In July 2005, the Chinese government announced that it was changing its official exchange rate regime. As American politicians had been demanding, the renminbi or yuan would no longer be pegged to the dollar. Rather the authorities would:
(1) set its value with reference to a basket of foreign currencies (with numerical weights unannounced), and (2) allow a margin of fluctuation in the exchange rate that, though small in any given day, could cumulate substantially over time.
What has the actual or de facto exchange rate regime been, as opposed to the official or de jure announcement? It would not be surprising if the two differed. Many currencies show such a discrepancy between de jure and de facto. Accordingly, statistical techniques were developed some years ago to discern the true exchange rate regime.
The standard techniques show that, in practice, the RMB initially continued to maintain a tight peg to the dollar after July 2005. Gradually, in 2006, the relationship loosened. Statistical analysis suggests that the People’s Bank of China did indeed begin to assign a little weight within the anchor basket to a few non-dollar currencies, beginning with the Korean won during a period centered on January-March 2007. However most of the weight remained on the dollar. [Frankel & Wei, in Economic Policy.]
The use of a new, more sophisticated, statistical equation reveals that during the course of 2007 the anchoring basket began for the first time to assign substantial weight to the euro. For a period that ran up to approximately May 2008, the anchor was a true basket that put virtually as much weight on the euro as on the dollar. There was also some limited flexibility around that anchor. When high or low international flows were working to push the currency away from the basket, the authorities would intervene, or “lean against the wind,” to push the currency back. [Frankel, 2009, forthcoming in Pacific Economic Review.])
During the course of 2008, however, weight began to return to the dollar. My newly updated estimations show that during the most recent period, September 2008-February 2009, all the weight has once again fallen on the US currency. The regime has come full circle, virtually back to what it was in late 2005.
At first glance, this sounds like news to get the juices of US Congressmen flowing. It sounds as though it might confirm recent complaints that the RMB has stopped its earlier slow-but-steady, appreciation against the dollar. Is it time to dust off the Schumer-Graham bill, which threatened tariffs against China’s exports if it did not stop “unfair manipulation” of its currency?
In fact, these results imply something quite different, almost the opposite. American politicians don’t really care whether the RMB is fixed or floating. What they want, of course, is for it to be stronger against the dollar rather than weaker, so that American firms have an easier time competing against Chinese exports. In 2007, when the RMB was loosely tied to a basket that put heavy weight on the euro, it appreciated against the dollar because the euro was appreciating against the dollar. Indeed from mid-2006 to the end of 2007, the overall value of the RMB did not in any month fluctuate outside a band of plus-or-minus 1%, if one defines the value in terms of a yardstick that assigns half-weight to the euro and half-weight to the dollar.
One can see in the graph below: (i) the steadiness during this period of the average (the green line in the middle), and (ii) the observed and approved appreciation of the yuan against the dollar (the magenta line on top). The appreciation was apparently due to the presence of the euro in the basket, and not in fact to appreciation against the basket as usually implied in the press.
The recent link to the dollar is visible in the flattening of the magneta line at the end. What has been the implication of the movement back toward a dollar peg over the last year? It has been to strengthen the RMB above what it would be if Beijing had stuck with the regime of 2007. Why? Because over the last year, the dollar has appreciated strongly against the euro. If the RMB had stuck with the basket peg in 2008 and 2009, it would have depreciated against the dollar (because the euro depreciated) by an estimated 14%. This would have been the opposite of what congressmen really want!
It is interesting to speculate why the Chinese monetary authorities have moved back to the dollar during the period when the US recession has worsened and gone truly global. One possibility is that the dollar feels like a security blanket to them, and its familiarity in time of crisis trumps the desire to maximize their price competitiveness on world markets. Another possibility is that they switched to a dollar peg sometime in 2008 because they expected that the dollar would continue to depreciate as it had in preceding years – a forecast that would not have sounded entirely unreasonable at the time, given that the financial crisis originated in the United States, on top of the preceding seven-year trend depreciation. If that is the answer, it is likely that the regime will change once again before long. But American politicians might want to think twice before demanding that the RMB abandon its link to the dollar.
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With the rising risk of the US falling into a fiscal trap, the possibility of a run on US treasuries and the dollar becomes more likely. If such an event were to occur before the US property market bottoms, either interest rates would spike or money would have to be printed to buy back bonds. In the former case, the downturn in real property becomes worse as does the fiscal trap. In the latter case, the value of the dollar is diluted. So in either case, the dollar would fall cataclysmically.China’s decision to peg to the dollar for now, like the G7′s recent decision not to allow any other major financial institutions to fail (if possible), seems to be part of a more general policy of gradualism.
Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.
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