Talking currencies is back in vogue again. The ebbs and flows of the news cycles surrounding the renminbi, yen, real, and dollar almost resemble the wild swings of the currencies themselves. Why the sudden revival of interest in the mass media about so esoteric a topic as exchange rates? After all, in the rarified world of economic theory, countries would allow their national monies to be freely determined by markets for foreign exchange; in return, the market-established rate would magically eliminate imbalances in national trading accounts. In the real world that we inhabit, however, politics matters, and it matters intimately.
With Nobel laureates and think-tank supremos (PDF) vociferously espousing the merits of direct economic confrontation with China, it is perhaps useful to examine the political economy of Chinese foreign exchange policy a little more carefully.
First, some background: The standard narrative surrounding explanations for Chinese reticence with regard to appreciating the yuan is that the Commerce Ministry---which is aligned with the country's powerful export industry---opposes such an appreciation. Their interests somehow prevail, which is why China has steadfastly refused to allow its currency very much wiggle room at all.
The problem with this story is that it doesn't take the other political-economic interest groups within China very seriously. For starters, producer prices have shot up rapidly during that time (see figure, and note especially the different axes used for CPI and PPI inflation). This casts doubt on the thesis that exporters are unequivocally insistent on currency rigidity, and is a reminder that the Chinese export machine is, after all, built on final goods assembly, making China as much an importer of intermediates from the rest of the world as it is an exporter. And importers clearly do not benefit from a weak renminbi.
Source: IMF IFS.
Even if we accept the view that exporting interests do, on net, prefer that the yuan remain undervalued, the political economic environment includes other major players. One such player is the central bank, which clearly has an interest in keeping inflationary pressures in check. Indeed, consumer prices have steadily crept up since the end of the first appreciation window in the fall of 2008 (see figure again). This is the natural consequence of fixing the nominal exchange rate when the real exchange rate is appreciating over time. Similarly, consumers, like importers, benefit from the stronger purchasing power afforded by a lower yuan-dollar exchange rate.
There is some anecdotal evidence that suggests that China does have such opposing domestic interests insofar as the currency is concerned. The PBoC has been reported to favor a stronger and more flexible currency. Workers unions are becoming increasingly vocal about improving their welfare by demands for higher wages and expanding their purchasing power more generally. It is therefore unclear why the PBoC would allow export alone to determine its choices with regard to inflation and output volatility---especially since it is, after all, in charge of actually implementing any currency interventions.
This concern over price increases goes beyond the CPI and PPI. The major coastal cities are famously facing potential housing price bubbles. Shanghai, for example, saw property prices spike in the middle of 2007, and while the rate of appreciation has since moderated, house prices in coastal metropolitan areas remain under significant upward pressure (see figure).
Finally, it is helpful to point out that even though China's producers are in a competitive position relative to American manufacturers, the country does, as a whole, have some vested interests in a healthy U.S. economy. China is, after all, the largest foreign holder of Treasury debt, and as a consequence has little incentive to see a tanking U.S. economy threaten the fiscal credibility of the government. Nor would it want to risk the U.S. government being tempted to monetize away its debt, a point that has been repeatedly made by Chinese authorities.[*] Indeed, the desire to avoid a sudden collapse in the value of its foreign reserve holdings may be the central driver behind China's desire to ensure that any yuan revaluation (or, equivalently, dollar devaluation) happens at a measured and controlled pace.
Of course, the bottom line is that we do observe a lack of flexibility in the Chinese renminbi. This is indisputable, and to the extent that this relative stability reflects intervention actions on the part of the PBoC, one must be led to conclude (by a revealed preference argument) that the current USD/RMB exchange rate is one of design. But this does not take away the fact that the individual and institutional drivers behind this ultimate decision are multifaceted, and ultimately a reflection of the often differing motivations of a myriad of domestic actors. A keener understanding of this fact can improve policy responses, since it recognizes that realized exchange rate policy, far from being a monolithic outcome, depends at the margin on the distribution of costs, benefits, and power between different domestic political actors.
The policy take-away from all this is that among the myriad solutions currently proposed by the punditry---some, undoubtedly, very clever---the ones that will ultimately succeed are those whose proposed actions are consistent with the preferences of the central political actors, whether these be powerful special interests, influential legislators, or the electorate at large. With the option of trade protectionism having been taken away by a combination of institutional design (courtesy of the WTO), dire warning (courtesy of economists), and political reality (courtesy of importer and consumer interest lobbies), politicians are now forced to bring an exceedingly blunt instrument, the exchange rate, into the policy spotlight.
*. Of course, the Federal Reserve is an independent central bank and as such has the freedom to resist printing dollars to finance the deficit. But recall that Congress did exercise its authority to do so in 2009, and while the bill did not end up being enacted in its original form, the danger of politicizing Fed decisionmaking in the future seems real.