chinas renminbi our currency, your problem

Ricky Lai prepared this case under the supervision of Dr Ka-fu Wong for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes.

© 2008 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means�electronic, mechanical, photocopying, recording, or otherwise (including the internet)�without the permission of The University of Hong Kong.

Ref. 07/352C

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K.C. FUNG KA-FU WONG

CHINA�S RENMINBI: �OUR CURRENCY, YOUR PROBLEM�? 1

Beijing, please do something�anything!�about your rigid currency regime and let the renminbi appreciate. That�s the message Washington, Tokyo, London and others have been blasting at the Chinese government for months now.

- Business Week (7 March 2005) �Who Wants China�s Yuan to Rise?�

In Beijing, Wen Jiabao, China�s prime minister, has been equally blunt. China�s currency, he argued this week, was an issue of �China�s own sovereignty�. �Any pressure or effort to politicise an economic matter�, he warned, �will not help solve problems�.

- The Economist (21 May 2005) �Time to Let Go: China�s Currency� Seldom had a currency caused so much controversy. In 2006, many countries claimed that China�s currency, the yuan, was undervalued and that China had manipulated its exchange rate to suppress the prices of its exports, costing them thousands of jobs. The US, which ran a huge trade deficit of US$233 billion with China in 2006,2 threatened to impose tariffs on Chinese imports if China did not revalue its currency. Many thought that the yuan�s exchange rate was not in line with market forces, that it should have appreciated over the past few years and that a de facto peg to the US dollar had been maintained only because of interventions from the Chinese central bank. They pointed to the remarkable 9% annual growth of China�s economy over the previous decade, the fact that China had become the world�s third-largest exporter with an estimated of at least US$970 billion for 20063 and to the stockpiling of US$1.2 trillion in foreign currency reserves.4

1 In 1971, US Treasury Secretary John B. Connally was attributed the statement, �the dollar is our currency, but it�s your problem,� in response to European visitors who accused the US of exporting inflation to the rest of the world. 2 US Census Bureau (2007) �Foreign Trade Statistics�, http://www.census.gov/foreign-trade/www/ (accessed 29 June 2007). 3 CIA (2007), The World Fact Book � Rank Order � Exports, https://www.cia.gov/library/publications/the-world-factbook/rankorder/2078rank.html (accessed 29 June 2007). 4 State Administration of Foreign Exchange (2007), China�s foreign reserves statistics (in Simplified Chinese), http://www.safe.gov.cn/model_safe/tjsj/tjsj_detail.jsp?ID=110400000000000000,18&id=5 (accessed 29 June 2007).

HKU710

07/352C China�s Renminbi: �Our Currency, Your Problem�?

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Chinese officials responded that these attacks were groundless, claiming that the yuan was not undervalued, at least not significantly, and that the peg contributed to maintaining a stable economic environment, which benefited all economic partners. They said that if the US was running a large trade and budget deficit, it was partly attributable to capital inflow from China and that the US should focus on the weaknesses of its own economy that generated these deficits instead of treating China as a scapegoat. Officials also said that China was a sovereign country with the right to choose its exchange rate policy. From 2005 to 2007, the debate was regularly in the news and it was likely that arguments would become tougher if US and European trade deficits with China continued to increase. Was China using its currency as an unfair weapon, leaving economic problems to others? Should China revalue its currency at a faster rate? What were the advantages of pegging one currency to another? Should China let its currency float freely instead?

A Brief History of the Renminbi

�Yuan� and �renminbi� were terms often used interchangeably for China�s currency. Since 1969, the official name of China�s currency had been the renminbi (literally, �the people�s currency�) or RMB, and the yuan was the denominated unit (for instance, �70 yuans�). However, �the yuan� was also frequently used to refer to the currency itself.

The Renminbi before the Economic Opening in 1978

Before 1978, when China began liberalising its economy, the country followed strict central planning. The government promoted economic self-sufficiency; foreign trade was negligible and there were almost no foreign companies in China. The renminbi was pegged to a basket of currencies and its exchange rate set to a very high (and unrealistic) value. The currency was virtually non-convertible. Foreign residents and tourists had to obtain foreign exchange certificates from the government to live and travel in China.

The Renminbi after 1978

In 1978, China launched its �open door policy�, whereby special economic zones (SEZs) were open to foreign investment. Meanwhile, the government allowed a tiny private sector to emerge. To promote exports, the official currency rate was devalued several times: RMB2.8 to the US dollar in 1981, RMB3.20 in 1985 and RMB5.32 in 1993 [see Exhibit 1].5 The importance of the official exchange rate, however, declined progressively in 1988 with the creation of market-determined rates in �swap centres�, which allowed exporters and importers to conduct transactions in SEZs. From 1988 to 1993, the official exchange rate and the market-determined rates co-existed. The market rates significantly depreciated (RMB8.7 in 1994) while the fixed official rate was still overvalued (RMB5.76 in 1993). In 1994, the official and market rates were unified: the official rate was adjusted to the market rate at US$1 = RMB8.7. At that time, only 20% of transactions were conducted at the official rate, the rest being conducted in swap centres. The de facto exchange rate was a peg to the US dollar [see Exhibit 1]. In 1995, the renminbi was revalued by 5% to RMB8.28, a rate maintained until July 2005. During the Asian crisis that began in 1997, when many other Asian countries abandoned their currency pegs, this quasi-peg was enforced even more strictly to discourage speculation, and before the July 2005 reform, the range of fluctuation was only ± 0.18%.

5 This historical analysis of the regimes governing the renminbi comes mainly from the following sources: Chou, W.L. and Shih, Y.C. (1998) �The Equilibrium Exchange Rate of the Chinese Renminbi�, Journal of Comparative Economics, 26; Huang, H. and Wang, S. (2004) �Exchange Rate Regimes: China�s Experience�, China Economic Review, 15.


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Restrictions on the Convertibility of the Renminbi

The renminbi was characterised by many restrictions that made this currency different from, say, the US dollar or the euro, especially in regard to capital flows. For operations on the current account,6 the renminbi was convertible, meaning that importers and exporters could exchange the renminbi against other currencies, as could Chinese citizens when they travelled abroad. But the capital account7 was tightly controlled, with Chinese citizens and companies barred from investing their savings abroad. Portfolio investments (inward and outward) were also restricted, although China could not completely avoid the inflow of money sent by speculators who bet on the revaluation of the renminbi. An exception to restrictions on the capital account was foreign direct investment (FDI), as China had become the world�s primary or secondary destination for FDI in the previous few years.

Interventions of the Central Bank

The Absorption of Foreign Currencies by the Central Bank

China had a number of legislations to limit the amount of foreign currency in circulation. After they received their revenues derived from exports, companies had to immediately sell their foreign currency to designated banks or deposit it into these banks. The renminbi could only be traded on an inter-bank centralised electronic market, the China Foreign Exchange Trade System (CFETS). This system comprised around 350 institutions that were exclusively authorised to conduct transactions of foreign currencies. CFETS was monitored by China�s central bank, the People�s Bank of China (PBoC), through the State Administration of Foreign Exchanges. On a daily basis, each member bank had to respect the ratios of foreign reserves relative to their total reserves. If a bank exceeded the ratio, it had to sell excess foreign currencies and, conversely, if a bank was below the ratio, it had to buy foreign currencies.8

The Accumulation of Foreign Reserves

After absorbing foreign currencies in circulation, the PBoC reinvested these funds mainly in US Treasury bonds�a safe but low-return investment�leading to the accumulation of US$1.2 trillion in foreign reserves by the end of March 20079 [see Exhibit 2]. Critics argued that China did not need to pile up such a mountain of foreign currency reserves to preserve the stability of its economy, saying that the build-up was a result of constant interventions from the PBoC to maintain the peg to the US dollar against natural forces of the market.

The Sterilisation of the Renminbi

The absorption of US dollars meant that the PBoC put into circulation around eight renminbi for each US dollar it bought from commercial banks. Domestic money supply automatically increased, creating a risk of over-investment and inflation in the country. While the inflation of consumer prices had remained under control, industrial prices were under pressure. The property market also showed signs of overheating. In Shanghai, the value of a 100-square-metre flat in a high-end district had doubled to US$550,000 between 2003 and 2005,10 followed by general predictions in 2007 of sustained bullish conditions for the following few 6 In the balance of payment, the current account covers exports and imports, wages and investment income, and current transfers. 7 In the balance of payment, the capital account covers short-term and long-term investment flows, including foreign direct investment, as well as the evolution of foreign currency reserves. 8 Wiemer, C. (2005) �The Currency a Tisket, a Tasket, a Band Not a Basket�, China Economic Quarterly, 9. 9 State Administration of Foreign Exchange (2007), China foreign reserves statistics (in Simplified Chinese), http://www.safe.gov.cn/model_safe/tjsj/tjsj_detail.jsp?ID=110400000000000000,18&id=5 (accessed 29 June 2007). 10 Business Week (4 April 2005) �Beware of Hot Money�.


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years despite various curb measures introduced by the government. To reduce inflationary trends, the PBoC had to remove (or �sterilise�) the excessive renminbi in the system by using various mechanisms. For example, government bonds were sold to commercial banks or tighter liquidity ratios were imposed on banks to slow down lending activities.

Revaluing the Renminbi and Abandoning the Peg to the US Dollar in 2005

On 21 July 2005, following prolonged pressure on China, the country reluctantly reformed its exchange rate regime. The renminbi was revalued by 2.1% to RMB8.11 to the US dollar. The peg to the US dollar was dropped and replaced by a peg to a basket of currencies whereby the renminbi was allowed to fluctuate within a 0.3% band against the US dollar each day. China was not the first country to adopt a basket of currencies on which to peg its currency. Singapore had also done so and, before the Asian crisis, Thailand had officially pegged the Thai baht to a basket, although the currency was pegged to the US dollar de facto. China disclosed the composition of its basket in August 2005 (unlike Singapore), but did not say what the weights (the percentage of each currency in the basket) were. The only information available was that China�s currency basket was dominated by the US dollar, the euro and the yen while other currencies (those of South Korea, Singapore, Great Britain, Malaysia, Russia, Australia, Thailand and Canada) were apportioned a smaller share. The Hong Kong and Taiwanese dollars were excluded. It was believed that the US dollar still represented at least 40% of the basket after the reform. According to Chinese officials, the currencies of the basket (and allegedly the weights) had been selected on the basis of trade volume conducted with China�s partners, the sources of FDI and the composition of China�s debt. The appreciation of the renminbi, though small, seemed to have given China�s neighbouring countries some room to let their own currencies appreciate against the US dollar. Before July 2005, the currencies of Japan, Taiwan, Malaysia, Singapore and Korea were widely considered undervalued against the US dollar by at least 10%. Following China�s revaluation, Malaysia abandoned its seven-year peg to the US dollar and adopted a peg to a basket of currencies. The currencies of South Korea, Thailand and Indonesia also appreciated against the US dollar between July 2005 and June 2007 [see Exhibit 3]. Meanwhile, China conducted other reforms to release upward pressure on the renminbi and to prepare for the elimination of capital controls in the future. Chinese tourists were allowed to carry more funds outside the territory when they travelled and a forward contracts market was established progressively to hedge the currency because, theoretically, the renminbi could fluctuate after the reform. Since the revaluation, the exchange rate had gone from RMB8.28 to the US dollar to RMB7.72 to the US dollar at the end of April 2007, surpassing the Hong Kong dollar�s pegged exchange rate of HK$7.8 to the US dollar. In May 2007, less than a year into the revaluation, the Chinese central bank announced a widening of the renminbi�s daily fluctuation band against the dollar from 0.3% to 0.5%11 in a bid to appease the US ahead of summit trade talks between the two nations. At that point, the renminbi had appreciated by a total of 7.2% against the dollar. Despite this, the US continued to lead international efforts in pressing for greater acceleration of the renminbi�s revaluation, fuelled by the continued rise of US and European trade deficits with China. 11 People�s Bank of China (2007) �Public Announcement of the People's Bank of China on Enlarging the Floating Band of the RMB Trading Prices against the US Dollar in the Inter-bank Spot Foreign Exchange Market�, http://www.pbc.gov.cn/english/detail.asp?col=6400&id=837 (accessed 27 June 2007).


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Controversial Valuation of the Renminbi

China should not hesitate any longer to take far more vigorous action to rebalance its economy, promote immediate RMB movement to tackle the currency�s undervaluation, and achieve far greater flexibility in the exchange rate regime. - US Treasury (June 2007) �Semiannual Report on International Economic and

Exchange Rate Policies�

The Arguments of China�s Trade Partners

Many countries claimed that the renminbi was undervalued. In December 2005, US senators Schumer and Graham proposed imposing a 27.5% tariff on Chinese imports if the Chinese government was not to further revaluate the renminbi. The Treasury Under Secretary for International Affairs announced that the US was �absolutely not satisfied� with the new regime adopted by China.12 It was claimed that the PBoC manipulated the exchange rate to lower the prices of exports and that a number of American factories had been forced into bankruptcy because of the unbeatable prices of Chinese imports. Economists generally concluded that the renminbi was undervalued, yet differed on the extent of the devaluation, with models ranging from 10% to 50%. The US was preoccupied with its high trade deficit with China, a whopping US$233 billion in 2006 [see Exhibit 4]. Yet, even the calculation of the trade deficit between the US and China was a matter of debate. China�s trade data showed a deficit of only US$144 billion. 13 According to some economists, the US data were more reliable but they had to be deflated by 25% due to various adjustments.14 The US pointed out that China�s exports had exploded at an annual rate exceeding 30% over the past years to reach US$593 billion in 2004 (6.5% of the world�s exports) and US$762 billion in 2005 [see Exhibit 5]. The Chinese current-account surplus was also increasing quickly, reaching US$177 billion in 2006.15 Another argument used to demonstrate the undervaluation of the currency was China�s inflow of FDI, which had dwarfed its outward FDI since the country�s economic opening in 1978. China had been the world�s second-largest recipient in 2004 with US$61 billion, and FDI had exceeded US$63 billion in 2006 [see Exhibit 6].16 The level of FDI into China had constantly exceeded US$40 billion since 1996. However, while outward FDI from China had traditionally been miniscule by comparison, it had nonetheless mushroomed from a tiny US$1.8 billion in 2004 (according to the Chinese Finance Ministry) to US$16.1 billion in 2006.17 Unlike the US and Europe, who frequently blamed China for economic imbalances, Japan and the newly industrialised economies (�NIEs�), including Taiwan and South Korea, were less vocal. These countries had considerably strengthened their economic links with China. For

12 Economist Intelligence Unit (5 January 2006) �China Finance: Renminbi Reform Continues�, ViewsWire, Financial Services Briefing. 13 China�s Ministry of Commerce (MOFCOM), 2006 Trade Statistics, http://zhs.mofcom.gov.cn/tongji2006.shtml (accessed 28 June 2007). 14 Although Hong Kong returned to China in 1997, US and Chinese statistics still treated Hong Kong as a separate entity from the rest of China due to its autonomous political status. Hong Kong, which was a re-exports centre for goods to be sent from or to China, mistakenly appeared as the final destination in these statistics. For a more in-depth description of the necessary adjustments to official data, refer to Fung, K.C. and Lau, L.J. (2003) �Adjusted Estimates of United States � China Bilateral Trade Balances: 1995�2002�, Journal of Asian Economics, 14. 15 MOFCOM, 2006 Trade Statistics, http://zhs.mofcom.gov.cn/tongji2006.shtml (accessed 28 June 2007). 16 MOFCOM, 2006 Trade Statistics, http://zhs.mofcom.gov.cn/tongji2006.shtml (accessed 28 June 2007). 17 MOFCOM, 2006 Trade Statistics, http://zhs.mofcom.gov.cn/aarticle/Nocategory/200702/20070204346781.html (accessed 28 June 2007).


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example, China imported 18% of its goods from Japan, its primary supplier in 2004. Japan and NIEs had transferred many factories to China, keeping only the production of high-value-added components at home. For example, a Korean manufacturer might produce the chip for an MP3 player, and then have the parts produced and assembled at much lower costs in China. This increasing division of labour had stimulated what was called �processing trade��raw materials or intermediate products were imported by a country which processed them (generally, assembly in the case of China) before re-exporting. It was through processing trade, which accounted for no less than half of China�s imports and exports,18 that China had integrated into the world�s economy. In fact, finished products that used to be exported from Japan or NIEs were increasingly exported from China, although most of the benefits of value-added processing were captured by Japan and NIEs. As for developing Asian countries, most were worried about China�s economic rise. They often competed with China in the same categories of products and China�s prices were often impossible to match. A revaluation of the renminbi would provide breathing space to develop their economies in a less competitive environment.

China�s Response

The Chinese government rejected external pressure, responding that the currency was not, or at least not significantly, undervalued. Officials said that its economic growth had nothing to do with the manipulation of its currency and that foreign pressure would only delay reforms of its exchange rate regime. China argued that an analysis focusing on Chinese exports and the US�China trade deficit was misleading. China�s imports�consisting mostly of intermediate goods from processing trade and raw materials�had soared as well, amounting to US$660 billion in 2005 (a year on year increase of 18%) and US$792 billion in 2006 (up 20%) [see Exhibit 7].19 While China ran a large trade surplus with the US and Europe, a fact frequently overlooked by journalists was that it had large deficits with other countries, especially with Asian countries [see Exhibit 8]. Officials said the PBoC�s interventions would also benefit the US, helping it to finance its huge budget and trade deficits (US$248.2 billion and US$758.5 billion, respectively, in 2006). 20 The US ran large deficits not only with China but with many Asian countries, including Japan, which also intervened to avoid an appreciation of their currencies [see Exhibit 9]. 21 Japan, China and other Asian countries bought large amounts of US Treasury bonds and many wondered whether they should continue to do so. If these countries stopped buying US Treasury bonds, interest rates in the US would be forced to rise, hurting the US economy. This was because a rising debt should translate into higher interest rates demanded by investors. Although the US dollar had remained strong from 2005 through mid-2006, that was partly because of the increase in interest rates conducted by the US Federal Reserve.

18 MOFCOM, 2005 Import-Export Composition, http://zhs.mofcom.gov.cn/aarticle/Nocategory/200602/20060201484767.html (accessed 3 October, 2007) 19 MOFCOM, 2005 Trade Statistics, http://zhs.mofcom.gov.cn/aarticle/Nocategory/200602/20060201484552.html; MOFCOM, 2006 Trade Statistics, http://zhs.mofcom.gov.cn/aarticle/Nocategory/200702/20070204346781.html (accessed 28 June 2007). 20 Budget of the United States Government, http://www.gpoaccess.gov/usbudget/fy08/pdf/hist.pdf and US Census Bureau, Foreign Trade Statistics, http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf (accessed 29 June 2007). 21 Takebe, M. (18 May 2004) �Sayonara, Mr. Dollar; Welcome, Mr. Euro?�, Wall Street Journal (Europe).


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China added that multinational companies had benefited from its low operating costs, with foreign-invested companies accounting for 55% of Chinese exports. 22 In fact, most multinationals were very discreet in the debate over the revaluation of the renminbi. A senior executive of Korea-based LG Electronics said, �A weaker yuan means cheaper land and labour and more competitively priced China-made exports. Given the importance of China as our production base, we don�t want a sudden change in the value of the renminbi.�23 China said that its reserves had been growing because of the large inflow of �hot money� [see Exhibit 10]. This term referred to the funds brought to China by speculators, Chinese and foreign, betting on a future revaluation of the renminbi. Despite its capital controls, China could not totally prevent this inflow. �The administrative controls aren�t working, because everyone is finding ways to circumvent the banks�, said the head of emerging-market research at JPMorgan Securities.24 China said that it was because of this inflow of speculative money that the exchange rate was under pressure.

Lessons from China�s Neighbours

The Appreciation of the Yen

Japan had been pressed to reform its exchange rate policy in the past. The yen was fixed at ¥360 to the US dollar from 1950 to 1971. During that period, the Japanese economy experienced high growth, with exports as an important driver increasing by 16.9% per year.25 In the early 1970s, high inflation in the US hurt the competitiveness of exports. The US dollar was devalued when the Bretton Woods system 26 ended in 1971. In 1973, the yen was officially floated with an exchange rate of ¥271, reaching ¥227 in 1980 in spite of Japan�s continued intervention to limit the rise. Despite the gradual appreciation of the yen, many sectors in the US, from steel to electronics, seemed flooded with Japanese imports in the early 1980s. The US government blamed the undervaluation of the yen and threatened to block Japanese imports if the yen were not revalued and if the Japanese market were not opened to US imports. In 1985, the five largest economies (the US, Japan, West Germany, UK and France) agreed in the Plaza Accord to let the US dollar depreciate against the yen and the Deutsche Mark. The US dollar lost half of its value against these currencies. In 1987, the same countries signed the Louvre Accord to stabilise the US dollar. It was agreed that their currencies would fluctuate within an unpublished set of ranges with the commitment to intervene if necessary, after which the US dollar regained value.

22 MOFCOM, 2006 Exporting Enterprise Breakdown, http://zhs.mofcom.gov.cn/aarticle/Nocategory/200702/20070204344012.html (accessed 3 October, 2007) 23 Business Week (7 March 2005) �Who Wants China�s Yuan to Rise?�. 24 Business Week (18 October 2004) �Untying the Yuan Would Get China out of a Bind�. 25 Eichengreen B. and Hatase, M. (July 2007), �Can a Rapidly-Growing Export-Oriented Economy Smoothly Exit an Exchange Rate Peg? Lessons for China from Japan�s High-Growth Era,� Explorations in Economic History, Madison. 26 Bretton Woods system of international monetary management established the rules for commercial and financial relations amongst the world's major industrial states in the wake of World War II. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value�plus or minus one percent�in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. Until its collapse from strain in 1971, the Bretton Woods system was effective in controlling conflict and in achieving the common goals of the leading states that had created it, especially the United States. Ironically, it was the United States' suspension of convertibility from dollars to gold that became the final straw.


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The Plaza Accord partly solved the US�s problem by reducing its trade deficit with Europe. It did not, however, reduce its deficit with Japan because of structural reasons: the two countries� companies were generally not selling the same categories of products and the Japanese market remained closed to US imports. However, the Japanese economy, which relied heavily on trade, was affected by the appreciation of the yen. The government reacted by launching an expansionary monetary policy that generated a property and stock bubble. In the late 1980s, the bubble burst, plunging the country into deflation throughout the 1990s.

The Asian Crisis

Before the Asian crisis, many Asian currencies had their currencies pegged to the US dollar. Between 1995 and 1997, the US dollar appreciated sharply and the Asian currencies followed. At that time, East Asian countries ran current account deficits, counter-balanced by large investment inflows coming from developed countries. In 1997, investors feared that the economic productivity of these countries had not improved fast enough, despite their high GDP growth, that the banks had accumulated substantial risks, and that currencies were overvalued. Speculators attacked Asian currencies and capital was withdrawn, severely hurting the real estate and stock markets. Governments were forced to abandon the peg to the US dollar, their currencies collapsed and a deep recession followed. To explain this debacle, many economists blamed the peg to the US dollar, a risky link between economies not sharing the same fundamentals. During the crisis, China maintained its peg. Capital controls made it easier to maintain the stability of the renminbi. China ruled out a devaluation of the renminbi, a decision praised by its neighbours as a gesture to avoid further instability.

The Peg of the Hong Kong Dollar to the US Dollar

The Hong Kong dollar had been pegged to the US dollar at a rate of HK$7.8 to the US dollar since October 1983, with a small fluctuation margin between HK$7.75 and HK$7.85. The monetary system was a currency board system wherein the issue of one Hong Kong dollar had to be fully backed by equivalent reserves in US dollars [see Exhibits 11 and 12]. As a result, Hong Kong owned the world�s eighth-largest US dollar reserves (US$136 billion in mid-2007).27 This system forced the Hong Kong Monetary Authority to adjust domestic interest rates to the US interest rate. In other words, there was no autonomous monetary policy. The peg had been maintained despite a number of crises in the past, including the Tiananmen crackdown in mainland China in 1989, the hand-over of Hong Kong to China and the Asian crisis in 1997, during which Hong Kong refused to follow its neighbours in devaluing its currency. The price Hong Kong paid was five years of deflation. Although the decision to maintain the peg helped protect the status of Hong Kong as a financial centre, there were periodic calls for an end to the peg and the adoption of a more flexible exchange rate system.

China Facing Important Decisions

The difficulty is that after a decade of a tight peg, China�s banks, firms and politicians are terrified of the uncertainty of a float.

- The Economist (21 May 2005) �Time to Let Go; China�s Currency�

27 Hong Kong Monetary Authority, �Economic and Financial Data for Hong Kong,� http://www.info.gov.hk/hkma/eng/statistics/index_efdhk.htm (accessed 29 June 2007).


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Although China refused to bend to external pressure, its officials were preoccupied by the exchange rate policy. The accumulation of US dollar-denominated reserves posed a risk in the long term. The US dollar could weaken because of the US trade and budget deficits, forcing China to partially write off its foreign currency reserves in case of revaluation. To mitigate this risk, the central banks of many Asian countries were progressively diversifying their reserves, increasing the share of currencies like the euro or the yen. In May 2007, the Chinese government announced a capital injection of US$3 billion into US private equity group, Blackstone, which most commentators viewed as a move toward riskier placements of funds from the country�s overflowing foreign reserves. China also risked the threat of retaliation measures adopted by economic partners if it did not act on the situation. For a country so reliant on trade, it was vital to maintain the growth of exports. China constantly had to find jobs for millions of farmers leaving the countryside for higher-paid jobs in cities. High economic growth was necessary to absorb this workforce and maintain social stability. Chinese exporters� profit margins were thin and a revaluation would be harmful to many of them. An official at China�s National Bureau of Statistics claimed that if a 3 to 5% revaluation were adopted, the annual growth of exports would be 10% instead of 30%, and if there were a 15% revaluation, exports could drop.28 Chinese officials believed, however, that before having a major revaluation or lifting capital controls, the priority was to reform the shaky banking sector. Although China�s economy had been growing remarkably fast, banks were plagued with a mountain of non-performing loans (up to 40%, according to various estimates29). State-owned banks had been instructed to support ailing public companies for years, and the country�s excessive liquidity encouraged banks to lend more. If capital controls were lifted, many Chinese would send their savings to safer banks overseas, threatening the stability of the financing system. The Chinese government was exploring alternatives to a revaluation of the renminbi. To this end, the authorities had launched a �go abroad� policy, encouraging Chinese companies to invest abroad. While China wanted to develop large internal groups and brands, outward FDI was also aimed at reducing the reserve of foreign currencies. In 2004 and 2005, however, high-profile acquisitions or bids (eg, Lenovo of IBM�s PC activities and CNOOC of Unocal) had generated additional tensions with the US. Another possible reform was to impose a voluntary export tax. 30 Unlike revaluation, a tax would not affect the value of foreign currency reserves, and export taxes were generally permitted by the WTO. In doing so, the Chinese government would also receive much-needed tax revenues. The mild revaluation of the renminbi in 2005 had done little to appease tensions between China and its partners and the issue was still extremely controversial through mid-2007. How much would China let its currency further appreciate? Accumulating even more US dollar-denominated reserves could be risky. But China was relying so much on exports that a revaluation could hurt its economic momentum. Whatever China decided, it would have important consequences on its economy and the economies of its partners. Was the renminbi undervalued? What would be the consequences of a revaluation on China and its trade partners? If a profound reform were to take place, should it be conducted gradually or not? If the renminbi were floated, how would it affect its exchange rate? What were the strengths and disadvantages of each exchange rate regime? What should be China�s exchange rate policy?

28 Quoted in The Economist (21 May 2005) �What�s it Worth?: Revaluing China�s Currency�. 29 Certain sectors were hit with exceptionally bad default rates, such as the car industry, according to South China Morning Post (6 May, 2007), �Car finance slumps after fraud, bad loans drive lenders out.� 30 Lau, J.L. (25 September 2003) �Is China Playing by the Rules? Free Trade, Fair Trade, and WTO Compliance�, Testimony at a Hearing of the Congressional-Executive Commission on China, Washington D.C.


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EXHIBIT 1: FLUCTUATIONS IN THE OFFICIAL RATE OF THE RENMINBI

Note: Data between 1988 and 1994 should be read with caution, as the overvalued official exchange rate (represented above) coexisted with market rates that represented 80% of transactions in 1993. Sources: China Statistical Yearbook, http://www.stats.gov.cn/english/ (accessed 29 June 2007) and Currency Converter for 164 Currencies, http://www.oanda.com/convert/classic (accessed 29 June, 2007).


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EXHIBIT 2: CHINA AND JAPAN�S FOREIGN CURRENCY RESERVES

0

200

400

600

800

1,000

1,200US

$ bi

llion

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

China Japan

Sources: China Statistical Yearbook, http://www.stats.gov.cn/english/ (accessed 29 June 2007) and Statistics Bureau of Japan, http://www.stat.go.jp/english/data/nenkan/index.htm (accessed 29 June, 2007)


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EXHIBIT 3: EVOLUTION OF ASIAN CURRENCIES AGAINST THE US DOLLAR AFTER THE RENMINBI REVALUATION IN JULY 2005

90

95

100

105

110

115

120

125

130

Jul 0

5

Sep 05

Nov 05

Jan 0

6

Mar 06

May 06

Jul 0

6

Sep 06

Nov 06

Jan 0

7

Mar 07

May 07

Korean WonThai BahtIndonesian RupiahMalaysian Ringgit

Basis 100: July 2005.

Source: Currency Converter for 164 Currencies, http://www.oanda.com/convert/classic (accessed 29 June, 2007).


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EXHIBIT 4: US MERCHANDISE TRADE DEFICIT WITH CHINA

0

50

100

150

200

250

US

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16

EXHIBIT 6: FDI INFLOW INTO CHINA AND SOURCES OF FDI

Year FDI

(US$ billion) 1979�1984 3.1 1985 1.7 1989 3.4 1990 3.5 1991 4.4 1992 11.0 1993 27.5 1994 33.8 1995 37.5 1996 41.7 1997 45.3 1998 45.5 1999 40.3 2000 40.7 2001 46.9 2002 52.7 2003 53.5 2004 60.6 2005 60.3 2006 63.0

Sources:

China Statistical Yearbook, http://www.stats.gov.cn/english/ (accessed 29 June 2007).

For 2006, MOFCOM, press announcement (preliminary data).

Source of FDI

in 2004 FDI (US$ million)

Hong Kong 18,998 Virgin Islands 6,730 South Korea 6,248 Japan 5,452 United States 3,941 Taiwan 3,117 Cayman Islands 2,043 Singapore 2,008 Samoa 1,129 Germany 1,058 Netherlands 811 United Kingdom 793 Australia 663 France 657 Canada 614

Source of FDI in 2005 FDI (US$ million)

Hong Kong 17,949 Virgin Islands 9,022 Japan 6,530 South Korea 5,168 United States 3,061 Singapore 2,204 Taiwan 2,152 Cayman Islands 1,948 Germany 1,530 Samoa 1,352 Netherlands 1,044 United Kingdom 965 France 615 Canada 454 Australia 401


17

EXHIBIT 7: COMPOSITION OF CHINA�S IMPORTS IN 2004 AND 2005

Source: China Statistical Yearbook, http://www.stats.gov.cn/english/ (accessed 29 June 2007).

Unit in US$ million 2004 2005 Primary goods 117,267 147,714

Food, live animals, beverages and tobacco 9,702 10,171 Non-edible raw materials 55,358 70,226 Mineral fuels, lubricants, etc. 47,993 63,947 Animal and vegetable oils, fats and waxes 4,214 3,370

Manufactured goods 443,962 512,239

Chemicals and related products 65,473 77,734 Light industrial products, rubber, minerals, iron, etc. 73,986 81,157

Machinery and transport equipment 252,830 290,478 Miscellaneous products 51,672 62,870

Total 561,229 659,953


18

EXHIBIT 8: CHINA�S MERCHANDISE TRADE SURPLUSES AND DEFICITS WITH MAJOR TRADE PARTNERS IN 2005 AND 2006

Unit in US$ billion 2005 2006

Country or region Exports Imports

China�s trade

surplus (+)/ deficit (-)

Exports Imports

China�s trade

surplus (+)/ deficit (-)

Total 762.0 660.1 101.9 969.1 791.6 177.5 North America 174.7 56.3 118.4 219.1 66.9 152.2 EU 143.7 73.6 70.1 215.4 114.9 100.5 Asia 366.4 441.5 -75.1 455.8 525.5 -69.7 ASEAN 55.4 75.0 -19.6 71.3 89.5 -18.2 Africa 18.7 21.1 -2.4 26.7 28.8 -2.1 Latin America 23.7 26.8 -3.1 36.0 34.2 1.8 Oceania 12.9 18.0 -5.1 16.0 21.3 -5.3 United States 162.9 48.7 114.2 203.5 59.2 144.3 Hong Kong 124.5 12.2 112.3 155.4 107.9 47.5 Canada 11.7 7.5 4.1 15.5 7.7 7.8 Singapore 16.6 16.5 0.1 23.2 17.7 5.5 India 8.9 9.8 -0.8 14.6 10.3 4.3 Australia 11.1 16.2 -5.1 13.6 19.3 -5.7 Brazil 4.8 10.0 -5.2 7.4 12.9 -5.5 Thailand 7.8 14.0 -6.2 9.8 18.0 -8.2 Philippines 4.7 12.9 -8.2 5.7 17.7 -11.9 Saudi Arabia 3.8 12.2 -8.4 5.1 15.1 -10.0 Malaysia 10.6 20.1 -9.5 13.5 23.6 -10.1 Japan 84.0 100.5 -16.5 91.6 115.7 -24.1 South Korea 35.1 76.8 -41.7 44.5 89.8 -45.3 Taiwan 16.5 74.7 -58.1 20.7 87.1 -66.4

Source: MOFCOM, http://english.mofcom.gov.cn/static/column/statistic/ie.html/1 (accessed 29 June, 2007).


19

EXHIBIT 9: FLUCTUATIONS OF THE EXCHANGE RATE OF THE RENMINBI AGAINST OTHER CURRENCIES

-30.0%

-25.0%

-20.0%

-15.0%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

GBPJPY

EURRMB

Note: This graph represents the percentage of appreciation/depreciation of each currency relative to the US dollar over the period 1995−2006 (1999−2006 for the euro).

Source: Currency Converter for 164 Currencies, http://www.oanda.com/convert/classic (accessed 29 June, 2007).


20

EXHIBIT 10: CHINA�S BALANCE OF PAYMENTS (US$ million) 2002 2003 2004 2005 2006

Current accountCurrent-account balance 35,422 45,875 68,659 160,818 249,866Trade balance 44,167 44,652 58,982 134,189 217,746Services balance -6,783 -8,572 -9,699 -9,392 -8,834Income balance -14,946 -7,838 -3,523 10,635 11,755Current transfers balance 12,984 17,635 22,898 25,386 29,199

Capital balanceGross financing requirement -45,593 -49,674 -35,723 24,200 81,368

Inward direct investment 49,308 47,077 54,937 79,127 78,095Outward direct investment -2,518 152 -1,805 -11,306 -17,830Net direct investment flows 46,790 47,229 53,132 67,821 60,265

Inward portfolio investment 1,562 6,663 8,719 17,602 42,211Outward portfolio investment("+" indicates invested funds coming back to China) -12,095 2,983 6,486 -26,157 -110,419Net portfolio investment flows -10,533 9,646 15,205 -8,555 -68,208

Other capital flows (net) 1,102 -3,692 33,784 -51,555 -29,721Change in international reserves("−" sign indicates an increase) -76,504 -117,023 -206,349 -207,014 -246,976

Memorandum itemsForeign-exchange reserves 291,128 408,151 614,500 821,514 1,068,490Current-account balance/GDP (%) 2.4 2.8 3.5 7.1 9.2*Trade balance/GDP (%) 3 2.7 3 5.9 8* Workers' remittances 13,012 17,815 19,014 22,492 28,500* * Economist Intelligence Unit estimates. Source: Economist Intelligence Unit (21 June 2006) �Country Risk Service, Updater�.


21

EXHIBIT 11: CLASSIFICATION OF EXCHANGE RATE REGIMES

Exchange Arrangements with No Separate Legal Tender

The currency of another country circulates as the sole legal tender (for instance, if a South American country uses the US dollar as its national currency), or the member belongs to a monetary or currency union (eg, euro) in which the same legal tender is shared by the members of the union. Adopting such regimes implies the complete surrender of the monetary authorities� independent control over domestic monetary policy.

Currency Board Arrangements

A monetary regime based on an explicit, legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfilment of its legal obligation. This implies that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, eliminating traditional central bank functions such as monetary control and lender-of-last-resort, and leaving little scope for discretionary monetary policy. Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement are.

Other Conventional Fixed Peg Arrangements

The country (formally or de facto) pegs its currency at a fixed rate to another currency or a basket of currencies. The basket is formed from the currencies of major trading or financial partners, and weights reflect the geographical distribution of trade, services or capital flows. The exchange rate may fluctuate within narrow margins. The monetary authority stands ready to maintain the fixed parity through direct intervention (eg, via sale or purchase of foreign exchange in the market) or indirect intervention (eg, via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity or through intervention by other public institutions). There is a limited degree of monetary policy discretion, depending on the bandwidth.

Crawling Pegs

The currency is maintained within a bandwidth around a central rate, which is adjusted periodically at a fixed pace or in response to changes in selective quantitative indicators, such as the evolution of a basket of currencies. The commitment to maintain the exchange rate within the band imposes constraints on monetary policy, the degree of policy independence being a function of the band width.

Managed Floating with No Predetermined Path for the Exchange Rate

The monetary authority attempts to influence the exchange rate without having a specific exchange rate path or target. Indicators for managing the rate are broadly judgmental (eg, balance of payments position or international reserves), and adjustments may not be automatic, as intervention may be direct or indirect.

Independently Floating

The exchange rate is market-determined, with any official foreign exchange market intervention aimed at moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than at establishing a level for it.

Source: Adapted from International Monetary Fund, �Exchange Arrangements and Foreign Exchange Markets: Developments and Issues�, http://www.imf.org/external/np/mfd/er/2004/eng/1204.htm (accessed 29 June 2007).


22

EXHIBIT 12: DE FACTO EXCHANGE RATE REGIMES This classification system is based on members� de facto arrangements as identified by staff at the International Monetary Fund and may differ from their officially announced arrangements.

Another currency as legal tender

Ecuador, El Salvador, Marshall Islands, Micronesia, Panama

ECCU Antigua and Barbuda, Dominica, Grenada, St. Lucia, St. Vincent and the Grenadines

CFA franc zone

Benin, Burkina Faso, Cameroon, Central African Republic, Chad, Congo, Côte d�Ivoire, Equatorial Guinea, Gabon, Guinea-Bissau, Mali, Niger, Senegal and Togo

Exchange arrangements with no separate legal tender

Euro zone Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain

Currency board arrangements

Bosnia and Herzegovina, Brunei, Bulgaria, Hong Kong, Djibouti, Estonia and Lithuania

Against a single currency

Aruba, the Bahamas,2 Bahrain, Barbados, Belize, Bhutan, Cape Verde, Comoros, Cyprus, Denmark, Eritrea, Guinea,1 Hungary,

Iraq,1 Jordan,1 Kuwait, Lebanon,1 Lesotho, Macedonia,1 Malaysia, Maldives, Namibia, Nepal, Netherlands Antilles, Oman, Qatar, Saudi Arabia, Seychelles,, Slovenia, Swaziland, Syria,2 Trinidad and Tobago,1 Tonga, Turkmenistan,1 Ukraine,1 United Arab Emirates and, Venezuela

Other conventional fixed peg arrangements

Against a composite

Botswana,2 Fiji, Latvia, Malta, Morocco, Samoa and Vanuatu

Crawling pegs Bolivia, China, Costa Rica, Honduras,1 Nicaragua, Solomon Islands1 and Tunisia Managed floating with no pre-determined path for the exchange rate

Afghanistan, Algeria, Angola, Argentina, Azerbaijan, Bangladesh, Burundi, Cambodia,2 Croatia, Czech Rep., Egypt, Ethiopia, Gambia,1 Georgia, Ghana,1 Guatemala,1 Guyana, Haiti,1 India, Indonesia, Iran, Jamaica,1 Kazakhstan, Kenya, Kyrgyz Rep., Mauritania, Mauritius, Moldova, Mongolia, Mozambique,1 Myanmar,1,2 Nigeria,1 Pakistan, Paraguay, Peru, Romania, Russian Federation, Rwanda, Serbia and Montenegro, Singapore, Slovak Rep., Sudan, Suriname,2 Tajikistan, Thailand, Uzbekistan,2 Vietnam, Zambia and Zimbabwe2

Independently floating

Albania, Armenia, Australia, Brazil, Canada, Chile, Colombia, Congo Rep. of, Dominican Rep. of, Iceland, Israel,1 Japan, Korea, Liberia,1 Madagascar, Malawi, Mexico, New Zealand, Norway, Papua New Guinea, Philippines, Poland, Sierra Leone,1 Somalia,2 South Africa, Sri Lanka, Sweden, Switzerland, Tanzania, Turkey, Uganda, United Kingdom, United States, Uruguay and Yemen

Note: This table was prepared with data as of December 2004, except for China, which has been updated. 1 The regime operating de facto in the country is different from its de jure regime. 2 The member maintains an exchange arrangement involving more than one foreign exchange market. The arrangement shown is that maintained in the major market.

Source: Adapted from International Monetary Fund �Classification of Exchange Rate Arrangements and Monetary Policy Frameworks�, http://www.imf.org/external/np/mfd/er/2004/eng/1204.htm (accessed 29 June 2007).

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