- After pegging the Chinese yuan to the US dollar for years, China has allowed its currency to appreciate by over 20% versus the dollar since 2005.
- Suddenly last year, the yuan's steady rise halted and it again appears to be pegged to the dollar.
- Despite criticisms, the dollar's stability remains an attractive attribute.
Currencies come in various flavors—dollars, pounds, yuan, riyals, dinars—and most float freely, meaning the market determines exchange rates. Virtually all developed countries allow their currencies to float (Hong Kong and Singapore being notable exceptions.) Others currencies are "managed" by governments and central banks, meaning exchange rates are allowed to fluctuate, but not by much. And some currencies are "fixed" or "pegged" to another currency, so the exchange rates barely budge. For instance, $1 will just about always buy you 3.75 Saudi riyals, 7.75 Hong Kong dollars, or 0.71 Jordanian dinars.
Countries peg their currencies for a number of reasons. Small, emerging countries might peg their currencies to a more economically stable country's currency to prevent wild exchange rate fluctuations. Others might peg their currencies with trading partners to prevent their currencies from appreciating markedly, which would make their products more expensive in their end markets.
For years, China's currency, the yuan (aka renminbi), was strictly pegged to the US dollar. From 1995-2005, one dollar was worth about 8.28 yuan. Critics of China's currency policy claimed the peg kept the yuan artificially low compared to the dollar to make Chinese exports cheaper in the US. Bowing to these criticisms, China eventually removed the strict dollar peg. In July 2005, the yuan was allowed to appreciate by 2% overnight, and a basket of currencies replaced the dollar peg (still mostly dollars, but China doesn't disclose the composition of the basket). At the time, China said it would allow the yuan to gradually appreciate. As promised, the yuan has steadily risen over 20% versus the dollar since 2005. But as turmoil in financial markets began to unfold last year, the yuan's steady appreciation halted, and the yuan/dollar exchange rate has barely budged since. Suddenly, it seems the yuan is pegged again—a somewhat ironic shift in currency policy considering China's outspoken criticisms of the dollar.
Why the change? The Chinese government and central bank haven't provided an explanation. The most likely answer is in these tough economic times, they prefer Chinese exporters not face the headwinds that come with a rising currency. Or maybe they feared the yuan would instead drop markedly. Most currencies, especially those of emerging markets, plummeted versus the greenback last year. The Indian rupee lost 19% versus the dollar in 2008, the Russian ruble lost 17%, and the Brazilian real fell 23%.
Now that the global economy is on more stable footing, most emerging market currencies are regaining some lost ground. Eventually, the yuan will likely resume its ascent versus the dollar. Currency and capital market liberalization are necessary steps as China's economy develops, but China still has a way to go. As we've said, the dollar is likely to remain the global currency of choice when the chips are down for a long, long time—China's resumption of its dollar peg is just another bit of proof.