For more than two decades, the valuation of the Chinese renminbi (RMB) has occupied a central place in debates over global trade imbalances and international monetary policy. European policymakers recently argued that the RMB is materially undervalued, allowing Chinese producers to enjoy an artificial competitive advantage in global markets. By contrast, successive assessments by the U.S. Treasury and the International Monetary Fund concluded that China is not manipulating its exchange rate to obtain an unfair trade advantage.
These positions may appear contradictory. However, they only seem at odds because determining whether a currency is overvalued or undervalued depends not upon a universally observable economic fact, but upon the theoretical framework used to define an equilibrium value. Every conclusion regarding currency misalignment is therefore conditional upon the assumptions embedded within the model from which it is derived. Just as stock analysts and investors argue over the true value of a stock based upon current cash flows, growth projections, or intangibles, currency analysts engage in similar arguments about what constitutes the true value of a currency.
To determine the value of a currency, international economics has produced a variety of models for evaluating exchange rates. Each is grounded in different theoretical foundations and designed to explain different aspects of currency behavior. Purchasing Power Parity relates exchange rates to relative price levels over long horizons; monetary models emphasize relative money supplies, interest rates, and inflation; Fundamental Equilibrium Exchange Rate (FEER) models derive equilibrium from sustainable external balances; while Behavioral Equilibrium Exchange Rate (BEER) models estimate exchange rates using a broader set of macroeconomic fundamentals.
Each of these approaches has demonstrated explanatory power under particular circumstances, yet none has consistently explained exchange-rate movements across countries and over time. Persistent deviations from predicted equilibrium are the rule rather than the exception, suggesting that exchange-rate valuation is necessarily model-dependent rather than objectively determined.
China presents a clear illustration of these limitations because different theoretical frameworks produce sharply different conclusions regarding the value of the renminbi. If we start from of external-balance models, China's large and persistent current account and trade surpluses imply that the RMB should appreciate in order to restore international equilibrium.
However, monetary models point in the opposite direction. Over the past two decades, China's broad money supply has expanded at rates that have consistently exceeded both real and nominal GDP growth, a condition that would ordinarily imply substantial currency depreciation were the exchange rate freely determined by market forces.
The same economy therefore appears undervalued under one model and overvalued under another. This apparent paradox raises the more fundamental question whether the renminbi is correctly priced. The apparent paradox arises because equilibrium is not solely a property of the currency itself, but also of the institutional environment in which the currency operates. Whether the renminbi is judged to be overvalued or undervalued depends fundamentally upon the assumptions made regarding capital mobility, exchange-rate management, and the mechanisms through which international adjustment occurs. Without first specifying those conditions, statements regarding the "correct" value of the RMB are necessarily incomplete.
Before asking whether a currency is correctly valued, it is therefore necessary to specify the market under which that valuation is being performed. Exchange-rate models implicitly assume particular institutional conditions regarding capital mobility, financial integration, and the mechanisms through which prices adjust. Those assumptions are often left unstated because they hold reasonably well for freely floating currencies. They are considerably less applicable to a currency operating under a managed exchange-rate regime.
China's exchange-rate system is neither a rigid pegged fixed exchange rate nor a freely floating currency. Instead, the renminbi operates within a comprehensive institutional framework constructed through administrative regulation. Cross-border capital movements remain subject to extensive controls with foreign exchange transactions occuring what is known as the one-to-one rule. Chinese banks can only send outside of China hard currency, primarily US dollars, that have been brought into China. Since the imposition of the one-to-one rule the total gross outflows of hard currency has large matched the total net inflows. In other words, China effectively imposed a currency board by banking regulatory fiat with inflows and outflows balancing.
Then domestic financial institutions operate under administrative guidance regarding foreign exchange settlement. The People's Bank of China establishes both the central parity rate for USD transactions and the band within which the currency is permitted to trade. Put another way, the PBOC sets the price every morning in Beijing and the allowed size and speed of price fluctuations. These policies should not be viewed merely as occasional interventions into an otherwise free market. The PBOC rephrases the Napoleonic dictat: The market? C’est moi.
This distinction is critical because much of the international debate has focused on whether China "manipulates" the renminbi. Framed in this manner, the discussion becomes largely semantic. If manipulation is defined narrowly as discretionary intervention designed to push the exchange rate away from its market-clearing value, recent assessments by the International Monetary Fund and the U.S. Treasury may reasonably conclude that China is not actively manipulating its currency. However, this definition overlooks the more fundamental reality that the institutional architecture within which the exchange rate is determined is itself the product of deliberate policy choices then executed by state owned banks.
Chinese authorities determine who may participate in foreign exchange markets, which transactions are permitted, how foreign exchange enters and exits the country, the its price, the range within which prices may fluctuate, and the mechanisms through which liquidity is supplied and absorbed. The observed exchange rate is therefore not a market price freely determined by the market; it is the generated by a market whose rules have been designed to ensure a singular outcome.
The International Monetary Fund and US Treasury position seem technically unmoored from the reality of how China manipulates the RMB. The state central banking authorities need not intervene in foreign exchange markets buy buying and selling when they can simply dictate the price, control its movement, and dictate its flows. There is no need to officially manipulate when the banks do everything. China has rewritten the market manifesto that the market price is whatever price the market will bear to be you will bear whatever price I tell you to bear.
Recognizing the institutional regime resolves much of the apparent contradiction between competing valuation models and the RMB. If the renminbi were assumed to operate within a world of unrestricted capital mobility, China's extraordinary monetary expansion would imply substantial downward pressure on the currency as domestic liquidity sought international assets. Under those conditions, monetary models would predict a materially weaker renminbi than is presently observed.
Capital controls constrain the international mobility of Chinese domestic financial assets, preventing much of China's monetary expansion from translating into capital outflows. As a consequence, external adjustment occurs primarily through the exchange of goods and services. Within that restrictive policy environment, China's persistent trade surpluses generate sustained appreciation pressure, leading external-balance models to dominate theoretically and conclude that the renminbi remains undervalued.
Put another way, in the absence of capital mobility where foreign exchange for trade support dominates the currency is undervalued.
The bifurcated state of the RMB therefore becomes obvious . The renminbi is neither objectively overvalued nor objectively undervalued independent of the policy conditions. Monetary models and external-balance models do not merely produce different answers because they emphasize different variables; they produce different answers because they implicitly describe different economic environments. Once the institutional regime is explicitly incorporated into the analysis, the contradiction largely disappears.
International investors have largely abandoned China because they take account of factors like the probability of moving capital out of China and conclude the risk is simply not worth the potential return. Conversely, physical goods traders receive the good. International investors and goods traders internalize the dynamic described in these models and the external balance model dominates.
In this sense, the renminbi resembles a quantum system only as a metaphor. Under assumptions of unrestricted capital mobility, the MRB appears materially overvalued because China's monetary expansion far exceeds what would ordinarily be consistent with market equilibrium. Under the institutional reality of a strictly managed exchange-rate regime in which capital mobility is strictly constrained and external adjustment occurs primarily through trade, the same currency appears materially undervalued.
These arguments may seem like arcane or theoretical points not worthy of the policy discussions but they strike at the heart of why different parties take the positions they take. The value of the RMB does not have a singular objective value but bears the weight of the assumptions you put upon it.
Note: This is the first in a series of pieces about Chinese foreign exchange policy to include reserve accumulation and political positions