China’s Dollar Peg to Wind Down

 
 

An editorial on the People’s Bank of China website recently made the case that China should tie the RMB to a basket of currencies rather than to the U.S. dollar. As it stands, China’s currency is pegged to a basket of currencies, but the dollar has appeared to dominate the RMB’s exchange value. China’s foreign exchange system may calculate a RMB exchange rate index against a basket of currencies that gives less weight to the dollar in order to reinforce market forces.

Reducing the weight of the dollar in the exchange rate will reduce constant comparisons between the RMB and the dollar; given appreciation expectations of the dollar, corresponding appreciation expectations of the RMB have followed, and where they have not, investors have displayed fears of devaluation. Changing the dollar dependence will also remove pressure on Beijing to further strengthen the RMB as the dollar gains value after the U.S. Federal Reserve interest rate hike. This will permit China to maintain a more independent monetary policy.

China’s efforts to peg the RMB to a basket of currencies, with less emphasis on the dollar, have failed in the past, particularly in the face of the global financial crisis. A tighter peg to the U.S. dollar helped China’s economy to maintain monetary stability as real economic indicators slid. Now that the global crisis appears to be somewhat contained, the time may be ripe for China to remove its strict adherence to the dollar.

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Moreover, inclusion of the RMB in the IMF basket of reserve currencies was a watershed event for China that leaves Beijing on the hook for picking up the pace of capital account and exchange rate liberalization. While some analysts believe that the RMB will not be freely floated anytime soon, adherence to a more equally weighted basket of currencies is a possibility, especially given China’s call to remove the dollar from its central role in the wake of the global financial crisis. China’s gradual opening of its capital account through the issuance of panda bonds, reduced restrictions on participation by foreign central banks, sovereign wealth funds and multinational firms in the interbank market, and implementation and expansion of the Shanghai-Hong Kong FTZ and Stock Connect will necessitate freer currency flows. Eventually, China will need to allow the RMB to better reflect market forces.

We do not know for sure whether the People’s Bank of China will really break away from the dollar at this time, but there are gains to be made in doing so. Maintaining a somewhat rigid peg to the dollar has required the central bank to heavily intervene in the currency markets and to maintain high levels of dollar reserves. This is a costly process that is generally considered undesirable. Now that the RMB has SDR currency status, China may have more latitude in valuing its currency. A decline in reliance on export production also reduces the need for China to peg the RMB to the currency of its largest trading partner.

So will they or won’t they? It seems likely that China will reduce its grip on the dollar and it makes sense that it would do so in the short to medium run. This will certainly mark a change in China’s development trajectory, as its currency has closely tracked the dollar for two decades.

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