from the San Francisco Fed
— this post authored by Thomas M. Mertens and Patrick Shultz
Exchange rate stabilization or currency “pegs” are among the most prevalent interventions in international financial markets. Removing a peg to a safer currency can make the home currency more risky and less attractive to investors. When a country with market influence removes its peg from a safer country, the risk associated with holding either currency can be affected. Analyzing the effects of a scenario that changes a peg of the renminbi from the U.S. dollar to a basket of currencies suggests that China’s interest rates increase while U.S. interest rates decrease.
Many countries stabilize their exchange rate relative to some target currency. If a country removes this so-called peg to a safer currency, recent research suggests it will increase the risk and reduce the attractiveness of its currency to investors. Furthermore, if the country removing the peg has market power, its decision can affect the risk associated with holding either of the currencies involved. In this Economic Letter, we use this framework to analyze a decoupling of the renminbi (RMB) from the U.S. dollar and outline the effects on U.S. financial markets. We find that a switch from an RMB-U.S. dollar peg to a peg relative to a basket of currencies increases China’s interest rates while decreasing U.S. interest rates.
China’s foreign exchange policies
According to the International Monetary Fund’s annual reports on exchange arrangements (IMF 2016 and various years), China has changed its foreign exchange policy repeatedly over the past decades. The IMF reports that the policy of the People’s Bank of China (PBOC), the country’s central bank, was classified as a conventional peg to the U.S. dollar from 2003 to 2005; from 2006 to 2008, the renminbi was allowed to gradually appreciate under a policy classified as a crawling peg to the U.S. dollar; and between 2008 and 2010, it was stabilized relative to the dollar. In 2010, the policy changed to a “crawl-like arrangement” relative to the U.S. dollar. In 2015, the China Foreign Exchange Trade System (CFETS), a division of the PBOC, published an exchange rate index of 13 currencies in an effort to shift markets away from interpreting renminbi exchange rate movements as being driven only by its connection to the U.S. dollar (CFETS 2015). In 2016, the IMF changed China’s classification from an arrangement in which the flexibility of the renminbi is limited vis-à-vis the U.S. dollar to one in which the flexibility is limited relative to a group or “basket” of currencies.
Figure 1 shows the RMB-U.S. dollar exchange rate since 2003, with vertical lines indicating changes in China’s policy. One can see that exchange rates were stable during the so-called hard peg from 2003 to 2005; the renminbi gradually appreciated from 2005 to 2008; the currencies were repegged between 2008 and 2010. The volatility of its value subsequently increased as the PBOC abandoned its stabilization relative to the dollar.
