(This post reproduces a thread I wrote on Twitter/X on July 29.)

A lot of the discussion about the depreciation of/undervaluation of China’s real effective exchange rate takes for granted that this is about the currency. After all, it’s called the “exchange rate”!

But it’s actually not. Mostly, it’s about prices. A rant:

China’s real effective exchange rate (REER) is a composite of two things, each themselves a composite: 1) an index of the renminbi’s exchange rate against a group of its trading partners, weighted by trade, 2) an index of China’s prices relative to its trading partners.

The standard reference for the REER is the calculation by the BIS. Its numbers show the pure currency part, the nominal effective exchange rate, is now right back at the recent peak of March 2022. The CFETS index, the trade-weighted exchange rate targeted by the PBOC, is not too different.

The REER, however, is down 14% from its peak in 2022. And that is purely, 100%, because of relative prices. Almost all of the move came in 2022-23, when China had a massive deflationary episode while the rest of the world had continued inflation.

So when people say, China’s real effective exchange rate has depreciated or is undervalued, the thing in the real world they are referring to is that prices in China (the CPI for this calculation) have stayed basically flat while rising elsewhere in the world.

Why has this happened? Ultimately, the domestic price level in an economy is under the control of the monetary authorities. This means that it is China’s own choice (mostly through inaction) to tolerate this persistent deflation/disinflation.

Many of China’s trading partners are understandably unhappy with this situation. China’s macroeconomic choices have had the effect of supercharging its export competitiveness: everything in China substantially cheaper relative to the rest of the world.

But there is debate over how to get the desired appreciation of the REER. Some people say that this issue could be solved if you could force China to simply revalue its nominal exchange rate, i.e. raise it enough to get rid of that 14% gap.

The problem with this idea is that a) you can’t force China to do something it doesn’t want to do, b) it’s not clear that a change in the nominal exchange rate would, in isolation, actually work to push up the domestic price level.

My view is that an appreciation of China’s REER is very much to be desired, but the real (haha) way to get there is through higher inflation domestically, and that means different macro policies.

Plus, if the markets recognized that China was actually doing more inflationary macro policy, the nominal exchange rate would appreciate, so you would get a double whammy of a rising price level and a rising exchange rate that would wipe out the REER depreciation.

The ultimate question, which no one has the answer to, is how to convince the Chinese authorities that different macro policies are required. I think complaining about trade surpluses and excess capacity has not worked, and is not going to work.

The key issue, in my view, is the domestic labor market, the true casualty of this tolerance of deflation. Policy decisions have condemned a generation of Chinese youth to widespread under- and un-employment. This is a political pressure point that might actually produce change.

If China would just pursue a conventional macro policy of moderate inflation and full employment, its own citizens would benefit massively and its trading partners would be much happier. There would be peace on earth and goodwill toward men! 🙂