In adjusting current accounts, what matters is the real exchange rate (which takes account of relative inflation rates at home and abroad). Movements in nominal exchange rates often do not achieve the desired adjustment in real rates because they may be offset by changing domestic prices. For example, the yen’s trade-weighted value is around 150% stronger than it was in 1985. Yet Japan’s current-account surplus remains big because that appreciation has been largely offset by a fall in domestic Japanese wholesale prices, so exporters remain competitive.Fred Bergsten (interviewed by Michael Casey):
An alternative way to lift a real exchange rate is through higher inflation than abroad. To an American buyer, a 5% increase in the yuan price of Chinese exports is the same as a 5% appreciation of the yuan against the dollar.
The real [inflation-adjusted] renmimbi exchange rate has appreciated against the dollar at an annual rate of about 12% since last June, although considerably less on a trade-weighted basis. The dollar has fallen against most other currencies, so on a trade-weighted basis, the renmimbi has risen less. On the other hand, one has to accept that the Chinese think of this totally in dollar terms. So the dollar exchange rate is a legitimate focus for them, and if you believe that the dollar is going to bounce around and come back over time it will drag the renmimbi back up with it [against those other currencies.]See also Bergsten's commentary "A Breakthrough on the Renminbi?" at the Peterson Institute's blog.
They have been letting [the real exchange rate] go up an average of 10 to 12% on an annual basis so it’s fair to say that if they would let that continue for another couple of years they would achieve a restoration of underlying equilibrium in the exchange rate. That would take away most, if not all, of the distortions that their persistent interventions have created....
[G]iven China’s history of hyperinflation, it would be far better to adjust via the nominal rate. It has always surprised me that they seem to prefer to do part of it through inflation. And now that they are really worried about inflation, which has become the focal point of their economic policy, this would be the perfect time for them to let the currency adjust. They know the currency is going to adjust over time anyway and it is better to let it happen through the nominal rate. At the same time, it’s an ideal time for us if they make the move now because it will help rebalance our external accounts and help deal with our high unemployment. From the standpoint of both sides there couldn’t be a better time to adjust the nominal exchange rate for the renmimbi.