In the recent US presidential campaign, China was accused again of currency manipulation. In other words, the Chinese central bank is accused of maintaining the exchange rate at an artificially low level compared to its equilibrium value, including heavy intervention in the foreign exchange market. There has been a fierce debate on this issue in recent years, including on VoxEU.org (e.g., Persaud 2011, Reisen 2011, Reisen et al. 2011, Storesletten et al. 2010).
Underlying this debate is the difficult question of determining the equilibrium value of the renminbi. In recent years, the degree of undervaluation has arguably become a less serious issue since the renminbi has significantly appreciated in real terms as Figure 1 illustrates.
Figure 1. Real effective exchange rates
Source: International Monetary Fund; Based on Consumer Price Index.
Besides measurement issues in the equilibrium currency value, several economists have objected to the ‘currency manipulation’ perspective on more conceptual grounds. For example, Song et al. (2010) argue that the accumulation of foreign reserves reflects the country’s net saving, caused in particular by financial market imperfections. With a related perspective, in a recent paper we examine the optimal exchange rate policy in a model economy that shares features with the Chinese economy. We consider a semi-open economy, where the private sector faces capital controls while the central bank has free access to international capital markets. We also assume that the economy faces tight credit constraints and grows at a fast rate. In such a setting, we show that the optimal policy is to initially depreciate the currency and accumulate reserves, and to gradually appreciate the exchange rate later on. This policy allows the central bank to provide saving instruments to economic agents through its liabilities, which helps them accumulate assets and overcome credit constraints. Our results suggest that China should keep on appreciating its currency as the need for additional saving instruments gradually subsides. This medium-term appreciation coming from a gradual decline in saving rates can be contrasted with the so-called ‘Balassa-Samuelson effect’, where the gradual appreciation comes from productivity differentials.
Capital controls, reserve accumulation and the real exchange rate
Economists usually consider that the equilibrium real exchange rate is related to domestic saving and investment. Other things being equal, higher desired saving (or lower desired investment) should reduce demand and pressure on domestic prices, implying a real depreciation. This can also be seen from the perspective of the current account, which equals the difference between domestic saving and investment. Higher domestic saving implies a larger current account surplus, which requires a depreciated real exchange rate if it is to materialise at full employment.
This has led some commentators to argue that China could not manipulate its exchange rate in the long term. An undervalued nominal exchange rate ought to boost exports, overheat the economy, and result in higher domestic prices. This would bring the real exchange rate back to an equilibrium value consistent with desired saving and investment.
However, in a semi-open economy with strict restrictions on private capital flows, the current account balance is essentially given by the increase in foreign reserves, which the central bank controls. But how can the central bank affect domestic saving and investment? The answer lies in the central bank balance sheet: the counterpart of foreign reserves is domestic liabilities, for instance sterilisation bonds, or accounts of commercial banks. A central bank which buys international reserves and finance them by issuing domestic saving instruments can force the private sector to increase its net saving. Adjustment comes from the domestic interest rate, which can deviate from the world interest r