The People’s Money

CHINA’S MODEL OF development, with its emphasis on cheap capital (hence domestic financial repression) and low-price exports (hence the importance of managing the exchange rate, as I will discuss later in this chapter), has driven the transformation of the real economy. But this extraordinary transformation has not been matched by a similar development on the monetary and currency front. The international use of the renminbi as a means of exchange, unit of account, and store of value—the functions that an international currency is expected to perform¹—is restricted by its limited convertibility, which is a consequence of the country’s uncompetitive banking and financial sector.

The link between a nation’s economic development and its international standing has always been reflected in the world of currencies. Countries that are well integrated at the regional or global level have both well-functioning and relatively open market economies and international currencies—and among them, the largest economies have key international currencies (or reserve currencies). Although China now does have a reserve currency, the footprint of its currency is still tiny compared to its economic heft. To paraphrase Nobel laureate Robert Mundell, China is a great nation without a great currency.²

Before the dollar, the pound sterling (or pound, for short) was the world’s key currency, widely circulated within the British Empire, and used to invoice, settle, and finance the largest proportion of world trade. Britain was the first industrial nation, the world’s largest economy (accounting for about 8 percent of global gross domestic product), a powerful empire, and an international center for trade and finance. Factories in Manchester, Sheffield, and northern England needed commodities and semimanufactured goods to build engines, steamships, locomotives, and railways, and those in the increasingly prosperous and expanding middle class were enthusiastic consumers of sugar, tea, coffee, spices, silver, and silk. Between 1860 and 1914, Britain absorbed more than 20 percent of exports from the rest of the world.

Until the outbreak of World War I, when its convertibility was suspended, the pound “bestrode the financial world like a colossus.”³ It kept Great Britain at the center of the world’s economy and finance well into the twentieth century, even though the British economy had been overtaken in terms of total national income by the United States by 1870 and in terms of industrial power by the United States around 1880 and by Germany around 1905. Even in 1947, pounds still accounted for about 87 percent of global foreign exchange reserves. It took ten years after the end of World War II (and a 30 percent devaluation) before the share of dollars held in official reserves exceeded that of pounds. By the early 1970s, most pegs to the pound were replaced by pegs to the dollar or to trade-weighted baskets, and the pound’s commercial role declined rapidly relative to the dollar during the oil crisis. As Catherine Schenk argues in The Decline of Sterling, rising international liquidity, inflation, geographical redistribution, and international cooperation were the cornerstones that eased the retreat of the pound from global to national status.⁴

The intertwined development of Britain and its pound, and then of the United States and its dollar (as discussed in chapter 1), emphasizes the anomaly of China’s development. Like Britain in the nineteenth century and the United States in the twentieth, China is now the world’s largest trading nation and a powerful country in geopolitical terms. But unlike Britain and the United States, it does not have a currency that reflects and complements its rise to the status of international power. In today’s multipolar world economy, in which the relative weight of the United States has decreased while that of China and other developing countries has increased, China’s lack of an international currency is as incongruous as the United States’ monetary hegemony is anomalous.

In this chapter and the next I delve into the paradox of a great nation without a great currency. I maintain that the current state is a consequence of financial repression and the related policies that promote China’s model of development—including the management of the exchange rate to promote economic growth and full employment and the continuation of controls on capital movements. The exchange rate is now a crucial part of China’s growth model. The policy of managing the exchange rate has served China well and indeed has been instrumental in the transformation of the Chinese economy. However, it has also cemented the renminbi’s status as a dwarf currency. As I discuss below, China has now reached a point in its economic development when managing the exchange rate and accumulating foreign exchange reserves have become too costly to continue.

This separation was particularly targeted at imports’ prices, ensuring that the prices of domestically manufactured goods matched those of imported manufactured goods in order to protect China’s domestic industries—in particular, the machinery industry. The import pricing policies supported the resulting trade regime, which was fundamentally oriented toward replacing imported goods with domestically produced goods (import substitution).⁷ Imported producer goods, that were essential to manufacturing final goods for the domestic market, were about 90 percent of China’s total imports and were made available to domestic producers at relatively low prices. This practice made the foreign price of most imports irrelevant to the domestic end-user. The tightly planned system meant that there was little opportunity for the price of foreign exchange to influence the volume of either imports or exports.

In order to keep import prices low, the central government set the renminbi’s official exchange rate artificially high—and kept it there. In 1955, the renminbi’s exchange rate was fixed at 2.46 per dollar and remained virtually unchanged for almost two decades—but on the black market, rates were twice as much.⁸ The artificial overvaluation of the renminbi created excess demand for foreign exchange that could then be exchanged at a better rate on the black market—a sort of arbitrage between the black market and the official one. Therefore, this demand needed to be managed through a rigid and highly centralized system of exchange controls. These controls, in turn, constrained China’s transactions and interactions with the rest of the world, as firms could not easily get foreign money to pay for imports or exchange into renminbi the foreign money that they had earned from exports.

This system was incompatible with Deng Xiaoping’s strategy of trade liberalization. When he came to power, exports were money losers in domestic-currency terms, with 70 percent accruing financial losses. As the Chinese economy was increasingly relying on imports (such as commodities and semimanufactured goods) as part of its supply chain, the state could no longer feasibly hang onto its traditional mechanism for currency control. To finance imports to feed its expanding manufacturing sector, China needed to grow exports quickly and thus generate foreign exchange.

Extensive domestic price reforms—and, in particular, the reform of the official exchange rate—were necessary. The first step was to reduce the value of the renminbi to a level that would not undermine the competitiveness of Chinese exports. In 1981, the value of the renminbi was reduced almost by half, but subsequent devaluations over the next fifteen years were much smaller. The slow pace of devaluation was dictated not only by economic considerations (the monetary authorities feared that devaluation would contribute to domestic price inflation) but also by the need to overcome political hostility, especially from the central bank, the State Bureau of Commodity Prices, and the State Planning Commission.⁹ In those years, when China’s economic model was based on producing what was needed domestically, the exchange rate needed to be strong in order to keep the prices of commodities and other imports low enough for domestic manufacturing. The devaluation shifted the focus from import prices to export prices—buttressing Deng’s model of development and establishing the principle that the official exchange rate should cover the cost of earning foreign exchange.¹⁰

To facilitate demand for and supply of foreign exchange, in 1986, Chinese authorities decided to establish foreign exchange adjustment centers, or “swap centers,” in major cities. These centers mediated the exchange of foreign currencies between Chinese firms with an excess supply of these currencies and those with an excess demand for them—at whatever rates these parties found acceptable. This policy marked a very significant step toward establishing a market mechanism to allocate foreign exchange. In subsequent years, these centers were made more accessible and were established in more cities. They proved critical to developing the idea of trading at market rates and to establishing swap markets where Chinese and foreign businesses could trade renminbi for dollars, and vice versa.¹¹ In other words, within these centers, the Chinese authorities created an embryonic foreign exchange market where firms could trade with each other.

Another devaluation of the renminbi against all foreign currencies—this time by 15.8 percent—was announced in July 1986. Other devaluations followed, with the rate moving from 5.2 per dollar in November 1990 to 8.7 per dollar in April 1994. The exchange rate then stayed steady at around 8.2 renminbi per dollar until July 2005. This was the value of the renminbi when China joined the World Trade Organization (WTO). The stable and predictable exchange rate was a boon to firms involved in foreign trade and especially to exporters, as Chinese exports had become relatively cheap in dollar terms.

Central banks and monetary authorities use currency pegging in order to control volatility and to provide a nominal anchor for national price levels. Developing countries and emerging-market economies peg their currencies to an international currency (normally the dollar) to “import” price stability and give credibility to currencies that otherwise would be less credible in their own right. In particular, through pegging, countries reduce the exchange rate risk and avoid any currency appreciation that would undermine the competitiveness of their exports. Japan learned the danger of this when, from the mid-1980s through the 1990s, the erratically appreciating yen reduced exporters’ competitiveness and created a domestic deflationary spiral.¹² Pegging can also make sense for small, open economies, such as, for example, Denmark, that trade mostly with countries in Europe’s monetary union—the Danish krone has been pegged to the euro since 1999.

The downside of pegging is that a country’s monetary policy becomes indirectly linked to that of the country issuing the anchoring currency—notably, the United States. If, for example, the Federal Reserve adopts a more accommodative monetary policy that weakens the dollar’s exchange rate, then countries with a currency pegged to the dollar may end up with an “imported” monetary policy that is too accommodative for its own domestic conditions. Depegging therefore gives a country more flexibility in setting its own monetary policy. However, this was not China’s main concern when it started talking about shifting to a more flexible way to anchor the renminbi to the dollar—what is known technically as crawling pegging, in which the exchange rate is set within a range of values. Instead, China was aiming to, in the words of the People’s Bank of China (PBoC), “promote basic equilibrium of the balance of payments and safeguard macroeconomic and financial stability.”¹³ In other words, it needed to get the exchange rate arrangements to better reflect trade shares—especially trade with Europe—and slow down the accumulation of dollars.

Another significant downside of pegging is that it requires interventions in the foreign exchange market to maintain the exchange rate in line with the peg. For neighboring countries and trade competitors, this may equate to a beggar-thy-neighbor policy. This has been the case for China and the United States, with the United States bristling not so much around the choice of exchange rate regime as around the fact that significant market interventions were necessary to maintain the exchange rate in line with the peg to the dollar and then to a basket of currencies, although China’s large trade surplus was pushing for the renminbi to appreciate. If China had chosen a floating exchange rate like the United States and other trade competitors, then the large current-account surplus (recall that before the global financial crisis China’s net exports were approximately 7 percent of GDP)¹⁴ would have been less significant as a stronger exchange rate would have made exports more expensive. Competitors in international trade see interventions like these as an unfair advantage, essentially lowering the price of that country’s exports by keeping the exchange rate weak.

In the case of China, over the years its exchange rate policy has generated a great deal of hostility in the United States, and on many occasions, this has been a stumbling block in the relationship between the two countries. Browsing through the U.S. Treasury Department’s semiannual report to Congress on international economic and exchange rate policies,¹⁵ it is clear that China’s large and growing trade surplus but steady exchange rate—“undervalued,” as the 2006 report states—raised the Treasury’s awareness of and concerns about “currency manipulation.” In 2005, the department even came close to labeling China a currency manipulator; this would have been the first time it had applied this label to a country in almost two decades and could have turned into a major dispute with China.

It didn’t come to that, as just a few weeks later, in July 2005, the Chinese authorities made a significant change to their decades-old exchange rate policy: they switched from pegging the renminbi to the dollar to anchoring it to a basket of currencies—where the central bank fixes the exchange rate each day against the value of the currencies in the basket. Although this move did appease the U.S. Congress for a while and was widely celebrated in the press (U.S. Treasury Secretary John Snow publicly praised Beijing’s decision, saying “I welcome China’s announcement today that it is adopting a more flexible exchange rate regime”¹⁶), diplomacy was not China’s main motivation. The Chinese authorities had reckoned that a more flexible, less dollar-dependent exchange rate arrangement would contribute to reducing the country’s exposure to the dollar and narrow its current-account surplus. It was China’s own interest in rebalancing the economy that prompted the change, not pressures from the United States or concerns for the rest of the world.¹⁷

Tensions between China and the United States were temporarily eased by the move, but they soon returned. Although the value of the renminbi rose over 8 percent against the dollar between 2005 and 2007, the U.S. Congress again began to claim that China’s exchange rate policy resulted in a de facto subsidy to its exports and therefore created an unfair advantage for China, in breach of the WTO rules. In 2006–2007, Senator Charles Schumer, backed by Senator Lindsey Graham, put forward in Congress a proposal to impose “a rate of duty of 27.5 percent ad valorem on any article that is the growth, product or manufacture, of the People’s Republic of China, imported directly or indirectly into the US” unless the president of the United States certified that China had ceased manipulating its currency “for purposes of preventing an effective balance of payments and gaining an unfair competitive advantage in international trade.”¹⁸ And in 2007, when the International Monetary Fund (IMF) member states were working on new rules for the surveillance of countries’ currencies, the U.S. Treasury Department made it clear that it was eager to see the renminbi designated as “fundamentally misaligned.”¹⁹

After a year of back-and-forth, in the summer of 2008 the IMF prepared an Article IV report on China that included an accusation that its currency was largely undervalued. However, Lehman Brothers collapsed just a few weeks before the final report was due to come out, the report was never released, and the issue of the Chinese currency fell off the U.S. agenda.²⁰ In the meantime, the global financial crisis forced Beijing to suspend the peg of the renminbi to a basket of currencies and switch back to pegging to the dollar in order to enhance the stability of its currency and minimize the impact of the crisis. This change inevitably triggered new skirmishes with the U.S. Congress, especially as focus finally began to shift away from the crisis. In June 2010,²¹ as pressure from Congress was mounting, China’s monetary authorities switched back to a “managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies” and once again pegged the renminbi to a basket of currencies. The Chinese authorities chose to “reform the exchange rate,” as they described this measure, a few days before the G20 summit in Toronto. Even if they hinted that the timing was coincidental and they did not feel “any difference in the pressure on the currency issue from the group of G20 nations,”²² the move nonetheless defused a potential confrontation with the United States on the matter of the exchange rate as part of the G20 discussion.

Concerns about the manipulation of the exchange rate resurfaced in 2014, when the PBoC widened the trading band and allowed the renminbi to move by 2 percent, up or down, around the exchange rate. The Chinese monetary authorities began to daily fix the value of the renminbi against the dollar, and by enlarging the trading band, they allowed the renminbi more flexibility for appreciation or depreciation. However, the move was not received well in the United States.

In the weeks following this policy measure, the renminbi weakened by almost 1.5 percent against the dollar, and worries that Beijing was manipulating its currency once again surfaced. Officials in the U.S. Treasury Department expressed concern that the “reform” signaled a change in China’s policy—moving away from arrangements that had become to resemble those of a market-determined exchange rate.²³ The department’s 2014 report to Congress singled out the renminbi as “significantly undervalued.” It also stressed the need for sustained progress toward a market-determined exchange rate, adding that “this includes refraining from intervention within the band and adjusting the reference rate if market pressures push the exchange rate to the edge of the band.”²⁴ As before, Congress focused on the drop in the renminbi’s value in the weeks immediately after the implementation of the policy change, without considering that the value of the renminbi was trending upward.

Beijing’s frequent interventions in the currency markets remain a bone of contention with the United States. However, in fact, the introduction of the trading band was a significant step toward making the renminbi exchange rate more flexible and therefore more able to reflect market demand.

The composition of the currency basket to which China pegs its exchange rate is not officially disclosed; neither is the weight of each currency in the basket. It is likely that the basket reflects the composition of the country’s trade, allowing it to achieve some stability around the exchange rate with the currencies of its main trading partners. Because the United States is one of China’s main trading partners and the dollar is the most used currency in international trade, the greenback is likely the dominant currency in this basket. In December 2015, after the inclusion of the renminbi in the group of currencies that compose the Special Drawing Right basket, the PBoC felt the urgency to explain in more detail how the system worked, stressing that the exchange rate is not automatically adjusted in line with the currencies in the basket. It also noted that some market participants, “for simplicity,” had been focusing on the bilateral renminbi/U.S. dollar exchange rate rather than on the basket. “Going forward, it is plausible for all market participants to shift their focus from the bilateral RMB/USD exchange rate to referring more to a basket of currencies. This adjustment process, of course, takes some time.”²⁵ Although this long explanation reassured market participants about the PBoC’s willingness to maintain and even improve exchange rate flexibility, it did not seem to add much to what was already known or give further information about the composition of the basket.

Keeping the exchange rate stable and anchored to a basket of currencies—notably, to the dollar—has for years been a pillar of the Chinese leadership’s economic strategy, and this strategy has been consistent with the goal of expanding the country’s trade—exchange rate stability is valuable to both exporters and importers. But as the economy keeps expanding and foreign money rolls in, the demand for renminbi has gone up, especially in the two to three years before and after the global financial crisis. Indeed, when economic activities expand, the demand for the currency issued by the expanding economy also increases as more jobs are created, investments build, and consumption grows: money is needed to grease the economy wheel. Foreign investors like to get in on the growing economy, and foreign consumers fuel the demand for goods produced in the growing country. As a result, the currency tends to appreciate.

To avoid exchange rate volatility and excessive appreciation, which would make China’s exports more expensive, the monetary authorities have been forced to intervene in the currency markets and buy or sell dollars in a large enough quantity to shift the dollar price of the renminbi. Because the increase in the supply of renminbi threatens price inflation or bubbles in the prices of such assets as real estate properties, the central bank needs to mop up the excess of domestic monetary liquidity that comes from foreign exchange interventions. This practice, commonly called sterilization, will be described in more detail in the next chapter. Other methods the PBoC has used to control monetary expansion include increasing the reserve requirement for large domestic banks—the required reserve ratio was increased to 17 percent of a bank’s capital in March 2016.²⁶ Measures like these have allowed the Chinese authorities to control and moderate the renminbi exchange rate, which appreciated about 3 percent a year between 2005 and 2007 and 5 percent in 2008. From 2009 to the end of 2013, the renminbi appreciated by slightly more than 10 percent. (By the same token, it has helped to manage the currency weakness throughout 2015 and 2016.)

China has other tools for managing the exchange rate beyond pegging and market intervention—notably, restrictions on its capital account. Before explaining how these restrictions help to control the exchange rate, I will describe what the capital account is and how it differs from the current account.

Money moves in and out of a country as a result of trade transactions and investments—for example, a country with a trade surplus (like China) gets currency inflows. The current account registers these currency inflows and outflows that result, for example, from trade transactions, such as payments for the import and export of goods and services; an open current account means that there are no restrictions on capital movements that arise from these transactions. Similarly, the capital account registers currency inflows and outflows that result from foreigners investing (or disinvesting) in the country and residents investing (or disinvesting) abroad; a country’s capital account is considered fully open when money moves in and out of a country in order to invest in financial assets.

Whereas China’s current account has been fully open since the early 2000s, as a result of the reforms that followed the country’s entrance into the WTO, its capital account is restricted. For the Chinese authorities, controlling capital movements is another way to maintain a stable exchange rate and also to ensure financial stability by avoiding sudden shifts in the demand for renminbi. For example, in the years after the global financial crisis—when interest rates in the United States were zero and the dollar was weak, whereas the Chinese economy was very robust—foreign investors would have largely turned to China if capital movements into (and out of) the country had not been restricted. This would have put pressure on the exchange rate, pushing up the value of the renminbi.

Furthermore, unrestricted capital movements would pose a problem for a country like China that has high savings rates but is financially repressed. As discussed in chapter 3, these high savings rates result in a high demand for financial and non-financial assets, but financial repression limits investment opportunities as well as investment returns. In order to avoid destabilizing capital movements, the authorities restrict the amount of money that people can move into and out of the country.

Finally, the policy of restricting capital movements reflects concerns about the vulnerability of the renminbi to external shocks if the currency is held by nonresidents. For example, if a change in external conditions—say, a significant increase in the interest rates in the United States and a stronger dollar—induces foreign investors to dump renminbi-denominated assets for dollar-denominated assets, this could trigger domestic financial instability through a stock market crash or a bank run.

However, although China does have restrictions on the capital account, it is important to bear in mind that the account is not closed—as it had been before 1979. Money can move into and out of the country, but the modalities of these inflows and outflows and, more importantly, how much money is allowed in and out are set by the authorities. They use administrative controls and regulations to manage capital inflows and outflows for both Chinese and foreign parties.

How are these capital movements controlled? Chinese firms are allowed to hold or sell foreign currencies—but only through authorized financial institutions and only with approval from the relevant authorities: the Ministry of Commerce, the National Development Reform Council (NDRC), and the State Administration of Foreign Exchange (SAFE). In addition, if these firms plan to use foreign exchange to invest abroad, they need to get the authorities’ permission through a time-consuming process that often involves different government departments; for example, overseas investments that exceed $100 million need to be approved by the NDRC, whereas amounts below this need the approval of the provincial Development and Reform Committee.²⁷ Individuals also face restrictions. For instance, they cannot exchange renminbi in an amount worth more than $50,000 for other currencies annually. (That many wealthy Chinese have become big buyers of overseas real estate indicates the existence of alternative channels—such as unofficial money changers or fake trade invoicing—through which renminbi can be moved abroad.)

The procedures are even more complicated for non-Chinese companies that want to acquire renminbi-denominated assets or exchange profits or payments in renminbi for other currencies. In addition to SAFE approval, foreign companies need to satisfy a number of conditions: all taxes must be fully paid, all losses from the previous financial years must be repaid, and the transactions must be conducted or guaranteed by a qualified bank.²⁸ In addition, foreigners—companies and individuals—cannot invest in stocks, bonds, and other financial assets in China. A non-Chinese national who lives in China is likely to encounter obstacles and restrictions when opening a bank account—unlike, for example, a non-American national who resides in the United States. All these restrictions make the renminbi a currency with restricted convertibility and thus with limited circulation outside China.

As with many other aspects of the Chinese economy, recent steps have made it easier for both Chinese and foreign businesses to move capital into and out of the country (although individuals’ capital movements remain considerably restricted). These steps have focused on gradually unrestricting long-term direct capital inflows—that is, money that moves into China and goes into long-term capital investment, such as, for instance, foreign direct investment—under the assumption that this type of investment tends to be less volatile and less driven by speculative motivations than are short-term indirect flows, such as bonds and stocks. The opening has been sequenced to start with inflows, direct investment, long-term bonds, and institutional investors.²⁹

In particular, arrangements like QDII (for qualified domestic institutional investors) and QFII (for qualified foreign institutional investors), introduced in 2006, have created a small channel for inflows and outflows. QDII allows domestic financial institutions, such as asset managers, to invest in stocks and fixed-income and money market assets overseas and to sell mutual funds that include overseas stocks and bonds to local investors.³⁰ QFII, in turn, allows foreign investors to buy and sell renminbi-denominated “A” shares that trade on the onshore stock exchanges. These programs were devised in response to growing pressure from external imbalances and fast-growing foreign exchange reserves and to the strong growth of the domestic equity market—although they were suspended in 2008, during the height of the global financial crisis. In July 2015, the China Securities Regulatory Commission increased the QFII quota from $80 billion to $150 billion.

The process of opening China’s capital account is a work in progress, and so far it has moved much more slowly than the opening of the current account. Using the IMF definition of categories of capital controls, Chinese economists Haihong Gao and Yongding Yu have shown that half of the cross-border capital transactions (under the capital account) are available for nonresidents and residents and half are subject to controls.³¹ The former has increased to about three-quarters in recent years,³² and in 2015, PBoC governor Zhou Xiaochuan indicated that thirty-five out of forty items are fully or partially convertible.³³ However, the transactions that are the most relevant for capital movement either remain restricted or are subject to cumbersome procedures and permissions. The monetary authorities thus continue to rely on capital controls to shelter the most vulnerable domestic sectors from external shocks. Through market intervention, they rein in excessive liquidity and harness large capital inflows that cannot be absorbed by the market, given the limited diversification of the domestic financial sector. As a result of these controls on capital movements, the renminbi is a nonconvertible currency, and this restricts its liquidity and its ability to function as an international currency.