RMB – A Managed Currency for Now

I am a bull for RMB as in the worst global recession since the Great Depression, China is the only large economy that is growing. It has over $2trillion in foreign exchange reserves, about 29% of all international reserve assets.

For now, China doesn’t want stronger RMB as it makes less competitive on a global stage for trade. It needs a relatively weak RMB to continue exporting its way to growth. That’s why the Bank of China manages the value of its currency. You see when dollar-based investments and revenues flow into China, converting these inflows to the RMB puts an upward pressure on the currency.

To offset the local demand to exchange US dollars to RMB, the Bank of China takes the other side of transactions – selling RMB and buying USD. This keeps the exchange rate stable and China builds vast amounts of dollar reserves.

For a decade, China maintained a fixed exchange rate policy – the RMB was pegged against the dollar at 8.27 RMB, and in 2005, China changed its currency policy. It abandoned the peg after political tensions rose between China and its key trading partners.

Under the ‘managed float’ policy, China agreed to let the RMB trade in a defined daily trading band while gradually allowing it to appreciate. This was China’s way of pacifying its trading partners while maintaining complete control over its currency. Over the next three years, the RMB climbed 17% against the USD and if the RMB was determined by market forces, it would trade around 5.80 to 6.00 level.

Since August 2007, RMB has been kept within tight trading band of around 6.80 level. Trading of RMB has been heavily restricted by the government – authorized only within mainland China and only through China’s agent banks.

Now for the first time, China is relaxing restrictions and allowing the RMB to trade off-shore with select Asian neighboring countries. This is the first step in China’s attempt to temper growth in its foreign currency reserves and to make the RMB a globally traded currency.

Despite China’s concern about the value of its large stock of US assets, reserve diversification will continue to be difficult, though the purchase of $50 billion in SDR-denominated bonds from the IMF will be only a small share of its $2 trillion in reserves. Investment in resource-rich countries will continue to be a major part of China’s asset allocation.