Exchange rate and monetary policy in China.

• Author: Lardy, Nicholas R.

By most metrics China's currency remains undervalued. Its current account surplus increased sharply over the past two years, rising from 817 billion or 1.5 percent of gross domestic product in 2001 to $46 billion or 3.2 percent of gross domestic product in 2003. China ran a trade surplus of $32 billion in 2004 compared with a surplus of about $25.5 billion in 2003. However, China's underlying current account surplus in both 2003 and 2004 is almost certainly significantly higher than the measured surplus for two reasons.

First, as discussed in greater detail below, the Chinese economy recently has been growing at a record-setting but clearly unsustainable pace. High growth has stimulated an unprecedented demand for imports, which grew by 40 percent in 2003 alone, making China the world's third largest importer. In 2004 China's imports grew an additional 36 percent. When economic growth eventually slows to a more sustainable pace, it is quite likely that import growth will slow down relative to the growth of exports and China's trade surplus will widen. That was the pattern in the last macroeconomic cycle when the trade account strengthened substantially between 1993 and 1997.

Second, largely because of the peg of the yuan to the dollar, the real trade-weighted value of the Chinese currency has declined since the beginning of 2002 when the value of the U.S. dollar reached a peak. The positive effect of this depreciation on the trade balance occurs with a lag so it is likely that, ceteris paribus, the current account will strengthen further. The combination of these two effects likely makes the underlying current account surplus about 1.5 percent greater than the measured value.

China also has run a surplus on its capital account every year since the Asian financial crisis. Not counting the exceptionally large capital inflows in 2003, which appear to reflect an expectation of exchange rate appreciation rather than underlying economic fundamentals, the capital account surplus since the Asian financial crisis has averaged about 1.5 percent of gross domestic product. This may be taken as a measure of China's normal net capital inflows.

One commonly used analytical framework to examine a country's balance of payments, the so-called underlying balance approach, identifies the equilibrium exchange rate as one that results in an overall equilibrium in the balance of payments--that is, normal capital inflows plus the underlying current account position sum to zero. The International Monetary Fund has used this approach extensively in its own work on exchange rates. On this metric China's current exchange rate is far from equilibrium. (1)

China's Exchange Bate Policy

Why has China not revalued its currency? The classic case of not revaluing in the face of a large external surplus is when there is a conflict with domestic macroeconomic objectives. A country with a fixed exchange rate and a strong (weak) external position typically would be reluctant to revalue (devalue) during a period of weak (strong) aggregate demand since revaluation (devaluation) would increase (decrease) the demand for imports and reduce (increase) the demand for exports thus reducing (increasing) already weak (strong) aggregate demand.

China did not face such a dilemma in 2003 or in the first quarter of 2004. In 2003 China's officially reported growth rate rose to 9.3 percent, the highest since the Asian financial crisis. Investment as a share of gross domestic product surged to a near all-time historic high, fueled by a record increase in bank lending. In short, China in 2003 was in a credit-led investment boom that propelled growth to a...