Friday, July 29, 2005

WSJ: Currency Wars

By RONALD I. MCKINNON July 29, 2005
[Mr. McKinnon, a professor of economics at Stanford, is the author, most recently, of "Exchange Rates under the East Asian Dollar Standard: Living with Conflicted Virtue" (MIT Press, 2005).]

In 1839, the first Opium War began when Chinese customs officials at Canton destroyed a large quantity of opium that British merchants were trying to smuggle into China in order to buy tea and silks. British gunboats were sent in to force the opening not only of Canton, but several more northern Chinese ports on the Yangtze river -- the most important being Shanghai. Hong Kong was ceded entirely to Britain as a Crown Colony. Several desultory wars and skirmishes later led to the Treaty of Tianjin in 1858, when China was forced to open 11 more treaty ports to foreigners -- including Americans, French and Russians -- to accept foreign goods and to legalize the importation of opium.
On July 21, 2005, China again gave in to concerted foreign pressure -- some of it no doubt well intentioned -- to give up the fixed exchange rate it had held and grown into over the course of a decade. Congress had threatened to pass (and may still do so) a bill that would impose an import tariff of 27.5% on Chinese imports unless the renminbi was appreciated, and had pressured the Bush administration to retain China's legal status as a "centrally planned" economy (despite its wide open character) so that other trade sanctions -- such as anti-dumping duties -- could be more easily imposed.
A decade ago, when negotiations over China's entry into the WTO began, a raft of Wall Street banks, investment banks, insurance companies, and other financial institutions subsequently pressured the U.S. Treasury to require China to loosen its capital controls and gradually permit the entry of foreign firms into China's domestic financial markets -- even though these financial conditions were not required of other WTO member countries. China is complying with these terms, as well as eliminating tariffs and quotas on imports beyond what was required by the WTO agreement.
While (uncertain) currency appreciation or the premature dismantling of capital controls on currency inflows and outflows are not as malign as an opium plague, the danger to China's heretofore robust economic growth and great success in lifting large numbers of people out of abject poverty should not be underestimated.
By holding the exchange rate of 8.28 yuan to the dollar constant for almost 10 years, and building monetary policy around this anchor, China's rate of inflation in its CPI has converged to that in the U.S., at a low level of about 2% per year. In part because other East Asian countries (except Japan) were also more or less pegged to the dollar in a region where almost all trade is invoiced in dollars, the fixed dollar exchange rate was a very successful anchor for China's monetary policy. This collective dollar pegging within East Asia also ensured exchange stability and price-level alignment, which allowed regional trade and investment to grow rapidly and efficiently. Under the fixed rate, China's own high GDP and productivity growth were particularly impressive.
However, on July 21, the renminbi was appreciated by 2% -- a small amount in and of itself -- while a narrow band of 0.3% on either side was maintained. More important was the implicit announcement that the old "parity" rate of 8.28 yuan per dollar was being abandoned, but there was no clear statement of how the heavily managed float would evolve. Now that the future exchange rate has become uncertain, executing monetary and foreign exchange policy in China will be much more difficult. I have five negative comments on the new policy:
(1) With the fixed exchange rate now unhinged, the People's Bank of China (PBC) will have to come up with a new anchor or rule that governs monetary policy. None was announced when the PBC let the exchange rate go. Will the PBC institute an internal inflation target? What will be the financial instruments it uses to achieve this target?
(2) Because China's inflation rate had converged to the American level (or slightly less), any substantial sustained appreciation of the RMB (the Americans want 20% to 25%) will drive China into deflation -- preceded by a slowdown in exports, domestic investment, and GDP growth more generally.
(3) If the PBC allows only small appreciations (as with the 2% appreciation announced on July 21) with the threat of more appreciations to follow, then hot money inflows will accelerate. If China attempts further financial liberalization such as interest rate decontrol, open market interest rates in China will be forced toward zero as arbitrageurs bet on a higher future value of the RMB. China is already very close to falling into a zero-interest liquidity trap much like Japan's -- the short-term interbank rate in Shanghai has fallen toward 1%. In a zero-interest liquidity trap, the PBC (like the Bank of Japan before it) would become helpless to combat deflationary pressure.
(4) Any appreciations, whether large and discrete or small and step-by-step, will have no predictable effect on China's trade surplus. The slowdown in economic growth will reduce China's demand for imports even as exports fall so that the effect on its net trade balance is indeterminate.
(5) Because the effect of appreciations on China's trade surplus will be ambiguous, American protectionists will come back again and again to complain that any appreciation is not big enough. So abandoning the "traditional" rate of 8.28 yuan per dollar will, at best, result in only a temporary relaxation of foreign pressure on China.
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Lest you think that my assessment of China's new policy is too negative, compare it to the experience of Japan two decades ago and earlier. From the 1980s into the mid 1990s, Japan-bashing was in vogue in the U.S., much as China-bashing is in vogue today. Back then, Japan had the biggest bilateral trade surplus with the U.S. and was continually threatened (more by the Congress than the president) with trade sanctions unless there were temporary "voluntary" export restraints on particular exports, and the yen be allowed to appreciate. Indeed, the yen appreciated episodically all the way from 360 to the dollar in 1971 to touch 80 to the dollar in April 1995. This unhinged the Japanese financial system (the bubble economy of the late 1980s) and eventually resulted in Japan's unrelenting deflationary slump of the 1990s -- its "lost" decade. Japan has yet to recover fully and remains today in a zero-interest liquidity trap, which prevents the Bank of Japan from reigniting economic growth. And Japan's trade surplus as a share of GNP has not been reduced in any obvious way.
Thanks in large part to pressure from our lawmakers in Washington, China is now in a nebulous no man's land regarding its monetary and exchange rate policies. Instead of clear guidelines with a well-defined monetary anchor, its macro economic decision-making will be ad hoc and anybody's guess -- as was (and still is) true for Japan.


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