There is a good economic rationale for China's wanting to keep the renminbi/dollar rate stable. First, as long as the fixed rate is credible - as it was between 1995 and 2004 at 8.28 yuan per dollar - it served as an effective monetary anchor for China's internal price level. After inflation had exploded to over 20 per cent per year in 1993-95, the fixed-rate anchor helped China regain price-level stability. Second, the big fiscal stimulus which Mr Wen is now contemplating would be most effective if China's exchange rate is kept stable - as it has been since last July.
However, China-bashing - that is, mainly US pressure to appreciate the renminbi - had become intense by 2004. To deflect American protectionist threats, the Chinese authorities began, as of July 21, 2005, to allow the renminbi to appreciate slowly: about 6 per cent per year against the dollar. But the resulting one-way bet that the renminbi always rises prevented private capital outflows from financing China's huge trade surplus. Chinese banks and other financial institutions refused to acquire predictably depreciating dollar assets. Compounding the situation, inflows of international “hot” money to buy ever-higher renminbi assets led to enormous balance of payments surpluses.
To prevent the renminbi from ratcheting upward, the People's Bank of China (PBC) intervened massively to sell renminbi and buy dollar assets. By July 2008, China had accumulated about 2 trillion US dollars in official exchange reserves. Despite massive sterilization efforts by the PBC, excess domestic money growth led to inflationary pressure from 2006 to July 2008. China's CPI inflation peaked out at 8 per cent in the spring of 2008.