I wanted to share with you this very clear explanation of the consequences of the undervalued renminbi with you. I found it in the book “Fault Lines” by Raghuram Rajan, former chief economist at the IMF.
To keep the renminbi from appreciating, China’s central bank, the PBOC buys dollars from Cinese exporters in exchange of Renminbi. By doing this, it increases the circulation of Renminbi and therefore can cause inflation. To avoid inflation, the PBOC issues its own debt at the same time as it buys dollars; in other terms it “sterilizes” the excess Renminbi, which is being used to buy this debt.
The PBOC uses dollars to buy US assets, mainly Treasury and Agency bonds. Therefore, it receives interests on US assets and pay interests on Renminbi claims. This forces the PBOC to mirror the United States monetary policy. Indeed, so that the PBOC does not loose money on interest differentials, it needs to set Renminbi interest rates lower than the US ones.
This low interest policy has several consequences:
- The PBOC cannot use interest rate setting as a tool for its monetary policy. Therefore, it needs to use other tools such as bank reserves ratio or credit control.
- Households make low returns on their savings and therefore need to save more to reach the same wealth. It therefore holds back domestic consumption and makes China yet more dependent on foreign demand.
- Cost of capital is low and therefore firms are incentivised to invest in capital-intensive machinery substituting for jobs. A country with labor surplus invests hugely in capital-intensive industry, creating fewer jobs than needed.
- Even if lending rates are low, deposit rates are even lower, creating a high profit margin for banks. Banks can be complacent and make lending mistakes and it excludes competing sources of finances such as for example the bond market. The financial system stays very inefficient, lends primarily to state-owned companies and creates competitive distortions to the detriment of non-state connected private companies.
