If China does let its currency start rising again, as widely speculated, the overriding issue is whether it will move quickly and substantially enough. The renminbi is undervalued by about 25 percent on a trade-weighted average basis and by about 40 percent against the dollar. No one expects China to curtail this huge misalignment in a single step. But it needs to both make a sufficient “down payment” to be credible and assure that appreciation will continue until the undervaluation has been eliminated.
China can readily implement such a strategy. It simply has to dial back its massive intervention in the foreign exchange market, a. k. a. “manipulation,” which now averages about $1 billion per day. Smaller purchases of dollars by the People’s Bank of China mean greater increases in the value of the renminbi. China will undoubtedly continue to manage its “float” to keep the rate from rising faster than it wants, however, which undoubtedly means that it will continue running sizable surpluses and investing in large amounts of additional US Treasury securities.
China’s best strategy would be to surprise the markets with a one-shot revaluation of 8 to 10 percent and simultaneously let it be known that it would do no more until 2011. This would head off an acceleration of capital inflows, which would occur under renewed upward movements of 0.5 to 1 percent monthly that present speculators with a one-way bet as in 2005–08, and indeed stimulate profit-taking reflows that would ease the conduct of monetary policy. It would represent a sufficient “down payment” to quell external pressure for at least a while. It would of course have to be followed up by similar steps in the next two or three years, which could also be timed to surprise the markets and outwit the speculators.
Such a sequence of policy steps would reduce China’s surplus to a reasonable level, reduce the US current account deficit by $100 billion to $150 billion and obviate the need for Treasury to label China a “currency manipulator” this year or in the future.
Also posted on CFR.org.