China’s Exchange Rate and Financial Repression: The Conflicted Emergence of the Renminbi as an International Currency

Instability in the world dollar standard, as most recently manifested in the U.S. Federal Reserve’s near-zero interest rate policy, has caused consternation in emerging markets with naturally higher interest rates. China has been provoked into speeding Renminbi “internationalization,” i.e., opening up domestic financial markets to reduce its dependence on the dollar for invoicing trade and making international payments. But despite rapid percentage growth in offshore financial markets in RMB, the Chinese authorities are essentially trapped into maintaining exchange controls—reinforced by financial repression in domestic interest rates—to avoid an avalanche of foreign capital inflows that would threaten inflation and asset price bubbles by driving nominal interest rates on RMB assets down further. Because a floating (appreciating) exchange rate could attract even more hot money inflows, the People’s Bank of China should focus on tightly stabilizing the yuan/dollar exchange rate in order to encourage naturally high wage increases for balancing China’s international competitiveness. But further internationalization of the RMB, as with the proposed Shanghai Pilot Free Trade Zone, is best deferred until world interest rates rise to more normal levels.