Since China revalued its currency against the U.S. dollar by 2.1 percent in July 2005, from RMB 8.27 per US$ to RMB 8.11, the RMB has appreciated by a further 14 per cent percent to about RMB 6.97 per US$ (as of May 2008). On a trade-weighted basis, however, the currency has appreciated less than half this amount. Using J.E Morgan's trade-weighted index (broad basis) for the RMB, the currency appreciated just 6.1 percent in nominal terms between August 2005 and May 2008. Although the currency has been very gradually appreciating, the flexibility promised by China's leaders has been more illusory than real, and, more importantly, the underlying international payment imbalances have continued to widen both in absolute terms and as a fraction of GDP.
In this article, I set out the magnitude of the problem of China's international payment imbalances, summarize the techniques used by the People's Bank of China to sterilize China's overall balance of payments surplus, and assess the costs and benefits of the PBC's sterilization strategy--both from a theoretical perspective and in the light of the experience of other East Asian currencies that have witnessed large-scale sterilization operations in the past. I also consider whether, for the purpose of ensuring satisfactory monetary arrangements in the 21st century, it is appropriate for a country of the size and stature of China to delay adjustment by means of large-scale sterilization.
China's International Payments Imbalance
In the period prior to 2002, there were few presumptions that China's currency would appreciate. There had been a long history of devaluations between 1960 and 1994. However, following the devaluation of 1994 and the subsequent monetary reforms the external value of the currency was held stable against the US$, notably throughout the Asian financial crisis of 1997-98. Nevertheless, the NDF (non-deliverable forward) value of China's currency traded at a persistent discount to the spot value of the currency (that is, weaker than the spot rate of around 8.27 per US$) until December 2002 when it moved to a premium for the first time (Figure 1). In the same year, the errors and omissions item in China's balance of payments shifted from negative to positive, suggesting a change from unreported outflows to unreported inflows. In 2003 and 2004 both the current account and the capital account showed marked increases in the size of their surpluses.
Since the revaluation of July 2005, and despite the gradual subsequent appreciation of the RMB against the U.S. dollar and other currencies, the low level of the Chinese currency is causing China to run increasingly large overall (current plus private sector capital account) surpluses in its balance of payments. The simplest measure of that overall (current and capital) surplus is the increase in China's foreign exchange reserves. (1) In 2006, the overall surplus was $246 billion or 9.1 percent of GDP, while the current account surplus was $249 billion or 9.2 percent of GDP (Table 1). In 2007, the current account surplus increased to $371.8 billion or 11.1 percent...