1 percent year-over-year in January, to a record high of 10.1 percent in August, before

declining to 6.6 percent in October.

In response to inflationary pressures, the authorities enacted an officially-described “tight”

monetary policy at the end of 2007, with quantitative restrictions on banks’ credit growth paired

with the PBOC’s sterilization activities. As consumer price inflation receded and external

growth weakened, policy attention shifted back to maintaining growth. In July 2008, a pre-

Olympics Politburo meeting led to a shift in the Chinese government’s top economic priority

from fighting inflation and overheating to maintaining “stable and relatively fast growth.”

Since September, authorities cut benchmark bank lending rates by 189 basis points and lowered

banks’ required reserve ratios by 150 basis points for large banks and 350 basis points for small

banks. In early November, the State Council announced a two-year $590 billion economic

stimulus package, although the amount of incremental new spending in this package is unclear.