June 21, 2010 Reading Time: 3 minutes

The Chinese government announced this weekend that they would move towards a greater degree of flexibility in the exchange rate. As stated by by the People’s Bank of China:

“In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People’s Bank of China has decided to proceed further with reform of the RMB [renminbi] exchange rate regime and to enhance the RMB exchange rate flexibility.”

This was immediately interpreted as a move towards letting the renminbi (the Chinese currency) appreciate against the dollar. However, the Chinese soon qualified this announcement by a second statement the day after stressing that it was “not in China’s interest” to let the currency undergo substantial appreciation and that we should therefore expect the exchange rate to remain relatively stable.

What these two statements would mean in practice seem unclear and will have to be assessed based on exchange rate policy decisions by the Chinese central bank in the days and weeks ahead.

Thus the focus of international financial markets as well as political leaders in Washington DC was directed towards the Chinese exhange rate on Monday morning. The message was mixed. The Chinese government let the reference point for the renminbi stay the same, but it also let the currency appreciate by 0.43 percent without intervening in currency markets. (The exchange rate is allowed to fluctuate by 0.5 percent in both directions from the reference point.)

The Chinese government face both domestic and international pressure–pulling in opposite directions. The sentiment among Chinese business men and nationalists is to keep the renminbi undervalued so as to boost exports and keep pushing the Chinese growth strategy in the same direction. For instance, a Chinese business paper–the National Business Daily–says that “Renminbi appreciation should wait until China’s economic restructuring has proceeded more and domestic demand has expanded.”

G20 countries, especially the U.S., has repeatedly expressed concerns about the weakness of the renminbi and how this furthers the “global imbalances” of too much Chinese savings and too high exports, something which is widely believed to have contributed to the financial imbalances leading up to the recent financial crisis.

The G20 has called for “rebalancing” the world economy through greater co-operation and policy co-ordination among the major economies. The formal change in the Chinese exchange rate policy regime could be seen as a move to avoid criticism at the upcoming G20 summit in Toronto, Canada.

China started to move towards a “managed floating exchange rate regime” in the summer of 2005, but in response to the financial crisis the currency was once more pegged to the dollar. The announcement on Saturday signals a return to reforming the exchange rate. However, the big question is how much the government will let the currency appreciate and how fast it will allow this upward movement in the value of the renminbi to take place. The Financial Times assess the situation as follows:

“The currency’s performance on Monday indicates that the Chinese authorities are prepared to see some gentle appreciation in the coming weeks–especially as international criticism of its exchange rate policy has been mounting–but that they will not allow any large jumps in the value of the renminbi.”

The main issue of currency reform is to look at how government interventions into currency and money markets create unstable global flows of goods and capital. By intervening in currency markets, the Chinese government has over the last decade been able to boost exports and build-up immense currency reserves–dollars that have been plowed back into U.S. bond markets. This has pushed down the yields on both private and government securities, fuelling the private and public spending binge that led up to the crisis. Currently, the spending binge continues in the public sector.

Marius Gustavson

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