On July 21, 2005, China surprised the world by abandoning its peg to the dollar that had been in place since 1995. It immediately appreciated by 2% and gradually appreciate until the financial crisis hit in 2008. It then looked to have been “re-pegged until late 2010, when it began appreciating again.
Since that fateful 2005 decision, the yuan has appreciated by a third against the US dollar in nominal terms. In real terms, it has been somewhat more as China has experienced somewhat faster inflation than the US. In terms of consumer prices, US inflation has averaged 2.1% since mid-2005 while China’s inflation has averaged 2.9%.
In the five years before the currency regime change, China’s trade surplus with the US (using BEA data), rose dramatically. It doubled from $63.8 bln in 2000 to $162.3 bln in 2004. Over the next 10 years, China’s trade surplus rose another 70% from $202.3 bln in 2005 to $343.1 bln in 2014. One clear implication is that currency appreciation alone as been insufficient to bring the trade accounts into balance.
From an even long-term perspective, note the sequence of events. When China began the liberalization process, there were several different exchange rates for the yuan. Overall the currency was being devalued. On the eve of the Plaza Agreement in 1985 to drive the dollar lower, there were a little less than three yuan to the dollar.
Chinese officials engineered a gradual depreciation of the yuan in the early 1990s and combined the exchange rates into a single one, engineered a sharp depreciation. At the beginning of 1994 there were 8.7 yuan to the dollar. Some accounts of the origins of the 1997-1998 Asian financial crisis emphasize this significant Chinese devaluation as a key factor changing the competitive landscape in East Asia.
The appreciation of the yuan since 2005 brings it back toward the levels that were prevailing prior to the large depreciation in 1994. The IMF has recently indicated that it no longer regards the yuan as under-valued. The US Treasury disagrees. Some US officials see the widening trade surplus as evidence that there is still room for currency adjustment.
As many pundits pronounced 9/11 as the end of globalization, China joined the World Trade Organization in late 2001. Chinese officials have gradually accepted the importance of market mechanisms. As a results of China’s own trajectory, encouraged by the Special Economic Dialog with the US, Chinese officials have indicated that they will no longer intervene in the foreign exchange market unless it needs to combat disorderly markets.
Unlike in earlier periods when its intervention was aimed at slowing the appreciation of the yuan, more recently, the PBOC seemed to act to avoid depreciation. China’s reserves have fallen four consecutive quarter, even though the trade surplus is still rising on a 12-month average basis. China appears to be experiencing net capital exports, which also represents a change from the past.
Given the tumultuous moves in the capital markets, with the sharp appreciation against the major currencies over the past year, the yuan has been remarkably steady against the US dollar. Since then, the euro has fallen nearly 20% and the yen by 18.5%. Sterling is off 9%. The yuan is off by 0.03% according to Bloomberg data.
Since the second half of March, the dollar has been trading in a range against the yuan CNY6.18-CNY6.22. And even this may exaggerate the range. It tested CNY6.18 one in late-March and has rarely been under CNY6.19. The CNY6.22 level has been approached slightly more often, but hardly trades above CNY6.21. The dollar is trading near CNY6.21 presently.
Some suspect that China is engineering a stable yuan because officials think that it will enhance the likelihood that it is invited to join the IMF’s Special Drawing Rights (SDRs). This goal may have also been behind last week’s decision to reveal its official gold holdings. A stable currency is not one of the official criteria the IMF uses for SDR purposes. It is more likely a defensive posture that avoids giving US critics more fodder for its reluctance to see the yuan in the SDR.
The key issue for inclusion in the SDR is not the level of the yuan — though the IMF’s assessment that it is near fair value is helpful. The decision will likely hang on whether the yuan is freely usable. Last week, while it was still deploying policies aimed at supporting the stock market, Chinese officials announced that foreign officials, including central banks, sovereign wealth funds and international financial institutions (e.g. IMF, World Bank, Asian Development Bank, AIIB) would not longer be bound by the quota system (QFII) and would have full access to the on-shore interbank bond market.
There is speculation that China may abandon its QFII and RQFII quota systems to inward-bound investment. That would seem to enhance the likelihood of the yuan’s inclusion in the SDR. Short of this, it would not be surprising to see other liberalization measures. One idea that gains some attention from time to time is for the 2% dollar-yuan band to be expanded. The other approved currency pairs trade in a 5% band. While a wider band is possible, it may be a distraction from demonstrating that it is freely usable. Although the yuan tested the 2% band limits against the dollar in Q1; since the beginning of Q2 the dollar has moved in a 1.0%-1.5% band.
As part of joining the SDR, China would be expected to adopt the best currency practices. This means reporting the currency composition of its reserves. It would report them in confidence to the IMF, which would incorporate them into its COFER report of allocated reserves. Using the COFER data, analysts would try to back into China’s currency allocation. It is generally assumed that China’s currency allocation is broadly in line with the global situation, with the US dollar accounting for a little more than 60% and the euro a little more than 20%.