Renminbi 101

Article excerpt

03.04.09

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China manages the renminbi-dollar exchange rate closely. Between mid-1995 and July 2005, the People's Bank of China pegged the renminbi at approximately 8.3 per U.S. dollar. Since then, the People's Bank has loosened its reigns, allowing the renminbi to appreciate to 6.8 per dollar. Many people claim, however, that China still manipulates the rate in an unfair bid to encourage large trade surpluses with the United States and to attract hefty inflows of investment funds. Such claims are not strictly correct. Nevertheless, China has never given the exchange-rate-adjustment mechanism free reign.

The above-mentioned exchange rates--called nominal in econ speak--have little to do with trade. What matters more than the nominal renminbi-dollar rate for China's long-term competitive advantage vis-a-vis the United States is the real renminbi-dollar rate. Basically, a real renminbi-dollar exchange rate incorporates the inflation rates of both China and the United States in its calculation. Between 1995 and 1998, the renminbi appreciated on a real basis against the dollar, despite a fixed nominal peg, because Chinas inflation rate exceeded the U.S. inflation rate. Between 1998 and 2004, however, the situation reversed. The renminbi depreciated against the dollar on a real basis, as inflation in China fell below inflation in the United States. Since 2004, and especially since China eliminated the peg, the renminbi has again appreciated against the dollar on a real basis.

While countries can control a nominal exchange rate fairly easily, managing a real exchange rate is a whole other--and difficult--ballgame. If, as the claim against China asserts, a country sets the nominal rate to gain a trade and investment advantage, inflation should eventually result and offset any temporary gain that the nominal exchange rate provided. …