The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of the U.S. Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia, and Panama. While not going that far, Senate Majority Leader Harry Reid and Sen. Charles Schumer have promised a vote on the issue sometime this year.
The root of the conflict for the United States -- and other countries -- is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011 -- fueling U.S. efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.
Although the U.S. Treasury has repeatedly stopped short of labeling China a "currency manipulator" in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank, and many economists have also argued for faster appreciation and a more flexible exchange-rate policy as part of a broader program of "rebalancing" the Chinese economy away from its traditional reliance on exports and investment and toward a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.
The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China's own economy by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest of both China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.
Chinese officials take a very different view. They see the exchange rate -- and prices and market mechanisms in general -- as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea, and Taiwan since World War II, or by Britain, the United States, and Germany in the 19th century. Because the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are "in China's interest." And because China -- unlike Japan in the 1970s and 1980s -- is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.
A second issue raised by China's currency and trade policies is the persistent trade surplus since 2004 that has contributed to about three-quarters of the nearly $3 trillion increase in China's foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. Treasury debt. Some fear that China has become the United States' banker and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China's recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China's intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All these concerns are based on serious misunderstandings of both international financial markets and China's domestic political economy. China is not in any practical sense "America's banker"; it is more a depositor than a lender, and its economic leverage over the United States is very modest.
And while China's leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China's domestic financial markets.