Source: The New York Times

How China Sees Its CurrencyIt is important to know when and how the renminbi became undervalued. This aspect of the story is rarely covered in United States commentaries on the issue of China’s currency. In my opinion, the renminbi became undervalued late 2003 when China’s trade surplus — especially its bilateral trade surplus with the United States — fairly suddenly began a steep incline.

The initial burst of China’s trade surplus, which had never been significant before, came on the heels of the sharp monetary expansion in the United States (and to a much lesser extent in some European Union countries) that was triggered by the switch to budget deficits in the early George W. Bush years. The Greenspan Fed’s interest rate cuts after the Nasdaq collapse and 9/11 also played a role.

China was the only major exporter that could and did respond quickly to the sharp increase in global demand driven by the massive credit expansion in the United States. In other words, China’s surplus exploded not because of anything China did with its exchange rate – it did nothing – but because of an explosion in external demand led by credit expansion in the United States.

When China fixed the nominal renminbi/dollar exchange rate at 8.27 in December 1997 — after the financial collapse of South Korea and contrary to international expectations of a renminbi devaluation — gaining an unfair trade advantage was clearly not China’s objective. If anything, the renminbi was slightly overvalued at 8.27.

China was applauded by Asian neighbors and by the U.S. Treasury for what it did at that time. It made the renminbi into a regional anchor currency, which helped the crisis economies in East Asia to overcome their economic and financial problems more quickly that otherwise would have been possible.

There were no international complaints about China’s fixed-exchange rate policy until the second half of 2003. Then, once the renminbi became undervalued, new dynamics set in.

Chinese officials were reluctant for a long time to admit that there was a problem with the exchange rate for several reasons: (a) they did not believe that the increased trade surplus was structural in nature, and (b) they did not want to reward the speculators who had found ways of bringing large amounts of “hot” money into the country, mainly to invest in the booming property markets of the big cities. They were also reluctant to respond to international political pressure led by the U.S.

If you accept this perspective on the question of how and when the renminbi became undervalued, you’ll understand better why almost all Chinese economists and political leaders sharply differ with American economists and political leaders in the interpretation of the currency issue as it stands today.