Wednesday, June 30, 2010

Would A Floating Yuan Necessarily Appreciate In Value?

Terence Corcoran has an interesting article about the controversy over the Chinese currency peg that I recommend you to read whose contents I mostly (but not entirely) agree with.

As the article points out, the most desirable Chinese currency reform would be to create Chinese currency convertibility, not necessarily to create a floating exchange rate. The semi-independent territory of Hong Kong have currency convertibility, but not a floating exchange rate, and that has worked quite well for Hong Kong.

Corcoran also interviews Steve Hanke who points out:

"Mr. Hanke said yesterday in an interview that if China were to follow the West’s advice on currency flexibility and also allow convertibility, the result would not make protectionists happy. “If they floated with full convertibility, I think there’s a pretty good chance the yuan would get weaker because there would be a helluva big outflow of funds.” Chinese companies, citizens and investors — sitting on a bottled up currency — would have a strong desire to diversify their portfolios outside China."

That is an important point. As I have pointed out before, the fact that the Chinese are increasing their foreign exchange reserves is not by itself proof that the yuan would have a higher value under a pure float scheme, as the reserve build up is largely made to counter foreign capital inflow betting on yuan appreciation. If there is a yuan float, then these inflows will likely disappear and maybe even be reversed, perhaps causing the yuan to depreciate in value even if the Chinese central bank ceases its foreign exchange reserve build up.

Paul Krugman's view that even the floating exchange rate of the euro versus the U.S. dollar might justify trade sanctions because it floats in a different direction than he had hoped for (despite the fact that he had earlier argued that floating exchange rates represents the ideal state of affairs) indicates that Krugman and other China bashers would likely not be content with the outcome of a complete abandonment of the Chinese peg, especially since the yuan might in fact depreciate in value then.