While policymakers in the US and the European Union do not place much emphasis on exchange rates as an input into the decision-making process, the exchange rate is a key policy variable in China.
It is reasonable, therefore, to ask what economic factors Chinese policymakers are most responsive to when setting the exchange rate. Policymakers’ concerns often focus on the exchange rate vis-à-vis all trading partners and the attention here is therefore on the nominal effective exchange rate (NEER) of the renminbi.
The NEER of the renminbi
The NEER can be measured in several ways depending on what precise basket of exchange rates is considered. The Bank for International Settlements (BIS) constructs measures of both the nominal and real effective exchange rates, using consumer prices, for China and its trading partners. That is helpful because it makes it possible to compute the price level in China relative to its trading partners.
Looking at the nominal and real effective exchange rates for China between 2004 and 2023, it is useful to distinguish between two periods. During the first period from 2004 to 2015, the renminbi appreciated gradually, except for some fluctuations around the time of the global financial crisis in 2008-9. The currencies of quickly growing economies often appreciate in both nominal and real terms in this way.
The second period starts in 2015. Since then, the real exchange rate has fluctuated around a broadly constant level, although since 2022 it has depreciated both in real and nominal terms.
The focus here is on the latter period. If the exchange rate is set (or heavily influenced) by policymakers, why did they desire a stronger exchange rate in 2015 and 2021 and a weaker exchange rate in 2016 and 2022-23?
Central banks often let their exchange rate move to help manage inflation. If inflation at home is higher than abroad, they may let the exchange rate strengthen to lower the cost of imports. Similarly, if inflation is too low, they may let the exchange rate depreciate to push up inflation.
They can also use the exchange rate to control economic activity. If the economy is overheating, it can strengthen the exchange rate to constrain foreign demand and shift domestic spending to foreign goods. And if the economy is slowing, it can weaken the exchange rate to stimulate exports and boost domestic demand. These factors appear to have played a role in Chinese exchange rate policy in the period under study.