Saturday, November 12, 2005

China's Irrational Currency Policy

As you probably know, because of the increasing U.S. trade deficit and the increasing Chinese trade surpluses there is strong pressure on Cina to revalue its currency.

I have somewhat mixed feelings on this subject. On the one hand, I don't think that a fixed exchange rate policy like China's is more of a "manipulation" than floating exchange rates. If anything, it is in fact less manipulation since under a free market monetary system -a gold standard- there would be no exchange rate fluctuations as there would be no exchange rates. And you can hardly accuse the Chinese of having set the current exchange rate for mercantilist purposes since they also refused to devalue in 1997-98 even though they then faced intense pressure to do so.

However, despite the above, I still think the Chinese leaders should revalue the yuan substantially. The reason for that is that it is nearly inevitable given the current size of the bilateral U.S.-Chinese trade imbalance that China will be blamed for U.S. economic woes during the coming U.S. recessions. This means in turn that if China holds on to its current peg it is nearly inevitable for the 27.5% across the board tariff that New York Senator Charles Schumer(D) and South Carolina Senator Lindsey Graham(R) have proposed will pass along with more quotas and other formal protectionist measures.

And with some 14% of China's GDP being constituted by goods exports to the U.S., this would have a devastating effect on China's economy.

While a revaluation would hurt the Chinese economy too, it would do much less damage since the lost export revenues would be partially compensated by a cheaper import bill. And by revaluing the yuan substantially, the risk of tariffs and quotas being slapped on Chinese exports would decrease greatly. And even if it didn't stop tariffs and quotas the damage done to China would be lower since the yuan value of Chinese exports and accordingly the U.S. exports to GDP ratio would be reduced.

China's leaders are probably aware of this, and it was because of this that they had the marginal 2.1% revaluation in July and it is because of this that they now imply that they will continue to gradually increase the value of its currency.

Yet keeping a pegged currency while saying it will not stay that way is one of the worst possible options. Not only will this mean that one of the benefits with a fixed exchange rates, namely reduced exchange rate uncertainty, will be lost. But even worse this will mean that the inflow of speculative capital betting on a stronger yuan into China will increase further. Such a strategy is certainly rational for the speculators since China have made it clear that a gradual appreciation will happen. But it is not good for China since this forces the Chinese to continue the massive build-up of foreign exchange reserves to compensate for the inflow of speculative capital. That in turn is bad for China as they will lose a lot of money on the falling yuan value of their growing reserves and it is also bad for the world economy since it increases the inflow of Chinese capital into western bonds and thus artifically keeps down bond yields.

China should get this revaluation business over with and either float the currency or revalue it to at least 7 or perhaps even 6 to the dollar. The Chinese leaders argue that it would be too disruptive, but in the end it is inevitable to avoid even more U.S. protectionism and delaying it will only cause more disruptions.


Blogger Edie said...

Is it really all that likely that protectionist measures imposing tariffs on China will pass in the US? If so, what is going to happen to the US economy, which has been dominated by the likes of Wal-Mart for the last decade? If prices on goods were suddenly raised, couldn't this cause a crisis?

4:23 AM  
Blogger stefankarlsson said...

Yes, edie, it would cause a crisis by greatly increasing price inflation. But since when did the fact that a policy is bad for the economy stop the politicians? China is a convenient scapegoat and that is what really matters.

9:15 PM  

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