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The interest rate differential between China and U.S. was another key exchange rate determinant. At late 2006, the interest rate differential has witnessed a noticeable decline with downward tending of the dollar interest rate while the RMB interest rate crawled up. Theoretically, if China’s financial system were liberalized by the interest rate determined by the market, then one would expect that the upward crawl in the Yuan tends to bid down nominal interest rates on RMB assets. However, it is not the case (see figure 2). Figure 2 shows a comparison between one year RMB interest rates of China Central Bank notes and one year dollar interest rates quoted in London (LIBOR) from January 2004 to November 2007. Figure 3 shows a comparison between China interbank offer rate (CHIBOR) and overnight rate for U.S. (the federal fund rate). Because of inflation, the interest rate differential between China and U.S. has deviated from the path of the Yuan appreciation. As illustrated, before early 2007 the interest rate differential between China and U.S. matched the RMB appreciation but deviated substantively after that.
The Chinese government worked hard to maintain “stable prices” in order to control domestic inflation. The PBC raised the RMB interest rate six times during 2007. On ther other hand, the U.S. has encouraged the Federal Reserve to ease its monetary policy by reducing interest rates to response to the credit crunch. As a result the interest rate differential between U.S. and China was reduced as illustrated in figures 2 and 3.
In July 2008, the Chinese government started to peg its currency back to the USD (6.83 Yuan/Dollar) in order to enhance exports during difficult economic conditions. In spite of that, the Chinese exports fall dawn for 13 months decreasing China’s trade surplus by 34% during 2009. Consequently, the trade gap between the U.S. and China ballooned to $227 billion causing American politicians to call for action in order to restrain what they have perceived to be “unfair trade practices by China”.
The trade imbalance encouraged American and Chinese economists to propose that a discrete Yuan appreciation against the dollar would have the predictable outcome of reducing China’s trade surplus and U.S. trade deficit.
The Chinese government announced on June 19th, 2010 that it is unhooking its two year old peg of around 6.83 Yuan per dollar to a more flexible exchange rate regime. After June 19, the Yuan has depreciated against the Dollar to reach 6.73 Yuan per Dollar by September 2010.
(McKinnon 2010) Because inflation in China was significantly higher compared to that in the U.S. especially in the 2nd half of 2010 (the annual CPI inflation was more than 5 % points higher in China than the U.S.), the RMB has been appreciating more rapidly against the dollar in real, inflation adjusted basis.

Figure-1

Figure 1: China-US Inflation Differential and the RMB/USD Exchange Rate Appreciation

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Figure 2: One-year Interest Rates Differential and the RMB/USD Exchange Rate Appreciation

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Figure 3: Overnight Interest Rate Differential and the RMB/USD Exchange Rate Appreciation