Sever The Yuan-Dollar Peg?
The revaluationists better be careful what they wish for.


China’s dollar-pegged exchange rate has been one of the bright spots of the international monetary system of the past decade — a period too often marred by currency turmoil and ensuing economic crises, most notably in Latin America and East Asia. More’s the pity, then, that the U.S. should be lured into the cabal of nations seeking protection against Chinese exports by insisting Beijing up-value its currency.

The current peg of 8.30 yuan to the dollar (give or take 0.3%) dates to May 1995. Prior to that, the Chinese currency had undergone a series of devaluations — most recently at the start of 1994 when it lost one-third of its value, with the yuan depreciating from $0.1728 to $0.1152 and the dollar appreciating from 5.7855 yuan to 8.6783.

The yuan-dollar peg has produced numerous benefits for China, but senior among them has been pro-growth monetary stability. Chinese consumer price inflation has been docile, averaging just 1 percent year-on-year from January 2000 through March 2005 (versus a 2.6% U.S. average over the same period). Consequently, Chinese interest rate — both real and nominal — are also low. It’s small wonder then that officials in Beijing have said the pressure to revalue the yuan is unfair and that the U.S., as well as other foreign governments, should “look into itself” for the source of any problems.

The true aim of the revaluationists is a change in the terms of trade with China. Their hope is to discourage imports from China by making them more expensive, not through protectionist tariffs or outright trade barriers but rather via an obliteration of China’s longstanding dollar peg and a substantial appreciation of the yuan.

The revaluationists better be careful what they wish for. While a stronger yuan would make China’s exports dearer (at least temporarily), it also would make its imports cheaper. And there’s the rub. Less expensive imports of raw materials, industrial equipment, manufacturing technology and the like would eventually translate into lower export prices (and higher quality goods) as input costs declined and labor productivity rose. Thus, any gain from a shift in the terms of trade would be transitory.

China’s export advantage will last as long as its labor costs remain low. These costs should rise, though, as the ratio of investment capital to labor capital increases, because greater automation and enhanced productivity typically leads to higher incomes and improved living standards. But that’s in a free market. What will happen in China’s hybrid capitalist-communist system is a matter of conjecture.

Even if Chinese officials were of a mind to acquiesce on revaluation, it’s hard to see how much tighter China’s central bankers could be without causing serious economic damage. In March, M1 money supply grew at a year-on-year rate of 10.4 percent and M2 rose at a 14.2 percent rate, while currency in circulation (M0) expanded at a rate of 10.1 percent. Although these rates of monetary expansion might seem lavish, they’re actually quite appropriate, given the vast dimensions of China’s somewhat pell-mell transition to quasi-capitalism and the rapidity of growth in GDP and industrial production.

Here, an adaptation of the Laffer inflation model (in which excess base-money creation is calculated by subtracting M1 growth from adjusted monetary-base growth) to China’s monetary aggregates offers a critical insight. When the growth in high-powered money (i.e., currency in circulation) is adjusted for rising money demand (M1), the results reveal that the People’s Bank of China has actually been rather stingy. With rare exception, money in circulation has grown significantly more slowly than the M1 money supply. The shortfall, over the past 48 months, averaged 6 percent, which explains why Chinese inflation has been more or less benign in recent years.

The yuan isn’t convertible, meaning its foreign exchange is set by fiat and the normal linkages between domestic money supply and foreign exchange rates therefore may or may not pertain. This isn’t to say, however, that no connections exist between China’s domestic economy and its forex rate. They most certainly do. In the latter half of the 1990s, for example, when the dollar deflated as a result of unaccommodating Fed policies, the yuan-dollar peg transmitted the deflation to Chinese domestic prices. Indeed, were China to up-value its currency, it could expect another bout of deflation.

Yuan deflation surely isn’t in China’s interest. Neither is it in America’s interest, for a sizable Chinese currency revaluation would “substantially dampen” U.S. economic growth, as Larry Kudlow has made abundantly clear (“The China Mess,” April 19). Yet this didn’t stop the Senate from voting 67-33 to allow debate on a proposal by senators Charles Schumer (D., N.Y.) and Lindsey Graham (R., S.C.) to levy a tariff of 27.5 percent on all Chinese-made goods imported into the U.S. unless China revalues the yuan.

Chinese currency convertibility, meanwhile, seems nearer than ever. People’s Bank of China governor Zhou Xiaochuan recently said the government is working on the “sequencing” of a change in currency policy. In an intermediary step, China is about to launch a new interbank foreign-exchange market, providing small- and medium-sized domestic financial institutions access to the international forex market. The decade-long buildup of international currency reserves, which now exceed $600 billion, was yet another part of the preparation for eventual currency convertibility.

Finally, any disruption of Chinese monetary stability would have adverse repercussions for the growing global trend toward dollarization. Indeed, dollar pegs like China’s shouldn’t be discouraged but rather encouraged. If a viable international monetary order were someday to be restored, replacing the current floating-exchange-rate system, the U.S. would likely employ a gold- or commodity-based price rule, with enough flexibility to avoid the rigidities that doomed Bretton Woods, and other countries would either follow the same rule or peg to the dollar — or even dollarize.

A severing of the yuan-dollar peg via a revaluation of the yuan is, in sum, precisely the wrong policy to advocate for any government interested in strengthening the global economy, eradicating demon inflation, and raising living standards, for such laudable goals can be achieved only through more, not less, international monetary stability.

– William P. Kucewicz is editor of and a former editorial board member of the Wall Street Journal.


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