February 2, 2005
Apparently, the industrial world is becoming
increasingly concerned about China’s currency policy.
The International Monetary Fund has just released a paper explaining
why a fluctuating Chinese currency is in that country’s own best interest.
China currency reforms will be a major agenda item at the next G-7
meeting of major industrial countries.
Why should China’s currency policy concern us, and
why are the concerns more intense now than even a year ago?
For years, the Chinese bought or sold yuan in the
foreign exchange markets in an effort to preserve a fixed rate of exchange
against their yuan and our dollar. A
few years ago, there was fear that China did not have enough foreign
exchange to support the yuan. However,
a surge of $206 billion in additional foreign exchange balances held by
China in the past twelve months indicates that the tables have turned.
A currency whose value is fixed to another might create
financial credibility. However,
one cost is loss of control over domestic monetary policy.
The country’s liquidity must expand or contract to preserve the
currency ratio and cannot also be changed to stimulate employment or
Not surprisingly, the IMF paper indicated that China
could regain control over its own monetary policy by allowing its currency
to freely fluctuate in the foreign exchange markets.
Thus, attempts to restrain commodity inflation and slow economic
growth (two goals of the Chinese government) would be improved after the
yuan’s price fixing to the dollar is abandoned.
When all currencies were fixed through a set price with
a commodity, usually gold, global economic imbalances could only be removed
through the impact that changes in foreign exchange balances had upon local
liquidity. Countries with large
inflows of foreign exchange, such as China, would experience significant
gains in liquidity as their balances grew, leading to domestic inflation.
Countries losing foreign exchange would suffer monetary restraint,
causing prices to fall (usually after a recession has begun).
While no one desired to have a recession or inflation
dictated through foreign exchange flows, the fixed system worked when world
imbalances were small. As
economic historians know, when Great Britain re-established a fixed exchange
rate in the mid-1920s, the distortions from an incorrect rate no longer were
small. The ensuing recessions (coupled with poor macroeconomic policies) led
to world depression.
China’s $206 billion one year increase in foreign
exchange balances to a total of more than $600 billion no longer is small.
Basic manufacturing in the U.S. and Europe is battling recession
tendencies. The excess world
liquidity required for this effort already has created commodity price
inflation and may be contributing to global excesses in real estate pricing.
While deflation has vanished from China, the subsequent
inflation remains mild (about a percentage point higher than in the U.S.)
If we wait for differential costs to remove the imbalances, the
current pace of Chinese inflation would require 40 years to restore global
balance. By that time, all the
quaint villages in the French, Italian, Austrian, German and Swiss Alps
would have long since lost their manufacturing base. American mill towns will be nearly ghost towns.
Why is the fixed exchange rate between China and the
U.S. not adjusting as rapidly as such conditions did in the past?
Half the explanation is the Chinese banking system.
During the period of collectivization, very large government
enterprises were created and many still exist.
They are woefully inefficient and need government subsidies.
In the past, these subsidies have been indirect, through credits from
the banking system. Thus,
Chinese bank capital is tainted by these bad government debts that cannot be
The Chinese are rebuilding bank capital and hoping that
normal banking functions can be performed by existing banks.
(National pride, as in Japan, prevents the Chinese from the obvious
solution of partnering with international financial institutions to create a
strong domestic financial structure.)
In the meantime, the liquidity created from foreign
exchange is only partially flowing into the domestic Chinese economy.
Instead, the balances are being reinvested in international financial
assets (much of which are 10 year U.S. government bonds.)
Thus, the lost U.S. foreign exchange is being returned to us, but at
Eventually, the Chinese foreign exchange balances will become so large that only a serious currency adjustment or massive world liquidity shifts, and resulting economic dislocations, will resolve the imbalances. A few economists don’t want that to happen. If only our Treasury and the Chinese would realize the urgency of removing this imbalance through flexible currency fluctuations (or does the Bush administration want those Chinese purchases of U.S. bonds in order to limit the current cost of government programs?)