By Ronald McKinnon
Tensions between the US and China escalated recently when Timothy Geithner, the new US Treasury secretary, suggested that China might be designated as a “currency manipulator’. Premier Wen Jiabao mounted a vigorous defence of China’s existing exchange rate policy at a high level meeting of world leaders at Davos, Switzerland. Mr Wen pledged to keep the renminbi at a “reasonable and balanced level”.
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.
Then, after the US credit crunch of July 2008, the weak dollar became the strong dollar: the surprise 20 to 30 per cent dollar appreciation against all major currencies, except the Japanese yen, that is still with us. This general dollar appreciation carried the renminbi, which was and is pegged to the dollar, upward with it. Unsurprisingly, the PBC stopped the gradual appreciation of the renminbi against the dollar so that the yuan/ dollar rate has been remarkably stable at about 6.85, plus or minus 0.3 per cent since last July. The end of the one-way bet on the yuan/dollar rate stopped hot money inflows and allowed the PBC to regain monetary control and cut the reserve requirements on China’s commercial banks. Official exchange reserves have fallen recently because more private capital (including trade credit) is flowing outward to help finance China’s trade surplus.
Ending China bashing once and for all is more than just a political question. In both the US and Europe, economists – and the politicians they indoctrinate – must discard the false theory that one can use changes in the exchange rate to control the net trade balance in a predictable way. Contrary to widely held beliefs in both China and the US, a discrete appreciation of the renminbi against the dollar would not reduce China’s trade surplus or America’s trade deficit. A discrete appreciation of the renminbi could have the perverse effect of causing investment in China to slump, as firms see China becoming a higher cost area. Then China’s net saving (trade) surplus could actually increase!
Instead of being an exchange rate question, the huge trade imbalance between the two countries has two related causes: “surplus” saving in China, ie domestic saving far beyond that which is needed to finance domestic investment; and from an even bigger net saving deficiency in the United States. Since the collapse of the housing bubble in 2008-09, US household consumption has plunged, and saving has risen, depressing the global economy while reducing the American trade deficit. In order to buoy China’s and the world economy while further correcting the festering trade imbalance between China and the United States, fiscal expansion in surplus-saving countries like China is desperately needed. Because US fiscal expansion would enlarge the US trade deficit, better to convince the Chinese that they should do most of the fiscal stimulating.
They know that fiscal expansion in China would be most effective in buoying the Chinese economy when the exchange rate is stable. Thus having the Americans agree to the People’s Bank of China stabilizing the yuan/dollar rate is the natural quid pro quo for China’s engaging in a much greater fiscal expansion than the welcome half-trillion dollar amount announced on November 9, 2008. Indeed, as the world goes into a severe economic downturn, the threat of beggar-thy-neighbour devaluations becomes acute, as in the 1930s. Thus, stabilizing the exchange rate between the world’s two largest trading countries could be a useful fixed point for checking the devaluationist proclivities of other nations around the world.
Ronald I. McKinnon is professor of international economics at Stanford University
