As China's economy has continued its remarkable expansion and gained an increasingly important role in the global economy, China's currency, the renminbi (RMB), has also captured growing attention from investors and policymakers around the world. In this article, I briefly discuss three significant issues concerning the renminbi--namely, the near-term direction of the exchange rate, the renminbi's convertibility in the medium term, and the currency's international role down the road in the future.
Exchange Rate Outlook
On July 21, 2005, China embarked on long-awaited currency reforms toward the goal of greater exchange rate flexibility. Since then the renminbi's annual nominal appreciation has averaged about 5 percent against the U.S. dollar. On a trade-weighted basis, however, the appreciation of the renminbi has been almost negligible. What will happen next? On the one hand, the Chinese authorities remain cautious toward fast-paced and substantial currency strengthening. On the other hand, it is also clear that pressures are continuing to build both at home and abroad--for far more pronounced renminbi appreciation. Domestically, China faces rising inflationary pressures and equally worrisome, rapidly developing equity and property bubbles. At the same time, rebalancing requires tighter macroeconomic policies and expenditure switching from net exports and fixed investment to private consumption.
First, let us take a quick review of key developments in China's domestic economy. Needless to say, the economy has been extremely buoyant, with red GDP growth averaging more than 11 percent for the last several quarters. Rapid credit expansion, fast growth in fixed investment, torrid pace in net exports, and an overheated property sector all present flash signs about the risk of overheating in China's economy. CPI inflation was zero or even slightly negative just a few years ago, but has since rapidly picked up, approaching high single digit levels, according to the official measures. I suspect the official inflation statistic has probably underestimated the true extent of inflation, because of a variety of measurement problems. For instance, the official CPI index does a rather poor job in capturing price increases in the rapidly expanding service sectors, such as health care, education, transportation, and housing-related services. Furthermore, continued government price controls and subsidies on crucial fuel and energy items distort the...