programming exercise (see below), the Ethiopian authorities would also give a nudge to domestic savings and therefore conduct a real undervaluation policy that would help boost Ethiopia’s external competitiveness. In practice, such policy would require that the NBE sterilizes the accumulation of reserves to avoid any increase in money supply and therefore any internal appreciation of the currency through inflation.

# **Box 9. The Chinese Undervaluation Experience of the 2000s**<sup>**110**</sup>

Since the early 2000s, China has regularly been suspected of “manipulating” its currency by accumulating large foreign exchange reserves, maintaining a real undervaluation of the renminbi, and therefore providing a competitive edge to Chinese exports in global markets. In fact, one can distinguish two periods in the Chinese capital account and banking policies in the 2000s.

From the middle of 2003 to the end of 2008, China’s financial sector accumulated foreign assets at a high pace, mostly in the form of foreign exchange reserves at the central bank. Total liabilities did not significantly increase during this period (as a share of GDP) because credit to the domestic real sector was reduced to offset the increase in foreign exchange reserves. The Chinese authorities induced forced saving by allocating the Chinese loanable funds to the accumulation of foreign reserves rather than credit to the domestic sector. China’s foreign exchange reserves, which had been relatively stable at less than 15 percent of GDP until 2003 began to grow rapidly to reach close to 45 percent of GDP by 2008. To mitigate the impact of reserve accumulation on deposit creation, the central bank issued an increasing amount of sterilization bonds and steadily increased the regulatory cash reserves of banks.

This policy mix was reversed in 2009 when the global financial crisis started. The Chinese authorities started to increase lending to the real sector in an attempt to stimulate the economy. Domestic spending was increased because less loanable funds were used to finance the accumulation of foreign exchange reserves. The ratio of foreign exchange reserves to GDP plateaued at 45 percent of GDP until 2011 before decreasing markedly afterwards to less than 25 percent of GDP by 2018.

This policy course can be interpreted as follows. Throughout the 2000s, China’s high rate of economic growth was pulled primarily by the development of its tradable sector. This should have led to an appreciation of the renminbi because of the Balassa‐Samuelson effect. However, between 2002 and 2008, because of the existence of stringent capital controls, the Chinese authorities were able to resist an appreciation of the renminbi by accumulating reserves and repressing domestic demand. They stopped doing that and started to stimulate domestic demand once the global financial crisis started. Between 2002 and 2008, the renminbi did not appreciate relative to the US dollar in real terms, whereas the underlying pressure was reflected instead in a booming trade surplus. After 2008, when reserve accumulation slowed down, the trade surplus was reduced at the same time as the renminbi began to appreciate.

Whether the policy of real undervaluation implemented in China and some other Southeast Asian countries during their phase of rapid take‐off could be recommended to, and implemented by, other developing countries remains essentially an open empirical question, as well as a political economy question. While a policy of “forced savings” may have a welfare cost by partly depriving the workers from the freedom to consume the fruits of their labor, the policy may also be successful in stimulating net exports, <u>growth and income, thereby offsetting or even overcompensating any welfare loss. Yet, in</u>

> 110 This box draws on Jeanne (2012).

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