The Chinese currency once again finds itself on the centre stage of attention for financial markets. Will the Chinese let their currency appreciate or won’t they?
When it comes to the Chinese currency, one needs to disentangle between myths, wishful thinking and facts. It starts with the name of the currency itself. Two days ago, two of my friends were debating whether it is called the “yuan” or the “renminbi”. Actually it is very simple, like the “pound sterling” it has a dual name, where yuan is the unit of account and renminbi the name of the currency. So you can say “renminbi yuan” (in Chinese the unit of account comes after the name of the currency). Of course, like the pound sterling, you can use either part of the official name.
Another intriguing aspect of the renminbi yuan of course is its current status. It is definitively not a free-floating currency. Between 1997, year of the Asian crisis, and July 2005 it was pegged against the US dollar at a rate of 8.27 yuan per dollar. Since July 21, 2005 the yuan officially was “managed against a basket of currencies”. However, after three years of rapid appreciation of roughly 15% against the US currency, since July 2009 the yuan once again is de facto pegged to the US dollar at around 6.82.
This re-pegging has certainly helped China to weather the global financial crisis much better than if the currency would have appreciated. Thanks to this, as well as to a strong fiscal boost, the Chinese economy is currently running at full speed. However, China once again is confronted with a dilemma. The catching-up of its economy will lead to an appreciation of its real exchange rate, i.e. the exchange rate adjusted with the foreign and home prices. This is an unavoidable law of economics.
In the 1960s, Japan and many European economies catching-up with the US went through a similar process. Their real exchange rates appreciated. Such a real exchange rate appreciation can occur in two ways: the nominal exchange rate appreciates or inflation rises in the country with real exchange rate appreciation pressure. One can also state it as a German or an Italian way: both countries experienced real exchange rate appreciation. However, while it was a surge in the Deutschmark accompanied by low inflation in Germany, Italy experienced a constant to depreciating Lira with high inflation.
The question now is which path will China choose: keeping its currency close to the US dollar and letting inflation surge (the Italian way), or holding inflation under control with an appreciation of the yuan (the German way). There is no good economic advice one can give here. Ultimately, it boils down to a social or political choice. However, one should be aware that (as always in economics) there is an inescapable trade-off that even the Chinese cannot ignore.
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