The rising price of a cheap renminbi

China’s exchange rate is a price, not merely a symptom of its economic imbalance. By keeping the renminbi undervalued, the government masks the true issue and prevents corrective mechanisms from operating. This has resulted in a self-destructive approach, according to the International Monetary Fund. In 2021–25, China’s real exchange rate fell by 14%, while its current account surplus grew to 3.8% of GDP.

The exchange rate serves a dual purpose: it maintains the currency at a specific level and provides exporters with a form of price stability. With most exports still billed in dollars, the tightly controlled exchange rate minimizes uncertainty about domestic revenues. While competitors can hedge against risk, they do so at a financial cost, with Chinese manufacturers primarily receiving protection from the state.

This policy stems from a "security-first" framework that prioritizes resilience and control over Taiwan, rather than solely maximizing welfare or growth. President Xi Jinping’s administration seeks to prepare for sanctions while ensuring control over Taiwan. The root cause of China’s surpluses lies in a policy mix that encourages excessive saving, including by limiting household consumption.

However, the solution is not straightforward. The IMF estimates that increasing social spending and reforming the hukou household-registration system could boost consumption by up to 3% of GDP. The primary obstacle to change is not the policy design itself but the government's preference for maintaining the status quo. By perceiving the exchange rate as merely an issue, as Gopinath, Gourinchas, and Rey suggest, one overlooks the significant impact of prices on behavior.

While it is true that China's saving excess leads to currency appreciation, absorbing this pressure through capital controls and state asset accumulation is not a long-term solution. The costs ultimately fall on balance sheets, and these costs are increasing. China’s government debt stands at approximately 127% of GDP, and commercial bank net interest margins have declined from 2.2% in 2019 to a record-low 1.4%.

The country is not running out of funds but is running out of painless methods to utilize them. A stable, weak renminbi benefits exporters, maintains employment and tax revenue, and delays the need for loss recognition on these balance sheets. However, it does not resolve the financial system issues; rather, it provides temporary relief.

Appreciation of the renminbi alone would not rebalance the economy. Nevertheless, it would increase households' purchasing power for imports and compress margins in tradable sectors, raising the cost of avoiding reform. Dollar invoicing compounds these effects, as the renminbi's value rise reduces the price of dollar-priced imports roughly in a one-to-one ratio, while sticky foreign-currency export prices push the adjustment onto domestic revenues.

Of course, as noted by Gopinath, Gourinchas, and Rey, the initial impact of renminbi appreciation would be deflationary. With the prevalence of dollar invoicing, the effect on export prices would be delayed. Nevertheless, if the savings-investment balance remains unchanged, a forced appreciation could result in falling prices, thereby reversing the real exchange rate and surplus to near their original levels.

However, this reversal is not neutral, as the deflation that corrects the appreciation also exacerbates the real debt burden across public and private sectors, a burden that cannot be sustained indefinitely. Eventually, China must choose between a deeper economic slowdown or the reflation it has been attempting to avoid. The G7 can expedite this process by leveraging the resistance to currency appreciation.

As Brad W Setser and Shahin Vallée of the German Council on Foreign Relations have pointed out, when economies accumulate reserves due to currency appreciation resistance, diversifying away from G7 currencies becomes challenging. This presents an underappreciated source of leverage for the G7. The group should employ this leverage by issuing a joint, conditional tariff threat on Chinese exports.

This approach would counteract the price advantage provided by an undervalued renminbi, as the cost of replacing this subsidy is rising. By framing reflation as China's own choice rather than capitulation, the tariff threat would create a face-saving exit route. The conditionality provides a way out for China. China's imbalances contribute to the current surpluses.