Chinese policymakers think that the cornerstone of China’s economic success has been their fixed exchange rate. The primary purpose for having a fixed rate policy was to promote exports by making the Chinese renminbi (RMB) more competitive. This fixed rate has made China hyper-competitive; a result is that trade surpluses and foreign exchange reserves have swelled.
Though the fixed rate policy was loosened in 2005, the still interventionist exchange rate policy is not sustainable because it is partly responsible for higher levels of inflation in China. Inflation in China has been on an upward trend and it was 8.5 percent in April 2008: a near 12 year high (the highest was 8.7 percent in February 2008). The exchange rate is believed to be partly responsible because of two reasons. They are: 1) the cheap exchange rate has led to massive capital inflows because of high trade surpluses, and 2) speculators have brought in a lot of money into China to make a capital gain from the expected exchange rate revaluation. When foreign money enters the system, it enters the monetary base and leads to inflationary pressures. The central bank can control the former, though only to an extent, through a process known as sterilized intervention while the latter is pretty much impossible to control. Inflation is defined as “too much money chasing too few goods” and these two types of inflows are causing the ‘too much money’ part.
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