China's Exchange Rate and Financial Repression: The Conflicted Emergence of the RMB as an International Currency

• DOI: http://doi.org/10.1111/j.1749-124X.2014.12066.x
• Author: Ronald McKinnon,Gunther Schnabl
• Published date: 01 May 2014
• Date: 01 May 2014

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China & World Economy / 1–35, Vol. 22, No. 3, 2014

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China’s Exchange Rate and Financial Repression:

The Conflicted Emergence of the RMB

as an International Currency

Ronald McKinnon, Gunther Schnabl*

Abstract

Instability in the world dollar standard, as most recently manifested in the US Federal

Reserve’s near-zero interest rate policy, has caused consternation in emerging markets

with naturally higher interest rates. China has been provoked into speeding RMB

“internationalization”; that is, opening up domestic financial markets to reduce its dependence

on the US dollar for invoicing trade and making international payments. However, despite

rapid percentage growth in offshore financial markets in RMB, the Chinese authorities are

essentially trapped into maintaining exchange controls (reinforced by financial repression

in domestic interest rates) to avoid an avalanche of foreign capital inflows that would

threaten inflation and asset price bubbles by driving nominal interest rates on RMB assets

down further. Because a floating (appreciating) exchange rate could attract even more hot

money inflows, the People’s Bank of China should focus on keeping the yuan/dollar rate

stable so as to encourage naturally high wage increases to help balance China’s international

competitiveness. However, further internationalization of the RMB, as with the proposed

Shanghai pilot free trade zone, is best deferred until world interest rates rise to more normal

levels.

Key words: China, exchange rate stabilization, financial repression, inflation, dollar standard,

internationalization of RMB

JEL codes: F3, F4, F5

I. Introduction

Despite past and present global monetary turmoil emanating from the USA, with policies of

*Ronald McKinnon, Professor, Economics Department, Stanford University, Stanford, USA. Email:

mckinnon@stanford.edu; Gunther Schnabl, Senior Fellow, Institute of Economic Policy, Leipzig University,

Leipzig, Germany. Email: schnabl@wifa.uni-leipzig.de. The authors thank Stefan Angrick, Raphael Fischer

and Zhao Liu for excellent research assistance.

2Ronald McKinnon, Gunther Schnabl / 1–35, Vol. 22, No. 3, 2014

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

zero short-term interest rates and longer-term quantitative easing expected to continue

with only modest reductions, the world (outside of Europe) is still on a US dollar standard

(McKinnon, 2013). In East Asia, international trade, including the burgeoning intra-industry

trade within the region, is mainly invoiced in US dollars. The US dollar remains the dominant

means of settlement for international payments among banks, and is the principal intervention

currency used by governments, such as China’s, for smoothing exchange rate fluctuations.

Because other countries choose to peg, or at least smooth their exchange rates against

the dollar, the USA does not have any direct exchange rate policy of its own. The US

government holds hardly any official foreign reserves and rarely intervenes in foreign

exchange markets. This passivity is critical to the smooth functioning of the international

dollar standard because it prevents direct conflict between foreign central banks in setting

their exchange rates. Once any one country, say China, targets 6.1 yuan/dollar, and other

countries in Asia and Latin America also set their exchange rates against the dollar, triangular

arbitrage determines the whole structure of cross rates (spot and forward) between any pair

of non-dollar currencies as long as the US bond markets remain open to foreigners to

transact freely at all terms to maturity (McKinnon, 1979). By abstaining from official

intervention, the USA, at the center of the world dollar standard, facilitates multilateral

exchange. By intervening only in dollars, foreign central banks avoid intervening at cross-

purposes with each other.

Despite global pressure to make the Chinese RMB more flexible and to let it appreciate

against the dollar, sometimes called “China bashing,” the People’s Bank of China (PBC)

has mostly kept the RMB stable against the US dollar since 1994, when the domestic

system of multiple exchange rates was unified at 8.28 yuan per dollar. True, the RMB was

allowed to gradually appreciate against the dollar from July 2005 to July 2008 and since

2010. However, over the past 20 years until the present rate of 6.1 yuan/dollar in early 2014,

the PBC has kept China’s dollar exchange rate remarkably stable in comparison to other

East Asian and emerging market (EM) currencies.

Since 2000, however, the American push for China to allow the RMB to appreciate

against the dollar, ostensibly to reduce China’s current account surplus, has persisted

(Cline and Williamson, 2012; Bergsten, 2013). Because full exchange rate flexibility is only

possible if the RMB is fully convertible and backed by large and developed financial

markets (McKinnon and Schnabl, 2004), demands to make the RMB more flexible have been

paired with demands to liberalize the Chinese capital market both nationally and

internationally (Ito, 2011; Prasad and Ye, 2012; Ballantyne et al., 2013). Indeed, the role of

the RMB in rapidly growing offshore financial markets (Craig et al., 2013), and bilateral

swap agreements with a growing number of central banks, has promoted a still-modest use

of the RMB in China’s border trade.

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China’s Exchange Rate and Financial Repression

©2014 Institute of World Economics and Politics, Chinese Academy of Social Sciences

However, with near-zero short-term interest rates and persistent quantitative easing in

the longer term in the USA and other large industrial countries (combined with

underdeveloped Chinese capital markets), China is well advised to keep the RMB tightly

pegged to the dollar. We shall also show that China should maintain tight capital controls

to avoid further hot money inflows that threaten exchange appreciation and a loss of

monetary control by the PBC, which would lead to general inflation and further upward

pressure on property prices.

For comparison, in Section II, we draw on Japan’s experience more than 30 years ago

with international pressure to appreciate the yen to reduce Japan’s trade surplus versus

the USA: “Japan bashing.” What were the repercussions for goods and financial markets

of massive yen appreciations from 360 yen/dollar in 1971 to 80 yen/dollar by 1995? We

argue that, given China’s role as an immature international creditor today, exchange rate

stability against the dollar, exchange controls on financial inflows and some repression in

interest rates on RMB assets is currently a better option than full financial liberalization.

Rapid increases in Chinese wages at a stable yuan/US dollar rate then become the natural

variable for balancing international competitiveness without inducing more hot money

flows from expected exchange rate appreciation.

II. Exchange Rate as a Contested Stabilizer

Since 1994, China’s fixed dollar exchange rate has been the basis for an impressive economic

catch-up driven by foreign direct investment (FDI) and rapid export expansion. Multinational

firms set up production platforms in China for worldwide sales, mainly invoicing in US

dollars. The sheer magnitude of this export success was bound to awaken a protectionist

reaction in the more mature industrial countries in North America, Europe and Japan. However,

under Premier Zhu Rongji, China joined the World Trade Organization (WTO) in 2001.

Thus, foreign member countries could not mount direct protectionist strategies using tariffs

or quotas to restrict imports from China, in contrast to what happened to Japan three

decades ago. Although antidumping duties on Chinese imports are legal under the WTO,

these procedures are sufficiently complex that they restrain protectionists. Compared to

the earlier experience of Japan, multinational firms are more reluctant to file dumping suits

against imports from China if only because they have Chinese manufacturing facilities of

their own.

Therefore, foreign governments, led by the USA, have focused more on the yuan/

dollar rate as the principal tool to contain Chinese exports. They claim that the RMB has

been deliberately kept undervalued to give Chinese exports an unfair mercantile advantage: